Why do Insurance companies make money and how do they work ?

Why do insurance companies make money and how do they work what is insurance ?

Why do Insurance companies make money and how do they work ?

Well insurance is a financial vehicle that helps spread risk by taking a risk from an individual and spreading that risk around the community the individual is able to go about their personal or business level and spreading that risk 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 $10, 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 10 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 

if one of those 100 people loses their phone and Jim pays $100 as compensation, he still has 900 bucks.

the insurance idea has been floating around since the ancient Chinese and the Babylonians spreading 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. 

Lloyd's 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 off shore, 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 writes 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 set 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 ?

well, the client( if he is still alive if not a representative of a client ) will speak to the insurance broker and the broker will visit with the lead underwriter and tell him the bad news.

the rest of the underwriters (there may well be as many as 20 on a big policy) are told the news and then the broker must negotiate the 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 premium is paid, and will help negotiate the best claims for his clients through gentlemanly honor 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 have reinsured the policy. 

reinsurance puts the underwriter in the position of the client. 

the underwriter sells the policy on to another underwriter 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 phone policy for nine dollars. rather than the ten dollars he received, then he gets to keep a dollar each for each 100 clients, meaning he has $100 completely risk-free. 

similarly, much of the modern-dayinsurance that flows through Lloyd's of London is reinsured out of the building to smaller insurance companies all across the world. 

so what starts as a simple agreement between the client and the broker (or Jim and Bob) is spread across a business community each stand to profit from the premium or take a cut of any losses. 

This is how insurance works - by the spreading of risk over communities. 

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 lost at sea.

But what about property insurance ?

well around the same time, 1666 the Great Fire of London devastated the city where modern day

insurance was born, and famous architect Sir Christopher Wren, in his great London redevelopment project in 1667, made sure to include an insurance office in his new plan. 

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. modern day insurance companies are fiercely competitive, which is good for you, the client, as policies are priced at their lowest possible point. 

companies now look to write as many policies as possible to create a financial pool. they take the premium from thousands of policies, and invest that money in other financial products. 

so the insurance underwriter may pay out more claims than they make in policy premiums. But they have invested all those premiums in a high interest investment scheme, so they make their money outside of the original insurance product.

 

Insurance in this example as a way of creating cash flow to be used in more lucrative investments. and if you're wondering what other creative and lucrative ways there are to make more cash, take a skill share class called "how to generate passive income". 

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so what do you think? do you have insurance to protect against the unexpected? 

to insurance companies charge too much? is it all just a scam? let us know your thoughts in the comments!