The basics of insurance

I have a confession to make. Last month, I took a financial literacy quiz that is used for high school competitions in North Carolina. And I did not get a perfect score… probably not a good thing to admit if you are State Treasurer!

In my defense though, the competitors don’t get perfect scores either, and the question I missed was about insurance. In my view, insurance is easily the most complicated financial literacy topic out there. In many cases, it’s like learning a foreign language… deductibles, co-insurance, co-payments, actuarial values and on and on. It can feel like the complexity is designed to confuse…

So, we thought we would take a stab at insurance this month. While there are literally thousands of types of insurance out there (a personal favorite: Oklahoma requires commercial turtle catchers to buy insurance… I didn’t know there was such a profession), the basic building blocks of insurance are what are important for you and me.

There are really two things that are meant by insurance today, and it’s important to distinguish between them. The first definition is the historic definition – a way to share catastrophic risk so that it doesn’t ruin your life if it occurs. Think about how terrible it would be for your house to burn down. That’s a risk that few people can handle on their own, and one that is fortunately unlikely to occur.

But the modern definition of insurance – primarily in health insurance – is often just a way to pre-pay relatively routine expenditures. There are, of course, elements of catastrophic coverage in health care, but most of the expenditures are predictable and consistent (think prescription drugs). It’s important to distinguish these concepts as you think about insurance. In my view, protecting yourself from a catastrophe is a must, and pre-paying for routine expenses requires some study each time.

Part of that study is understanding the basics of how the insurance company works. The basic recipe for insurance companies is to collect premiums, hold them for some time to make investment returns off the premiums, and pay claims later. Insurance companies make money in two ways – underwriting profits and investment profits. Underwriting profits are what’s left over after the company pays expenses and claims out of the premiums received. And investment profits are what they make while they hold the money in the period between receiving the premiums and paying out claims and expenses.

Many insurance companies don’t make much, if any, underwriting profits. Between their claims and their costs to administer, they spend as much as they take in from premiums. In many lines of insurance, particularly in healthcare, there are strict limitations on underwriting profits, so it is most often the case that insurance companies are encouraged to pay claims appropriately. But you should know that investment profits are largely a function of how long it takes to pay your claim. The longer they take, the more they can make off your money that they are holding. So in considering what insurer to use for any of your needs, be sure to examine their history of paying claims, not only fairly, but on a timely basis as well.

There are many other topics in insurance, and as mentioned up front, even professionals like me don’t know all the detail in this complicated landscape. But by knowing the basics of the two fundamental uses for insurance, and the two ways that insurance companies make money, you’ll be prepared to make almost all the important insurance decisions you’ll face in life!