What a year you had! You broke your leg right before your beach vacation (which you had to cancel), your sore tooth needed a crown, and your fender bender necessitated major car repairs. Luckily you had medical, dental, auto, and even trip insurance. The money you received in insurance claims was more than the total you paid in premiums this year. That’s good, right?

　　If every person had a bad year like this, how would insurance companies stay in business? Insurance companies have to make sure the claims they pay out in total are covered by the premiums they collect from all their policyholders. This balance of premiums versus payouts is how insurance works.

　　What is insurance?Insurance is an agreement in which a person makes payments to a company and the company promises to pay out money if the person has a specific loss.

　　Auto insurance. Covers losses you or another driver incur from an accident.Mortgage insurance. Protects the bank if you bought a home with a small down payment.Homeowner’s insurance. Protects you if your house catches fire or someone is hurt in your home.Rental insurance. Covers losses from theft or damage if you rent your home.Life insurance. Helps your family weather the financial hit if you pass away.Health insurance. Covers everything from doctor visits and medications to catastrophic illness and injuries.Dental and vision insurance. May cover annual exams, cleanings (dental), and glasses or contacts (vision).Trip insurance. May cover expenses if you have to cancel or reschedule a vacation.Liability insurance. Helps pay for legal liabilities if you injure others or are negligent.What are insurable risks?Insurance companies typically collect money from large groups of policyholders. They put all the money into one pool that’s used to make payouts. Because the group of policyholders is diverse, it’s unlikely that everyone will have large claims at one time. In fact, a risk that is insurable must meet some requirements:

　　The insured objects must be numerous enough and similar enough to calculate the probability of how many and how severe losses might be.The insured objects must not be subject to simultaneous destruction. For example, one company would not want to insure every home in the same subdivision along the same stretch of Florida coast because, if a hurricane were to wipe out the whole area, that company would likely become insolvent and unable to pay its claims.The possible loss must be accidental and beyond the control of the person who is insured.How does insurance work?In order to be profitable, insurance companies use certain techniques to help mitigate the risk of losses:

　　Underwriting. The process of underwriting assesses the risks of each individual policyholder, such as age, health status, driving record, location, or occupation. Actuaries then use mathematical and statistical models to calculate premiums by predicting future claims. The goal of the insurance company is to charge more in premiums than they pay out, resulting in profit from underwriting. Investments. Insurance companies are allowed to invest the money they collect in premiums, holding enough in liquid reserves (i.e., funds they can pay out to satisfy claims) to comply with capital requirements. These investments generate additional revenue for the companies.Reinsurance. Some insurance companies purchase their own insurance from large reinsurance companies, providing an additional layer of protection against large claims. Insurance is regulated at the state levelAlthough the federal government has the authority to make sure that insurance companies don’t have misleading advertising or act as monopolies, most regulation is at the state level. States regulate in four areas:

　　Rate making. Rates must be high enough to cover expected losses, but not excessive nor unfairly discriminatory among different classes of risk. For example, the difference in life insurance costs for smokers compared to nonsmokers can’t be unfairly large.Minimum standards for financial solvency. Companies must follow specific accounting practices, hold minimum security deposits with state insurance commissioners, have minimum amounts of capital available to pay claims, and have procedures in place in case the insurance company can’t pay its claims.Investments. The types and quality of investments are regulated by the state.Marketing. Advertising, licensing of agents, wording of forms, procedures for handling claim disputes, and other specific operations are state regulated.Risk pooling, adverse selection, and cherry-pickingRisk pooling is the process of combining different people into one group so that some people are at high risk and other people are at low risk of having a claim. For example, a health insurance risk pool would include healthy and less healthy people together to balance out the risk of claims outpacing premiums. The problem is that each side (insurer and insured) may have a vested interest in tipping the scales in their favor.

　　Adverse selection. If the insurance companies don’t have adequate information about their customers, in an attempt to pool the risk, they may end up with only higher-risk clients. This situation is called “adverse selection.” An example of adverse selection would be when a person raises the insurable limit on a dental policy because they just cracked a tooth and know they’ll likely need a root canal and a crown soon. Another would be when a person whose cholesterol just went up increases the payout on a term life insurance policy. Adverse selection creates higher insurance costs. When only high-risk people have the insurance, they will likely file more claims, which uses up the money from premiums held by the insurance company. Rates must therefore be raised to cover the costs.

　　Cherry-picking. As a way to get around adverse selection, insurance companies may try to “cherry-pick” their customers. For example, they might try to insure only nonsmokers or young people or those with a clean driving record. Some auto insurers offer discounts to people who install safe-driving software on their phones. Some low-risk professions (such as the American Institute of Certified Public Accountants) offer life insurance only to their own members. In other cases, insurance companies raise prices or don’t even offer insurance to customers with very high risk, such as in hurricane zones in Florida or areas of California that are prone to wildfires.

　　Cherry-picking is seen by some as unethical, as it penalizes the most vulnerable people who actually need insurance. But on the other hand, for the customer with a very low risk of a claim, it seems unfair to pay for those who will be making significant claims. For example, residents in the Southeast who live inland—hundreds of miles from the coast—wouldn’t want their premiums to reflect the same level of storm risk as those who live right on the Atlantic.

　　Before the Affordable Care Act, health insurance companies could deny coverage to those with preexisting conditions. But that left millions of people vulnerable to catastrophic risks. Federal regulation has ended that practice to make sure that all U.S. citizens are eligible for medical insurance. Still, insurance is always a balancing act between premiums and claims.

　　The bottom lineThe first American insurance company was organized by Benjamin Franklin in 1752. Since then, insurance companies have tried to weather disasters ranging from the Great Chicago Fire in 1871 and the San Francisco earthquake of 1906 to Hurricane Katrina in 2005. Many insurance companies have gone under trying to pay out multiple simultaneous large claims.

　　By using underwriting, risk pooling, and investing their assets, as well as by following state regulations, insurance companies hope to be able to pay claims so that all insured customers are covered in case of loss.

　　If you’re at a high risk for a type of insurance, such as having cancer or having a poor driving record, expect to pay more for coverage. But it pays to shop around, as different companies may offer better values. Or become part of a group that will help spread the cost of insurance among other lower-risk customers.

　　If you’re one of those who pay premiums but rarely (or never) file claims, you may feel like you got the short end of the stick financially. But really, what you got was peace of mind. On the other side of the coin, someone may have paid a few thousand dollars in homeowner’s insurance, then their house caught on fire, causing $100,000 in damages. Did that person really “win” financially? No, not at all.