Introduction
In
insurance, the insured makes payments called "premiums" to an insurer, and in return is able to claim a payment from the insurer if the insured suffers a defined type of loss. This relationship is usually drawn up in a formal legal contract, also known as a
policy. The contract will set out in detail the exact circumstances under which a benefit payment will be made and the amount of the premiums.
In one classic example of insurance, a ship-owner insures a ship and receives payment if the ship is damaged or destroyed. This example is one of the earliest uses and developments of concepts like insurance. Interestingly, ships are now more often insured through risk pooling and spreading organizations such as Lloyd's of London because the loss of a large ship going down is too great for one insurer to accept.
In the case of annuities, such as a pension, similar concepts apply, but in some sense in the reverse. When applied to annuities, the terms
risk and
loss are somewhat different from traditional insurance as they concern the chances of living beyond life expectancy and the need for income during the period between annuitization and death.
Insurance attempts to quantify risk by pooling together a large number of risks. This makes use of the law of large numbers. As applied to insurance, this means that the greater the number of similar risks, the greater accuracy with which insurers can estimate the overall risk.
For example, many individual people purchase
health insurance policies and they each pay an enormous monthly or yearly premium to an insurance company. When a policyholder gets ill, the insurance company provides money to cover medical treatment. For some individuals the insurance benefits may total far more money than they have ever paid into the insurance policy. Others may never make a claim. When averaged out over all of the people buying policies, value of the claims even out. Insurance companies set their premiums based on their calculated payouts. They plan to take in more money (in premiums and in profit from the
float, see below) than they pay out in the end to cover expenses. For-profit insurance companies set their rates to make a profit rather than to break even.
Insurance companies also earn investment profits, because they have the use of the premium money from the time they receive it until the time they need it to pay claims. This money is called the
float. When the investments of float are successful, they may earn large profits, even if the insurance company pays out in claims every penny received as premiums. In fact, most insurance companies pay out more money than they receive in premiums. The excess amount that they pay to policyholders is the
cost of float. An insurance company will profit if they invest the money at a greater return than their cost of float.
Insurance can also be thought of as a wager or bet that executes over the policy period. The insurance company bets that you or your property will not suffer a loss while you put money on the opposite outcome. The difference in the fees paid to the insurance company vs the amount they can be held liable for if an accident happens is roughly analogous to the odds one might expect when betting on a racehorse, i.e 10:1. For this reason, a number of religious groups including the Amish avoid insurance and instead depend on support provided by their communities when disasters strike. In closing, supportive communities where others will actually step in to rebuild lost property, this arrangement can work. Most societies could not effectively support this type of system.
