Insurance policies work by taking premiums from customers in exchange for baring the risk of certain costly events occurring.
For example, if there is one fire in your town each month, everyone could just sit tight and hope their house doesn’t burn down next, or could pitch in and pay an insurance premium each month and this is then used to rebuild the house that burns down.
Very simply this is how insurance works. It is a method of spreading a risk over a far wider area, so that it will not be as devastating as if it was concentrated solely on the person who experiences the loss.
There are a few problems with this however and they attract much criticism. One criticism is that by taking on the risk for people, insurance makes people take greater risks than they otherwise would.
For example, if you know your home contents are insured against burglary, then you may not be as careful about locking the doors and windows every time you leave the house. Or if your bike is insured, you may not bother to lock it as much as if it wasn’t insured. In the insurance industry, this problem is known as the moral hazard.
Insurance companies protect themselves against this by inserting exclusion clauses into their contracts, which remove their obligation to pay out if the insured performs or fails to perform certain stated actions. They might for instance require that you fit smoke detectors, or use good locks on your doors, or other things that will reduce the risk of the insured against event occurring.
There are also certain risks that you are not allowed to insure against in most countries. This is first of all because it would be too difficult for the insurance companies to quantify, but mostly it’s because they are risks that governments want the person at risk to bare himself or herself. They generally apply to multinational companies.
This can lead to consumers being misled or buying insurance policies on unfavourable terms. To get around this, most countries regulate the content of insurance contracts to ensure that they remain fair to consumers.
There is also the option of using the services of an insurance broker to shop the market for you.
Video: Criticism of Insurance
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