Why does the insurance industry exist?
The insurance Industry exists to address risk.
Insurance has roots going back thousands of years, and it has become a key element of modern society. Many everyday risks are covered by insurance e.g. building fire, car accidents, getting sued etc.
For the few who experience major events such as a fire, the impacts can be catastrophic. Other than the potential loss of life, there could also be the immediate loss of all assets resulting in poverty or business failure. Insurance is there to protect businesses and individuals. It spreads the risk, so the impact for everyone is predictable and affordable.
Insurance Industry Video Intro
The video outlines the origins of insurance, discusses how the modern insurance industry has evolved, and its impact on the economy and society.
Basic Mechanics of the Industry
Multiple individuals/companies pay money (“premiums”) to insurance companies as a fee to take on the risks that individual or company faces.
For some types of insurance e.g. ‘life insurance’ the insurance company reimburses losses to those who experience an event, the rest receive nothing back from their payment.
For other types of insurance e.g. whole of Life & Annuities, insurance companies invest the premium they’re paid, and in most cases they pay a larger sum of money back in the future.
In order to pay this money, insurance companies need to have collected enough premiums to cover their losses, to cover their operating expenses, and they must have made sufficient investment returns for multi-year products.
Individuals and companies who experience an event benefit by having the cost of the claim paid by the insurance company, which may be many times more than what they have paid in premiums. For the large majority of customers who don’t claim in a given year, they receive nothing back from the premiums they paid and the benefit they receive is knowing that they were protected.
Guiding Principles for Insurance Companies
In order to stay in business, insurance companies need to accurately predict the future. They need to predict how likely an event is to occur to predict how many insured parties will experience an event. They also need to predict how much an event will cost and how long it will be before the insurance company will need to pay the money. If the risks are underestimated, the insurance company won’t have collected enough revenue to cover the claims.
Predicting risk is primarily done through statistical risk modeling, known as Actuarial Science. This is a mixture of science and art: pricing risk involves being able to make judgements on how similar or different cases are to each other and to your expectations.
Video, Types of Insurance
The video outlines the different types of Insurance Products old by insurance companies.
Types of Insurance Products
A ‘product’ in an insurance company is a ‘policy’. A policy is a contract between the insured and the insurer. Each policy outlines the terms of the risks and the coverage for that risk, including details on what is included and excluded, and what amounts will be paid in the event of the risk coming to pass.
There are 2 broad insurance categories: 'Property & Casualty', and 'Life, Annuities and health'
Property & Casualty (P&C)
Property is the part that covers the asset that is insured like a building or a car.
Casualty is the risk related to third parties i.e. liability (or the risk of being sued because of something you did or failed to do).
For Property, the damage is more predictable and has a known value or one that can be estimated, but for Casualty the exposure is much less predictable because it depends on so many external factors and parties, so it’s generally defined with a limit to bring certainty to the situation, e.g. $1m liability.
Most policies cover both Property and Casualty, though there are policies specific to one or the other.
Under Property & Casualty there are 2 further segments - Personal and Commercial.
Personal Insurance
Generally 4 categories of personal insurance which are often referred to as “Lines of Business” (“LOB”).
- Motor (“Auto” in the US): owned car, non-owned car (e.g. when you’re driving a friend’s car, rental car, etc). Biggest category under personal
- Home: homeowners, renters, condo
- Umbrella: on top of your existing insurance to provide additional liability coverage
- Other: e.g. pets, travel etc. You can insure many different types of risk
Commercial Insurance
There are multiple categories of commercial insurance including
- Commercial motor/auto
- Commercial property
- General liability
- Professional Liability/Errors and omissions/professional indemnity: differs a lot based on the profession. Medical malpractice vs contractor’s liability risks and costs will be different
- Worker’s comp
- Cyber security
- Directors & Officers
Life, Annuities and Health (LAH)
Life Insurance
Life insurance provides financial protection to an individual's loved ones in the event of their death. It is a contract between an insured person and an insurer in which the insurer guarantees payment of a sum of money to designated beneficiaries upon the death of the insured person. There are two main types of life insurance: term life insurance and whole life insurance.
