Insurance Explained - How Do Insurance Companies Make Money and How Do They Work

Well some of us may think that there’s nothing
more boring than attending an insurance conference

on a wet Tuesday night in Boston.

And we may well be right, but if we look back
to see how the industry began, it isn’t

as dull as it might first appear.

From swashbuckling pirates to a ferocious
fire that ravaged the world’s greatest city,

insurance has had a colorful past.

But how do those grey suits who sell insurance
really make money, and how do the inner workings

of one of the most complicated fiscal models
really work?

If these questions whet your curiosity, then
stay tuned to today’s episode of the The

Infographics Show – Why do insurance companies
make money and how do they work?

What is insurance?

Well, insurance is a financial vehicle that
helps spread risk.

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, let’s look at two

One is named Bob and the other Jim.

Bob says to Jim, I’ll give you ten dollars,
but if I lose my cell phone, you’ll have

to buy me a new one.

If Jim agrees, then that’s insurance right

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 ten dollars


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


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.

Lloyds 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 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 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 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.

Once the terms of the policy are agreed to,
it is made legal, and the client is happy

and the ship sets sail - but not before paying
the insurance premium to the broker, who will

take about 10%, and pass the rest on to the

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 the 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 onto 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 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 what starts as a simple agreement between
the client and the broker (or Jim and Bob)

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 how maritime insurance was born.

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 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

Over time the business model has evolved.

Modern day insurance companies are fiercely
competitive, which is good for you, the client,

as polices are priced at their lowest 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


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

Insurance in this example is a way of creating
cash flow to be used in more lucrative investments.
So, what do you think?

Do you have insurance to protect against the

Do insurance companies charge too much?

Is it all just a scam?

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