Insurance

Insurance is designed to mitigate the risk of an event. It does this by capping the maximum amount the insured person will pay in the event whatever is insured is lost, damaged, or in need of repair. To get this protection a person agrees to pay a certain amount called a premium, and before the insurance company makes a payment on any claim, the insured person has to pay a certain amount called a deductible.

There is an inverse relationship between the policy’s deductible and its premium. The higher the deductible, the lower the premium and vice versa. So, when choosing an insurance policy, it is important to consider both the deductible and its premium. If you are likely to make a claim against the policy, then you are going to want a lower deductible, even though it would mean paying more for the policy.

To see how insurance works, let’s take the following situation. You purchase a car insurance policy which costs $100 a month and has a deductible of $500. Five months after purchasing the policy you are in an accident which results in $1,500 worth of damage. We will look at how much you would have to pay if you had insurance and compare it to how much you would have to pay if you didn’t have insurance. The table below shows the comparison.

Months 1 2 3 4 Total
Cost with Insurance $100 $100 $100 $600 $900
Cost without Insurance $0 $0 $0 $1,500 $1,500

During the first three months, you have to pay the $100 premium each month. Then on month 4, the month the accident you have to pay the $100 premium and the $500 deductible for a total of $600. So, over the four-month time period, you would be responsible for $900.

If you were to not have insurance during the first three months, you don’t have to pay anything. However, in the fourth month, you would be responsible for paying the entire $1,500. So, the total you would have to pay during the four months is $1,500.

In this case, it is more expensive to not have insurance than to have it because of the accident. If the accident never happened then, it would be cheaper to not have insurance. However, you are taking on all of the risks if something were to happen.