ELI5: How is insurance both profitable and useful to a customer?

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Insurance replaces a risk with a predictable cost. For example, instead of having to pay an unknown amount at an unknown time for damage to your house, you pay a known premium every month. You benefit from the certainty that provides. Insurance is usually a net loss for the customer. The cost of the premiums has to pay for the insurer’s expenses and usually delivers a profit to the insurer as well. If the risk is negligible, or you can afford the cost of the thing you’re insuring, it’s not a good deal to buy insurance. For example with a bit of savings you might not need collision insurance on your car, because you could buy a new one if you really had to. This is also how deductibles work; you probably can’t afford to replace your house, but you can afford small repairs and don’t need to be insured against those costs so having the deductible lets you pay lower premiums.


To the customer, insurance is a fixed loss to prevent a rare but potentially catastrophic loss. Insurance is built around risk pools. If 1 out of 1000 $500k homes burns down every year then the insurance company will bundle people in similar risk homes together, everyone pays $510 per year so the insurance company takes in $510k but pays out one $500k fire claim each year profiting $10k. Each person is out $510 per year, if they were to instead save that premium for 10 years they’d only have $5100 which wouldn’t do them any good if their $500k house burned to the ground. The odds of their $500k house burning to the ground are reasonably low, but in the event that it occurs it would be financially devastating. In general, people cannot effectively save enough to cover what their insurance potentially covers. Insurance protects you against rare but exceptionally expensive events for a fixed cost. Its not gambling because you never “win”, you just lessen your losses


The insurance company is selling you a product they don’t want you to use. You’re purchasing a product that you *also* don’t want to use, but will if some misfortune befalls you to limit your total cost. The insurance company has collected an enormous amount of data over the decades to know exactly how likely you are to actually use the insurance, and they set the prices accordingly. If you have a 2% chance of filing a claim, they’ll charge you a little over what 2% of the likely cost to them would be. Aggregated over many people they turn a profit by raising more in premium than they pay out. Most customers never use the insurance and lose money, but a few do and avoid an even greater loss. You’ll have a hard time finding insurance for things that are guaranteed disasters like a track car.


No. Insurance works by aggregating risk. If the odds of your house burning down are 1 in 1,000, the insurance company collects 0.11% of the cost of a house from 1,000 people. So they have 110% the value of a house. When 1 house burns down they pay 100% of the value of the house and keep 10%. Everyone else is out 0.11% of the value of their house. The person who’s house burned down is not out the value of their house. If the person who’s house burned down had not bought insurance, they would be out 100% of the value of their house instead of 0.11% of the value of their house. So insurance lets you pay a small amount to protect yourself from an unlikely event that would be devastating if you did not have insurance.


> wouldn’t it be better for customers to just save the money they’re giving to an insurance company instead of going through the company How much money can you save? Last time I needed to use my car insurance it paid out to the policy limit, which was more money than probably 99.99% of people could ever reasonably save. I could pay my premium for about 100 more years before they’ll have made a profit off me. So in my case, I won the gamble against the insurance company. It didn’t feel like winning at the time, but it was certainly better than bankruptcy.