How Insurance Works
Insurance is the process of contractually distributing the risk of loss from one person (you) to another (the insurance company) for a nominated fee (an insurance premium).
In this section, we will explore exactly how insurance works and you will learn about the following:
The insurance industry structure
- The business model of New Zealand insurance companies
- Insurance providers
- Insurance alternatives
- The insurance industry structure
The insurance industry structure
There are two main types of insurance in New Zealand:
- General insurance
- Life insurance
There are many insurance industry organisations that help maintain these streams:
- Insurance brokers and insurance advisors
- Insurance investigators and insurance loss adjusters
The business model of insurance companies
The structure of insurance companies is very simple:
Investment income from premiums collected
Insurance companies or insurers profit in two ways:
The process where insurers determine the risk to insure an individual or situation and then decide how much to charge in premiums for accepting the risks associated with the insurance policy.
The process of investing the premiums collected from insured parties.
The most complicated part of the insurance business is the underwriting of insurance policies. Underwriting is the process by which an insurance underwriter assesses the likelihood that an insurance claim will be made against their insurance policy. They then determine the price or insurance premium according to the perceived risk.
Insurance companies use actuarial science to quantify the risks they are willing to assume and the premiums they will charge. Actuarial science is the discipline that applies mathematical and statistical methods to assess risk.
The objective of insurance companies is to collect more from premiums than they pay out on claims. The difference is profit, which they then invest. This is called earning investment profits on “float.” “Float” is the difference between the money collected from insurance premiums and the money paid out on insurance claims. Typically, insurance companies start investing the collected insurance premiums as soon as they receive them. They continue earning interest until the claims are paid out.
There are alternatives when purchasing insurance. Some communities create virtual insurance amongst themselves. In particular, there are several religious groups that operate on this principle. Amish and some Muslim groups rely on this form of insurance when a disaster strikes.
Collectively, the group or organisation would incur the cost of replacing or rebuilding lost or damaged property. This only works in a supportive community where the people or members trust and follow the community leaders. This type of insurance is very uncommon here in New Zealand due to our small population, compared to larger countries such as America, England and India.
In the UK, the Crown did not insure government buildings. If a building was damaged, the repair costs would be met from public funds. This is because, in the long run, it was cheaper for the taxpayers than paying ongoing insurance premiums. It’s not as common now that many of the government buildings have been sold to property companies and then rented back to the government.