Insurance is confusing to lawyers and non-lawyers alike. When you apply for insurance, a homeowner's insurance policy for example, the insurance agent will ask you anywhere from what your roof is made of to whether you have a fire extinguisher to what type of breed your dog Spike is. After compiling that information, he gives you what your insurance will cost and sends you a packet full of numbers, information, and language that appears to come from another planet. It is at this moment that you ask yourself: What exactly is it that I'm buying? Why did he have to ask me all of those questions? What are all of these numbers? Is this policy language in English? It is in this stream of blogs, “Understanding Insurance,” that I will attempt to answer these questions.

What Exactly is it that I'm Buying?

We risk potential accidents every day simply by living our lives. When we drive to work, we risk a potential car crash; when we cook at home, we risk the possibility that something will catch fire; when we interact with other people, we risk the chance that we will get sick.

A risk, however, is a “chance” of loss rather than a “guarantee” of one. If there was somehow a 100% guarantee that you were going to get into a car accident, or set your house on fire, or get sick, then an insurance company would not offer you insurance because it is not the role of insurance to take on guaranteed losses (this is why most insurance policies do not reimburse loss that occurred due to an intentional wrongdoing). The role of insurance, therefore, is to take on your “chance” of loss and to reimburse you for that loss if it does in fact occur. In a way, then, you are also purchasing a sense of comfort in knowing that you will not have to carry the entire financial burden in the event that a loss occurs.

But who carries the financial burden? In one sense, the insurance company takes on that burden, but in another sense, so does everyone else that has purchased insurance from that company. This is known as risk allocation or distribution: the insurance company essentially takes your risk of loss and spreads it amongst many.

Here's how it works. Let's pretend you purchase homeowner's insurance for $500 a year and you are that insurance company's only customer. In this case, the concept of insurance will not work because in the event that your house burns down the insurance company will only be able to reimburse you the amount you have paid them. In other words, there is actually a disadvantage to giving the insurance company your money because in one case your house won't burn down and you will never see that money again, and in another case your house will burn down and you will only receive what you paid them to begin with. In this situation, it would be better for you to pocket your money because your risk of loss is not being distributed amongst anyone but yourself.

Now let's pretend you purchase homeowner's insurance for $500 a year and you are that insurance company's 500th customer. If everyone paid the same amount, that is $250,000 that the insurance company gets every year, or 500 times what you have paid. Out of the 500 customers, it is likely that most will survive the year without any damage to their home and that only a few will have accidents. In the event that an accident does occur, however, the customer—if necessary—will be able to receive more in reimbursement than what they paid for in that year because their risk of loss has been distributed and paid for by many. In other words, it is very unlikely that your home will be damaged and more likely that your money will actually go towards helping someone else who has had an accident. If you do have an accident, however, your reimbursement will be greater than what you paid for if it needs to be because you are getting financial assistance from 499 other people.

It's important to note that when you purchase insurance, the insurance company will always tell you what you are purchasing, or up to how much in financial reimbursement they will give you in the event of a loss, and an insurance company is obligated to pay whatever the policy promises regardless of how much they collect in premiums. Go back to example 1 where you are the insurance company's only customer: if you pay $500 a year, they promise to reimburse you up to $100,000 for damage to your home, and your home burns down in the first year, the insurance company is obligated to give you what they promised to give you even if they managed their business poorly. In reality, however, this is unlikely to happen. The reality of example 1 is that if you are the insurance company's only customer, they will charge you such a huge premium that there will be no practical point in buying it.

Now you are probably thinking: that sounds good and all, but I know for a fact that not everyone pays the same amount for the same policy. What is that all about? Answer: a good question reserved for another day…