Insurance Explained - How Do Insurance Companies Make Money and How Do They Work

Summary

This episode of The Infographics Show explores the intriguing history and mechanics of insurance, from its colorful beginnings with pirates and the Great Fire of London to the complex fiscal models of today. It explains how insurance companies spread risk and profit by evaluating and pooling premiums, often investing in lucrative ventures. The show also touches on different types of insurance and the competitive nature of the modern insurance industry.

Takeaways

• 🎓 Insurance is a financial mechanism for spreading risk among a community to protect individuals from financial ruin.
• 🏴‍☠️ The concept of insurance dates back to ancient Chinese and Babylonian practices of spreading shipping risks.
• 📈 Insurance companies make money by evaluating and taking on risks, hoping that the cost of claims will be less than the collected premiums.
• 💼 The insurance process involves clients, brokers, and underwriters, each playing a specific role in assessing risk and setting policy terms.
• 🔖 The underwriter is a key figure in the insurance process, often taking the largest share of risk and making major decisions on policy acceptance and claims.
• 📝 A policy's terms are finalized when the client and broker agree, leading to the payment of the insurance premium, a portion of which goes to the broker as commission.
• 🔄 Reinsurance is a strategy used by underwriters to mitigate risk by selling part of the policy to another underwriter or firm, retaining a share of the premium.
• 🏢 Modern insurance companies operate on a competitive basis, aiming to write as many policies as possible to create a financial pool for investment.
• 💰 Insurance companies invest the collected premiums in financial products to generate income beyond the premiums, using the cash flow for more lucrative investments.
• 🏠 Property insurance became more common after the Great Fire of London in 1666, with Sir Christopher Wren including an insurance office in his redevelopment plans.
• 👨‍🏫 The script also promotes Skillshare, an online learning platform offering classes on various topics, with a special offer for new members using a promo code.

Q & A

What is the primary purpose of insurance?

Insurance is a financial vehicle that helps spread risk, allowing individuals to avoid financial ruin by distributing the risk across a community.

How do insurance companies make money?

Insurance companies make money by evaluating risk and determining whether it is worth the gamble. They collect premiums from many clients and pay out claims, often investing the premiums to generate additional income.

What is the role of an insurance broker in the insurance process?

The insurance broker assesses the client's risk, draws up an insurance policy, and negotiates with underwriters. The broker takes a commission from the premium and helps negotiate claims settlements.

Who are underwriters and what is their function?

Underwriters evaluate and assume the risk of insurance policies. They decide on the terms of the policy, including what risks to cover, and are responsible for paying out claims.

What is reinsurance and why is it used?

Reinsurance is the practice of underwriters selling a portion of their risk to other underwriters or insurance companies. This spreads the risk further and allows the original underwriter to reduce potential losses.

How did modern insurance begin?

Modern insurance began in the 17th century in London, particularly at coffee houses where merchants and traders would gather. Lloyd's of London, a key player in worldwide insurance, originated from these gatherings.

What significant historical event led to the development of property insurance?

The Great Fire of London in 1666, which devastated the city, led to the development of property insurance as part of the city's redevelopment plans.

How do insurance companies remain competitive in modern times?

Insurance companies remain competitive by pricing policies at their lowest possible point and writing as many policies as possible to create a large financial pool. They also invest the collected premiums in high-interest financial products.

What types of insurance policies are commonly held today?

Common insurance policies today include property, medical, life, travel, car, dental, and even pet insurance.

How does the insurance industry benefit from high-interest investment schemes?

Insurance companies invest the premiums collected from policyholders into high-interest investment schemes. This allows them to generate income from these investments, even if they pay out more in claims than they collect in premiums.

Outlines

00:00

🏛 The Origins and Function of Insurance

This paragraph delves into the history and purpose of insurance, challenging the common perception of it as a dull industry. It explains insurance as a financial tool designed to spread risk among a community, protecting individuals from financial ruin. The concept is illustrated with a simple example involving two individuals, Bob and Jim, and their cell phone insurance agreement. The paragraph also traces the origins of insurance back to ancient civilizations and highlights the pivotal role of London's coffee shops in the 17th century, where the modern insurance model was conceived, particularly the establishment of Lloyds of London. The process of insurance, from client concern to underwriter involvement, is outlined, including the assessment of risk, policy creation, and claim settlement. The paragraph concludes by introducing the concept of reinsurance, which allows underwriters to share risk with other parties.

