How Do Insurance Companies Make Money
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| How Do Insurance Companies Make Money |
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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 Infographics Show – Why do insurance companies make money and how do
they work?
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 hung 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 normally take the largest proportion of the risk and sign his name
first on the policy document.
He is known as the underwriter, as he writers 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, if not, 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
premium is 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
reinsured 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 for 9 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 who each 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 architect Sir
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 polices are
priced at their lowest possible point. Companies now look to write as many
polices as 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.
Do you have insurance to protect against the unexpected?
Do insurance companies charge too much?
Is it all just a scam? Let us know your thoughts in the comments! Also, be
sure to check out our other video called US Teachers vs UK Teachers! Thanks
for watching, and, as always, don’t forget to like, share, and
subscribe.
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