Overview – Understanding Insurance
If you live in Canada or the U.S., chances are you have a Canadian and/or U.S. bank account. In the event that your bank deposits (or the deposits of other clients) are stolen, and it was proven in court that the bank was at fault for this occurrence, the last thing a bank wants to do is reimburse every client using the bank’s funds.
To help prevent this, Canadian banks insure the deposits of their clients through the Canadian Deposit Insurance Corporation (CDIC). The American equivalent is the Federal Deposit Insurance Corporation (FDIC).
In the months leading up to the 2007-2008 Global Financial Crisis, one of the major players involved in the whole ordeal was American International Group (AIG). Put very simply (this article explains AIG’s role in the Global Financial Crisis in much greater depth), AIG offered insurance to financial institutions that were selling high-risk bonds, but ultimately the insurance being offered was insufficient in covering all the liabilities.
Chances are you’ve at least heard about insurance, but how exactly does it work?
This article will provide an introduction as to what insurance is and how it works.
*Disclaimer: Please note that this article is strictly introductory/informative in nature, and its sole purpose is to provide readers an introduction to how insurance works. Nothing in this article should be interpreted as insurance/legal advice. Please seek the services of an insurance professional and/or insurance attorney for your insurance needs.*
The Purpose of Insurance
Imagine you buy a new house. One day, a small fire starts in your kitchen and proceeds to engulf the kitchen and the adjacent living room in flames.
You get an appraisal for the damage, and the damage done to your home is over $100,000. It’s safe to say that most people don’t have $100,000 just lying around. Even if they did, $100,000 is still a hefty sum to pay.
Assuming you didn’t purchase any sort of fire protection insurance, you’re forced to pay that $100,000 yourself if you want to repair your home. This is a financial situation most people hope they never find themselves in.
Had you decided to purchase fire protection insurance, you wouldn’t need to worry about scraping together $100,000. Instead, you would exercise your insurance plan by filing a claim. Whether the insurance company agrees to pay all or only part of the bill, this is much better than having to foot the entire bill yourself.
When you purchase insurance, you’re essentially off-loading a potential financial risk to somebody else, in this case, an insurance company. When that risk materializes, because you have purchased insurance, the insurance company is the one who takes the financial hit, not you.
Insurance companies exist because very few people have the funds on hand needed to pay large financial liabilities on their own. Not everyone has enough funds readily available to buy a new car, repair a burnt house, or pay hefty medical bills – these bills can cost tens, if not hundreds, of thousands of dollars (or perhaps even millions).
Instead of saving every penny for an unexpected emergency, insurance companies sell insurance plans to individuals – in exchange for a recurring fee, insurance companies pay these hefty bills on behalf of the individual (more on this later).
Before continuing, there are some terms you should be familiar with.
When a client wishes to have a bill paid for by their insurance company (i.e., they exercise their insurance plan), they file a “claim”. A claim is made by a client when they wish to exercise their insurance plan.
When an insurance company agrees to give the client the money they request, the insurance company has “paid the claim”. Just because a client makes a claim doesn’t mean the insurance company has to honour it (more on this later).
How Insurance Companies Foot the Bill
Obviously, insurance companies are still businesses, meaning they don’t take on financial risk for purely altruistic reasons.
Insurance companies are able to pay such large bills because they have access to a large pool of money. When one of their clients needs to get part of their home repaired for $100,000, then the insurance company takes from their pool of funds to pay for that.
Insurance companies are able to accumulate such a vast pool of funds because they collect intermittent payments from their clients called “premiums”. This is the trade-off insurance companies offer: in exchange for protection against large financial liabilities, clients must pay a premium.
Let’s say that an insurance company has 1,000 clients and charges them a monthly premium of $100 for auto insurance. Every month, this insurance company collects $100,000 in premiums, or $1.2 million in premiums every year. The money they collect goes towards the pool of funds they tap into when one of their clients files a claim.
Because insurance companies bring in so much cash via premiums, and because they usually bring in more cash in premiums than they pay out via claims, it would be foolish to have this cash sitting around idly.
So, as you may have suspected, insurance companies invest the funds they receive, usually in marketable securities such as stocks and bonds. If you ever look at an insurance company’s balance sheet, they usually outline which investments they own.
Below is an image of Manulife Financial’s 2019 Balance Sheet – notice how they quantify what portion of their assets are currently invested:
Different insurance companies charge their clients different premiums, and the premiums clients owe can even vary based on the type of insurance they have purchased (i.e., premiums for car insurance and home insurance will most likely be different).
Below is a visual representation summarizing the premium collection process and how those premium funds are used:
Insurance Companies and Risk Management
At their core, insurance companies are in the business of managing risk. They shoulder the financial risks of their clients, but they don’t want to constantly be paying claims.
