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PAGE ONE Economics


Insurance: Managing Risk and Balancing
Responsibility with Affordability
Kris Bertelsen, Senior Economic Education Specialist

Beneficiary: The person designated in the
policy to receive benefits.
Co-payment (co-pay): A set dollar amount
the customer pays, with the insurance
company paying the difference.
Coverage: How much risk or liability is
protected with an insurance policy.
Deductible: An amount you must pay for
expenses before the insurance company
pays. The deductible amount is specified
by the terms of the insurance policy.
Liability: Legal responsibility.
Permanent insurance: A policy that does
not expire until death, or age 100.
Premium: The fee paid for insurance
Probability: The likelihood or chance of an
event occurring.
Risk: The chance of loss.
Term insurance: A policy providing coverage for a specific time period, such as 10
years. When the policy term ends, the
insurance expires.

“I’ve never been able to skydive, and I’ve always wanted to. I’ve probably
done everything else, but for some reason the insurance company
won’t let me do it.”1
—Nick Cannon, rapper, comedian, entrepreneur, record producer

Have you ever wanted to go bungee jumping, hang gliding, or drive a
race car? How about skydiving? Nick Cannon would like to try skydiving,
but his insurance company doesn’t want him to take the risk. Why would
an insurance company be involved in Nick Cannon’s activities? The insurance company probably doesn’t care whether or not Nick Cannon performs stand-up comedy, so why object to skydiving? As you’ve probably
guessed, the difference is that skydiving is riskier than standing on a stage
being funny. Cannon would be putting himself—and his insurance company—at risk. He could get seriously injured—or worse—and the company
would have to pay hospital bills and maybe lost income, which, considering
Cannon’s income, could be very expensive. Nick Cannon probably carries
insurance just in case something bad happens, and a lot of other people
carry insurance for that same reason. Transferring risk, or the chance of loss,
is the main reason people buy insurance. When people buy insurance,
they pay fees, or premiums, to protect themselves in the event of an accident or other covered loss. Insurance differs from many goods and services
because people generally do not want to have to use their insurance
coverage; most people don’t want to get hurt bungee jumping. So, how
did insurance get started?

A Brief History of Insurance
Fear of loss provides a strong motivation for people to protect themselves
and their property. But accidents do happen, so insurance has existed in
some form since ancient times. In Babylonia during the eighteenth century
BC,2 the Code of Hammurabi included the first record of a form of insurance. While it wasn’t like today’s insurance, the Hammurabi Code provided
a debtor legal freedom from repayment of loans if extreme difficulties
prevented the borrower from repaying the debt. Examples of covered
events included disasters such as floods, the inability to work, or death.3

February 2017	

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PAGE ONE Economics®
In the Middle and Dark ages, tradespeople worked in
apprenticeships for little or no pay until they became
masters at their trade. As masters, they paid into organizations called guilds. In the event of a fire, robbery, death,
or disability, the guild would pay for the costs of rebuilding or providing for the family affected by the loss. This
arrangement of shared risk is the basis of group insurance,
which is still around today.4 Because many people pay
into a fund and individual losses are paid from the larger
pool of money, no single loss is as devastating to an
individual or the group. This spreading of risk provides
protection at a smaller cost to each individual or family
than covering the full cost of losses with their own savings.
Over time, insurance has become more sophisticated,
using a math called actuary science. The risk of a loss
caused by fire, tornado, death, or other catastrophic event
is based on its probability, or how likely it is to occur. In
the seventeenth century, Blaise Pascal, a mathematician,
physicist, and religious philosopher, worked with another
mathematician, Pierre de Fermat,5 and figured out how
to determine the probability that certain events would
occur. This meant insurers could make a reasonable
guess as to the likelihood they’d have to pay for specific
types of losses. The methods they used to calculate the
risk of certain events are used in modern-day underwriting and rate setting—that is, determining how much to
charge customers for different types of insurance.6

Types of Insurance
The ancient approach to managing losses by contributing to a group fund is very similar to today’s insurance
protection. Today, you can buy insurance coverage for
your most expensive possessions, such as cars, houses,
and businesses, as well as for your health and life.
Insurance is generally divided into two broad categories: life, health, and disability insurance and property
and casualty insurance. Property and casualty insurance
is for material items, such as houses and cars, and for
damage your actions might cause others.

