Probability is something we have to deal with in our everyday lives. We deal with it with regards to our health, the weather and, it's a very big part of what we do in investment management.
So what is probability? Simply put, it's the likelihood that a specific event will occur. In order to calculate probability, the formula is to divide the specific outcome you are looking for by the total number of possible outcomes. For example, if you flip a coin you could get a head or you could get a tail: those are the two possible outcomes. If you want to consider the chance of flipping a head as your desired outcome your chance is 1 out of 2, or, 50 percent. Everybody knows this intuitively but it's important to look at how does that figure into some of these other aspects of our daily lives which are filled with uncertainty. If you think about something that has absolutely no chance of happening you would have a 0 percent probability, and anything that is actually guaranteed to happen would be 100 percent.
In reality, there are not too many things in life that are 100 percent guaranteed, but there definitely are some. In this post we are going to look at situations that are a little bit more uncertain and look at things in everyday life that depend on probability. One example of this would be life insurance. There are different types of life insurance: term insurance which is a temporary insurance or, permanent insurance.
If anybody out there has gone to look for life insurance when they're 30 or 35 years old, for example, they would find that it is typically inexpensive. And why would it be inexpensive? Well, because the life insurance companies know that at age 30 or 35, there is a relatively small risk of dying. However, that doesn't mean that people don't die at age 30 or 35, it just means that on an individual basis, there's a relatively low chance of that happening. The insurance companies look at the 30-35 year olds that they are going to provide insurance to and they know what percentage of that population will die approximately and they can price their premiums accordingly.
When your family is young and the risk of dying, even though it's small, if it were to happen, it could have a big impact on your family because they would have to replace the lost income that you would have had as well as your income potential for the next 30 years or so. The probability of them replacing that income if you died is zero percent if you don't have insurance. As a person who needs insurance at a young age, the insurance companies can offer you a very good premium because the likelihood of your dying at that age is low. So it kind of works for everybody and it's just a form of risk management. It's not that you're expecting to die, but you could.
Now, the other side of that there is also permanent insurance which comes in different forms. Generally it is referred to as "Term to 100", which basically means you have insurance for as long as you are alive. Or it can be whole life or universal insurance, but the bottom line is with permanent insurance, the insurance company knows that you will die and they will payout on your policy. And so for that reason, the pricing is a lot different on permanent insurance because the insurance company has to be able to recoup all of the costs that they are going to pay out over time through your premiums. That's why when you buy permanent insurance, which basically says "my beneficiaries will get the money when I die", will tend to be a lot more expensive. Insurance is a case where probability is such an extremely important part of the business as a whole.
Stay happy, stay safe, stay well!
The CM Group