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MSE’s Academy of Money
MSE’s Academy of Money

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8 Why do we buy insurance?

You should now be familiar with the four-step decision-making model. You are now going to test out the model by applying it to one category of household spending – the purchase of insurance products.

There are several reasons for testing the model on insurance:

  • Purchasing insurance products is an activity regularly undertaken by virtually all households.
  • There are different types of insurance – motor, home, pet, health, travel and others – each with different features. There are many providers of insurance products too. This means that there is an array of information that needs to be digested by consumers. The four-step model provides the means to assess these different insurance products rigorously and facilitate appropriate choices.
  • Each year most households spend large sums on insurance. So, if applying the model can improve product selection the savings generated could be substantial.
The figure is a photo of a man holding an insurance contract up in front. The man holds a pen pointing to the place where the contract has to be signed.
Figure 5 Check the small print on insurance policies before you need to make a claim

First let’s look at the basics of insurance.

Insurance is a method whereby individuals or households (or organisations) can protect themselves against the unexpected. To do this, they pay a sum of money called a premium to an insurer in exchange for being indemnified (protected) against the losses that result from specific perils, under conditions specified in a contract. This contract is called an insurance policy.

When you take out an insurance policy you’re transferring to the insurer the risk of the financial loss arising from the peril, and so you’re reducing the potential consequences to yourself.

Actuaries provide statistics to insurers to help quantify the risks that insurers are taking on. Insurers need data on the probabilities of the perils for which they offer insurance – death, illness, disease, burglary, accidents and so forth – and data on people of different ages, genders, locations, postcodes and households, so that they can estimate their risks of paying out.

Actuarial data will give an approximation of the future claims that the insurer might face across the range of perils they insure. Insurers will then aim to set premiums so that, on average, total premium income will cover the cost of paying out for claims, building up reserves and making a profit.

Insurers spread their risk by insuring many individuals and households against various risks. By insuring a large number of risks, the average number of times that insurers have to pay out will be more predictable, and so will be the total amount that they have to pay out in any given year. In taking on the risks of many and aggregating them, the insurer faces a more predictable future than individual policy holders would if they had to face their risks themselves.

What are the different strategies people could apply for managing risk and uncertainty themselves?

One approach is to ignore the risk. If the peril then materialises, there could be major negative financial ramifications, and so this would be a high-risk strategy.

Another approach is to try to eliminate or reduce risk. Strategies here could include fitting house alarms (to reduce the risk of burglary or fire) or eating healthily and exercising (to reduce the risk of premature death). These might be beneficial in themselves – although they may have costs attached too – but they cannot eliminate all of life’s risks and uncertainties.

A different strategy is ‘risk assumption’. This involves accepting and taking on the potential financial impact of the peril materialising. It could also be called ‘self-insurance’: putting savings aside to cover the costs of any potential financial loss.

This can be a strategy adopted by choice by people who are risk-takers or who have enough income or savings to cover possible losses. It can also be adopted by default when other types of insurance are not available or are too expensive.

Yet where the financial impact of something happening may be large, for example, redecorating your home and buying new furniture and personal items after a home fire, people who can afford to buy insurance tend to do so to transfer the financial risk to the insurance company.

The reality is that certain insurance products are compulsory – certainly motor insurance if you have a vehicle and home insurance if you have a mortgage (lenders generally require this).

With other insurance products purchase is optional – for example home contents insurance and travel insurance. But you might want to consider whether you really want to self-insure against some of the more extreme costs that could fall to you (e.g. hospitalisation during a holiday in the USA which can easily run in to tens of thousands of dollars).

Elsewhere you may feel that the social fabric of the UK negates the need to buy insurance – the best example here being the existence of the NHS which, arguably, make the purchase of health insurance illogical (unless perhaps it’s offered for free or heavily discounted through your employer).

Either way each insurance category is different and making effective choices between the products – or, indeed, deciding whether you need to buy insurance in the first place – is a good place to use the four-step model.

Activity 9 Estimating an insurer’s potential liability

Timing: Allow approximately 5 minutes for this activity

What are the two categories of information an insurer needs to forecast the amount of money they will have to pay out under the insurance contracts they have sold?

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The two categories are:

  • the probability of claims being made by those who are insured
  • the cost of meeting those claims (provided the claims are covered by the terms of the insurance)

This can alternatively be expressed as:

Total cost to the insurer = expected number of claims x expected average cost of a claim

The data compiled by insurers from previous claims can provide a very good guide to the average expectation of future claims, and how much they may need to pay out per claim.

But, the risk to the insurer is that they get a high number of claims one year that means the total amount they pay out is (well) above average. For example, claims under home and contents insurance policies are huge when the country gets hit by exceptional weather conditions like the Great Storm of October 1987, or the more recent floods.