August 20, 2014

How Insurance Works

What is insurance?
What are the different types of insurance?
What are the social benefits of insurance?
What happens to the premiums collected by insurance companies?
How are premiums determined?
How does fraud impact what we pay for insurance?
How are insurance companies regulated?

What is insurance?

Insurance basically involves a group of people agreeing to share risks.  It is a very old idea which started back when sailing ships got destroyed or lost their cargoes.  Merchants found that by dividing their cargoes among several boats, they protected themselves from total financial ruin.  That way, if one of the boats was destroyed, no merchant lost everything.  Each stood to lose only a small portion.

Today there are many forms of insurance -- life, health, home and auto -- are just a few.  When you buy insurance, you join many others who pay money to an insurance company.  The insurance company uses the money collected to pay claims that are submitted by those who have purchased insurance.  The money is "pooled" and losses and expenses are shared.  An important aspect is the members of a pool share similar risk characteristics.

When you buy insurance, you get a policy.  That policy is a legal contract.  It spells out exactly what you are buying; it lists what is covered and what is not.  It lets you know how much you must pay (the premium) and when it must be paid.  You need to read your policy and try to understand it -- even if it seems complicated.  You should contact your agent or your insurance company representative and ask questions about anything you do not understand.  Insurance agents sell policies for an insurance company.  Some agents work exclusively for one company, sometimes referred to as captive agents.  Others sell for many different insurance companies (these are called independent agents).

What are the different types of insurance?

Insurance can protect you for almost anything that might happen unexpectedly or accidentally.  You buy protection against the chance of losses that can burden you financially.

There are many types of insurance available.  You can buy insurance to provide income to your dependents in the event of your untimely death.  It can also protect you in the event your car is damaged or you are injured in a crash.  You need protection for your home and your personal property.  Renters need protection for their personal belongings.  Insurance can assist if you have a serious illness and costly medical bills.  Workers' compensation is insurance purchased by employers to help pay the expenses of employees who are injured on the job.

What are the social benefits of insurance?

Along with the personal benefits of insurance, it helps society by reimbursing people and businesses for covered losses, encouraging accident prevention, providing funds for investment, enabling people to borrow money and reducing worry and stress related to accidents or unfortunate events that may occur.

What happens to the premiums collected by insurance companies?

Insurance companies basically do three things with the premium dollar.  First, they pool the money to pay claims.  Second, insurance companies pay for expenses involved in selling and providing insurance protection.  Third, insurance companies invest money.  Earnings from investments help keep down the cost of insurance to policyholders.  In fact, in Michigan and other states investment returns are considered by regulators in assessing whether rates are too low and/or excessive.

The overall cost of overall property/casualty underwriting operations in 2010 was $1.02 for every $1 dollar in premium collected.  Underwriting operations include claims and associated expenses, costs involved in sales and administration, state taxes and licensing fees, but exclude investment income.  Insurance companies generally do not make a profit from their underwriting operations.  The proceeds from invested funds in capital and surplus accounts, along with money set aside for reserves, enable insurance companies to continue insurance operations when underwriting losses exceed the amount collected from premiums.

How are premiums determined?

Insurance rate setting is a complex process.  Insurance can't be priced like most products, since the money people pay is intended to help cover the costs of unforeseen events, such as auto accidents or fires.  Since premiums are paid in advance, the price must be determined before the actual costs are known.  While there are many factors considered in ratemaking, rates basically are dependent on two trends: the frequency of claims (how many) and the severity (cost) of each claim.

How does fraud impact what we pay for insurance?

Insurance fraud cost property/casualty insurance companies about $30 billion a year. When you add other types of insurance the total is closer to $80 billion.  Fraud is more prevalent in a recession, and after major catastrophes.

Fraud may be committed at different points in the insurance transaction by individuals and organized fraud rings.  Common fraud schemes include "padding" or inflating actual claims, misrepresenting facts on an insurance application, submitting claims for injuries or damages that never occurred or billing for medical services never rendered.

How are insurance companies regulated?

All legal businesses are subject to government oversight.  Insurance companies are primarily regulated by state governments.  Each state and the District of Columbia has an agency, headed by a chief insurance regulator, that is responsible for administering the insurance laws approved by their state Legislature.  Therefore, insurance laws vary from state to state.  In Michigan, the state agency with regulatory authority over insurance companies is called the Department of Insurance and Financial Services.  The chief insurance regulator in Michigan is the Director of the Insurance and Financial Services Department.

Copyright 2010 by Insurance Institute of Michigan