Why do insurance companies make money and how do they work?

What is insurance? 

What is insurance? Generally, it is a risk mitigation relationship between an insured party and an insurer. The insured party is the individual who is protected. 

They are mitigating the risk of suffering,some sort of costs, damages, liability, etcetera, based on a specific type of occurrence. An insurer is the individual willing to or accepting responsibility for indemnifying or holding the insured harmless in the event that a certain occurrence occurs. 

So insurance comes back in any number of contexts or situations but there are a couple of key concepts that you need to understand there. To start with, the concept of risk mitigation and the purpose of insurance in that way, and then the protected individual, the insured and then the individual doing the protecting that is the individual mitigating the risk for the insured being the insurer. 

Other than that, you need to understand the value that is exchanged there. The insured will pay premiums to the insurer,that is any form of value to the insurer in exchange for that insurer promising to indemnify against, hold harmless or cover any costs, damages, etcetera associated with a specific type of occurrence. And this is memorialized in an insurance contractor’s insurance policy. Now, the key characteristics of that insurance contract or policy are the potential risks that are covered and the limits of coverage. 

So the policy will identify a specific type of risk. It can be the occurrence of any number of types of events but it will specifically identify a range of coverage of specific contingencies,things that could arise at some point in the future. After that, the extent to which it will cover,indemnify or pay for any resulting damages suffered by the insured in the event that that occurrence comes about. Now, just to give you some examples of some occurrences, it could be that you wreck your vehicle. It could be that you suffer some kind of a health ailment. 

So the policy provides coverage for any payment for costs incurred for the treatment of that. It could be a policy in the event you commit professional malpractice. It could be a policy that prevents damage to property. All of these are contingent events that could potentially arise in the future. If they did, it would cause some form of risk of harm so the insurer and the insured enter into this relationship. In the event this comes about, the insurer will again pay or hold the insurer harmless up to a certain amount, the limits of coverage. As long as you have these key concepts then this is the basis for what is insurance and the insurance relationship.

What is insurance?
Image by Gerd Altmann from Pixabay

Why do insurance companies make money and how do they work? 

Well some of us may think that there’s nothing more boring than attending an insurance conference on a wet Tuesday night in Boston. And we may well be right, but if we look back to see how the industry began, it isn’t as dull as it might first appear. 

From swashbuckling pirates to a ferocious fire that ravaged the world’s greatest city, insurance has had a colorful past. But how do those grey suits who sell insurance really make money, and how do the inner workings of one of the most complicated fiscal models really work? If these questions whet your curiosity, then stay tuned to today’s episode of the The Infographics Show 

  1. Why do insurance companies make money and how do they work? 
  2. What is insurance? 

Well, insurance is a financial vehicle that helps spread risk. By taking a risk from an individual, and spreading that risk around a community, the individual is able to go about their personal or business life without crumbling from financial ruin. In the simplest terms, let’s look at two people. One is named Bob and the other Jim. Bob says to Jim, I’ll give you ten dollars,but if I lose my cell phone, you’ll have to buy me a new one. If Jim agrees, then that’s insurance right there.

Insurance companies make money because they evaluate the risk and decide whether it is worth the gamble. Jim believes that Bob probably won’t lose his phone and he’ll therefore be ten dollars richer. If Jim finds 100 more people who are willing to give him 10 bucks each to cover their phones, he has 1,000 dollars. If one of those 100 people loses their phone and Jim pays 100 dollars as compensation, he still has 900 bucks. 

This insurance idea has been floating around since the ancient Chinese and the Babylonians spread their shipping risks. But it wasn’t until around the 17th century in London that modern insurance really took off. Merchant marine men and traders often hang out in coffee shops in the business district of London, and while drinking copious amounts of coffee, the idea of modern day insurance was born. 

Lloyds of London, the heart of worldwide insurance,was developed inside one of these coffee houses and here’s how it worked. First, you have the client. Say the client has a ship that he is nervous about losing to pirates offshore, or perhaps the vessel will be destroyed in bad weather. The client approaches an insurance broker. The broker looks at the ship, or pays someone to look at the ship, and they decide how much the total value of that ship is worth. 

The broker then assesses the risk. He asks the client where he is traveling to and what cargo he will be carrying. With all this information, he draws up an insurance policy which he shows to the third person in the chain – the underwriter. For a cheaper premium, the underwriter may exclude a few risks. And for a few more bucks, he may include some extra risks.

Now there are normally lots of underwriters approached, but one will be the lead, and the lead underwriter, like Jim, will normallytake the largest proportion of the risk and sign his name first on the policy document. He is known as the underwriter, as he writes his name under the risk on the insurance policy.

The lead underwriter makes the major decisions when it comes to accepting the policy, and will be the main man to agree to any claims on the policy. Once the terms of the policy are agreed to,it is made legal, and the client is happy and the ship sets sail – but not before paying the insurance premium to the broker, who will take about 10%, and pass the rest on to the underwriter.

But what should happen if pirates board the ship, steal the cargo, and burn it at sea? Well, the client (if he is still alive, ifnot, a representative of the client) will speak to the insurance broker and the broker will visit with the lead underwriter and tell him the bad news. The rest of the underwriters (there may well be as many as 20 on a big policy) are told the news and then the broker must negotiate the best claim settlement for the client or his or her representatives. 

The underwriters pay the money to the broker,who passes it on to the client, without deducting any cut. The broker makes his money once the premiums are paid, and will help negotiate the best claims for his clients through gentlemanly honor and the prospect of future business. Now it may not be all bad news for the Underwriter. If he is wise and not greedy, he may have insured the policy. Reinsurance puts the underwriter in the position of the client. 

The underwriter sells the policy onto another underwriter or firm of underwriters, while retaining a share of the premium. Confused yet? Think back to Jim and his phone insurance. If Jim resold his 10 dollar phone policy for9 dollars, rather than the 10 he received, then he gets to keep a dollar each for each of his 100 clients, meaning he has 100 dollars completely risk free. Similarly, much of the modern day insurance that flows through Lloyds of London is reinsured out of the building to smaller insurance companies all across the world.

So what starts as a simple agreement between the client and the broker (or Jim and Bob) is spread across a business community whoeach stand to profit from the premium or take a cut of any losses. This is how insurance works – by the spreading of risk over communities. So that is how maritime insurance was born. It was developed through the need of ship-owners to carry on in business should they lose everything whilst at sea.

But what about property insurance? Well around the same time, 1666, the great fire of London devastated the city where modern day insurance was born, and famous architectSir Christopher Wren, in his great London redevelopment project in 1667, made sure to include an insurance office in his new plan. Now property insurance is commonplace with most homeowners having a policy in place. 

Also medical, life, travel, car, and dental insurance are all commonly held policies. Even pet insurance is a major insurance business nowadays. Over time the business model has evolved. Modern day insurance companies are fiercely competitive, which is good for you, the client, as policies are priced at their lowest possible point. Companies now look to write as many policesas possible to create a financial pool. 

They take the premium from thousands of policies,and invest that money in another financial product. So the insurance underwriter may pay out more claims than they make in policy premiums. But they have invested all those premiums in a high interest investment scheme, so they make their money outside of the original insurance product. Insurance in this example is a way of creating cash flow to be used in more lucrative investments.

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