It can be so frustrating to pay your monthly insurance premium, especially when things are tight and you don't use the benefit. But if we can come to understand the real purpose of insurance, I think it will become less frustrating. The whole purpose behind any type of insurance, whether it's life, health, disability, or auto, is to transfer risk. That's it! So by not purchasing insurance, you assume all of the risk yourself.
So how does it work? Well, insurance only works when lots of people are involved. Insurance companies are very good at what they do and can figure out through statistics what is going to happen. They use what's called the Law of Large Numbers to figure this stuff out. Basically it says that the more people involved, the easier and more accurate to predict the outcome. They can determine how many people will die in a given year, how many claims will be made for accidents, and so forth. Now obviously if Armageddon happens their model won't work, but under normal conditions it is quite accurate. That's how they know how much to charge for their insurance, or risk protection.
So let's look at some examples to illustrate how insurance is a transfer of risk.
Let's say that Bob is the main provider for his family. He earns $50,000 per year and is able to save 5% of that each year. So at the end of each year, he adds an additional $2,500 to his savings account. Bob dies of an unforeseen accident after 5 years and neglected to buy life insurance. His family has $12,500 to bury him and live on. Even if the burial cost nothing they would only be able to live for just over 3 months.
Let's say that Fred is the main provider for his family. He earns $50,000 per year and is able to save 3% of that each year because he bought life insurance. So at the end of each year, he adds an additional $1,500 to his savings account. Fred dies of an unforeseen accident after 5 years and owned a $500,000 life insurance policy. His family would have $7,500 in savings plus the $500,000 tax free death benefit from the policy. They could live 11 years on that money alone.
So which scenario would you like to be in? This is the same thing regardless of which type of insurance you purchase. The risks are real, and by purchasing insurance you are giving the risk to the insurance company.
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