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How Insurance Works

How Insurance Works

A simplified example of automobile insurance might work this way. Suppose that a group of 100 drivers can be divided into three groups. In a given year, 60 of those people have only a few door dings or chipped paint, which costs $100 each. Another 30 of the drivers have medium-sized accidents that cost an average of$1,000 in damages, and 10 of the drivers have large accidents that cost $15,000 in damages. For the moment, let’s imagine that at the beginning of any year, there is no way of identifying the drivers who are low-risk, medium-risk, or high-risk. The total damage incurred by car accidents in this group of 100 drivers will be$186,000, that is:

$$\begin{array}{rcl}\text{Total damage}& \text{=}& \text{(60 × \100) + (30 × \1,000) + (10 × \15,000)}\\ & \text{=}& \text{\600 + \30,000 + \150,000}\\ & \text{=}& \text{\186,000}\end{array}$$

If each of the 100 drivers pays a premium of $1,860 each year, the insurance company will collect the$186,000 that is needed to cover the costs of the accidents that occur.

Since insurance companies have such a large number of clients, they are able to negotiate with providers of health care and other services for lower rates than the individual would be able to get, thus increasing the benefit to consumers of becoming insured and saving the insurance company itself money when it pays out claims.

Insurance companies receive income, as shown in this figure, from insurance premiums and investment income. Investment income is derived from investing the funds that insurance companies received in the past but did not pay out as insurance claims in prior years. The insurance company receives a rate of return from investing these funds or reserves. The investments are typically made in fairly safe, liquid (easy to convert into cash) investments, as the insurance companies needs to be able to readily access these funds when a major disaster strikes.

An Insurance Company: What Comes In, What Goes Out

Money flows into an insurance company through premiums and investments and out through the payment of claims and operating expenses.