05:03

🏘️ The Evolution and Modernization of Insurance

The second paragraph discusses the evolution of insurance from its maritime beginnings to include various types of insurance common today, such as property, medical, life, travel, car, and even pet insurance. It highlights the role of Sir Christopher Wren in incorporating an insurance office into his post-Great Fire of London redevelopment plan, signifying the growing importance of insurance in society. The paragraph explains how the insurance business model has become more competitive, with companies aiming to write as many policies as possible to create a financial pool. This pool of premiums is then invested in other financial products to generate profit. The concept of reinsurance is further explored, illustrating how underwriters can manage risk by selling parts of their policies to other underwriters or firms. The paragraph concludes with a call to action for viewers to consider their own insurance needs and to explore creative ways to generate income through Skillshare classes, offering a promotional code for The Infographic Show's audience.

Keywords

💡Insurance

Insurance is a financial product that provides protection against potential future losses. It is the core subject of the video, illustrating how it has evolved from ancient practices to a complex fiscal model. The script uses the concept of insurance to explain how risk is spread among a community, protecting individuals from financial ruin. For example, the video script describes a simple insurance agreement between two individuals, Bob and Jim, where Bob pays Jim to cover the potential loss of his cell phone.

💡Risk Spreading

Risk spreading is the fundamental principle of insurance where the potential loss of one individual is distributed among many. This concept is central to the video's theme, demonstrating how insurance companies manage and mitigate financial risks. The script explains that by taking a risk from an individual and spreading it across a community, the burden of potential loss is lessened. This is exemplified in the script through the story of Jim, who collects money from multiple people to cover their phones, thus spreading the risk.

💡Insurance Companies

Insurance companies are the entities that provide insurance policies to individuals or businesses. They are key players in the video's narrative, showcasing how they operate and profit from the insurance model. The script describes how these companies evaluate risks and decide whether to offer insurance, using the example of Jim who evaluates the likelihood of Bob losing his phone and charges a premium accordingly.

💡Insurance Broker

An insurance broker is an intermediary who connects clients with insurance underwriters. In the video, the role of the broker is to assess the value of the insured item, such as a ship, and determine the risk involved. The script explains that the broker presents the insurance policy to the underwriter after assessing the client's needs and the potential risks, as seen in the example of the ship-owner worried about pirates or bad weather.

💡Underwriter

An underwriter is a person or company that accepts the risk of insurance by agreeing to cover the loss in exchange for a premium. The video script describes the underwriter's role in the insurance process, including their decision-making regarding policy acceptance and claims. The underwriter is depicted as the main party responsible for agreeing to the terms of the insurance policy and potentially reinsuring the policy to spread the risk further.

💡Policy Premium

A policy premium is the amount paid by the insured to the insurer for coverage under an insurance policy. The script discusses how insurance companies make money by collecting premiums from numerous policies. It illustrates the concept using Jim's phone insurance example, where he collects $10 from each of his 100 clients, accumulating a pool of money to cover potential claims.

💡Claims

Claims are requests for payment made by the insured to the insurer when a loss occurs. The video script explains the process of claims settlement, where the insured party seeks compensation for a loss, such as a ship lost to pirates. The script describes how the insurance broker and underwriter work together to negotiate and settle claims, ensuring the insured party receives compensation without the broker taking a cut.

💡Reinsurance

Reinsurance is a form of insurance for insurers, where the underwriter sells the policy to another underwriter or firm to spread the risk. The script uses reinsurance to explain how underwriters can mitigate their risk, similar to Jim reselling his phone insurance policy for a reduced amount to keep a portion of the premium without bearing the full risk.

💡Lloyds of London

Lloyds of London is a prominent insurance market that originated in a coffee house in the 17th century. The video script highlights its role as the heart of worldwide insurance, describing how it developed as a place where marine insurance was discussed and policies were created. The script uses Lloyds of London to illustrate the historical development of modern insurance practices.

💡Financial Pool

A financial pool refers to a large sum of money collected from multiple sources, such as insurance premiums. The video script explains how modern insurance companies create financial pools by collecting premiums from thousands of policies. This pool of money is then invested in other financial products to generate additional income, demonstrating the investment aspect of the insurance business model.

💡Passive Income

Passive income is money earned with little to no effort by the recipient, often through investments or other money-making strategies. While not the main focus of the video, the concept is mentioned in the context of Skillshare classes that teach viewers how to generate passive income. The script suggests that learning about passive income can provide additional financial opportunities beyond traditional insurance models.

Highlights

Skillshare sponsorship: Get 2 months free using the link in the description.

Insurance conferences may seem boring, but the history of the industry is fascinating, involving pirates and major fires.

