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How insurance works

Insurance is a way to protect yourself from financial risks by paying a company a small amount of money, called a premium. If something bad happens, like a car accident or a house fire, the insurance company helps cover the costs so you don't have to pay for everything yourself. Created by Sal Khan.

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  • blobby green style avatar for user lakshman666
    Sal sys "........So for example, if across millions of people, all of them are paying $200 and there's a 1% chance of having to pay out $10,000, well that means on average 1% of $10,000 is $100, on average, they're gonna be paying out about $100 per insured person who's just like that...."

    I did get how insurance companies make money but how and why did sal say 1% of 10000$?? I don't understand how to interpret this.
    (0 votes)
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    • piceratops ultimate style avatar for user Anirudh Sathish
      Hi Lakshman666,

      Sal is using a concept called "expected value" in statistics:

      Let's break it down a bit more.

      Imagine you have 100 toy cars. Each toy car represents a person who has insurance. Now, the insurance company thinks that out of these 100 toy cars, only 1 (that's the 1% chance) will have an accident.

      If that accident happens, the insurance company will need to pay $10,000. But remember, this only happens to 1 toy car out of 100 (since the chance is only 1%).

      So, if we spread that $10,000 cost across all 100 toy cars, it's like each toy car is carrying a tiny piece of that cost.

      When you do the math ([0.01 * 10000]), it turns out each toy car is carrying $100 of that cost.

      That's why Sal says the insurance company is expecting to pay out $100 per person. It's like each person is carrying a tiny piece of the risk.

      Does that make sense?
      (5 votes)
  • piceratops ultimate style avatar for user Anirudh Sathish
    Does the amount you must pay for your insurance depend on your records? For example, in the car insurance example mentioned in the video, would they give a higher rate to someone who crashed their car twice in the last five years than to someone who has never crashed their vehicle in their five years of driving? If yes, for which insurance do they check your records? What information would they check for?

    P.S. I'm sorry if this question is long. I just wanted to be specific.
    (2 votes)
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    • male robot hal style avatar for user CBair
      Yes, you will pay a higher premium if you have a reportable accident on your driving record. Also most moving violations. Your record is kept by the state issuing your driver's license and is available to insurance companies. And you will be asked when filling out an application if you have had any accidents within a certain amount of time. Don't lie. Usually the penalty rate is only in effect for a certain amount of time (a few years).
      (0 votes)
  • leaf green style avatar for user theneuron1
    I strongly disagree with some of these 'correct' answers. Why can't we ask questions after answering each question? I can't remember the questions or the answers and don't see any way to go back.
    (1 vote)
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  • mr pink green style avatar for user 2045687
    What is insurance?
    (0 votes)
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    • aqualine tree style avatar for user David Alexander
      There are many kinds of insurance: auto, fire, home, life, crop, and on and on. Basically it is a system where you place a bet with a company. You put in some money first, saying to the company, "I bet a terrible thing will happen in the next year." (for example, with life insurance, you are betting that you will die). The company says, "We take your bet. We'll take your money, and if you die, we'll pay a whole lot of money to the person you name who should get that."

      So, now there's a bet out there. If you don't die, the company keeps your money, and you make another bet (or maybe you don't) the next year. But if you win the bet (by dying), the company loses.

      It works the same way with fire insurance, crop insurance, homeowners insurance and other stuff that you can insure about.
      (4 votes)
  • blobby green style avatar for user Adrian
    a smaller financial shield to lighten thit cost of accidents or damage.
    (0 votes)
    Default Khan Academy avatar avatar for user

Video transcript

- Let's say that you have a car that right now is worth about $10,000 and you don't have $10,000 as a cushion. If by chance your car were to get totaled or if it were to get stolen or something were to happen to it, you don't have an extra $10,000 to then buy another car just like it. So one option you have to try to transfer some of that risk is to buy car insurance. And this video is about all forms of insurance, but I'll just use that as an example to just help think about how insurance works. So what's going to happen in that situation is that you would likely go to an insurance agent and you're just, like, "I would like to insure my car in case it gets stolen, in case it gets totaled, in case something bad happens to it and I have to pay a lot of money for that." And so then the agent, they might work for an insurance company or they might be able to get you quotes from many different insurance companies, but they'll come back to you and say, "Okay, if you pay $200 a year," and I'm making up these numbers, these aren't necessarily the types of numbers that you will see when you when you go to an insurance agent. "But if you pay $200 a year, we got you covered. If anything were to happen we will cover the cost of the car." You're like, "Okay, I do. I can pay $200 a year," and I'm willing to pay $200 a year because I don't have $10,000 if something bad were to happen, so I agree to do that. Now the question you might have is, "Well, how does the insurance company make money here?" Well, they have a whole bunch of people looking at the statistics of it all, statisticians, they're usually called actuaries when they're at an insurance company, and they look at the probability of something like that happening. So let's say they decide that there's a 1% chance in a given year that they are going to have to pay out $10,000. Now, if it was just one person, and in that if you're the only person they insured, and in that year you paid $200, but they had to pay out 10,000, that's not that good of a business, (chuckles) or at least for that year they would've obviously lost a lot of money. But the way the insurance companies work through it is that they're actually insuring millions of people and they're working on percentages. So for example, if across millions of people, all of them are paying $200 and there's a 1% chance of having to pay out $10,000, well that means on average 1% of $10,000 is $100, on average, they're gonna be paying out about $100 per insured person who's just like that, and if they're getting $200, well then they're going to be on average making about a $100 profit. People are paying $200, that's called the premium, what you pay the insurance company, and then their actual statistical cost is $100. So that's how they would actually make money. Now, let's say one of these bad scenarios happens to you, your car gets stolen, it gets totaled in some way, well, then you would make a claim to your insurance company, usually, someone there would then investigate the claim if you made a police report they would take a look at that, they would interview you, make sure that you're not committing insurance fraud, which is like, you know, you made the car disappear but it really didn't disappear. Don't do that, highly, highly illegal, you will get into trouble for that. But then if it's a legitimate claim then they will then make the payout to you. So think about insurance, but also think about, you know, how they're benefiting and how you can benefit. And also try to shop around for different types of insurance policies. You'll often see some pretty dramatic differences in the price of the premium, that's that $200 a year that I just talked about.