Insurance (as it should work) explained

Suppose a village with 100 homes. Suppose on average two burn down every year (or on average per year). It’s a terrible burden on the afflicted. In older societies the villagers might come to the rescue by helping to rebuild the lost homes. This system is built on trust. It’s a very nice system if it works.

With urbanization driven by the Industrial Revolution such collaboration was no longer practical although it might come back in the form of Internet Crowd Funding. The Capitalist solution is to use capital to solve the problem. Capitalism, not being coercive like religion or dictatorship, presents a problem, you can’t count on everyone insuring so you have to rely on statistics, on actuarial science. Also, not all homes are identical.

Putting those problem aside, let’s assume that the village has 100 identical homes two of which burn down every year and it costs $10,000 to rebuild each one.

The fund to cover this expense is $20,000. That means that each household has to pay $200 per year to cover the cost.

That’s all insurance is, prepaid disaster relief of predictable disasters like death. The more technical description is “The transfer of risk that one cannot bear to someone else who can.” Brushing your teeth daily is a something we can all afford. An annual checkup is a bit more problematic, the homeless will need help but most people can afford it. Most people can afford food, the homeless rely on community kitchens.

In terms of insurance, one should only buy insurance to cover risks one cannot afford to deal with. Buying more is just wasted money. Insuring major medical expenses makes sense. Buying prepaid healthcare is a waste of money.

The Scots were the first to create funds to support the widows of clergymen – same principle!

Key moments from our history

  • In March 1812, a number of eminent Scotsmen gathered in the Royal Exchange Coffee Rooms in Edinburgh, to consider setting up ‘a general fund for securing provisions to widows, sisters and other females’.

Who We Are | About Scottish Widows.

The coffee house run by Mr. Lloyd in London was where betting on shipping disasters gave rise to maritime insurance.

Lloyd's Coffee House - Wikipedia.

The Captain

insured his sailboat with Lloyd’s of London because the rates and conditions were much better than available from local insurers.