How Insurance Works
How Insurance Works. Insurance is the cornerstone of modern life. Without insurance, many aspects of society and the economy today cannot work. The insurance industry protects against economic, climate, technological, political and demographic risks that enable individuals to live their daily lives and businesses to work, innovate and prosper. However, the way insurance works and its value is not always well understood.
This article explains how insurance, the value it provides and the importance of the regulatory environment work to maximize the benefits insurance can offer. How insurance works: The basics of 5 insurance are risk transfer.
It transfers the risk of financial loss as a result of a specific but unpredictable event from an individual or entity to an insurance company for costs or premiums. In the event of a particular event, the individual or entity may claim compensation or services from the insurance company. Therefore, insurance is a way to reduce uncertainty.
Buying an insurance policy at a smaller and known premium eliminates the possibility of larger losses. By collecting premiums and insured events, between groups of policyholders and/or over time, the financial impact of an event that could be catastrophic for a single policyholder is distributed among a wider group.
So risk collection is the key?
Basically, yes. Assembly differentiates the cost of loss between a number of document holders. Take, for example, home content insurance against fires. When the fire risk is collected, the huge costs of a small number of people who have suffered from the fire are spread among all members of the pool.
The average cost to pool members (premium) is relatively low, as only a small number of them tend to incur losses. The insurance price must be so that the individual is willing to pay a smaller and known premium for not having to pay the unknown - and possibly enormous - financial costs of the insured event. Each policyholder must pay a fair premium according to the risk of loss it brings to the pool.
How is a fair premium calculated?
As long as there is sufficient experience or knowledge of past events, insurance companies can use the resulting statistics to make complex calculations. This process , called underwriting, involves calculating the likelihood of risk for each insured or category of insured. Based on the principle of large amounts, the more policyholders, the more accurately the risk risk can be calculated.
The premium paid depends on this account. Inevitably there will be differences in the cost of claims at different times, so premiums will also include margins to allow the insurance company to build a reserve to use in bad years. A unique and rare risk - a professional footballer's foot injury, for example - can sometimes be insured, but the premium will be relatively high.
Insurance protects people and companies from the risk of unexpected events. It is a risk transfer mechanism in which the costs of many people's losses are paid for by many people, with a premium based on the risks of each individual or entity. 6 More details 7 modern insurance - although based on a very simple principle - is a highly sophisticated mechanism for risk transfer coming in many forms.
Insurance has evolved over the centuries. It starts with raw marine insurance in which traders agree to make contributions to those who suffer losses after they occur. The problem with this system is that it does not convey uncertainty completely; it does not convey uncertainty altogether. Traders never knew how much they might have to pay.
Therefore, modern insurance has been developed so that policyholders know in advance the extent of the required share of losses (i.e. their premiums). The value of this certainty for individuals, societies and economies is enormous (see page 13). Indeed, it is fair to say that modern society cannot operate without insurance.
Many of the daily activities that we take for granted involve some risk of loss and may not be carried out if they are not for insurance. In general, there are a large number of similar risks necessary for insurance to be economical. Unique risk insurance is still possible, but it can be very expensive. There are some preconditions that must be met in order to insure something (see page 10) and regulations have an important role to play here (see page 17).
How do insurance companies assess risk?
The process by which the policyholder's risk is assessed is called underwriting. The premiums and conditions of the insurance contract depend on the insurance company's assessment of the level of risk. Every individual or entity that wants to be insured brings a different level of risk to the insurance company; wooden houses are more likely to burn than brick ones, for example.
To ensure that each insured pays a fair premium, the insurance company uses a series of classification factors to determine the level of risk. In general, the higher the risk, the higher the premium. The underwriting process will vary from an insurance company to an insurance company, depending , for example, on the level of risk they are willing to receive.
Policy terms and conditions may be applied to increase risk homogeneity by removing certain events or circumstances in which claims will be paid. Terms and conditions are also important to help reduce the impact of ethical risks and negative elections. Risk assessment is economically effective, as it allows the insurance price to reverse the cost of saving it.
Although underwriting must be consistent with the law, 8 any restrictions on insurance companies' freedom to cover and set prices according to the risks they receive tend to lead to higher insurance prices and thus availability, affordability and lower choices for consumers. The role of the organization here is described in more detail later.
Does risk-based pricing have any other advantages?
Yes, risk-based pricing encourages insurance companies to innovate in order to compete more effectively in terms of price and product. The development of new or more sophisticated classification factors can allow insurance companies to offer more competitive rates, or provide risk insurance that was previously insured.
