How Insurance Works

A quick overview of what insurance can do for you.

Essentially, insurance is a risk spreading arrangement in which a large number of people buy policies by paying a relatively small amount of money into a pool. When one of the losses covered by the policy is experienced by a policy owner, he files a claim with the insurance company, which reimburses him for the loss according to the terms of the policy. The insurance company, the holder of the pooled money of the policy owners, charges an administrative fee and adds on a margin of profit to the premium paid by each policy owner.

Sounds simple, doesn't it? In reality, however, insurance has become a far more complicated matter than it sounds. Today, there are nearly 6,000 companies writing a variety of insurance policies covering everything from life and health to property damage and business coverage. The three largest life insurance companies alone have assets in excess of $200 billion dollars. According to some studies, every man, woman and child in the United States pays more than $1,300 in insurance premiums per year.

Of course, most of that money is returned to policy owners when they file claims on their policies, right? Wrong. According to a study reported in Consumer Reports, the average American family spent a total of nearly $9,000 just for automobile insurance during the 1980s. But the average family filed only one claim for the same period, which on average totaled $600. So where did all the rest of the money paid in premiums go?

Much of it went to pay insurance company executives and employees their salaries, to pay commissions to insurance company salespeople, to buy giant office buildings and furnish those offices with fine art and expensive furniture. Another big chunk went to lawyers who defended insurance companies from lawsuits filed by their own policy holders after their claims were denied. Some of it was paid as a dividend to the owners of the insurance companies. And some of it went to investments. In fact, of all the money paid in insurance premiums, only about half of it went to pay the claims of insurance company policy holders.

Insurance companies argue that the chief cause of high rates is the increasing number of lawsuits that are filed each year in the United States. What they don't tell you is that some of these suits are filed because some insurance companies do their best to find a reason not to pay claims, even legitimate ones. In fact, if it wasn't for the explosion in the sale of insurance, especially liability insurance, there might not have been a corresponding explosion in litigation at all.

Think about it for a moment; in the early years of this nation, before there were so many homeowner insurance policies sold, if your neighbor or a relative slipped on the stairs in front of your home, chances are he'd pick himself up, dust himself off, go on with his business and make nothing more of it. But today, the first thing many people think of when they fall on their neighbor's property is making a claim against the homeowner, even when the accident is the result of the person's own negligence. After all, he's insured, isn't he? And since we all know insurance companies have lots of money, what's wrong with getting a share of it by claiming medical expenses, lost wages and damages for pain and suffering?

There are plenty of lawyers who are willing to handle these cases for a contingency fee, a percentage of any settlement they receive, but who wouldn't go near a personal injury case if there wasn't a big pot of money shimmering in the distance.

A large portion of the responsibility for high insurance rates also lies with individual consumers, who have been indoctrinated to believe that they are entitled to compensation for every injury, no matter how slight. Recently, a business man who lives in New York City slipped and fell on a street in midtown Manhattan. There was no one around him at the time he fell, no cars that he was trying to dodge, and no injury other than a slight tear in the knee of his pants. And yet he felt compelled to call an attorney to find out if there was some way he could sue the city for his injury.

"I figured I should check it out with a lawyer," he said. "Besides, my friends all tell me that since the city has insurance it ought to be liable, and I ought to get something out of this."

Of course, one of the ways consumers are indoctrinated in this belief is through the advertising and sales pitches utilized by insurers and insurance agents and brokers. We are convinced to buy insurance out of fear that someone will file a claim against us that we won't be able to pay out of our own resources. Insurance agents love to tell prospective clients horror stories about the multi-million dollar judgments handed out by courts against businesses and individuals who didn't have adequate insurance coverage. In these stories, the injury suffered by the successful claimant hardly seemed significant, but was ultimately ruinous for the unwise, unwary and uninsured plaintiff.

Having said all of this, it's a simple fact of life that in modern day America you really can't afford to be without adequate insurance coverage. But before you buy, there are some important facts you need to know.