Insurance Town – An Illustration
Insurance, at its core, is the transfer of risk – from the insured person to the insurer. We can illustrate the value of this transfer with the following example.
Imagine we have a town of 100 people, whose residents have a 10% chance of contracting a deadly disease (it’s probably not a tourist hot spot!). Statistically, we would expect 10 of the 100 people to get the disease and die.
An insurer comes along and offers everyone a simple insurance contract. They will pay for the cure, if you’re unfortunate enough to need it, and will charge $1,100 for this insurance policy upfront.
The town’s people benefit as $1,100 is more manageable and there is value in reducing one’s risk. Everyone purchases the insurance. Those who catch the disease are affordably cured, and those who do not are only out of pocket $1,100. A reasonable price to pay for the security.
The insurer benefits, at the same time, because $1,100 multiplied by the town population is $110,000. The insurer now carries the risk of the disease, but based on the 10% likelihood the insurer pays $100,000 to cure 10 people and earns $10,000 for this service.
Both parties benefit and that is why insurance exists in our world today.
In reality, not everyone buys insurance, but many do and so the system works. As well, not everyone has the same chance of disease or something else negative happening. Therefore, the transfer of risk (the insurance) will not cost the same for everyone.
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