Life Insurance
Life insurance is used primarily to replace the income of
a deceased person and pay for funeral expenses. Life
insurance can protect a family financially if the income
of the person who dies is essential to the family. For
example, if two parents each earn $50,000 per year and

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one dies, the family income is immediately cut in half.
That would mean that a family might have to cut up to
half of its spending. Many people buy life insurance to
protect their family from serious financial loss temporarily in the event of a death, giving the family time to adjust
financially. There are two basic types of life insurance,
term and permanent. Term insurance is a specified death
benefit amount purchased for a specific time period, say,
$50,000 for 10 years. If the insured person were to die
anytime within those 10 years, the insurance company
would pay $50,000 to the person’s beneficiary, the person designated in the policy to receive benefits. After
10 years, the insurance ends and there would be no
payment. There are many variations of term insurance,
however—for example, for 10-, 20-, and 30-year terms
or as an annually renewable term—among others.
Permanent insurance is purchased for a specified
amount, again, say $50,000, but it is priced so the policy
remains in force for the insured person’s entire life, up
to age 100. Per­manent insurance is likely to cost more
because a payout is certain (for those 99 years of age or
younger), but that is just one factor in the cost. For both
term and permanent insurance, several factors are considered in determining not only the cost but also whether
insurance will be granted in the first place. Underwriters
consider the applicant’s age and physical characteristics,
such as height and weight, heart rate, and blood pressure.
In addition, companies consider a person’s health history,
tobacco use, and other lifestyle choices. Remember probability? Underwriters will also consider the probability of
death at certain ages as the result of tobacco use, certain
health problems, or even jumping out of airplanes.

Health Insurance
If you broke your arm, would you have $2,500 to pay for
treatment? What if your injury were more serious? The
emergency room visit alone would cost over $1,000.7
Health insurance provides coverage to offset the costs
associated with injury and illness. When people purchase
insurance and pay premiums, the coverage usually provides for discounted payments for doctor visits, hospital
stays, and medical treatment. Many health insurance
policies have a co-payment (co-pay) for office visits.
Co-pays are a set dollar amount the customer pays before
the insurance company pays the difference. A typical
co-pay for an office visit costs $15 to $30, while the actu-

PAGE ONE Economics®
al charge for the office visit could be $120 to $150. In addition to co-pays, health insurance usually requires a
deductible, an amount you must pay for expenses
before the insurance company pays. The deductible
amount is specified by the terms of the insurance policy.
For example, if you have a $500 annual deductible, you
must pay the first $500 of medical expenses for that year.

Disability Insurance
Sometimes an injury that results in an emergency room
visit can also result in a long-term disability. If you couldn’t
work, what would you do for money? Disability insurance
(sometimes called disability income insurance) would
provide income in such a case. Again, there are many
variations, but policies typically have a 30-, 60-, or 90-day
waiting period before the policy starts paying. Disability
insurance usually replaces less than 100 percent of a
disabled person’s income and has a time limit for payment—a year, for example. However, disability insurance
can be the bridge that gets a person through a tough
time of no work and no income.

Property and Casualty Insurance
Home and Renter’s Insurance. Homeowners can transfer
risk to a larger group by buying insurance, just as guild
members did in the Middle Ages. In 2012, some people
lost their homes in Hurricane Sandy. Were you one of
them? Chances are you weren’t, but it could be that your
family’s insurance premiums contributed to the home
repairs of a Hurricane Sandy victim. The large repair bills
were paid by many people’s insurance premiums, so the
risk was spread among many. In the event of a loss, such
as a hurricane, fire, or tornado, insurance helps replace
structures and personal belongings without requiring the
homeowner to solely cover all of the expenses. Renters
can buy insurance for their personal property. Under­
writers evaluate properties, conditions, and applicants
to determine good and bad risks for insurance companies. When evaluating risk for a building, underwriters
look at the building’s location, when and how it was built,
the type of construction, its condition, and even how
close it is to a fire hydrant.
Auto Insurance. Chances are you know someone who
has been involved in a car accident or has had car damage
caused by fire, theft, or an errant tree limb. Once again,
insurance comes to the rescue. But, what if you, while

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Limits of Liability
Car insurance policies vary in terms of liability amounts—how
much the insurance company will pay on your behalf; these
amounts are referred to as limits of liability. For example, you
might see liability limits like these on a car insurance policy:
BI 100/300 PD100. The BI 100 means $100,000 per person and
the 300 means a maximum of $300,000 of bodily injury coverage
per accident. The PD100 means $100,000 in property damage
coverage. In this case, the insurance policy will pay no more
than $100,000 per person and no more than $300,000 in total
for injuries to all persons resulting from an accident. And the
insurance company won’t pay more than $100,000 to someone
else for property damage you caused. So, be particularly careful
when driving behind an Aston Martin because these cars are
expensive to repair. Anything over these amounts would be
your responsibility.

driving your car, cause damage to someone else’s property? Most states require liability insurance coverage on
motor vehicles. Liability means legal responsibility.
Liability coverage pays for the damage you cause—or
are responsible for—if you are at fault in an accident.
The minimum coverages and requirements vary slightly
from state to state, however, so make sure you understand your state’s laws. See the “Limits of Liability” boxed
insert for more on this important aspect of insurance.
A separate type of insurance pays for damage to your own
car from any covered event except a collision. Com­pre­
hensive coverage, called “comp” for short, includes fire,
theft, or that errant tree limb. Collision coverage applies
to damage caused by colliding with anything, such as
another car, a mailbox, or a street sign. Both comp and
collision coverage are voluntary and usually subject to a
deductible. For example, if you have a $1,000 deductible
for comp coverage, you must pay for the first $1,000 of
repairs before the company pays, per incident. If there is
a loan on the car, the bank will probably require comp
and collision coverage.