When an insurance company learns more about diagnosing and treating a particular disease, for example, coverage may be provided for diseases that were previously insured. Similarly, better flood risk modelling can make homes that were not previously insured insured. Risk-based pricing can also have a positive impact on individual behaviour (see page 14 on promoting safe practices).
So what's the moral danger?
The moral risk is the risk that the policyholder's conduct changes after he signs an insurance contract in such a way that the risk event is more likely to occur. For example, car owners can drive less carefully after they have insurance that exceeds the risk of vehicle damage to the insurance company.
Ethical risks can lead to more claims than an insurance company expects based on their subscription and can increase premiums for all policyholders if they are not managed effectively. That's why it's important that the terms and conditions of the insurance contract are strictly clear.
What is negative selection?
Negative choice is a situation in which high-risk individuals are more likely to get insurance. One of the objectives of the subscription is to avoid this by identifying relevant risk factors and setting premiums to properly reflect the risk.
For example, if life insurance is provided to smokers and non-smokers at the same price (based on the life expectancy of both groups), the premium will be better value for smokers - who can be expected to have a higher than average mortality rate - compared to non-smokers.
As a result, more smokers than non-smokers tend to get insurance. The insurance company will end up with a mortality rate of 9 above average (and therefore a higher claim) than expected when determining the price of the product, which will affect its reserves or premiums that it charges afterwards. However, taking into account smoking as a rating factor in the underwriting process, insurance companies can offer lower life insurance premiums to non-smokers than smokers.
Finally, what is reinsurance?
Simply put, reinsurance is insurance for an insurance company. Like insurance, reinsurance reduces the risk of losing an insurance company by sharing risks with one or more reinsurance companies. Reinsurance generally works by transferring part of the significant risk taken by the insurance company (optional reinsurance), or by transferring part of all risk pools (or books) (reinsurance agreements) to reinsurance for part of the original premium.
In the event of a claim, reinsurance compensates the insurance company for its share of the risk. Financial compensation required in the event of a commercial plane crash, for example, could be too large for a single insurance company, so reinsurance companies are required to share losses. Alternatively, a certain level of risk may be transferred, for example, from the car insurance or life business of the insurance company to reinsurance.
The subscription process benefits the holder of the document. The more information you have about individual risks, the more premiums can be adjusted for these risks. If the insurance company's freedom of coverage and price is limited, both the price, the availability of the policy or the profitability of the insurance company will be affected.
What can be insured?
In order for risk insurance to be in place, there must be a number of preconditions: risks must be financially quantifiable and quantifiable, insurance provides financial compensation for realized risks or provides interest or services in the event of such risks. Therefore, the risks should be fully identifiable, in order to eliminate disputes over whether losses occurred (and therefore when the payment of claims is due).
It should also be possible to determine the cost of loss and to determine the level of compensation required. For auto theft insurance, for example, determining when the event occurred and how much compensation to pay is relatively easy. For injuries sustained in an accident, the court often decides the level of compensation. For a lifetime warranty, where financial losses are less easy, compensation is determined in advance.
The risk must be random and independent
It is impossible to insure against an event that is certain to occur, because it does not involve uncertainty and therefore no transfer of risk occurs. An insured event must be unpredictable and occur by pure accident, or at least outside the control of the insurance company, otherwise there may be a moral risk.
Specific events, such as damages caused by wear and tear or consumption, and events caused by the insured can usually be insured voluntarily, deliberately or by a person who works for the insured. The guarantee of working life in this principle is that although death is certain, time is unknown. The insured must have an insured interest and there must be an identifiable relationship between the insured and his or her risks.
Typically, these "insurable interests" are created through ownership or direct relationships. For example, people have interests that can be insured in their homes and vehicles, but not in the interest of their neighbors.
The insurance company must be able to calculate a fair risk premium
as described in p5, the premium imposed on the policyholder must be economically reasonable. On the one hand, the insurance company should be able to charge a premium high enough to cover future claims for its risk group and expenses while continuing to make 12 profit.
On the other hand, the amount collected for insurance for an individual or entity must be an amount that the insured wishes to pay and must be much lower than the amount covered or it is unreasonable to purchase coverage. This balance is better achieved in an open and competitive private insurance market.
The potential risks must be calculated to calculate a fair premium, and the insurance company must be able to calculate the potential risks. It involves calculating the average severity and average frequency of risks similar to a certain degree of accuracy. Doing so requires a significant analysis of the claim date for a particular event, based on the experience of the insurance company itself, industry data or other sources.
