Insurance Explained, How do insurance Companies Make money..?
Some of us may think that there’s nothingmore boring than attending an insurance conference on a wet Tuesday night in Boston. And we may well be right, but if we look backto see how the industry began, it isn’t as dull as it might first appear. From swashbuckling pirates to a ferociousfire that ravaged the world’s greatest city, insurance has had a colorful past. But how do those grey suits who sell insurancereally make money, and how do the inner workings of one of the most complicated fiscal modelsreally work? If these questions whet your curiosity, thenstay tuned to today’s episode of the The Infographics Show – Why do insurance companiesmake money and how do they work? What is insurance? Well, insurance is a financial vehicle thathelps spread risk. By taking a risk from an individual, and spreadingthat risk around a community, the individual is able to go about their personal or businesslife 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 rightthere. Insurance companies make money because theyevaluate the risk and decide whether it is worth the gamble. Jim believes that Bob probably won’t losehis phone and he’ll therefore be ten dollars richer. If Jim finds 100 more people who are willingto give him 10 bucks each to cover their phones, he has 1,000 dollars. If one of those 100 people loses their phoneand Jim pays 100 dollars as compensation, he still has 900 bucks. This insurance idea has been floating aroundsince the ancient Chinese and the Babylonians spread their shipping risks. But it wasn’t until around the 17th centuryin London that modern insurance really took off. Merchant marine men and traders often hungout in coffee shops in the business district of London, and while drinking copious amountsof 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 nervousabout 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 someoneto 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 toand what cargo he will be carrying. With all this information, he draws up aninsurance policy which he shows to the third person in the chain - the underwriter. For a cheaper premium, the underwriter mayexclude a few risks. And for a few more bucks, he may include someextra risks. Now there are normally lots of underwritersapproached, but one will be the lead, and the lead underwriter, like Jim, will normallytake the largest proportion of the risk and sign his name first on the policy document. He is known as the underwriter, as he writershis name under the risk on the insurance policy. The lead underwriter makes the major decisionswhen it comes to accepting the policy, and will be the main man to agree to any claimson 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 payingthe insurance premium to the broker, who will take about 10%, and pass the rest on to theunderwriter. But what should happen if pirates board theship, steal the cargo, and burn it at sea? Well, the client (if he is still alive, ifnot, a representative of the client) will speak to the insurance broker and the brokerwill visit with the lead underwriter and tell him the bad news.
The rest of the underwriters (there may wellbe as many as 20 on a big policy) are told the news and then the broker must negotiatethe 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 premiumis paid, and will help negotiate the best claims for his clients through gentlemanlyhonor 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 havereinsured the policy. Reinsurance puts the underwriter in the positionof the client. The underwriter sells the policy onto anotherunderwriter 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 for9 dollars, rather than the 10 he received, then he gets to keep a dollar each for eachof his 100 clients, meaning he has 100 dollars completely risk free. Similarly, much of the modern day insurancethat flows through Lloyds of London is reinsured out of the building to smaller insurance companiesall across the world. So what starts as a simple agreement betweenthe client and the broker (or Jim and Bob) is spread across a business community whoeach stand to profit from the premium or take a cut of any losses.
This is how insurance works – by the spreadingof risk over communities. So that is how maritime insurance was born. It was developed through the need of ship-ownersto carry on in business should they lose everything whilst at sea. But what about property insurance? Well around the same time, 1666, the greatfire of London devastated the city where modern day insurance was born, and famous architectSir Christopher Wren, in his great London redevelopment project in 1667, made sure toinclude an insurance office in his new plan. Now property insurance is commonplace withmost homeowners having a policy in place. Also medical, life, travel, car, and dentalinsurance are all commonly held policies. Even pet insurance is a major insurance businessnowadays. Over time the business model has evolved. Modern day insurance companies are fiercelycompetitive, which is good for you, the client, as polices are priced at their lowest possiblepoint. Companies now look to write as many policesas 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 moreclaims than they make in policy premiums. But they have invested all those premiumsin a high interest investment scheme, so they make their money outside of the original insuranceproduct. Insurance in this example is a way of creatingcash flow to be used in more lucrative investments. And if you are wondering what other creativeand lucrative ways there are to make more cash, take a Skillshare class called “Howto generate Passive Income.” Skillshare is an online learning communitywith over 20,000 classes in management, marketing, UI/UX design, and more. If you use our promo code infographics9, youwill get Premium Membership for 2 months completely free! Premium Membership gives you unlimited accessto all of the classes available on Skillshare! Join the millions of other people who arealready members, and support The Infographic Show at the same time, by going to Skillshare.com/infographics9 or clicking the link in the description, and start learning today! So, what do you think? Do you have insurance to protect against theunexpected? 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 videocalled US Teachers vs UK Teachers!