How do insurance companies work?
Show answer & explanation
Answer: Pool risk across many people
They predict who gets unlucky — Wrong. Insurance companies can't predict individual outcomes. They work by pooling risk—collecting small premiums from many people to pay large costs for the unlucky few. Statistics tell them how many claims to expect from a group, not who specifically will file claims.
Pool risk across many people ✓ — Correct! Insurance pools risk. If 1 in 100 homes burn down yearly, each homeowner faces 1% risk of $200,000 loss. Instead of risking $200,000, 100 homeowners each pay $2,500 premiums. The insurer collects $250,000, pays out $200,000 for the one fire, and keeps $50,000 for expenses/profit. Risk is spread!
They invest premiums in stocks — Wrong. While insurers do invest premiums to earn returns, this isn't why insurance 'works.' The basic mechanism is risk pooling—spreading unpredictable individual losses across many people through premium payments.