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How Does Insurance Work?

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Insurance exists because risk exists. There is a possibility that anyone could become a victim of fire, theft, auto accidents, other injury accidents, illness, severe weather, lawsuits and more. We are subject to risk at home, at work, in our cars, traveling, in the hospital or anywhere at any time.

Transfer of Risk
Insurance cannot remove the risk or the likelihood that one might become a victim of any of these events, but what it does is transfer all or some of the financial impact of any of these events. Insurance exists to help individuals recover from the financial consequences of these events by pooling the resources of a large group to pay for the losses of a small group.

A Little Background About Insurance
Insurance has been around in some form since traders first began to travel over water to trade their goods. There is documented evidence that Chinese and Babylonian traders began to protect themselves against risk as far back as the 3rd century BC. Traders realized that if they spread their goods among multiple vessels, rather than putting all of their cargo on one vessel, they had a better chance of avoiding complete loss.

In later years, shippers in Great Britain reasoned that if 100 ship owners each chipped in money, if some of those ships were damaged or lost, the money collected from all 100 ships could be used to repair or replace the few. Extreme losses following the Great Fire of London in 1666 led to the creation of the world's first actual insurance company, The Insurance Office, or The Fire Office. And in the United States, the first insurance company was started in Charleston, South Carolina in 1732. Benjamin Franklin is recognized as helping to make insurance popular and to standardize the practice of insurance.

Law of Large Numbers
In order to afford to cover the financial losses of its customers, an insurance company needs a very large base of members. For each different type of loss that they insure against, insurance companies have years of statistics that help them calculate how many losses they are likely to have. They are counting on the law of large numbers which, when applied to insurance, states that the more members in an insured group, the more likely it is that the number of actual losses will be very close to the number of expected losses. This law also applies to gambling casinos.

Determining Premium Payments
The insurance premium that each member of the insured "pool" has to pay is different and is based on many factors. For life and health insurance, for example, the insured person's age is the most important factor. It is statistically provable that younger people have fewer claims for life and health (except for pregnancy and childbirth), so their insurance premiums will be lower than an older person or someone with health issues.

For car insurance, the driver's age, gender, geographic location, type of car and driving history all factor in to the amount they will have to pay for insurance coverage. Teenagers have to pay higher auto insurance rates because statistical history has proven that they have more accidents with higher losses than a 40 year old driver. The larger the pool of insureds, the more the risk is spread out, and the lower the premiums can be.

These same principles of transferring risk and the law of large numbers also apply to business insurance, liability insurance, accident insurance, specialty insurance and more. To illustrate, if 10,000 people each pay $1,000 a year for home, auto, health or any other type of insurance, the insurance company would receive $10 million dollars. If 500 members of this pool sustain losses during the year of $10,000 each, the pool would be large enough to pay all of their losses, $5 million, and still have $5 million for future claims.

So in order to remain viable, an insurance company needs at least 3 basic things:

  • A large pool of insureds in a diverse demographic (age, gender, health, location, occupation, history)
  • Reliable, current statistics on the probability of loss for each type of insurance offered
  • Sufficient premium payments to cover the anticipated losses

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