Insurance companies – World is full of randomness. However, humans hate randomness and bad surprises and prefer more of predictability. Insurance companies help level the risk across an entire population and reduce the number of surprises. This reduces life’s randomness and enables us to be less stressed.
Let us take the case of auto insurance that pays for the damages when you are in an accident.
Assume that one in 1000 will get into an accident in a year. If you get into an accident you have to pay 100,000 rupees in damages and if you don’t get into an accident you don’t pay anything.
You never know whether you will be that one who gets into an accident this year. There are a lot of random events that could happen. If you get into an accident, you won’t have that 100,000 to pay. Everyone is worried that they could be that one.
To reduce the risk, you start pooling your money with 999 other people and each of you decide to pay 100 rupees every year. The pool now has 1000 * 100 = 100,000. Statistically, one of the 1000 will get into an accident and whoever gets into that accident will that pool money.
You have now bought peace of money with 100 rupees. Now, your best case and worst case is losing 100 rupees. In other words, you can do your activities without worrying about random events.
Since, it is not easy to form a pool of money with that large a number of people, specialized companies come into play. Insurance companies are just companies that pool the money and make sure the right people get the money. They have two primary jobs:
To evaluate the risk (evaluating whether 1 in 1000 or 1 in 300 will get into an accident this year)
Fraud detection – making sure that the guy who gets the pool money is really in an accident.
For doing these two activities, they get a profit. Instead of collecting 100 rupees from each person, they will collect 110 rupees.