When you look at your insurance policy you may think that the concept of insurance is hard one to understand. But just because your policy documents have a lot of pages and seemingly sophisticated terminology, that doesn’t mean that insurance is a difficult concept to grasp.
In order to have a general understanding of how insurance works, you need to understand four major concepts: Risk pooling, Underwriting, Indemnification and Policy reserves.
Insurance Part 1: Risk Pooling
The most fundamental concept governing the success of insurance is risk pooling. When you pool risks, you spread them out into a large pool of people. For instance, let’s say everyone in your neighborhood puts a dollar into a jar in order to pay for the injuries of the next person who trips on the sidewalk. If your neighborhood has 50 different people living in it, you will collect $50. You can probably assume that all 50 people are not going to trip over the sidewalk, but it’s certainly possible that about one or two out of the group will. The $50 you collected would never pay for the injuries of all 50 people, but it could pay for the bandages, ointments, etc. of the one or two that do. So by spreading the risk into this large pool of individuals and collecting money from each, you reduce the impact of the event on the person it actually happens to.
The same can be said for insurance. Not every policyholder will have claims, and not every policyholder will have a claim that is as costly as another—but ever policyholder will pay a premium. This protects the insurance company from having more claims than they do resources to pay for them.
Insurance Part 2: Underwriting
Before you get a policy, the amount of risk you present to the insurer must be determined. This process is called underwriting and during this time, you will be asked to submit information to the insurer that helps them determine your individual risk. The information you must submit will vary depending on the type of insurance you are applying for.
Underwriters have some leeway when evaluating your application for coverage. If you present standard risk, they can charge you standard premiums. But if you are exposed to more risk than other people in your situation they can charge you additional premiums either through permanent premium charges or temporary “extras.” Temporary extras are usually used when you are doing something that will only last temporarily, and will stop being as risky over time—like aviation lessons. Likewise, if you offer less risk than others in your group then the insurance company can charge you less than a standard premium.
Insurance Part 3: Indemnification
If it weren’t for the protection aspect of insurance, no one would buy it. So the third concept that is vital to insurance is the indemnity, or protection, it offers policyholders. As a policyholder, you are assured to receive coverage for insurable events based on the terms and conditions of your policy. Your end of the bargain is simply to pay your premium on time and keep up with any preventative maintenance that you can in order to prevent insurable incidents from occurring.
But indemnification isn’t about creating a profit for the policyholder, it is about making them whole. So no matter what kind of insurable damage you suffer or what property is damaged or ruined, the policyholder will only receive enough compensation to make them whole and return them to the “place” they were before the event.
Insurance Part 4: Policy Reserves
Insurance companies do a lot of different things with the premiums they receive from policyholders. They use them to pay commissions, pay staff payroll, office overhead, advertising, and many other expenses. In order to ensure that insurers do not overspend and leave their bank accounts empty of money for the claims they are obligated to pay, insurance companies are required to set aside a certain amount of premiums into policy reserves. Policy reserves are determined based on the likely claims that the insurer will have based on actuarial determinations and past experience. Insurers can also factor in future premium payments and interest earnings to the total amount that they set aside.
And that, in a nutshell, is how insurance works. While there are other terms and processes that you can explore to help broaden your understanding of this valuable and necessary product, these four concepts are the heart and soul of the insurance industry and all you really need to get by.