There must be a limited risk of huge losses the financial impact of losses should not be so great that the insurance company cannot expect to pay for the loss. For events that can result in significant losses, insurance companies may use techniques such as reinsurance to reduce their exposure. This usually happens with natural disaster insurance or airlines.
Coverage is generally only to compensate payments made after an insured event only compensates for losses that have already occurred to the policyholder. Policyholders cannot take advantage of claims because this may change their behavior to make losses more likely to occur.
Not all risks can be insured. In order to insure the risk, it must have a number of special characteristics.
Why do we need insurance?
14 Insurance helps people and companies assess, manage and reduce their risk. This benefits policyholders because it provides a way to convert large and unexpected fees into smaller, manageable payments.
Without insurance, people will be less likely to engage in some modern life activities because the potential financial costs they will face will be too high. For example, people will be less likely to start their own business, as they will have to take full responsibility for the cost of an accident or fire. They may also be less likely to buy their own homes for the same reason.
Benefits: Consumer confidence and commercial
insurance give individuals and companies the confidence to live their daily lives, businesses and conduct transactions with others. They can be safe to know that the company in which they do business will be able to continue working and will be able to meet their obligations. For example, tourists get the comfort and confidence of booking with a hotel with insurance that refunds their deposit in the event of an important event, such as a fire, and the closure of the hotel.
Benefits: Risk control and enhanced safe practices
generally benefit communities from a competitive insurance market that can use advanced risk pricing to drive better risk management practices. The possibility of lower premiums can change behavior, encouraging individuals and companies to reduce their risk wherever they can by changing their behavior or taking precautions.
Examples include individuals who have quit smoking to reduce life insurance premiums or set smoke alarms to reduce home insurance costs, and companies that implement more effective risk management systems to reduce their obligation premiums. Another common example is the promotion of safer driving through discounts without motorcycle premium claims.
Benefits: Insurance companies invest in long-term investments in the economy
With the excellent income they receive, making them one of the largest institutional investors. For life insurance companies in particular, the products they write are of a long-term nature and therefore long-term investments are made and kept until maturity. This steady long-term flow of capital provided by the insurance industry to the financial markets is essential for the financial system as a whole 15, as it reduces market volatility and thus contributes significantly to market stability and performance.
Benefits: Stable and sustainable savings and pension provisions
The insurance company is a provider of important savings and pension products. The products they offer are essential to the financial security of aging, especially given the ageing population. In addition to using their expertise and advanced models to ensure fair premiums, insurance companies can combine a variety of risks. This reduces the likelihood of claims that are significantly different from what is assumed in the subscription and in turn reduces the cost of delivering products.
For example, risking the inherent longevity of pension products and the risk of death from life insurance products reduce the financial impact of changes in life expectancy (the increase in life expectancy will increase the costs to pension product insurers, as they need to pay longer, but have balanced benefits for life insurance companies).
Without a competitive and innovative insurance industry, many aspects of our modern society and economy will disappear or work more effectively.
The importance of regulatory environment
Regulations are necessary to ensure that policyholders can feel confident in purchasing insurance products. However, improper regulation can have a significant impact on the insurance company's ability to operate effectively, sustainably and provide insurance products that individuals and companies want to purchase.
Against the backdrop of high public debt and an ageing population in developed countries, and the consequent pressures on the social well-being of the State and the tax system, it is becoming increasingly important to ensure that the regulatory environment supports the properly functioning private insurance sector.
The company's product development and pricing strategies are often driven by the regulatory environment in which it operates. Individual companies may be affected by regulations that are not appropriate for their business.
International groups can be affected by contradictions in the regulatory environment that can even lead to corporate restructuring. Here are only four examples of areas where regulation can affect the optimal performance of the insurance market. It shows how important it is to consider all potential implications when developing or revising regulations.
Sufficient capital, but not much the insurance company must be able to provide cost-effective insurance to the policyholder with sufficient capital to pay the claim. It is very important that the capital that the insurance company must own is commensurate with the risks to which it is exposed. Regulatory requirements should inspire consumer confidence but should not be overly cautious.
If the company is forced to acquire excessive capital, there is a risk that additional costs will be passed on to the policyholder through higher premiums, that the product may be redesigned to provide less guarantees and interest to the policyholder, or that the product may be withdrawn altogether. This can lead to individuals and companies purchasing less insurance, thereby maintaining more risks on their own, with serious consequences for society and the economy.
Recognizing the value of long-term insurance the size of the private pension market held by insurance companies is very important. Insurance companies are also major long-term institutional investors. If regulations prevent insurance companies from holding long-term assets, these 18 things may affect the insurance industry's ability to provide effective savings and retirement products.
