Insurance is a critical subject to understand for full financial literacy. There are many different kinds of insurance available to serve for different purposes.

Getting insurance is about mitigating risk. No matter how hard we try, we will always have some level of risk in our activities. We collectively and individually decide how much risk we are willing to tolerate.

When we reach the limit to how much we’re willing to spend or sacrifice to avoid risk, then we need insurance against the risk that remains.

You pay a premium to an insurer to cover any risks you can’t eliminate some other way. If the thing you’re insuring against should happen, the insurer pays a claim to you.

Insurance companies group large numbers of people together to cover losses. Only a very small fraction of those insured people will actually have a loss, so the risk is spread out among them.

Risk pooling also pools risks over time as well as over individuals. An earthquake might strike and damage a lot of cars at once. Since that doesn’t happen very often, insurance companies can prepare for disasters by spreading risk over several years.

Types of risks

Insurers have to contend with several different types of risks.

  • Personal risk is the threat of some kind of loss to you. You might get sick, die prematurely, or grow old and need supplemental income. There are insurance products for all of these risks. Even becoming unemployed is a personal risk that people are insured against.
  • Liability risk is a risk you pose to others. You might hit someone with your car, or your dog might bite someone. You would need insurance to cover losses you are liable for.
  • Property risk is risk to your property, whether from theft, or damage. If your house burns in a fire, your insurance should cover not just the damage done directly by the fire, but indirect costs as well, like securing a place to live while your home is repaired or rebuilt.