- Term life insurance provides coverage for a specific period of time, such as 10, 20, or 30 years. If the insured person dies during the term of the policy, the insurer pays the death benefit to the beneficiaries. If the insured person does not die during the term of the policy, the policy expires and no death benefit is paid.
- Whole life insurance, also known as 'permanent' or 'universal' life insurance, provides coverage for the entire life of the insured person. In addition to providing a death benefit, permanent life insurance can also include a savings component, which allows the policyholder to build up a cash value over time. This cash value can be used to pay premiums or can be borrowed against or withdrawn.
Life insurance can be a valuable tool for helping to protect the financial stability of an individual's family or loved ones in the event of their death. It can be used to help cover expenses such as funeral costs, outstanding debts, and living expenses. It can also be used to provide financial support for dependents, such as children or elderly parents, or to fund future goals, such as education or retirement.
Another important part of life insurance category is disability insurance
- Disability insurance is a type of insurance that provides financial protection in the event that an individual becomes unable to work due to a disability. It is designed to help replace a portion of an individual's income if they are unable to work due to a physical or mental impairment that prevents them from performing the duties of their job. There are two main types of disability insurance: short-term disability insurance and long-term disability insurance.
- Short-term disability insurance provides coverage for a specific period of time, usually a few weeks to a few months. It is typically designed to provide income replacement during the initial recovery period after a disability.
- Long-term disability insurance provides coverage for a longer period of time, often several years or until the individual reaches retirement age. It is designed to provide income replacement for those who are unable to work due to a long-term disability or illness.
Disability insurance can be a valuable financial tool for individuals who rely on their income to support themselves and their families. It can help to cover living expenses, medical bills, and other expenses that may arise as a result of a disability. Some employers offer disability insurance as part of their employee benefit packages, but it can also be purchased individually.
Annuities
An annuity is more of a financial product that behaves like insurance. Annuities provide a stream of payments to an individual, typically in exchange for a lump sum of money. There are several types of annuities, including immediate annuities (which play out immediately after their purchase) and deferred annuities (which start to pay out at a later date). Both of these types of annuities can be structured to provide a fixed amount of income for a specific period of time, or for the lifetime of the annuitant.
Annuities can be used for a variety of purposes, such as supplementing retirement income, providing a source of guaranteed income for the rest of your life, or saving for a specific goal, such as paying for a child's education.
Annuities can be purchased from insurance companies and other financial institutions, and they typically have fees associated with them, such as administrative fees and surrender charges.
Health Insurance
Health insurance is a type of insurance that helps cover the cost of medical care. It can help pay for expenses such as doctor's visits, prescription medications, hospital stays, and surgeries.
There are several types of health insurance plans available, including employer-sponsored group plans, individual plans, and government-sponsored plans. Each type of plan has its own set of benefits and limitations.
Group plans are typically offered through an employer and may cover the employee and their dependents. Individual plans can be purchased directly from an insurance company or through a marketplace. Government-sponsored plans (such as Medicare in the USA), are available to eligible individuals based on factors such as age, income, and disability status.
Health insurance plans often come with deductibles, copayments, and coinsurance, which are out-of-pocket costs that the insured person is responsible for paying. Some plans also have an annual out-of-pocket maximum, which is the maximum amount that the insured person will have to pay out of pocket in a given year.
Follow up
As a follow up article we will be writing "How does the Insurance Industry Work? Part 2"
The article will cover:
- What is the Insurance Value chain?
- Who are the Players in the Insurance Ecosystem?
- What are Business Models and Profit Drivers for Insurers?
- What does the Insurer Balance Sheet look like?
- What are the Insurer Operating Models?
- And what are the New Trends Emerging in the Insurance Industry?
Frequently Asked Questions