If an insurance company brings in $1 million in premiums every year but pays $999,000 in claims, this is hardly what anyone would call a sustainable business model. Remember that insurance companies still have the goal of generating profit, meaning they don’t want to constantly pay out claims.
Insurance companies want to ensure that the risk they’re taking on from their clients doesn’t overtake their ability to generate a profit. In fact, the calculation of risk in insurance, business, and finance has an entire field of study dedicated to it: actuarial science.
Individuals who are trained in actuarial science are called actuaries, and they’re usually hired by insurance companies to calculate insurance risk using mathematics (namely probability and statistics).
One of the methods insurance companies use to make their risk exposure more tolerable is to have a large client base. By having a larger client base, insurance companies are essentially spreading the risk equally amongst their clients.
Statistically speaking, a small portion of their client base will pose a very large risk; that is, this minority will file very large claims, or at least file a claim very frequently.
If an insurance company’s client base is small, it’s possible that they won’t have enough funds on hand to pay for these large and/or frequent claims. In other words, the money they pay in claims exceeds the money they bring in via premiums.
By expanding the client base, the hope is that the majority of clients will simply pay their premiums but hardly file a claim (or at least file very small claims). There will still be a small portion of clients who file large claims, but the insurance company can better handle this risk because the majority of clients bring in more money to the company than they take out via claims.
Higher Risk = Higher Premiums
Imagine you are a Canadian insurance company that provides health insurance and are looking to bring in new clients.
Your actuaries find out that, statistically speaking, older Canadians are more likely to experience serious health conditions and medical emergencies than younger people. Not only that, but your actuaries also discover that Canadians born between 1991 – 2006 have a life expectancy of approximately 80 years.
Putting the pieces together, you come to the conclusion that because people are living longer, and because people generally experience deteriorating health as they age, older people are more likely to seek health care services than younger people.
As a health insurance company, this means that older people pose a greater financial risk because they are the group of people who will most likely be responsible for the bulk of claims that need to be paid.
Because older people pose a greater financial risk than young people, the most logical solution is to charge them higher premiums. Charging higher health care premiums to older people is not unheard of.
The same logic applies as to why young drivers pay higher auto insurance premiums than older drivers.
Young drivers are, generally speaking, less experienced, have a greater tendency to drive more aggressively, and are more likely to drive recklessly – all of these are factors that increase the likelihood of an accident happening, and subsequently, a claim that needs to be paid.
Every insurance company follows its own methods when assessing premiums, but the rule of thumb virtually all of them follow is that when a client poses a greater financial risk, they are usually charged higher premiums.
This is why after a car crash, it’s very likely that a driver’s auto insurance premiums will go up.
Logically, this makes sense: if a certain group of clients is more likely to exercise their insurance plans, these individuals pose a greater financial risk to the company.
No insurance company would willingly shoulder increased financial risk without adequate compensation, so the logical response would be to charge these clients higher premiums in exchange for the higher risk they pose to the company.
Not Every Claim is Honoured
Just because you file a claim doesn’t mean all you need to do is wait for it to be paid. It’s not unheard of for insurance companies to deny claims.
Again, just as there are several types of insurance plans (health insurance, home insurance, auto insurance, etc.), there are various reasons (usually legal) as to why claims can be denied.
For example, here are 22 reasons why life insurance claims are denied, and here are 6 reasons why car accident claims are denied.
From a business perspective, insurance companies want to keep claims on a tight leash because that represents money leaving the business. Anytime insurance companies pay a claim, that shows up as an expense in their income statement:
If insurance companies paid every claim they received, they would quickly shut their doors – if the bulk of revenue from premiums and investments went towards paying every claim, they would have insufficient funds to meet other business obligations such as employee salaries, shareholder dividends, and debts.
Insurance companies exist to shoulder the financial risk of their clients, yes, but that doesn’t mean they are willing to pay every claim that is filed. The bigger the claim, the more resistance clients will run into when trying to get that claim paid: no insurance company would shell out $500,000 in claims unless they absolutely had to.
Because of the inevitable butting of heads between clients and insurance companies, an entire field of law is concerned solely with insurance: insurance law.
Wrapping Up
Insurance is commonplace in today’s world. It allows individuals and institutions to avail or offer certain services without constantly having to worry about what may happen in the event of a financial emergency.
Insurance companies are in the risk management business. They take on the financial risks of clients, and in return cover those liabilities on behalf of the clients in exchange for regular payments called premiums.
Because the vast majority of insurance companies are for-profit businesses, they spend a lot of time, effort, and money ensuring that they can still turn a profit without overextending their ability to cover claims.
Disputes between clients and insurance companies are bound to happen, so insurance law lays out the legal groundwork needed to ensure insurers and clients both get the outcomes they desire.
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