What is insurance? Insurance is a contract between an individual (the policyholder) and an insurance company. This contract provides that the insurance company will cover some portion of a policyholder’s loss as long as the policyholder meets certain conditions stipulated in the insurance contract. The policyholder pays a premium to obtain insurance coverage. If the policyholder experiences a loss covered by insurance, such as a car accident or a house fire, the policyholder files a claim for reimbursement with the insurance company. The policyholder will pay a deductible to cover part of the loss, and the insurance company will pay the rest.
When you buy an insurance policy, you’re pooling your loss risk with the loss risk of everyone else who has purchased insurance from the same company. If you get your homeowners insurance from State Farm, which sells far more homeowners insurance policies than any of its competitors, you’re joining forces with millions of other homeowners to collectively protect each other against loss. Each homeowner pays annual premiums; State Farm collected more than $39.593 billion in earned premiums in 2016, according to its annual report.
It only makes sense to purchase insurance to cover significant losses you can’t easily afford on your own. Few drivers who are found at fault in a major car accident can afford to pay tens of thousands of dollars in someone else’s medical bills, so they carry auto insurance that provides for medical payments to others. We have health insurance because if we get an expensive illness like cancer, insurance is the only way we’d be able to pay for our treatment.
It doesn’t make sense to purchase insurance where the cost of coverage is so high that you’ll likely end up paying for your entire potential loss in premiums whether you experience that loss or not. Nor does insurance make sense when you can comfortably afford to cover the loss yourself, which is why experts generally advise against insurance policies or extended warranties for basic consumer electronics like smartphones and televisions.