Well some of us may think there’s nothing more boring than attending a conference on insurance. 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 you are in the right place.
- Why are insurance firms making money?
- How do they work?
- What is insurance?
Well, insurance is a tool that helps to spread risk. By taking an individual’s risk, and distributing the risk across a society, the individual can go about their personal or business life without collapsing from financial ruin.
So, What is insurance in simple terms?
In the simplest terms, let’s look at two people. One is named Ram and the other Shyam. Ram says to Shyam, I’ll give you ten dollars, but if I lose my cell phone, you’ll have to buy me a new one. If Shyam agrees, then that’s insurance right there. Insurance firms make money as they measure risk and determine if the bet is worth it.
Shyam believes that Ram probably won’t lose his phone and he’ll, therefore, be ten dollars richer. If Shyam 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 Shyam pays 100 dollars as compensation, he still has 900 bucks.
After the ancient Chinese and the Babylonians spread their shipping risks, this insurance idea has drifted around. But it wasn’t until around the 17th century in London that modern insurance really took off. Marine merchants and traders often hung out at coffee shops in London’s business district, and while drinking lots of coffee, the idea of modern insurance.
Idea of insurance Skyrocket with coffee shop
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 he’s nervous about losing to offshore pirates or maybe the ship will be lost 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 that 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 Shyam, 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 writes 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 contract have been negotiated, it becomes legal, and the client is satisfied and the ship sets sail-but not before paying the insurance premium to the broker, who takes about 10 percent and sends the remainder to the underwriter.
But what if pirates board the ship and steal the cargo and burn it at sea? Okay, the client (if he’s still alive, if not a company representative) will speak to the insurance broker and the broker will meet with the lead underwriter to 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.
What you should know about Reinsurance?
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 Shyam and his phone insurance. If Shyam 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 customers that means it is completely free of risk for $100.
Likewise, much of the modern-day insurance flowing into London’s Lloyds is being reinsured from the company to smaller insurance companies all over the world. So what starts as a simple agreement between the client and the broker (or Shyam and Ram) is spread across a business community who each stand to profit from the premium or take a cut of any losses. That is how insurance works-by the distribution of risk through societies.
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.
What Is Property Insurance? What Does Property Insurance Cover?
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, ensured that his new strategy included an insurance office. Today property insurance is standard, with a scheme in place for most homeowners. In addition, all widely owned plans are medical, personal, transportation, auto, and dental insurance.
Even nowadays pet insurance is a major insurance company.
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 point. Now businesses are trying to write as many policies as possible to create a pool of capital. They are taking the premium from thousands of programs, and investing the money in another company.
So the insurance underwriter may pay out more claims than they make in policy premiums. Yet all those premiums have been invested in a high-interest investment plan, and they make their money outside of the initial insurance policy.
Conclusions: Insurance | Behind the Scenes
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 unexpected?
Do insurance companies charge too much? Is it all just a scam?
Let us know your thoughts in the comments.