How insurance works | Insurance | Financial literacy | Khan Academy

Let's say that you have a car that right now is worth about ten thousand dollars. You don't have ten thousand dollars as a cushion if, by chance, your car were to get totaled, or if it were to get stolen, or something were to happen. You don't have an extra ten thousand dollars to then buy another car just like it.

So, one option you have to try to transfer some of that risk is to buy car insurance. This video is about all forms of insurance, but I'll just use that as an example to help think about how insurance works.

What's going to happen in that situation is that you would likely go to an insurance agent and say, "I would like to insure my car in case it gets stolen, in case it gets totaled, in case something bad happens to it and I have to pay a lot of money for that." The agent might work for an insurance company, or they might be able to get you quotes from many different insurance companies.

They'll come back to you and say, "Okay, if you pay two hundred dollars a year"—I'm making up these numbers; these aren't necessarily the types of numbers that you will see when you go to an insurance agent—"but if you pay 200 a year, we got you covered. If anything were to happen, we will cover the cost of the car." You're like, "Okay, I can pay 200 a year, and I'm willing to pay 200 a year because I don't have ten thousand dollars if something bad were to happen." So, I agree to do that.

Now, the question you might have is, "Well, how does the insurance company make money here?" Well, they have a whole bunch of people looking at the statistics of it all. Statisticians, they're usually called actuaries when they're at an insurance company, and they look at the probability of something like that happening.

Let's say they decide that there's a one percent chance in a given year that they are going to have to pay out ten thousand dollars. Now, if it was just one person, and you're the only person they insured, and in that year you paid 200, but they had to pay out ten thousand, that's not that good of a business, at least for that year. They would have obviously lost a lot of money.

But the way insurance companies work through it is that they're actually insuring millions of people and they're working on percentages. For example, if across millions of people all of them are paying two hundred dollars and there's a one percent chance of having to pay out ten thousand dollars, well, that means on average one percent of ten thousand is a hundred dollars.

On average, they're going to be paying out about a hundred dollars per insured person who's just like that. If they're getting two hundred dollars, well then they're going to be on average making about a hundred dollars profit. People are paying two hundred dollars; that's called the premium, what you pay the insurance company, and then their actual statistical cost is a hundred dollars. So, that's how they would actually make money.

Now, let's say, as one of these bad scenarios, it happens to you—your car gets stolen, it gets totaled in some way. Well then, you would make a claim to your insurance company. Usually, someone there would then investigate the claim. If you made a police report, they would take a look at that; they would interview you to make sure that you're not committing insurance fraud, which is like, you know, you made the car disappear, but it really didn't disappear. Don't do that; it's highly, highly illegal, and you will get into trouble for that.

But then, if it's a legitimate claim, then they will make the payout to you. So think about insurance, but also think about, you know, how they are benefiting and how you can benefit, and also try to shop around for different types of insurance policies. You'll often see some pretty dramatic differences in the price of the premium—that's that 200 a year that I just talked about.