How insurance works: the basics

Insurance is the transfer of risk. It transfers the risk of financial losses as a result of specified but unpredictable events from an individual or entity to an insurer in return for a fee or premium. If a specified event occurs, the individual or entity can claim compensation or a service from the insurer.

Insurance is therefore a means of reducing uncertainty. In return for buying an insurance policy for a smaller, known premium, the possibility of a larger loss is removed. By pooling premiums and insured events, the financial impact of an event that could be disastrous for one policyholder is spread among a wider group.

So risk pooling is the key?
Essentially, yes. Pooling spreads the cost of losses between a numbers of policyholders. Take household contents insurance against fire, for example. When the risk of a fire is pooled, the large cost to the few who suffer from a fire is spread between all members of the pool. The average cost to members of the pool (the premium) is relatively low, as only a small number of them is likely to suffer a loss. The price of the insurance should be such that the individual is prepared to pay the smaller, known premium in return for not having to pay the unknown — and potentially very large — financial cost of the insured event. Each policyholder should pay a fair premium according to the risk of loss that they bring to the pool.

How is a fair premium calculated?
As long as there is sufficient experience or knowledge of past events, insurers can use the resulting statistics to make sophisticated calculations. This process — called underwriting — involves calculating the probability of the risk for each insured or category of insureds. Based on the principle of large numbers, the larger the pool of policyholders, the more accurately the probability of the risk can be calculated. The premiums charged are based on these calculations. Inevitably there will be variations in claims costs at different times, so the premium will also include a margin to enable the insurer to build up a reserve to draw on in bad years. Unique and rare risks — injury to a professional footballer’s legs, for example — can sometimes also be insured, but the premiums will be comparatively high.

Insurance protects people and businesses against the risk of unforeseeable events. It is a risk transfer mechanism by which the losses of the few are paid for by the many, with the premiums based on the risk of each individual or entity.