Personal Finance Chapter 8

Personal Finance Chapter 8 - baj01275_c08_190-217 02:08am...

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Starting Point Go to to assess your knowledge of insuring your home and automobile. Determine where you need to concentrate your effort. What You’ll Learn in This Chapter Homeowner’s policies Insurance claims and features Auto insurance After Studying This Chapter, You’ll Be Able To Analyze how insurance works Assess your homeowner’s or renter’s property and liability risk exposures Select the right homeowner’s or renter’s insurance for you Compare your automobile insurance coverage requirements, options, and costs File claims for homeowner’s or auto insurance 8 INSURING YOUR HOME AND AUTOMOBILE Managing Risk baj01275_c08_190-217 2/09/07 02:08am Page 190
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8.1 HOW INSURANCE WORKS 191 INTRODUCTION Personal financial planning is all about risk management. Modern life is full of risks. Your house might be hit by lightning, or you might be the victim of a drunk driver. As many people learned in the stock market downturn of the early twenty-first century, you are also exposed to the risk of financial loss through your investments. When you buy insurance, you’re paying a company to reim- burse you for losses. You should shop around for both auto and homeowner’s insurance, and you need to understand your risks. 8.1 How Insurance Works Insurance companies are financial institutions that provide a valuable risk- spreading service by pooling premium dollars and using the money to pay losses incurred by policyholders during the policy period. In this section, we examine risk pooling and other basic insurance principles. 8.1.1 Risk Pooling and Insurance The concept of risk pooling is based on the law of large numbers, which holds that, for large pools of identical risks, the risk that actual losses per person will be greater than predicted decreases as the size of the pool increases. To better understand how an insurance pool works, consider a group of 1,000 homeowners, all in different cities in the United States. Each owns a home worth $150,000. Let’s assume that each homeowner has the same risk of having his or her home destroyed by a fire: 1 in 1,000. On average, then, we can expect that 1 of these 1,000 homeowners will suffer the devastating loss of a home in the coming year. Now suppose all the homeowners got together at the beginning of the year, and each contributed an amount of money equal to his or her share of the pool’s total expected loss of $150,000 (the value of one home). The cost to each would be only $150 ($150,000/1,000 5 $150 per home). Then, at the end of the year, the person who experienced the loss could collect the money from the pool. If, however, two houses happened to burn down that year, the pool would not have enough funds to cover the $300,000 total loss. In that case, we could go back to the pool members and ask each of them to chip in another $150. Do you think everyone would pay up? Suppose, instead, that the pool is even larger, perhaps 100,000 homeowners
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Personal Finance Chapter 8 - baj01275_c08_190-217 02:08am...

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