Money, banking and financial marketsCar insurances companies eliminates risk (or come close) by selling a large number of policies . Explain how they do this.

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justaguide | College Teacher | (Level 2) Distinguished Educator

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Insurance is a game involving probabilities. Let's equate a person getting involved in a car crash or not with the two faces of a coin. If you flip a coin the chance of it showing tails is (1/2). If you were to flip 2 coins the chance of both showing tails is (1/4). The probability of all the coins showing tails decreases as the number of coins is increased.

Insurance companies work with a similar principle. The total amount that has to be paid out multiplied by the probability of it happening has to be less than the amount that is collected by the company as premium. If it is not the case, either the company would have to increase its premium or decrease the amount it pays out.

About the remark made by #7, there is legislature in the US that does not allow the genetic information of a person from being used by employers, insurance companies and the alike. So people can use genetic testing for its benefits without the fear of it being misused.

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accessteacher | High School Teacher | (Level 3) Distinguished Educator

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There is no way that any insurance company can completely erase risk in their business. There will always be the risk that a number of their policy holders have accidents. However, as a general rule, the more policies they manage to sell and have, the greater the profit they will make, because in all likelihood they will have a smaller number of customers who have accidents compared to the growing amount that do not.

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vangoghfan | College Teacher | (Level 2) Educator Emeritus

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All the previous responses are excellent. I was particularly intrigued by stolperia's response.  This is probably the wave of the future: ever more (and ever more reliable) information to the companies about who is a risky person to insure. This is one reason that genetic testing may create problems in the future for people who are genetically more liable to develop certain diseases and medical conditions.

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rrteacher | College Teacher | (Level 2) Educator Emeritus

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In response to Post 5, the risk that is added is more than compensated by the additional premiums. Put it this way: If you insure two people, which is actually how insurance used to work centuries ago, and one of them is injured and files a claim, then you are going to lose much of the money you make on premiums in the payout.

If you insure millions, you take on millions of additional individual risks. But it is VERY unlikely that millions of individuals will suffer serious injuries at the same time, and so the additional premiums make the expansion very lucrative.

litteacher8's profile pic

litteacher8 | High School Teacher | (Level 3) Distinguished Educator

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If an insurance company has a large number of policies, the percentage of policies that will come to be paid will be lower, but it may not eliminate risk.  More policies out means more could come due, even if they are spread out over the country.

pohnpei397's profile pic

pohnpei397 | College Teacher | (Level 3) Distinguished Educator

Posted on

The way that insurance companies do this is like the process of diversifying a stock portfolio.  The more "baskets" you have to put your "eggs" in, the less likely it is that you will run out of eggs.  If you sell lots of policies to lots of people, you are likely to take in enough money in premiums to over the money you have to pay out.  More baskets equals more ways to replace the eggs that get broken.

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stolperia | (Level 1) Educator Emeritus

Posted on

Excellent explanation. As technology is evolving, car companies are also creating programs and equipment to record your driving habits. If you connect their device to your car's computer and it records that you use seat belts and turn signals and reasonable speeds and responsible braking patterns and all those other habits that tend to contribute to safe driving records, some companies are offering a discount on premium costs. This may attract more safe drivers to those companies, which also helps to reduce their exposure to potentially bad drivers.

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kapokkid | High School Teacher | (Level 1) Educator Emeritus

Posted on

If a company can sell a huge number of policies, they will collect premiums from a huge number of customers.  But the likelihood of most of those customers getting in a serious accident requiring a large payout is rather small.  So they haven't quite eliminated risk, but by spreading it out amongst a huge population, they have done so quite effectively for themselves and their profit margins.

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