Questions: Insurance Principles and Types

Question 1

You are choosing between two auto insurance plans with identical coverage. Plan A has a $500 deductible and costs $1,200/year. Plan B has a $2,000 deductible and costs $800/year. What is the break-even point — how many years of Plan B savings does it take to offset the higher deductible if you make one claim?

• A. 1.5 years
• B. 3.75 years
• C. 4 years
• D. You always come out ahead with the lower deductible

Answer: (B)

Plan B saves $400/year in premiums but exposes you to $1,500 more deductible ($2,000 - $500). Break-even = $1,500 ÷ $400 = 3.75 years. If you go more than 3.75 years without a claim, Plan B saves money overall. This calculation reveals that the 'safer' lower-deductible plan is often more expensive for people who rarely file claims.

Question 2

You should buy insurance for most possible risk in your life to ensure you are fully financially protected.

• T. True
• F. False

Answer: False

Insurance is most valuable for catastrophic, low-probability losses you cannot self-fund — a house fire, a serious illness, a major car accident. For small, predictable expenses, paying out of pocket (self-insuring) is typically cheaper because insurance premiums must cover administrative costs and profit on top of the expected payout. Insuring every small risk is an inefficient use of money.

Question 3

Explain why insurance is most valuable for catastrophic risks but often poor value for small, predictable expenses.

Model answer: Insurance pools risk across many people; the insurer charges premiums that cover expected payouts plus operating costs and profit. For small, predictable expenses, you pay more in premiums than the expected loss, making it cheaper to pay out of pocket. Catastrophic losses, however, are unaffordable without pooling — that's where insurance provides irreplaceable value.

An extended warranty on a $50 appliance is almost always poor value: you're paying an insurer's overhead and profit margin for a small, predictable risk. But health insurance or homeowners insurance covers events that could cost tens of thousands of dollars — losses that would be financially devastating without pooling. The emergency fund concept from personal budgeting covers the 'self-insure small risks' side of this equation.