It will also reduce the role of industry as a long-term investor in financial markets and thus its important role as a stabilizing factor for market volatility. Any reduction in the level of savings or special pension allocations could increase the costs of the social welfare system and could have an impact on the wider economy. Differentiation, not discrimination, the smaller the number and type of classification factors that insurance companies can use, the more competitive and innovative they are.
This benefits the holder of the document and society as a whole, as described in the previous section. This risk assessment does not constitute unfair discrimination, on the contrary. Differentiation is the fairest way to ensure that premiums accurately reflect risks. It is also the fairest way to ensure that as many people as possible can be provided with insurance at affordable prices.
Risk assessment is not only economically effective, but also helps reduce ethical risks and negative choice, as described in the example of smokers and non-smokers in p8. People looking for insurance will always know more about their risks than insurance companies. However, the risks to insurance companies can be minimized by assessing risks and collecting appropriate information.
This benefits all insured. If lawmakers impose restrictions on information that insurance companies can collect or use, perhaps to avoid perceived injustice, insurance companies may charge policyholders higher premiums to compensate for a higher level of uncertainty about the risks they face. It is also important to note the importance of free data collection and dissemination, such as ensuring public access to local authority flood risk data.
The freedom to insure what can be insured
as we have seen, risk assessment and risk-based pricing in the private market not only allows insurance companies to set fair premiums but is also allowed to invent and develop new or more sophisticated products for current or emerging risks. This insurance market is the most dynamic and cost-effective.
Therefore, any regulation to require a particular type of insurance must always be carefully considered, because despite good faith, could in fact have the opposite effect of the intended type; that is, hindering innovation and economic efficiency.
An effective regulatory environment is the key to the successful operation of the insurance market. In order for the regulation to be effective, it must take full account of the unique characteristics of insurance.
How is the premium calculated?
Insurance premiums are calculated so that they can reasonably be expected to cover potential claims arising from insurance contracts with a guarantee margin to ensure the long-term survival of the insurance company. The calculation is generally based on the likelihood of an insured event, coupled with potential financial losses resulting from the claim.
This "risk premium" is then adjusted to cover the costs of the insurance company and provide certain benefits: (number of claims expected × probability) + expenses + profit + margin of guarantee = premiums
The cost adjustment must include:
- initial costs of product writing (including application processing and underwriting)
- Normal costs associated with product maintenance
- Any additional costs incurred at the claim point (including claim processing and any costs due to claim verification)
depend on how these costs are charged to the premium on the type and structure of the product And how to incur costs. It may be a fixed amount, or the percentage increases depending on the size of the number of potential claims (the amount insured) or a combination of both.
The probability of claims is generally determined by analyzing historical statements from homogeneous groups representing similar risks and by analyzing forward-looking risks. For example, life guarantee policyholders can be divided into groups based on:
- Age
- Occupation
- Geographical location
- Smokers/non-smokers
This assumes that individuals in the same group suffer widely consistent deaths. An analysis of the historical data of this risk group gives a good indication that the holder of the document listed in each group (in this example claims that the policyholder will die) each year after the policy has begun.
In general, the greater the risk factors that can be included in dividing policyholders into equal groups, the more accurate the assumptions on which the probability of a claim will be made. However, when determining the number of risk groups to divide policyholders, a balance must be struck between very few of the groups (in which case the risk is heterogeneous) and a very large number of groups (in which case the number of policyholders in each group may be too small for analysis to be statistically significant).
Similarly, groups should be selected so that sufficient historical data are available for meaningful analysis. If historical data is not available, the insurance company may look to other sources such as industry data, publicly available statistics or data from reinsurance companies. The final installment also depends on the insurance company's individual business strategy. For example, the company may want to position its products as the cheapest on the market in order to gain market share by reducing the level of profit in premiums.
What is the combined ratio?
It is important for companies to regularly review the experience of their claims for premiums charged to ensure that premiums remain in line with risks and that underwriting practices are consistent with premium rates, so that the risks taken by the company are consistent with those that have been rewarded. One way to do this in non-life insurance is to use a combined ratio.
This is the ratio of claims costs and losses to premiums and can be applied to monitor the quality of the company in pricing its products (relative to its business plan) and the efficiency of its subscription in matching risks with the pricing structure. If the combined ratio is less than 100%, the premium paid is enough to cover the payment and there is an underwriting feature.If the combined ratio is greater than 100%, the company will achieve underwriting losses.
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