PRM - How Does Insurance Work? Lesson

How Does Insurance Work?

Insurance companies use a strategy called shared risk or risk pooling. This concept allows a group of policyholders to pay their monthly premium to the insurance company and the money is pooled together. Hence, when someone from this group of policyholders has an accident, the loss is paid for from the money that everyone pooled together. This strategy works because insurance companies know that everyone in the group will not have an accident at the same time, if at all. So, they could have 200 policyholders pay their monthly premium and have only 1-2 accidents that they need to pay. The money to cover the accident is taken from the pool to cover the costs.

In addition, the level of risk that each person poses is evaluated using probability and statistics. The insurance company considers things like age, gender, and previous insurance claims to determine if you are high risk or low risk, and your monthly insurance premium or rates, are determined based on that level of risk. The higher your risk, the more your premium costs.

Risk is assessed by studying data from large numbers of people in specific groups to determine the likelihood of an accident or incident. This could be groups like teenagers or senior citizens. The larger the pool of people in the study, the greater the accuracy of the assessment and estimate. For example, senior citizens pay more for health insurance than young adults because the research shows they are more likely to have recurring health issues. Also, teens pay more for auto insurance than those in their 30s because the data proves that teens have more accidents. The same concept applies when determining you have a 1 in 700,000 chance of getting struck by lightning in a year or a 1 in 175,000,000 chance of winning the lottery.

Insurable and Non-Insurable Risk

Although it is common for individuals to purchase insurance to minimize their economic loss there are situations where insurance cannot be obtained for the risk. While insurance companies do assume risk and pay for losses when individuals pay their premium, they still want to make a profit. In some cases, if they cannot predict the cost of a loss and determine how much they will gain, they will not provide insurance. See the table below that shows insurable and non-insurable risks.

Risks	Gains	Losses	Explanation	Example
Insurable Risks	Yes	Yes	Risks that can be researched and estimated. Insurance companies can determine they will have gains and some possible losses.	Ex. Auto insurance   Research can be done to see how many accidents there were within a certain age group in previous years. This helps insurance companies predict how much they will make and how much they will pay in losses.
Non-Insurable Risks	Uncertain	Yes	Insurance companies cannot research and determine gains. It is too unpredictable and they only know that there will be losses.	Ex. Acts of God   There is no way to determine how much damage a hurricane or earthquake will cause so it is a non-insurable risk.

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