To begin, let me define what insurance should be. Insurance, by definition, should be an inexpensive way to spread the risk of a financial catastrophe among a group of policy holders. For example lets say that there is a 1 in 5000 chance that a worker in a ball bearing factory will lose an arm in the machinery every year. In the country’s 22 ball bearing factories there are 50,000 workers.

Now, if a worker loses an arm, he will have medical costs that will covered by workers compensation insurance. But to go through the rehabilitation and be retrained he will need to pay for retraining and he will need to have some income. It has been estimated that the typical cost for this process is approximately $50,000.00.

You don’t have to be a mathematical genius to see that individual workers who are making an average of $35,000.00 a year will most likely no be able to accumulate the $50,000.00 necessary to make it through that year. So, ABC Insurance company decides to write a policy that will pay out $50,000.00 in the event that a worker loses his arm on the job. The company signs up all 50,000.00 workers in the U.S. for this policy. The reason is simple; all the workers can see that the risk is high enough and the cost of $2.50 per month is reasonable enough to have that $50,000.00 benefit waiting for them if they are one of the unfortunate ten in the upcoming year. This is a simple risk/cost/benefit analysis that people should understand every time they purchase insurance.

The arithmetic works this way. 50,000 workers pay $30.00 per year. This means that there is total revenue to the insurance company of $1.5 million. Out of this revenue insurance company must pay commission for the agents who sold the policies. There are also come overhead costs to keep the lights and the heat on and to pay claims personnel, and salaries for actuaries as well as all of the other people at the insurance company. They too have a business to run. Let’s say that cost is $500,000.00. That means that there is a pool of money from which to pay claims of $1 million. The average over the past few years has been that ten people out of the 50,000 who will lose an arm. So if everything goes according to the table, the insurance company will make $500,000.00 in profit. If however, 20 people file claims there is no profit. If 15 people lose arms there is a profit of $250,000.00.

Since the insurance company assumes the risk here, they are entitles to the profit, that is, if all parties agree that the premium is fair and the amount paid out for a claim is fair. In the free market system that is how things work. An product has a price that enough consumers are willing to pay to receive the benefit of that product, while the company producing the product is entitled to the profit from creating a product that serves a need, works and is priced so that people believe the benefit of having the product is worth the price.

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