Insurance: How Does It Work?

Insurance is a means of protection from financial loss. Insurance, in other words, is the annoying necessity that we all pay for to ensure we don’t end up in massive debt. If our house burns down, if we crash our car, or if something tragic happens, insurance helps us maintain peace of mind, knowing that, even if something terrible does happen, someone else will pay for what it costs to fix it.

Though, to an untrained eye, this can be a little perplexing. I mean, if you pay $200 a month for home insurance and, after only six months, your home burns down, the insurance company will buy you a new house, likely in a matter of hundreds of thousands of dollars, but you would have only given them $1,200. Why would they do that?

The Basics of Insurance

The basic concept of insurance is that the insurer offers a guarantee for a certain risk that may or may not occur. Then another party, the insured, pays the insurer in exchange for protection against that risk.

When many people do the same thing for the same risk, eventually, the insurer gets a lot of income, but the probability of that risk happening is spread out among a bunch of people and stays about the same. Insurance companies make money by figuring out how much money they need to bring in to turn a profit on a given risk with a given probability. That calculation then influences how much each of the insured pays each month. In general, It’s simple math, but in actuality, insurance companies have highly complex models for all of this.

How Insurance Companies Work

Not every insurance company offers the same insurance. Most insurance companies will specialize in their kind of insurance. This is because each company has to develop a complex model to ensure that they can make money, ensuring a profit. If you estimated that 1 in 100 houses burned down each year, but it was 5 in 100, then you’d be losing money pretty fast. If you insured those houses, you’d probably charge too little for everyone’s insurance and then end up on the hook for those four extra houses. There are many types of insurance companies, from auto to health, life, and homeowners. Most people in the world have these core insurance policies, some of which are legally required to be held, like auto insurance.

You might be wondering, though, why wouldn’t you want to save your money each month, get to hold on to it in a bank account? Then, if nothing bad ever happens, you have a lot more money. Well, while that may be true, it makes you the one exposed to the risk. If you put away $200 a month for a year to save on home, insurance you’ll have an extra $2400 at the end of the year.

However, if your house burns down the next year, well, then you’re going to be out the few hundred thousand dollars that it’s going to take to fix it. A pretty bad deal. Is that a risk you’re willing to take? Chances are it isn’t. That’s why getting insurance is generally a good thing? It takes all of the risk, anxiety, and financial burden off of you and puts it onto a much larger company that can afford it. When you understand insurance as just a way of paying a company to assume your risk, you can start understanding that insurance could, in theory, be offered on virtually anything.

Are you worried that while you’re toasting a cinnamon raisin bagel, your toaster will overheat one of the raisins, causing it to burst into a spontaneous plasma and destroy your entire pantry full of stockpiled bags of lucky charms and baked beans? Well, that’s oddly specific, but someone could probably insure you for that exact thing. Likewise, maybe you’re really attractive and worried that if you fall one time, you’re going to hit your face, stop being attractive and be depressed because no one will like you anymore. Well, somebody could probably insure you against that too. This isn’t too far off from reality: celebrities will often have parts of their bodies insured because their image is a source of their income.


Reinsurance is insurance for insurance companies. It’s a way insurance companies transfer, or “cede,” some of the financial risk they assume in insuring cars, homes, and businesses to another insurance company, the reinsurer. Reinsurance is a highly complex global business.

For instance, if an insurance company realizes that they’re overexposed to home fire insurance and a hot summer is coming, they could take out reinsurance policies on their insurance policies to protect them from high losses in case all the houses they insure burst into flames because of global warming and whatnot. Then all the risk is on the reinsurance agency.

This is a necessary thing, think of it as an insurance company insured everyone in Florida’s cars, but then a hurricane came through and destroyed all the cars, well, that insurance company may owe more in payouts than they have and once they run out of money. Well, then, no one would get money for their destroyed car like they thought they would.

Reinsurance is necessary and important to ensure that insurance companies remain profitable and solvent to pay insureds when there are claims.

Insurance Claims

In terms of claims, insurance companies also don’t just automatically pay out. If you have car insurance and you show them a crashed car, the insurance company will investigate to make sure that you didn’t intentionally crash your car to get the payout. If they find out that you did do that. Well, that’s called fraud and you can go to jail. Faking insurance claims actually does happen quite frequently. People see it as a way to either get a big cash windfall if they’re in hard times or get out of a car or house payment that they can’t afford.

However, car insurance agencies employ top-of-the-line investigators to make sure that they don’t make faulty payouts. So now you can likely see that insurance is a big business and if you have the right models, assume the right kinds of risk and have good investigators to make sure that you are not being defrauded, then you can make a lot of money.

Conversely, if you buy insurance and something bad happens, it can save you a lot of money. In most cases, insurance is a winning formula for all parties involved. It helps consumers be less worried about bad events, and it makes companies a lot of money. And that’s basically how insurance works.

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