How Do Insurance Companies Make Money and How Do They Work
How 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 – 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?
The underwriters pay the money to the broker, who passes it on to the client, without deducting any cut. 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.
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?
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. 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.