Health Insurance Explained Part 1

There's been a lot of talk in the US over the past few years about our health care system.  Politicians trying to respond to the general publics complaints over health insurance being too high.  The problem is that most people don't understand how insurance works or what it's really for.  In part 1, I explain the basics of insurance.


The main goal of insurance is to REDUCE RISK.  Insurance does this by averaging the costs of many different people.  So in a simple example, let's say that there are 1000 houses each worth $100,000 dollars.  Let's also assume that there is a 1 in 1000 chance that a house will burn down in a given year.  Most homeowners wouldn't be able to cope with the sudden loss of $100,000 to their net worth if their house burned down.  So they all agree to chip in $100 a year so that if anyone's house burns down, they can take the money from the pot and buy a new house.  This acts to spread the risk out among all the different home owners.

However it's not as simple as everyone throwing their money together.  There needs to be someone who collects the money and is responsible for it.  They need to make sure that there agreement is compliant with the law.  They need to make sure that people aren't commiting FRAUD.  Can you imagine how tempting it would be to claim your house burned down just so you can get your hands on $100k?  Someone needs to check that you truelly did suffer a loss.  These all add expense to your agreement.

There are also insurance fuctions that REDUCE expense.  Let's say that the insurance company tells all the homeowners that they have to put smoke alarms in their houses.  This reduces the chance of a fire from 1 in a 1,000 to 1 in 10,000.  This means that the insurance company can charge less since they were able to prevent more houses from being burned down.