What is insurance and how does it work?

The surprisingly non-boring history of insurance

Like many of the best things in life, it started over coffee. Back in the late 1660s, merchants hung out at Edward Lloyd’s coffeehouse in London. They talked business. Shipping furniture, clothing, books, sugar and other goods to the American colonies was profitable—but risky. They wanted a way to protect themselves from financial ruin if these items ended up at the bottom of the sea. Investors stepped up to help. They agreed to take on the risk.

The deal? Each merchant would pay money—a “premium”—to the investor. If a ship wrecked and the goods did not reach the colonies, the investors would pay the merchants to make up for the loss. If all went well, the investors would keep the premiums.

In the mid-1770s, Ben Franklin used this “marine insurance” idea to start a fire insurance company in Philadelphia. Right, the guy famous for flying kites in lightning storms helping others manage risk. Ben had already organized the city’s first volunteer fire department, which led to many others. The firefighters pooled their money in “The Philadelphia Contributionship for the Insurance of Houses from Loss by Fire.” Each contributor agreed the pot of money could be used to pay members for any property they lost in a fire. They also insisted that members do whatever they could to prevent fires.

So how does insurance work now?

Today, insurance works pretty much the same. Sure, the numbers of contributors—policyholders—are millions of times larger. So are the dollar amounts. But the core idea remains: Insurance transfers risk from an individual to a company, and reduces the risk by pooling very large numbers of individuals.

“Large numbers” is the key. The law of large numbers lets insurance companies predict—very accurately—how many losses their members will experience each year. That lets insurance companies plan ahead for the amount of money they will pay in claims to members.

Here’s a simple example of the law of large numbers: Toss a coin 10 times, and it might land heads up 8 times and tails up 2 times. Toss it 10,000 times, and the heads:tails ratio will be extremely close to 50:50.

The law of large numbers applied to insurance: Assume that, in a certain state, one percent of renters have a kitchen fire each year. If 200 people in that state buy renters insurance, insurance companies cannot accurately predict how many will experience a kitchen fire. However, if 20,000 people in that state buy it, they can safely plan to pay 200 claims for losses from kitchen fires.

How do insurance companies make money?

When you and millions of others pay premiums, the insurance company uses the money to: 1) pay individual members of this large pool when they have a loss 2) use the money that they collect today but may not have to pay out until far into the future to invest in stocks, bonds and other assets to make the most “return on investment” or “ROI” with the least risk Insurance companies do not make much profit.

They have to keep their premium prices low enough to compete with other companies. But these prices need to be high enough to help cover their costs when they pay policyholders for losses. They keep a huge cash reserve so the money is there when they—and you—need it. It’s not just good business; it’s what the law requires them to do.

What is a “loss?”

There are three main types of loss and essentially three different industries in insurance—property and casualty (Jetty has your back here), health and life. In general, insurance covers losses as follows: Property and casualty (P&C) insurance is also called “property and liability insurance.” (Casualty is just “insurance lingo” for liability—nothing to do with dying, here!)

These policies help you to pay for replacing or repairing property, such as bikes, cars, houses, boats, business equipment and much more. A loss can also mean loss of income, such as missing work after a bad car accident. 

Liability coverage can help you to pay legal fees or other costs when you are held liable for someone else’s loss, such as accidentally breaking their window.

Doctors, accountants, engineers and many other professionals buy professional liability insurance.

Health insurance reimburses you for medical expenses, such as doctor visits and prescription drugs. IOW, financial losses caused by injury or illness.

Life insurance is actually “death insurance.” When the policyholder dies, the insurance company pays money to the people or charities listed as beneficiaries.

What are some other basic concepts?

We try to avoid it, but insurance does have its own language. Here are some quick translations:

  • Claim. When you have a loss that is covered on your policy, and you request reimbursement from your insurance company, you are making a claim.
  • Coverage. This is the specific types of loss the insurance company will allow you to claim. For example, a policy for a boat might cover theft of the boat itself as well as any portable property stored on the boat.
  • Deductible. A deductible is the amount of money you pay out of pocket before your insurance kicks in. If your claim is $1,000 and your deductible is $200, your insurance company will pay you a maximum of $800 for the loss. The higher your deductible, the lower your monthly or yearly premium. Why do insurance companies include this in their policies? To keep administrative costs—and premium prices—as low as possible.
  • Hazard. Hazards are conditions that make losses more frequent or more severe. For example, physical hazards include icy sidewalks and defective locks. Moral hazards include dishonesty, which can lead people to file false or exaggerated claims. This is not only illegal, it makes insurance prices rise for everyone.
  • Limit. Insurance policies pay for losses, and set limits, in different ways. Some will pay you a specific dollar amount for a loss, such as $1,000 for the loss of your camera equipment. Others will limit the payment to a percentage of the entire loss, such as 75% of the replacement cost of your stolen HDTV.
  • Peril. The peril is the event that caused the loss. If your computer is fried by a power surge, the peril is the lightning bolt that hit your house. Perils that cause loss to property include fire, wind, hail, earthquake, burglary and theft. Some perils, such as floods, are not covered by standard renter’s or homeowners insurance policies.
  • Policy. This is the agreement, or contract, between you and the insurance company. The policy is a legal document that includes the exact date and time the coverage starts and ends, name(s) of covered individual(s), what is and is not covered, what you should do to report a loss, and much more.
  • Subrogation. If someone runs a red light and totals your car, your insurance company will pay you for the covered loss of your car. Then—acting on your behalf—the insurance company will work directly with the person who hit your car, or their insurance company, to recoup the money. This is subrogation: an insurance company seeking damages from a negligent person, manufacturer or other type of business on your behalf.