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How does insurance work?

Insurance 101

Understand how insurance works so that you can make the decision on whether you need it or not.

It’s hard to know what value you’re getting from paying an insurance premium each month when it feels like you’re getting nothing in return. Especially when you’ve heard stories about your second cousin's uncle who beat the insurance system by self-insuring. All he did was put the insurance premiums he would’ve paid into an interest-earning account and, after 10 years with no car accidents, he accumulated a hefty balance in his savings account.

It’s stories like this that get you thinking about whether or not insurance is necessary. After all, insurance costs money and you get nothing back unless you claim, which is so unlikely, right?

Maybe, but maybe not. Let’s look at the statistical theory behind insurance so that you can make up your own mind.

The basics of insurance

When you buy an insurance policy, you are making regular monthly payments called premiums to your insurer. If you suffer a loss that is covered by your policy, your insurer will return you to the position you were in before the loss happened.

The monthly premiums that you pay are pooled together with the money received from other policyholders. It is from this pool that any claims you make are paid out. For the insurer to have enough money in this pool, they have to predict the total number of claims across all policyholders — which leads us to our next point.

Why insurers are in a better position to take on risk

When you flip a coin there’s an equal chance of heads or tails. You wouldn’t make any big bets on the outcome, because it’s pure randomness: there’s a 50/50 chance of heads or tails. But what happens when you flip the coin 1,000 times? Interestingly, there’s a very narrow range for the likely number of times the coin will land on its head — around 500 times.

Insurance is similar to this. When one person drives around, it’s really down to randomness whether they have an accident or not.

Conversely, insurers are more immune to randomness; when there are thousands of people with car insurance — while the insurer won’t be able to predict exactly who will have an accident in a particular year or how much each accident will cost — the insurer will be able to predict a narrow range of total payouts in claims with a high degree of certainty.

It’s for this reason that insurers don’t have to collect premiums equal to the total value of all the cars that they insure. Instead, they can hold an amount that's far smaller but enough to cover the predicted range of total payouts in claims.

On the flip side, if you self-insure, there’s no way of knowing if the coin will land on heads or tails (i.e. whether you’ll have an accident or not). You’ll have to set aside savings equal to the full value of your car. And there’s always the chance that you could have multiple accidents or have your car stolen more than once in a year, which would be devastating. In contrast, insurers aren’t exposed to this same randomness. If one customer has two or even three accidents it doesn’t affect the insurer's book because they’ve already accounted for this in their prediction of how many claims they can expect to payout.

If you’re like most people, insuring the expensive things you love with an insurance company usually makes more sense than trying to self-insure them. Especially when you consider the time it takes to build up savings — along with the fact that accidents (or other bad things) might not wait until you’ve saved enough.

But some things could still make you wonder if insurance is the way to go. Let’s tackle a few of them.

How insurers can pay more claims than they originally predicted

There’s always the possibility (albeit small) that an insurer’s range of expected claims could be a little off due to the nature of randomness. For example, in some cases, thefts might skyrocket in a certain area or there might be extreme events (like Joburg hail storms or the recent Knysna fires) causing multiple claims. Will the insurer still have enough money to pay claims if this happens?

Fortunately, the insurance regulator (the Financial Sector Conduct Authority (FSCA)), forces insurers to hold loads of money aside for situations like this, so that in a really bad year they will still have more than enough money to pay claims.

Most insurers also purchase their own insurance to protect them against really large claims or when they have more claims than expected. Like at Naked, we’re backed by the insurance giant, Hollard.

Different premiums for good and bad apples

You may be the type to take very good care of your things — you drive safely, you lock your stuff away and you don’t drink coffee over your laptop. By getting insurance, you might think that you’re pooled with people who are the complete opposite or at least somewhere in between. The good news is that most insurers have a complex and sophisticated way of determining individual premiums and will offer the good apples a lower premium when they can see they make an effort to protect their stuff. Another factor that could work in favour of the good apples is that many insurers will use accident history as an indication of how likely future claims are.

Play it safe or take a shot in the dark?

There’s a benefit in handing over risk to an insurer — it’s often easier and less stressful to purchase insurance than to keep enough savings aside.

That said, the process of insurance can still be quite confusing, and there are things to look out for to ensure you choose the right cover at affordable premiums. This article and others in the Naked blog series (mentioned below) can help in equipping you to make more informed decisions about whether to buy insurance and which options to choose when buying cover – so that you can get on with life knowing that someone’s got your back.

A few more topics that could help you:

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