Money and You: Course Notes

We’ve already examined one big insurance program: Social Security. We’ve never discussed what insurance actually is. Insurance is an agreement of sorts. Someone who is exposed to a certain risk of something bad happening may want the security of being able to survive or afford getting through that bad thing, should it happen. Suppose, for example, someone is concerned that their car may be stolen one day. They may want some kind of protection financially should their care actually get stolen. Insurance is a way for this security to happen.

A person or company may be willing the help someone get through a certain negative experience in exchange for money. That is, for example, perhaps some company is willing to reimburse the person if their car were actually stolen. The risk of a stolen car gets moved from the person to the company. The company would not take on this risk for free though. The person would need to pay the company compensation for taking on the risk. This is essentially how insurance works at its most basic.

When you are concerned about the possibility of a bad event (getting injured, your car gets damaged, your house burns down, etc.), you may want to protect yourself financially from these events. For example, maybe you want to protect yourself from needing to pay a medical bill or needing to fix your car or needing to rebuild your house. For many of these possible bad events, an insurance provider may be willing to take on your financial obligations should something bad occur in exchange for compensation. This financial compensation is usually through regular payments called premiums.

Let’s take a house as an example. Suppose that you own a house that would cost $300,000 to rebuild or replace. You likely don’t have that money and wouldn’t be able to take out another loan to rebuild your house, should something happen. You could protect yourself from that scenario by setting up an insurance policy with a provider. They may charge you something in the range of $500-$900 for a premium per month to take on the finances of rebuilding your home. That sounds like a lot of money to pay each month, but it depends on how much you value protection.

Once you have a policy in place, you are covered by your insurance provider in the event that a covered event happens. For example, more house insurance policy will cover damage from accidental fire, but they won’t cover fire damage if you purposely set your house on fire. When a covered event happens, you get in contact with your insurance company to file a claim. Over a bit of time, the insurance company will either give you a check for you to use to pay for bills and other expenses related to the event or pay the various service providers directly.

Theoretically, any “bad” event in life could be covered by some insurance policy. The big ones are medical issues, automobile issues, building issues, early death, and property loss. However, you can get insurance on things like weather delaying your plane flight, alien abductions, and someone not showing up to their wedding.

The important thing about insurance is that you need to have a policy with a provider before a bad event happens, never after. In some respects, insurance is a form of cost sharing. Multiple people pay premiums for their insurance coverage, and those premiums are used to pay for any covered losses or events that anyone in that pool experiences. However, to get the benefits of this cost sharing, you need to contribution your own premiums before something bad happens.

In some instances, whether or not you want to take on the risk of paying for a bad event, you may be required legally to carry certain insurance policies.

If you own a car in Massachusetts and want to legally drive it, you are required to carry a certain kind of insurance. If you are responsible for a car accident, you would be required to pay for repairing or replacing the other person’s car. You will also likely have some injury, and you would be responsible for paying for those medical expenses (up to a certain amount). You are required to carry insurance that would cover those expenses. This required insurance can make owning a car really expensive. The rationale for this requirement is that most people cannot pay for the expenses relating to an accident when they cause one. It is also expensive and difficult for the victim in the accident to get any sort of payment from the “at-fault” driver. While it may seem like this required insurance is an unnecessary expense that protects others, as a whole group, you are just as protected with every else’s insurance policies.

If you take out a loan to purchase something, often a house or car, the lending bank will almost certainly require you to carry insurance that will completely replace the thing should anything happen. So, if you want to take out a mortgage for a house, you’ll be required to carry insurance on the house. If you take out a loan for a car, you’ll need to carry additional insurance that will replace or repair your car should it get damaged or stolen. The purpose here is for lenders to protect the collateral on the loans. The items you buy with the loaned money serve has collateral for the loan. The bank wants to maintain that collateral. Again, it appears that this kind of insurance is something to benefit the banks and not you. Keep in mind that if this requirement were not part of loans, the loans themselves would be much more expensive each month.

The Affordable Care Act brings a requirement that every citizen have a certain level of “coverage” for medical expenses. The actual requirements are long and complicated, but just understand that every citizen is required to have some level of medial insurance. The penalty for not having adequate coverage is a tax penalty. However, it is easy to avoid this penalty by stating that you have a religious exemption to insurance coverage. One of the main rationales for this law is to make everyone part of the “cost sharing” in medical insurance. Again, it’s the situation in which if you only think of your medical issues in isolation or a vacuum, the requirement seems like a punishment, but if you consider the financial effects through cost sharing, you can see the benefit you get.