Insurance: Protecting Yourself from Damage
"Insurance: Protecting Yourself from Damage" is the sixth video in the Federal Reserve Bank of St. Louis series, "No-Frills Money Skills." This episode begins with examples of activities with varying amounts of risk and introduces insurance, explaining how it is used to transfer or reduce risk. With a story about a homeowner, students learn several key insurance related concepts and terms. The content for these videos was reviewed by members of the Missouri Insurance Education Foundation.
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No-Frills Money Skills is a video series that covers a variety of personal finance topics. The brief videos use clear, simple language and graphic elements so that students can better visualize the personal finance content being presented. In the end, they will see how important these concepts are to their everyday lives.
Transcript:
Below is a full transcript of this video presentation. It has not been edited or reviewed for accuracy or readability.
What if your property were engulfed by flames or damaged by a natural disaster? Odds are, your family would not have enough cash saved to replace everything you own. Few people would.
On today’s episode of No Frills Money Skills, we’ll attempt to sidestep peril and learn the ins and outs of insurance.
To understand insurance, you need to understand risk. Think about the following activities. Would you take these risks?
Would you go—hang gliding, parajumping, snowboarding, downhill skiing, or bungee jumping? Everyone will likely make different choices because each activity has some level of risk for injury. If you wear a helmet, you can lower your risk of a head injury. But what if you get hurt? How do you lower the risk of having to pay a lot of money? Well, insurance is a way to transfer the cost of loss or damage to someone else...for a fee.
Here’s a simple example of how insurance started not too long ago, and still works today.
Imagine we’re in the 1800s living in a community with 20 farm families. We all have similar barns, and for easy numbers let’s say each barn costs $1,000 to build. In this case, if any family has a barn burn down, they have to come up with $1,000 to build a new one. But then we get to talking and come up with a great idea to reduce the cost for any one family: We all agree that each family will put $50 into a special fund. If any family has a barn go up in flames, then they’ll get the $1,000 in that fund to build a new one. If no barn burns down, then the money will just stay in the bank and earn interest.
But what if two barns were to burn down in the same year? Well, in that case, every family would have to pay additional money into the insurance fund. Simple, right? Well, today’s insurance is only slightly more complex. But there is one huge difference: Today, insurance companies are multibillion-dollar businesses. They offer coverage by pooling their customers’ money rather than groups of people pooling their own money.
People pay money—called premiums—to insurance companies to buy insurance, which protects their property in the event of damage. Insurance coverage defines how much the insurance company will pay for particular types of damages. If damage occurs, the insurance company, will indemnify—or compensate—the insurance owner for the damage. There are many types of insurance—for example, property—including Homeowners’ and renters’ insurance, health, auto, and life.
Here is an example of how property insurance works: Meet Jane. She borrowed $180,000 from the bank to build a home. If anything happens to that property, she doesn't want to lose her investment, and the bank doesn’t either. To make sure she and the bank are protected, Jane buys property insurance. When she does that, she transfers the risk of loss to an insurance company. Jane will pay the insurance company a premium—a certain dollar amount—every year. Will Jane ever receive anything for that premium? She doesn’t know. However, in the event of a fire or any other covered loss, Jane could collect a lot more than she paid in premiums—especially if the insurance company has to pay to rebuild her house. For example, let’s say Jane insured the house for $180,000, paid the premium—$2,000—and a fire caused $75,000 in damages. That would be a big payout for the insurance company. But, that is the risk the insurance company takes.
On the other hand, Jane could pay the $2,000 premium every year for 37 years and never file a claim. A claim is when you ask to be paid for a loss. So, Jane would have paid $74,000 for peace of mind.
You may be wondering how insurance companies know how much risk to take. They hire people called actuaries and underwriters to calculate the risk of various activities and losses to property. Actuaries use statistics, economics and probabilities to determine the premiums to charge for the types and amounts of insurance requested. Underwriters evaluate properties, conditions, and applicants to determine good and bad risks for insurance companies. When evaluating risk for a building, underwriters look at things such as where the building is located, the type of construction, the condition of the building, and even how close it is to a fire hydrant.
When people choose not to buy insurance, they take all the risk of a loss. For example, if Jane said, “I’m not buying property insurance!” she would be solely responsible for any damage to her home. In this case, though, it would be unlikely that any bank would lend her the money to buy the building. Any bank would want proof that the money to replace the property would be available if disaster struck.
When you make a claim, most types of insurance will not pay 100% of the damages. Almost all types of insurance have a deductible.
A deductible is a dollar amount that you must pay before the insurance company pays. For example, if a fire caused $75,000 in damages to Jane’s house, if she had a $1,000 deductible, her insurance company would deduct $1,000 from her claim payment.
Protection for your home is not all you get with a homeowner’s policy. The typical policy includes coverage for your personal property, other structures (such as a storage shed), liability, and medical. Liability insurance protects you in the event of a lawsuit. For example, if someone is bitten by your dog or injured while on your property, your liability coverage would provide legal protection. Medical payments on your homeowner's policy pays for medical expenses from injuries to people at your home, no matter whose fault it is, usually up to $1000. The coverage is usually not subject to a deductible.
You may be wondering, “What if I don’t own a home, can I still get insurance for my personal belongings?” Yes. You can buy renters insurance to protect your property, and like a homeowner’s policy, renters insurance includes personal liability and medical payments.
Insurance is a great way to ensure that your assets are covered in case of damage or loss. Today we talked about property insurance. In the next episode of NFMS, we'll navigate the world of car insurance, using specific examples to help drive home the point. I'm Kris Bertelsen, and I'll see you next time.
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