The dictionary defines insurance as –
An arrangement by which a company or the state i.e the insurer undertakes to provide a guarantee of compensation for specified loss, damage, illness, or death of the insured in return for payment of a specified premium.
Basically, an insurance company does three things-:
Risk Control-: Insurance companies help their clients to reduce and control risks.
Risk Financing-: If a client is still unavoidably exposed to risk, an insurance company takes the risk off him by accepting to bear the costs of the damage whenever it occurs.
Risks Sharing-: An insurance company also brings together different people who are willing to insure themselves or property against risks together.
The type of risks that insurance companies cover for includes-:
a. Personal risks-: These are health and safety risks that may affect an individual such as illnesses, diseases, accidents or death.
b. Property risks-: This involves risks that an individual or business would lose its property due to natural or unforeseen circumstances like fire, floods, earthquakes etc.
c. Liability risks-: A person or business might be found guilty of negligence when they cause other people to lose their property or lives through careless or willful acts. For instance, a doctor may be found guilty of negligence if he engages in acts that put his patients at risks like giving wrong prescriptions or not carrying adequate tests.
In such a situation, if something bad happens to the patient and he decides to sue the doctor, he may be found guilty of negligence and asked to compensate the patient; this is where the insurance company would come in and take up the responsibility of compensating such patients.
An insurance company accepts risks from the insured and so that it can make profit, the insurance company has to estimate the extent to which losses may occur and then the insurance company sets an amount known as the premium which would cover for losses, expenses and also leave enough for profit.
What happens if your car crashes or your house burns down or your baggage gets lost on your next flight or you are diagnosed with a critical illness whose treatment is going to cost you tons of money? Will you dig deep into your coffers every time such a crisis occurs? What if you don’t even have the necessary amount in the first place?
How Insurance Companies Make Money
There are different types of insurance companies offering different kind of products but the way they make their money is the same. Insurance companies make their money through-:
1. Insurance premiums-: Insurance companies are ‘risk poolers’. This means that they bring together, people who are willing to protect their businesses or property against potential future losses under one umbrella. Let’s say an insurance company has 1,000 clients whose vehicles it has insured for $5,000 each, the insurance company would have all 1,000 customers pay a certain amount as insurance premium.
In this case, let’s assume that the premium is set at $250 each in exchange for insuring those vehicles for $5,000. Now it’s almost impossible that all 1,000 would make claims that year. So, let’s assume that out of the 1,000 insured, only about 200 made claims, the company pays out claims to the 200 and what is gotten from the remaining 800 who did not make claims is kept as profit. This kind of profit is known as underwriting profit.
2. Investments-: Insurance companies get a lot of money from premiums and instead of leaving the money lying around fallow, they invest it in different assets that would yield profits for them eventually. Such investments are mostly real estate, government bonds, treasury bills and private equity so that when the insurance company has claims to deal with, it not only has enough to settle the claims but also has enough profit left to keep. Insurance companies are always careful with investments which is why most of their investments are in government bonds and low-risk investments.
3. Reserves-: Due to the nature of its business, an insurance company would usually have more money than it needs most of the time. These extra funds are usually kept as reserves and used to pay claims when the need arises.
4. Risk Measurement-: An insurance company also makes money by measuring risks. If a business or area is prone to high levels of risks, an insurance company may elect to avoid offering insurance coverage for that type of business.
For instance, if an area is prone to earthquake, insurance companies may avoid insuring homes in that area. So an insurance company makes money by measuring risks and covering property or business that pose low level risks and that way the number of people that would file claims would reduce and that would also lead to an increase in the company’s profits.
No comments:
Post a Comment