What is insurance?
Insurance is a financial tool that spreads risk among
multiple parties. By taking a risk from an individual, and spreading that risk
around a community, the individual is able to go about their personal or
business life without crumbling from financial ruin.
In the simplest terms of Insurance, let’s talk about two people.
There are two people called Bob and there are two people
called Jim. If I lost my cell, I would give you $10, but if I found it, you had
to pay for a new one. If Jim agrees, then that’s insurance right there.
Why do insurance companies make money and how do they work?
Insurance companies earn their profits by evaluating the
risks involved and deciding whether it is worthwhile for them to take the
gamble. Jim predicts that Bob won't likely misplace his phone and will instead
get $10. If Jim finds 100 more people who are willing to give him 10 bucks each
to cover their phones, he has 1,000 dollars. If one of those 100 people loses
their phone and Jim pays 100 dollars as compensation, he still has 900 bucks.
This insurance idea has been floating around since the
ancient Chinese and the Babylonians spread 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.
Here's how it worked: within one of these coffee shops,
Lloyds of London, the center of global insurance, was created. First, you have
the client. Say the client has a ship that he is nervous about 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 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 of this data, he creates an insurance policy, which he then presents to the
underwriter, the third link in the chain.
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 writers 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. The insurance premium must first be paid to the broker, who will keep
roughly 10% and give the remaining funds to the underwriter, before the policy
is legally binding, the client is satisfied, and the ship departs.
But what should happen if pirates board the ship, steal the
cargo, and burn it at sea? The client (or, if he's deceased, a representative
of the client) will communicate with the insurance broker, who will then go see
the lead underwriter and deliver the bad news. The rest of the insurers (there
can be as many as 20 in a large policy) are given the message and then the
broker must negotiate the best claims settlement for the client or their
agents.
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.
Presently it may not be all awful information for the
Underwriter. If he is wise and not greedy, he may have reinsured the policy.
Reinsurance sets the financier in the place of the client. The underwriter
sells the policy onto another underwriter or firm of underwriters, while
retaining a share of the premium.
Confused yet? Recall Jim and his telephone protection. If
Jim resold his 10 dollar phone policy for 9 dollars, rather than the 10 he
received, then he gets to keep a dollar each for each of his 100 clients,
meaning he has 100 dollars completely risk free. Similarly, much of the modern
day insurance that flows through Lloyds of London is reinsured out of the
building to smaller insurance companies all across the world.
So which begins as a straightforward understanding between
the client and the dealer (or Jim and Sway) is spread across a business
community who 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 the way oceanic protection was conceived. It was
developed through the need of ship-owners to carry on in business should they
lose everything whilst at sea. But what about property insurance? Well around
the same time, 1666, the great fire of London devastated the city where modern
day protection was conceived, and renowned modeler Sir Christopher Wren, in his
extraordinary London redevelopment project in 1667, tried to remember a
protection office for his new arrangement.
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 insurance
companies are highly competitive, which is good for you as a customer because
the policies are as cheap as possible. Companies now look to write as many
polices as 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 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. Protection in this model is an approach to making income to be utilized in additional rewarding ventures.