How does Insurance work?

You need insurance because of the existence of various kinds of risks in your day-to-day life. You could easily suffer a financial loss as a result of fire, bad weather, a car accident, the burglary in your house or a thousand other factors. Risk is present in every aspect of our lives whether you are sitting at home, walking on the road or driving a car. Insurance can do nothing to prevent these things happening but what it can do is to transfer some or all of the financial implications to the shoulders of somebody else namely the insurer. Insurance can offer protection against the financial consequences of risks because it pools the resources of a large number of people (the insurance premiums) in order to pay for the losses of a few. Insurance has been around for many years and dates back to the inception of active trading and traders traveling outside their home countries.

In fact, in many ways, insurance and gambling operate on the same principles. You are risking a little money upfront in the expectation that you may need a large payoff at some time in the future. The major difference is that gamblers are seeking risk in a quest for more money while you are paying a small sum to reduce your risk. Gambling casinos and insurance companies alike work on the statistical principle called the Law of Large Numbers. The law says that the more you have of something, the more the characteristics of what you have to tend to average. In other words, the more people who spin the roulette wheel or throw the dice at the casino, the more accurately the losses and gains can be predicted. The more the people in a particular kind of insurance coverage, the more accurately the insurance company can predict its gains and losses and set its premiums accordingly.

The premium that each member of a pool of policyholders has to pay is determined by a number of factors. For instance, a major factor in the determination of the premium for life and health insurance is age. The statistical data shows that younger people are likely to make fewer claims than people who are older and therefore pay lower premiums. In the case of car insurance, the factors determining the premium are age, gender location and driving history. The statistics show that younger people tend to be involved in more accidents than older people and therefore have to pay a higher premium.

Let us take an example that illustrates these principles of insurance. If 100,000 people pay $1000 each for medical insurance, the insurance company will receive $100 million in premiums. If they have to pay 5000 people $10,000 each, they would have paid out $50 million from the pool and still have $50 million left over for future claims. It follows that for an insurance company to trade profitably and viably, these are the prerequisites:

  • a large pool of insurance policyholders who have very diverse demographics (age, gender, occupation, location and so on)
  • a reliable database of statistics and historical data about the likelihood of having to pay out for losses on each type of cover
  • premiums set in such a fashion that losses are covered with a reasonable surplus left over.

Leave a Reply

Your email address will not be published. Required fields are marked *