Insurance is the most important thing we never think about. That’s what is so great about insurance, we never have to think about it. This is not an introduction to the types of insurance nor a commentary of all the bad press insurance companies always seem to get.

Insurance is nothing but a big game of rolling the dice. You give the insurance company money for protection from the financial impact of an unforeseen event. That insurance company in turn invests that money in stocks, bonds, and all that jazz. The most stressful job in insurance has to be the underwriter. He or she must weigh the chances you will actually need to use your insurance vs how much of a return they can get on their investment with your premium. On top of that, they must then price the product competitively so you will choose their service over a competitor’s.

Whoa that was too much too fast. Let’s start from the beginning and use car insurance as an example. Remember filling out all those forms? How much you drive, what kind of car you drive, how many wrecks, how many speeding tickets, etc? They cross that with your driving record for accuracy. Then you are given some kind of risk score. Using countless statistics and studies, they calculate the likelihood that you’ll ever need to use more than you’ve paid in premiums. Of course the riskier you seem to be, the more you will pay. In theory then, everyone is insurable for a certain price.

So it’s not sufficient for the insurance company to just pool all that money together and divvy the loot as needed. While that is safe, it would likely bankrupt most insurance providers. So the companies have their own investment gurus that go out and play the securities market just like the rest of us. This is why insurance company’s revenue suffers like investment firms when the market is down. Their profits are tied to the market, not just how many Obama Mamas back their Suburbans into police cars.

The movie “Along Came Polly” does an excellent job of explaining what insurance companies are doing all the time. While they simplified the process a bit, its easy to imagine someone becoming paranoid about the germs on bar nuts after spending their lives looking at statistics.

Actuarial science is the name of the game. Bury your face in piles of statistics and in the end make the best possible guess on the right amount to charge. Sometimes they miss, I think I’m way underpaying for car insurance. Sometimes they charge too much, as my last car insurer did, and lose the customer’s business. Most of the time they seem to get it right though.

By The Weakonomist

The Weakonomist is the founder of Weakonomics. Clicking the picture of the puppy will tell you more about him. If you like what you're reading consider subscribing to the blog, following him on Twitter, and checking out the related posts below. Please consider a donation if you really enjoy Weakonomics.

categories: business, college of weakonomics, investing, personal finance