Insurance is a financial vehicle that helps spread risk across a community, preventing individuals from facing financial ruin.

Basic insurance concept: Bob pays Jim $10, and if Bob loses his phone, Jim buys him a new one.

Insurance companies make money by evaluating risk and setting premiums accordingly.

Historical origins: Insurance ideas date back to ancient Chinese and Babylonians spreading shipping risks.

Modern insurance took off in 17th century London, particularly in coffee houses where Lloyds of London was developed.

The process of marine insurance involves the client, broker, and underwriter assessing and agreeing on policy terms.

Underwriters may reinsure policies, spreading risk further and retaining a share of the premium.

Reinsurance allows underwriters to sell policies to other firms, reducing their own risk.

The Great Fire of London in 1666 prompted the development of property insurance.

Modern insurance covers various aspects including property, medical, life, travel, car, dental, and even pet insurance.

Insurance companies invest the premiums from policies to create cash flow and profit from other financial products.

Fierce competition in the insurance industry benefits clients by driving policy prices down.

Promotion of Skillshare class on generating passive income, highlighting over 20,000 classes available.

Encouragement to join Skillshare with a promo code for 2 months of free Premium Membership.

Call to action for viewers to share their thoughts on insurance, its costs, and whether they view it as a scam.

Transcripts

This episode is brought to you by Skillshare.

Get 2 months of Skillshare free and learn new skills by using the link in the description.

Well some of us may think that there’s nothing more boring than attending an insurance conference

on a wet Tuesday night in Boston.

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 stay tuned to today’s episode of the The

Infographics Show – Why do insurance companies make money and how do they work?

What is insurance?

Well, insurance is a financial vehicle that helps spread risk.

By taking a risk from an individual, and spreading that risk around a community, the individual

is able to go about their personal or business life without crumbling from financial ruin.

In the simplest terms, let’s look at two people.

One is named Bob and the other Jim.

Bob says to Jim, I’ll give you ten dollars, but if I lose my cell phone, you’ll have

to buy me a new one.

If Jim agrees, then that’s insurance right there.

Insurance companies make money because they evaluate the risk and decide whether it is

worth the gamble.

Jim believes that Bob probably won’t lose his phone and he’ll therefore be ten dollars

richer.

If Jim 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 Jim pays 100 dollars as compensation,

he still has 900 bucks.

This insurance idea has been floating around since the ancient Chinese and the Babylonians

spread their shipping risks.

But it wasn’t until around the 17th century in London that modern insurance really took

off.

Merchant marine men and traders often hung out in coffee shops in the business district

of London, and while drinking copious amounts of coffee, the idea of modern day insurance

was born.

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 that he is nervous about losing to pirates offshore, or perhaps

the vessel will be destroyed 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 which 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 Jim, 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 writers 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 policy are agreed to, it is made legal, and the client is happy

and the ship sets sail - but not before paying the insurance premium to the broker, who will

take about 10%, and pass the rest on to the underwriter.

But what should happen if pirates board the ship, steal the cargo, and burn it at sea?

Well, the client (if he is still alive, if not, a representative of the client) will

speak to the insurance broker and the broker will visit with the lead underwriter and 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.

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 Jim and his phone insurance.

If Jim 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 clients, meaning he has 100 dollars

completely risk free.

Similarly, much of the modern day insurance that flows through Lloyds of London is reinsured

out of the building to smaller insurance companies all across the world.

So what starts as a simple agreement between the client and the broker (or Jim and Bob)

is spread across a business community who each stand to profit from the premium or take

a cut of any losses.

This is how insurance works – by the spreading of risk over communities.

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.

But what about property insurance?

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, made sure to include an insurance office in his new plan.

Now property insurance is commonplace with most homeowners having a policy in place.

Also medical, life, travel, car, and dental insurance are all commonly held policies.

Even pet insurance is a major insurance business nowadays.

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.

Companies now look to write as many polices as possible to create a financial pool.

They take the premium from thousands of policies, and invest that money in another financial

product.

So the insurance underwriter may pay out more claims than they make in policy premiums.

But they have invested all those premiums in a high interest investment scheme, so they

make their money outside of the original insurance product.

Insurance in this example is a way of creating cash flow to be used in more lucrative investments.

And if you are wondering what other creative and lucrative ways there are to make more

cash, take a Skillshare class called “How to generate Passive Income.”

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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!

Also, be sure to check out our other video called US Teachers vs UK Teachers!

Thanks for watching, and, as always, don’t forget to like, share, and subscribe.

See you next time!