Explain How Insurance Works

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Insurance transfers the risk of financial loss from an individual to a company. The insurance company is based on cash reserves from the premiums paid by its customers. The risk of loss is shared among these individuals, who agree to pay a specific amount in premiums in return for the promise of recouping a certain amount in the event of a loss.

The Concept of Insurance

When you purchase insurance, you are buying indemnity for your car, house, health, life or anything else that you contract for. You are stating that the value of something, such as your home or the cost of restoring your health, is so great that you would be unable to replace or restore them from your own cash reserves. The insurance policy promises to replace the home or pay for your medical costs in return for the premiums that you pay even though the payout far exceeds the amount that you will pay.


Insurance is a bet, for both you and the insurance company. As an example, both of you know that statistically there is only a minute chance that your house will be destroyed by fire. The insurance company’s actuaries develop the statistics for quantifying the amount of risk involved in the insurance transaction. They will look at all of the factors surrounding the item being insured to determine if the risk of loss is high or low, and set the premiums and policy limits accordingly. This is why the auto insurance premium for a 16-year-old is significantly higher than his grandmother’s.

Pooled Risk

If you and the insurance company were the only parties involved in the insurance interaction, it would not work. Your premiums would have to pay into a fund that has sufficient monies to pay for your loss. You would be better off putting the money in a savings account. To make the transaction work, the insurance company contracts with hundreds of thousands of your neighbors, and each of you pays a premium that goes into a pool of money. The size of the pool is determined by how many claims the insurance company anticipates paying in the coming year. If the homeowners' insurance pool sees that it will have to replace five homes at $200,000 each, it will need a pool of $1,000,000 in reserve. The company will divide this anticipated risk among all of the homeowners that it contracts with to fill the pool. If it replaces fewer homes than anticipated, the premiums for the next year can be lowered; if it has to pay for more claims than it's prepared for, premiums will rise to fill the pool.

Property Insurance

Insuring your car, home or other property differs from health or life insurance. Property insurance takes into account the declining (auto) or increasing (home) value of your property and the anticipated costs of covering their loss. Many drivers are unpleasantly surprised, when making a claim, to discover that the payout is much less than the cost of a new car. The insurance policy is specific to your car; so if you are driving a 1985 pickup truck, its current depreciated value is what the insurer is covering. Home values, on the other hand, appreciate over time, and you must review your policy to ensure that the full replacement value, at current prices, is built into the contract.

Health Insurance

You purchase health insurance so that, in the event of a catastrophic illness, you will be able to cover the costs of paying the physicians and hospital. In order for the insurance company to stay in business, the premiums of a sufficient number of healthy people not making claims must exceed the amount of money paid out for higher-risk participants. The cost of a health insurance policy continues to escalate because more and more services, coverage areas and day-to-day costs are being demanded of commercial policies.