An insurance company is defined as a business that provides its clients with financial protection in case of an accident or an unforeseen event, such as the loss or damage of something. Our homes, our cars, our businesses, even our lives can be insured. But have you ever really stopped to think about how insurance actually functions?
In order for insurance to work properly, an insurance company needs to have many clients. Those clients pay insurance premiums for financial protection from accidents and unforseen events. The premiums paid by all clients are “pooled” together. When one of the clients suffers a loss, he/she can submit a claim to the insurance company: a request for compensation for losses incurred. If the incurred loss was indeed insurable and covered in the client’s policy, the insurance company withdraws money from the collective “pool” and uses it to reimburse the client. In this way, all clients are essentially “sharing” the risk together.
The success of insurance companies depends on balancing the amount of premiums customers have to pay with the number of claims they expect, since premiums are both the income of the company and the source of the pool which serves to protect clients. In other words, the company must collect more in premiums (and financial investments) than it gives away in reimbursements. To this effect, insurers utilise actuarial science – meaning they set their prices based on a multitude of factors, such as the probability of various accidents and/or events and how much money on average it takes to settle claims relating to those events.
To help make the clients’ claims more manageable, there are even insurers for insurers. This concept is called reinsurance. To sign up for reinsurance, insurance companies pay out part of the premiums they receive to another company. In exchange, the reinsurance company agrees to reimburse part of the money the insurance company pays out to its customers.
All in all, insurance is not as simple as it may seem!
For more information on the topic, please consult the website of the Insurance Council of Australia.
Source: CGU Insurance Blog