How insurance works ?
Insurance is the transfer of risk. It transfers the risk of financial losses as a result ofspecified but unpredictable events from an individual or entity to an insurer in return
for a fee or premium. If a specified event occurs, the individual or entity can claim
compensation or a service from the insurer.
Insurance is therefore a means of reducing uncertainty. In return for buying an
insurance policy for a smaller, known premium, the possibility of a larger loss is
removed. By pooling premiums and insured events, the financial impact of an event
that could be disastrous for one policyholder is spread among a wider group.
So risk pooling is the key?
Essentially, yes. Pooling spreads the cost of losses between a number of policyholders.
Take household contents insurance against fire, for example. When the risk of a fire
is pooled, the large cost to the few who suffer from a fire is spread between all
members of the pool. The average cost to members of the pool (the premium) is
relatively low, as only a small number of them is likely to suffer a loss.
The price of the insurance should be such that the individual is prepared to pay
the smaller, known premium in return for not having to pay the unknown — and
potentially very large — financial cost of the insured event. Each policyholder should
pay a fair premium according to the risk of loss that they bring to the pool.
How is a fair premium calculated?
As long as there is sufficient experience or knowledge of past events, insurers can
use the resulting statistics to make sophisticated calculations. This process — called
underwriting — involves calculating the probability of the risk for each insured or
category of insureds. Based on the principle of large numbers, the larger the pool of
policyholders, the more accurately the probability of the risk can be calculated. The
premiums charged are based on these calculations. Inevitably there will be variations
in claims costs at different times, so the premium will also include a margin to
enable the insurer to build up a reserve to draw on in bad years.
Unique and rare risks — injury to a professional footballer’s legs, for example — can
sometimes also be insured, but the premiums will be comparatively high.
0 Comments