The problem with your explanation lies in the way companies calculate the cost of insurance. They do not base it solely on the nominal value of potential losses; instead, they account for the real value. For instance, if there’s a potential loss of $1,000, insurance companies calculate the cost by considering its real value, including factors like the money they’ll collect and invest over time, leveraging the compounding effect. As a result, compounding does not make insurance profitable for the insured in the long run.
When evaluating insurance, the key factor to consider is the expected value of your money. No matter how you calculate it, the expected value of your money when you use insurance will always be lower than if you didn’t use it. This is because insurance is inherently a financial product designed to profit the company offering it.
However, insurance remains logical for most people because the potential impact of losing all their money—or falling into significant debt—goes far beyond the nominal value of the loss. This is due to the fact that money’s value isn’t constant; its impact on a person’s life depends on their financial situation. For someone with limited resources, losing $100 has a much greater effect on their quality of life than it would for a wealthy individual.
This disparity is why it often makes sense for an average person to insure against significant damages, even if insurance is, technically speaking, a financial loss in the long term. For individuals with smaller financial reserves, the potential damage from a significant loss outweighs the cost of insurance. Meanwhile, the insurance company is able to absorb and spread that risk across a large pool of clients, which minimizes the impact of any individual claim.
The problem with your explanation lies in the way companies calculate the cost of insurance. They do not base it solely on the nominal value of potential losses; instead, they account for the real value. For instance, if there’s a potential loss of $1,000, insurance companies calculate the cost by considering its real value, including factors like the money they’ll collect and invest over time, leveraging the compounding effect. As a result, compounding does not make insurance profitable for the insured in the long run.
When evaluating insurance, the key factor to consider is the expected value of your money. No matter how you calculate it, the expected value of your money when you use insurance will always be lower than if you didn’t use it. This is because insurance is inherently a financial product designed to profit the company offering it.
However, insurance remains logical for most people because the potential impact of losing all their money—or falling into significant debt—goes far beyond the nominal value of the loss. This is due to the fact that money’s value isn’t constant; its impact on a person’s life depends on their financial situation. For someone with limited resources, losing $100 has a much greater effect on their quality of life than it would for a wealthy individual.
This disparity is why it often makes sense for an average person to insure against significant damages, even if insurance is, technically speaking, a financial loss in the long term. For individuals with smaller financial reserves, the potential damage from a significant loss outweighs the cost of insurance. Meanwhile, the insurance company is able to absorb and spread that risk across a large pool of clients, which minimizes the impact of any individual claim.