How Insurance Works

How Insurance Works

              Insurance is a form of risk management. Its purpose is to guard against catastrophic monetary losses that policy holders could not cover themselves. Insurance became popularized in this country by Benjamin Franklin. He founded an insurance company and sold policies to protect homes in the case of fire.
              Benjamin Franklin’s company sold fire insurance to individuals. The individuals paid premiums to the insurance company which in turn invests the premiums. If one of the policy holder’s houses burnt down then they would be reimbursed so that they could rebuild their house. The individuals who bought insurance from Franklin had a pooled risk.
Pooled risk is when each individual has a relatively low likelihood of having a catastrophic loss (in this case their house burning down). But if that rare catastrophic loss does happen to them, it would ruin them financially. Therefore individuals pay premiums to insurance companies to guard against catastrophic losses. Insurance companies calculate out the relative risk of catastrophe and set premiums (which they invest) to a level that would allow them to pay out for catastrophes. If insurance companies set their premiums too low they go bankrupt; too high and people will shop elsewhere.
Of course there are other factors that make insurance more complicated. There is the fact that not everyone’s risk is equal. Most everyone is aware of this in how it pertains to auto-insurance. A forty year old safe driver pays much less in premiums for the same insurance that a sixteen year old new driver needs to pay. Why is this? It’s about relative risk. Statistically the sixteen year old is far more likely to be in an accident than the forty year old. Therefore the insurance company needs to increase its rates to cover against future losses.
Think about it this way. If there are two insurance companies All-State and State Farm. All-State is only allowed to cover new drivers ages 16-20, while State Farm is only allowed to insure people ages 30-45 who have never been in an accident. Which insurance company is going to be paying more money out? Which group is going to have more accidents? It’s obvious. This is the reason insurance premiums vary so much between individuals, because risk varies.
This sort of risk management is less obvious in all cases, but it has been around as long as insurance has been. For the simple fact that insurance can not exist without it. Benjamin Franklin refused to sell fire insurance to houses that were made purely of wood. He deemed that risk was too high, so refused to cover them. This process of assessing risk to determine premiums (or whether an insurance company will cover someone) is called insurance underwriting.
It is important to have a solid understanding of insurance underwriting to understand the health care crisis in the United States. Insurance underwriting is simplest to understand when thinking about driving records and insurance premiums for automobiles.
It is also important to recognize the benefits of insurance for the economy as a whole. Insurance offers a tremendous benefit to society because it prevents bankruptcies to individuals who suffer from rare events like having their houses catch fire. Instead of having every person whose house catches fire go bankrupt, people don’t have to. In that way everybody wins. It may not seem like the people who pay premiums but don’t get a pay out from the insurance company wins, but they do as well
The economy as a whole does a lot better without having its citizen’s crash into bankruptcy. If there was no insurance for anything, the risk of bankruptcy would be very real for everyone. This would cause people to spend less, and be far more fiscally conservative because we would need to save up for a rainy day.