Insurance Agents and Websites
Insurance agents—and oftentimes, websites—serve as
the public face of an insurance company. Agents gather
potential client information during the application process. An applicant’s credit score is a key factor in whether
insurance is granted.
Young men typically pay more for insurance than women.
Statistically, they get more tickets for speeding and reck-

PAGE ONE Economics®
Factors Considered for Car Insurance
Car insurers study a number of factors before accepting an applicant. Motor vehicle reports, school grades, and the type of car you
drive are also considered.* In addition, applicants answer questions such as the following:

•	 How old are you?
•	 Are you married?
•	 How many miles do you drive in a year?
•	 Have you had any at-fault accidents or speeding tickets in the 	
	 past five years?

•	 Has your license ever been revoked or suspended?
•	 What type of car do you drive?
•	 Are there any other drivers in your household?
*Watch the St. Louis Fed’s Economic Education website for two new
No-Frills Money Skills videos to come soon (

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usually inexpensive and will help replace your personal
possessions in the event of a loss. When considering car,
homeowner’s, or renter’s insurance, check the price of
the coverage at various deductibles. The lower the deductible, the higher the monthly or annual premium will be.
If you plan well and have savings to cover a higher deductible in the event of a loss, you can save money with lower
premiums. If you work—or when you start—make sure
you understand what benefits your employer provides
and coordinate your health, life, and disability insurance
with those benefits. It’s important to find a good balance
between having enough insurance to protect yourself,
your assets, and your family, but not more than you can
afford. n


“Insurance Quotes.”

less driving and they tend to engage in riskier behaviors.
Young men also have more expensive accidents and
make the most insurance claims. So, until age 25, male
drivers pay much higher rates. In general, though, insurance rates decrease as drivers grow older if they don’t
have accidents or traffic tickets. Also, some insurance
companies even offer a good student discount for students with a “B” average or above, so it pays to keep your
grades up.

Andrews, Evan. “8 Things You May Not Know About Hammurabi’s Code.”
December 17, 2013;

Beatie, Andrew. “The History of Insurance.” September 20, 2014;

Beatie, Andrew. “The History of Insurance.” September 20, 2014;

“Blaise Pascal Biography.” website, November 19, 2015;

Beatie, Andrew. “The History of Insurance.” September 20, 2014;

Managing Risk in Your Life with Insurance
With all the insurance options available, you may feel
overwhelmed just thinking about it! Buying insurance
involves important decisions, but it can be done using
logic and cost-benefit analysis. Some insurance is mandatory, like car liability insurance. If you buy a house and
have a mortgage, the bank will require insurance, too,
but some insurance simply makes sense for people to
have…just in case. Renter’s insurance, for example, is


Kliff, Sarah. “An Average ER Visit Costs More than an Average Month’s Rent.”
Wonkblog (blog), Washington Post, March 2, 2013;

Please visit our website and archives for more information and resources.
© 2017, Federal Reserve Bank of St. Louis. Views expressed do not necessarily reflect official positions of the Federal Reserve System.

PAGE ONE Economics®

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Name___________________________________ Period_______
Federal Reserve Bank of St. Louis Page One Economics ®:

“Insurance: Managing Risk and Balancing Responsibility with Affordability”
After reading the article, answer the following questions:
1.	 Why would an insurance company want people to avoid risk, like Nick Cannon having to avoid skydiving?

2.	 What is the primary reason people buy insurance?

3.	 Explain why the Code of Hammurabi is considered the first written form of insurance.

4.	 Summarize how guilds were similar to modern-day insurance.

5.	 How did Blaise Pascal’s and Pierre de Fermat’s introduction of probability change insurance?

PAGE ONE Economics®

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6.	 Why do underwriters consider the applicant’s age and physical characteristics, such as height and weight,
	 heart rate, and blood pressure, for life and health insurance?

7.	 Fill in the blanks using the following terms:

Permanent insurance






Term insurance

People often buy insurance to transfer ________________. When people buy insurance, they pay ________________
for the ________________. For most types of insurance, the company does not pay 100 percent of the loss. For
instance, health insurance often requires a ________________ for office visits, and auto and home policies usually
have a ________________. Life insurance doesn’t require a deductible from the person(s) designated to receive the
money, also known as the ________________. There are two basic types of life insurance. Insurance lasting until age
100, ________________, never expires, but ________________ is for a set time period.
8.	 List three questions applicants may have to answer when applying for car insurance.

9.	 Explain what BI 100/300 PD100 means.

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10.	 List what each of the following policy sections pays for:




11.	 Complete the following sentences:

The ________________ the potential for loss, the higher the premium. The higher the deductible, the 			


________________ the premium.

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