The basics of insurance

- [Instructor] If you buy one lottery ticket every day forever, for the rest of your life, it's very likely you'll be a net loser over your lifetime, yet people still play the lottery even though they know this intuitively. Why? Why is that? The answer is they want exposure to what's called positive skew. Being a small amount less wealthy every year in exchange for the chance, albeit a small one, at a very large payoff. Insurance is the opposite. People pay an insurance company even though they know on average that they're never going to need the insurance company. Also that they can avoid the risk of having a very large loss at some point during their lives and that's how insurance fits into your personal finances. Insurance is related to this idea called risk aversion. Risk aversion means that investors want to avoid risk and are willing to pay a premium to ensure they are protected in the event of a big loss or tragedy. For instance, think about the example of carrying home insurance to protect against the risk of a fire. Individuals generally prefer to minimize their risk of large losses while at the same time maximizing their chances of big gains, even if it costs them money on average over time. There are three primary types of insurance that you should be aware of and use as a way to hedge your risk in your finances. Health insurance, life insurance, and property and auto insurance, which call under the general bundle of what's called P&C or property and casualty insurance. Health insurance protects against losses related to a person's health. Life insurance provides a payout after a person dies and helps to provide for the deceased's family and property and auto, again, called property and casualty, protects in the event of a disaster that damages one's property. These three distinct classes of insurance all represent different types of businesses but they all operate on the same premise. The insured person, that's you, pays a premium to be protected in the event of a major negative unexpected event. Remember, a premium is the monthly bill that you pay to the insurance company. The insurance company's business model is built around the risk aversion people feel and the fact that people pay a premium to avoid these issues. Three major metrics define the insurance business. The loss ratio is the amount of every dollar in premiums that gets paid back out to insured people. For instance, if a home insurance company brings in a million dollars in premium payments and pays out 800000 to cover fires, floods, other sorts of disasters, what have you, then the loss ratio is 0.8 or 80%. 800000 divided by 1000000. The expense ratio is the amount of every dollar in premiums that gets used by the insurance company to pay their own office and overhead expenses. For instance, if that insurance company brings in a million in premium payments and then spends 120000 on office expenses and customer service for their customers, well the expense ratio is 0.12 or 12%. That's 120000 divided by 1000000. Finally, the combined ratio is the amount when the expense ratio is combined with the loss ratio. It's the total amount of every dollar in premiums the insurance company spends on all of its costs plus its payouts to insured people. In our example, the combined ratio is 800000 plus 120000 divided by 1000000. This then tells us that the profit for the insurance company is 8%, which is just one minus that combined ratio. Now you should have more of an understanding of how the insurance industry works and why it's valuable and necessary for people like you.