insurance awareness study material

Insurance Awareness: How Insurance Works – Chapter 4

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How does insurance work?

You must be knowing the basics of insurance. But let’s try to understand how insurance actually works. Let’s understand this with an example of car insurance.

  • You buy insurance for your car.
  • Suppose the insurance company provides you insurance of Rs 10 lakhs. This is the insurance cover.
  • In return, you have to pay some fees to the insurance company. This fee is known as premium.
  • The insurance policy is valid for some time that is mentioned in the agreement. This is known as the policy period/duration.
  • Let here the policy duration be 1 year.

how insurance works

Now there can be two conditions:

There is no damage to the car during the policy period: Then the insurance company will not pay you anything.

There is some damage to the car during the policy period: Then your car insurance comes into play. In this case, you will get some amount from the insurance company that depends on the amount of damage. But this will be less than the amount insured (in this case Rs 10 lakhs). Suppose the damage to your car is of Rs 5 lakh. Hence the insurance company pays you Rs 5 lakh. But from where does the insurance company brings this extra 4,90,000. As you paid the premium of only Rs 10,000.

Has the insurance company borne loss due to you?  

To understand this, you need to understand that like you there are lakhs of people who have opted for any such insurance. As in our case car insurance. All these policyholders will pay the premium to the car company. This is the total income for the insurance company.

how does insurance works

Let Number of people with Car Insurance be 1 lakh.

Hence total premium for the car insurance company ( @ Rs 10,000)= Rs 100 Crore

But not all these people will have a car accident. Suppose out of this 1 lakh; 1% people have a car accident. i.e 1000 people. To each policyholder, the car insurance company pays Rs 5 lakh each. Hence the amount paid by Insurance Company= Rs 50 crore

Still, the insurance company has a profit of Rs 50 Crore.

This was just an example with only a single insurance product. Each insurance company has multiple insurance products.

So now you can understand insurance in 4 steps

  • The insurance company estimates/calculate the premium to accept the risk of covering your insurance. Premiums are calculated based on what amount of money the insurance companies think they will need to pay for the coming year’s claims. The person calculating such amount is known as an actuary. 
  • You pay this premium to your insurance company (monthly or annually) for insuring your risk. 
  • Since there are multiple policyholders like you, the insurance company will put all the premiums into one large pool. Your insurance is an annual contract, so the pool operates for only one year at a time. 
  • The insurance company uses this pool of money to pay for the losses of the few who make claims in that year.

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