How Do Insurance Companies Make Money and How Do They Work

Insurance

companies make money by assessing risk and determining whether it is
worthwhile to take a chance. Jim thinks Bob won’t lose his phone, and
he’ll be ten bucks richer as a result. Jim will have $1,000 if he can
locate 100 more people ready to give him $10 each to cover their phones.
If one of those 100 persons loses their phone and Jim compensates them
with $100, he still has $900. Since the ancient Chinese and Babylonians
dispersed their transportation risks, this insurance concept has been
floating around. Modern insurance, however, did not take off until the
17th century in London.

The idea of modern-day insurance was
developed while merchant marine men and traders hung around in coffee
cafes in London’s business center, where they drank excessive amounts of
coffee. The core of global insurance, Lloyds of London, was born in one
of these coffee shops, and here’s how it worked.

First, there’s
the customer. Let’s say the client owns a ship that he is concerned
about losing to pirates off the coast or being damaged by terrible weather. The client seeks the assistance of an insurance
broker. The
broker inspects the ship, or hires someone to inspect the ship, and
determines the entire value of the ship. After that, the broker
evaluates the risk. He inquires about the client’s trip plans and the
cargo he will be transporting. With all of this information, he creates
an insurance policy, which he shows to the underwriter, the third link
in the chain. A few hazards may be excluded by the underwriter in
exchange for a lower premium. For a few additional dollars, he might
throw in some extra risks.

Now, there will usually be several
underwriters approached, but one will be the lead, and the lead
underwriter, like Jim, will typically assume the highest share of the
risk and sign the policy form first. Because he signs his name under the
risk on the insurance policy, he is known as the underwriter. The lead
underwriter is the one who takes the final decision on whether or not to
accept the policy and will be the one to consent to any claims made
against it. Once the policy’s conditions have been agreed upon, it is
made legal, the client is satisfied, and the ship sets sail – but not
before paying the insurance premium to the broker, who will keep around
10% and pass the remainder on to the underwriter. What if pirates hijack
the ship, steal the cargo, then set fire to it at sea?

So,
the client (if he is still alive; if not, a representative of the
client) will contact the insurance broker, who will then contact the
lead underwriter and deliver the terrible news to him. The rest of the
underwriters (up to 20 on a large policy) are informed, and the broker
must then negotiate the best claim payment for the customer or his or
her representatives. The money is paid by the underwriters to the
broker, who then passes it on to the client without taking a cut. Once
the premium is paid, the broker makes his money, and he will assist his
clients in negotiating the best claims for them based on gentlemanly
honor and the potential of future business.

It’s not all doom and
gloom for the Underwriter now. He may have reinsured the coverage if he
is prudent and not greedy. In reinsurance, the underwriter assumes the
role of the client. While keeping a portion of the premium, the underwriter sells the policy to another underwriter or group of
underwriters. Are you perplexed yet? Remember Jim and his phone
insurance? If Jim resold his ten-dollar phone policy for nine dollars
instead of the ten he received, he gets to keep a dollar for each of his
100 clients, giving him a total of one hundred dollars risk-free.

Similarly,
much of the current insurance that passes through Lloyds of London is
re-insured by smaller insurance companies all around the world. As a
result, what begins as a basic agreement between the client and the
broker (or Jim and Bob) is spread through a corporate community, with
each party hoping to profit from the premium or share in any losses.
This is how insurance works: risk is distributed across communities. As a
result, maritime insurance was created. It was created in response to
the requirement for shipowners to continue operating if they lost
everything while at sea. What about property insurance, though?

Around
the same time, in 1666, the Great Fire of London damaged the metropolis
where modern-day insurance was created, and legendary architect Sir
Christopher Wren made sure to include an insurance office in his new
plan for the city’s restoration in 1667. Property insurance is now
standard, with the majority of homeowners owning a policy. Medical,
life, travel, automobile, and dental insurance are all common coverage.
In today’s world, even pet insurance is a big business. The business
model has changed over time.

Insurance firms now are very
competitive, which is beneficial for you, the customer, because plans
are priced as cheap as possible. Companies are now attempting to build a
financial pool by writing as many policies as possible. They invest the
premiums from tens of thousands of policies in another financial
instrument. As a result, the insurance company may pay out more claims
than it receives in policy premiums. They have, however, put all of
those premiums in a high-interest investment program, so they are
profiting from something other than the original insurance policy.

In this case, insurance is a technique of generating cash flow that may be
put toward more profitable ventures. Take a look at our article ‘How to
Generate Passive Income’ if you’re looking for alternative innovative
and profitable ways to create extra money.

So, what are your thoughts? Do you have insurance to cover the unforeseeable? Do insurance
companies overcharge? Is this all a ruse? Let us know what you think in
the comments section!