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How do insurance companies work
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  • Posted by: nicol

How do insurance companies work

Whether you are in the hospital or your car has suffered damage during an accident, you have to pay a lot of money. Sometimes the amount payable is in the thousands of dollars. It is very tough to pay such a large sum of money, which sometimes has dire consequences. This is where insurance companies come in. But how do insurance companies work?

The working procedure of insurance companies includes pooling the money of a large number of people to pay for the damages incurred by a small number of people. This money is gathered by the companies by collecting premiums every month. The companies calculate the risk of paying the claim and set the premium accordingly.

Let’s take a deeper look at the working method of insurance companies.

What is insurance?

Before learning how an insurance company works, one has to know what is insurance itself. Insurance is a guarantee provided by an agency that it will pay for certain damages in return for a certain amount of premium. For example, suppose you have life insurance. The insurance company has guaranteed that it will provide your family with a fixed amount of money when you pass away.

How does an insurance company work?

Ever wonder where does the money for your insurance claim come from? Why is there a scheme like insurance in the first place? Surely the insurance companies don’t operate on a loss? Let’s see how an insurance company operates and where it gets its funds from.

How does an insurance company work

An insurance company has a lot of clients. These clients deposit a monthly premium to the insurance company in return for the company to provide them with indemnity in case they suffer damages. But if the insurance companies continue on this path, they are sure to go bankrupt very soon. But they don’t, why?

The trick is that insurance companies know that accidents are just that, accidents. Most people don’t suffer the damages they are buying insurance for. For example, you have car insurance. Now, the general idea is that you will be covered by the insurance company if you are involved in an accident. But how many people do you know have been involved in a car accident?

The chances are, the percentage of people who have suffered due to a car accident among the people you know is meager. This is where insurance companies earn their money. Only a low percentage of people having car insurance are involved in car accidents, so only those people are the ones who are indemnified by the insurance companies, but everyone having insurance has to pay premiums.

The money generated through premiums is used to pay for the damages suffered by claimants. Now, there is the issue of calculating the premiums. Is the amount of premium people pay the same? If they aren’t, on what basis do they differ? They do it through the process of underwriting.

What is Underwriting?

Underwriting is the process of assessing risk and setting up premiums according to those risks by an insurance company. Not every insurance has the same amount of premium. Because the insurance companies assess the risk involved with that particular scheme and calculate how much it will have to pay should there ever be a claim made by the insured.

For example, you have health insurance. The goal for you is to minimize the medical bill you pay when you fall sick. But the insurance company will look at it differently. They will assess your current health condition and see whether they’ll have to pay the money within a short time or not. They’ll also calculate how much money they’ll have to pay should you make a claim.

If they find you less risky to fall ill or have a terminal illness, they will set you up with a relatively low premium. On the other hand, if they think you bear a higher risk of claiming your insurance, the premium they’ll set a high premium for you.

When you weigh up your options concerning which insurance company you will choose, you will see that different companies have different premiums for one kind of insurance. This is because every company underwrites differently. This is very important as if a company underwrites low, then it’ll generate a low amount of money through premiums.

On the other hand, if a company sets premiums that are too high, they’ll discourage people to choose them as their insurance company of choice. So, they have to strike a balance between customer satisfaction and generating enough revenue.

While reading this, some of you might wonder, does it make sense for you to keep paying a premium without knowing when you’ll be able to claim the insurance, if at all? If that is the case, you might want to look at the next section.

What is Term Insurance?

If you don’t want to spend your whole life paying the premium for apparently nothing, then you might consider buying term insurance. Term insurance is a kind of insurance that lasts for a certain period, during which you will pay the premium and be eligible for claims if something happens that is covered by the insurance.

Once the term ends, you no longer have to pay the premium but you won’t be eligible for claiming the insurance either.

Final Words

If you want to buy insurance, you must know “how do insurance companies work?” It will help you in two ways. First, you will be able to know the inner workings of an insurance company and second, you can be wiser when it comes to choosing the right insurance for yourself.


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