All the terms about drive a person mad: perils, premiums, hazards, losses and limits. There seems no end to it, and what does it all mean? Well, insurance always boils down to a very basic idea. It is a mechanism to mitigate the negative outcomes of low frequency but high consequence events.

One might think, glad we got that cleared up...

Well, let's look at a very basic insurance mechanism, the spare tire. The infrequent, yet high consequence, event is having a flat tire. That is the peril, or the insured risk. Hazards are the things that increase the chance of a loss. The nail in the roadway for example. The loss, in this case being a flat. Everyone knows the consequences of the loss. The vehicle is no longer usable. The insurance mechanism is the spare tire, and the limit of coverage is one flat per occurrence. The premium is the portion of the purchase price of the vehicle needed to pay for the spare tire.

A far more serious example would be the RMS Titanic. The insurance mechanism was the lifeboats. The peril was the ship sinking. The hazard that did cause the loss was the iceberg. The number of lifeboats was the coverage limit. The premium was the cost that the lifeboats added to the cost of building the ship.

The Titanic hit an iceberg and sank. The consequence of the loss was the death of many of the passengers because the limit of coverage, the number of lifeboats, was not enough to cover the loss. Yet many people did survive the event because the lifeboats mitigated the loss.

So, what does this "insurance" do for us? Well, what insurance does is give people the confidence to do big things in spite of the risks and perils that they face. Whether it is taking out a car loan or loaning money to build a factory, none of these things could happen without the security that insurance provides should the unexpected and the tragic happen.

After all, who would drive to Disneyland without a spare in the trunk?