The foundation of insurance

14.03.2019: the gist of the crash course

Pooling risks

The concept of Insurance started around 1800s because of the shipping need. Shipping during those days was a risky business. The merchants generally had to spend a lot of money on cargoes. If the shipper has a sudden accident, he will lose everything. Therefore, to protect themselves, he would ask people to share the risks. If he loses the entire cargoes, everyone only loses a portion of the goods. This is called “pooling risks”.

For the time being, insurance also plays an important role in human life that is to bring PEACE of MIND to the family! As long as we have some certainty of the upcoming future in case of loss, we will definitely have less worries and mental burdens.

How the conversation began with the topic of insurance this morning? Steven first shared me his decision related to his current company which is Prudential. Then I suddenly questioned “how is the structure of Prudential, a very big organization?” that I had never been curious before. He said most of the companies have the same structure but Prudential have so much difference compared to other companies. To get me across the concept of a company structure, he gave me a thorough explanation of how insurance works first and the structure of business model of Prudential.

How does Insurance work?

Insurance means you have to pay someone when a defined event happens. When? There are death, disability, illness, old age, retrenchment, professional liability… Life insurance ensures your economic and mental values.

I buy insurance to get financial support in case of certain types of accidents which must be statistically proven and I have to pay for the company on an annual basis to maintain the lifelong support. If I am fine all the year, I don’t get anything back for what I pay for the whole year. The amount of payment for the insurance is called “Premium”. In particular, there are so many unpredictable incidents and even deaths that might let the company unable to pay for the insurance. One death equals 1 million dollar meanwhile the company only earns from the little premium which is about 1000 dollars. Do how to manage this huge loss?

That’s why there needs research and analysis on probability that predicts the approximate death & incidents rates. That means the loss for the “abnormal” cases can be compensated by the “normal” cases. Usually, the number of deaths and threats are much smaller than the ordinary groups of people according to the research although the age and amount of “incident people” are different each year.

For example

John decides to be insured for 1 million dollars and he has to pay 10000$ per year which is called premium, the cost of buying insurance. If he dies within this year because of an accident, the company pay him 1 million, so the net gain is the minus of 1 million and 10.000 $.

No insurance company wants to lose this huge amount of money, they can’t operate this way. Everyone will die anyway, more or less we will have to pay for this natural truth. John will die one day, but we do not know specifically who will die and we know on a given day, how many people will die.

Let assume at 8:30, 3 out of 1000 people will die. If the statistic is true, the gain for the insurance company is (1000 people x 10.000 premium/year) - 3.million (the insurance payment), equaling a surplus of 7 million. This is the concept of pooling of risks. This is how the insurance companies sustain their business based on the law of large numbers. Unless there is such “equivalent rates” in terms of financial resources among the whole population throughout human life span, the bet of taking the 1000-dollar premium and paying up to 1-million once in a while is out of reach!

However, will insurance company make money?

Continue the earnings from the lives, this money is not considered “profit” yet due to the various expense on such work as customer service, logistics, commission…This is the reason for the birth of the investment department to serve the purpose of getting more money through investment.

However, it’s not that easy to calculate the statistics on a large scale. The company also needs to track and understand the background of each individual to see the level of risks they can encounter in order to categorize the proper insurance packages. There comes the process of researching as well as customer service.

How to ascertain the group of healthier people to join the insurance to help the poor people? How to know that they are healthy? You have to answer a list of questions that is all about personal background, personality, lifestyle… By carefully selecting buyers, the company can reduce the cost of paying sum insured and have more profits.

The law of large numbers

You can buy a great Toyota car with full of functions and nice design, especially little cost. Why? As Toyota is a popular choice of customers, they are produced in large numbers so that the company can save the cost of manufacturing as well as other services like marketing…In a sense, you might think you are beneficial from little charge and the Toyota company tends to suffer monetary loss, the truth seems to be different. The large number of products actually bring much distribution efficiency and revenues for the producer. On the other hand, the cost of a unique “Roll Royce” car is definitely higher than the ordinary cars because of the expenses on all of the unique parts of making the unique car irregularly.

How does Economics work in real life?

Then one thought popped up in my mind that why an economic student like me has not got any insurance lesson up to now. I realized it takes place in the third year… but I have never been interested in what I learn at school for seeing too little relevant points to apply to my life. I told this to Steven and he said Economics at school might be very academic but in fact, economics is very practical and interesting. Let explore and read some books to understand the practicality of Economics in reality. For example, why people want to buy a 5-dollar coffee instead of a 1-dollar one? Behind the theory of supply and demand, it is the answer of the question “How do we make money?”. On top of the essence, it is about the understanding of human behavior to get the insights into economics.

How can Insurance help people to overcome the vicious circle of poverty?

Then “should insurance element be incorporated into SOG’s curriculum?” I asked. No, it’s better for BoP Hub’s programs because insurance is a huge need of the poor instead of the rich. In terms of economic value, insurance is important for the marginalized groups to live a better life.

The end of the Insurance Crash course taught by Steven Lau!

#eyeopen

#gratitude