Spreading the risk – how insurance works
By Sally Praskey, Editor, Insurance Canada ConsumerInfo
While it sometimes seems that insurance companies work in mysterious ways, the idea behind insurance is simple: it uses the payments of many to cover the losses of a few. The money you pay for your insurance – your premiums – goes into one large pool at the insurance company. Those of us who suffer a loss that is insured can then draw from that pool. Because only a few of us need to draw from the pool in any given year, there is enough money in it to pay major losses like those incurred as a result of fire or a serious automobile accident. This concept is called spreading the risk, or risk sharing.
However, the pool must be replenished, or refilled, each year, so it will hold enough money to cover the coming year's losses. You can imagine how quickly it can be drained by one major disaster. The 1998 Quebec ice storm alone resulted in an estimated 700,000 claims for damage totalling $1.14 billion, according to the Insurance Bureau of Canada. That's enough to suck the pool, if not dry, at least to ankle depth. In fact, many insurance companies do not even make a profit on the premiums they receive as compared with the money they pay out in claims and spend to operate the business. Rather, their profit derives from their investments.
Your insurance policy represents a promise to protect you against certain "perils" – or causes of loss – for a given period of time, usually a year. This promise is renewed on a year-by-year basis; your premiums do not "build up" for you to draw upon when needed (except in the case of certain life insurance products – whole life, for example – that are designed with an investment component). In fact, this is one of the most common misconceptions about insurance. Consumers complain that they faithfully pay their premiums year after year. Yet, when they finally need their insurance to cover a small loss, they can't make a claim, because the cost of the deductible (the portion of the claim that you have to pay) may be as high as, or even higher than, the amount of the claim itself. Then there's always the risk – there's that word again! – of premiums going up as a result of a claim, even a small one. It's a familiar, and understandable, litany.
Another common misconception is that insurance covers every misfortune that might befall you. If that were the case, no one could afford the premiums. Neither is insurance intended to be a maintenance policy, so don't even think of contacting your insurer if your aging roof leaks and damages your broadloom, or your sofa gets ratty from wear and tear. Nor is it intended to cover minor losses that consumers could afford to pay for themselves. Rather, insurance is intended primarily to protect you against serious, and unforeseen, loss or injury that you could not pay for otherwise – for example, a major car accident, a fire that destroys your home, the theft of your precious jewellery, the death of a spouse and the consequent loss of that individual's income. It is not designed to replace your $200 lost sweater, as inconvenient and annoying as that loss may be. If insurers were to pay all of these smaller claims, there would not be enough money left in the pool to pay the large ones. If you ever suffer a major loss, you will soon realize that that's when insurance really pays its way.
Many consumer complaints stem from a lack of understanding of how insurance works and what it is designed to cover. The insurance industry, for the most part, has failed to communicate this information to consumers, although a number of initiatives are now in place to rectify this shortcoming.