Thursday, September 4, 2014

Insurance in Simple Words

Insurance often confuses and more so in the sense when people club investment with insurance. Let's get this straight. Insurance is insurance and is about risk mitigation. Investment is a wealth multiplier and involves risk taking. When you think of insurance, think that if everything goes wrong do you still have the means to live a frugal but decent life. Investment comes more in the category of taking risk which might lead to your wealth getting multiplied or might wipe out the complete investment. Buying stock is a classical example of investment and hedging it is an insurance.

Let's first understand how insurance works. Let's take an example of say four people who want to take health insurance. The question is how much health insurance they should take and what is the premium that the insurance company should charge them. These are identified by two terms: cover and premium.
  • Cover: It's the amount that the insurance company is bound to pay if the said event happens. For example if you have taken health insurance of one million, then insurance company is bound to cover the treatment cost to that amount.
  • Premium: It's the amount that you need to pay to the insurance company, generally on yearly basis so that you can get the cover if you get ill and require treatment.
So how the cover and premium is calculated. Generally cover is decided by the person who wants to take insurance. This is govern by the cost that is associated with the insured event. For example, let's say that the cost of treatment will be fifty thousand, if one falls ill. So in our example of four person, each would like to take a cover of fifty thousand. If all get ill, then the company will have to pay Two hundred thousand. And if none get ill, than company does not have to pay anything. So the question comes now how much company should charge the premium. They cannot charge fifty thousand definitely, as then there will be no motivation to take the insurance. Also they cannot charge zero, as then insurance as a business does not makes sense. So how insurance company is going to decide, how much premium to decide. There comes the concept of chance or for mathematically inclined people, probability.

So the insurance company will try to judge that what is the chance of a person getting ill or in other words how many people can get ill out of four. Let's say after studying data from various hospitals and research agencies, they come up with a number 25%. So one out of four will get ill. That means they will have to pay fifty thousand to that person. However they don't know which person. Even the person himself does not knows. That's what is chance. So Insurance company will divide fifty thousand among four and charge each person Twelve thousand five hundred. 

Things don't end here. As insurance company has to hire people to manage all process and as a business they have to earn some profit. So they will charge Twelve thousand five hundred plus something to take care  of expenses and profit. 

The other question that often crosses our mind is how much insurance is enough? That is a difficult question in the sense that each one of us have to answer in the perspective of our context. A good parameter is to think about all the risk that is possible and see that if that risk materializes what is the outcome if you are not insured. Also you need to evaluate what all kinds of insurance you need. Definitely one needs health and term insurance in modern day world. However you may not want to insure your dining table and cupboards. Look insurance as a risk mitigation instrument and mitigate the risk to the extent it is required to be mitigated.

In the case of term insurance, for example, if one is no more one still would like the family to live a decent life with basic needs met. Don't try to make the family billionaire with the insurance cover if one is a millionaire.

Apart from that understand the terms and conditions of your insurance. Let your insurance agent explain it to you in clear terms about what is covered and what is not covered. Especially what is not covered. For example in health insurance what kind of diseases are not covered and if pre existing diseases are covered? In auto insurance check for how the insurance works in terms of driver and co passenger. Insist your insurance agent to explain it.

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