Study Notes
Insurance -
How it works
Insurance – How it works
The basic insurance concept
Figure 1: Basic Insurance process
The insurer and the insured get a legal contract for the insurance, which is called the
insurance policy.
The insurer is an Insurance company and the insured becomes the policyholder.
The insurance policy has details about the conditions and circumstances under which
the insurance company will pay out the insurance amount to either the insured person
or the nominees.
The insured pays regular premiums to the insurer (an insurance company) during the
term of the policy.
In return, the insurance company underwrites this risk. The insurance company lives up
to expectations by pooling risk.
o The premium collected from various policyholders creates an Insurance pool
with the insurance company.
o Probability of real loss occurrence is very less from the group of policy holders
which makes insuring company profitable.
o For example, many of the individual have accidental life insured but in reality
insured event occurrences are very few. Insuring company will pay for your
losses as per the cover in the event they occur.
Note: Any individual or company can seek insurance from an insurance company, but the
decision to provide insurance is at the discretion of the insurance company. The insurance
company will evaluate the claim application to make a decision.
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Insurance – How it works
How insurance works for Insured
Non-occurrence of
Keep paying premium
insured event
Insured should:
Recognise the risk File a Claim:
Choose type of Insurance company will
insurance for the risk Occurrence of determine if there is
Choose an insurance insured event cover available under
company the policy
Choose the best type Once the claim is
of policy established, insurance
Pay premium to company will pay the
purchase the insured amount/loss
insurance amount to the
insured/beneficiary
How insurance works for Insurance Company (Insurer)
An insurance company pools risk and collects premium from many policyholders, in the
expectation that the policy claims will be far less. In order to ensure that, it is vital for the
insurance company to choose the risks and individuals it will want to insure and the premium it
will charge for providing that risk cover.
The process of determining the issuing of an insurance policy is referred to as the underwriting
process.
1. Underwriting Process
An underwriter evaluates the risk of the applicant. During this evaluation, the underwriter will
decide
how much coverage will be offered to the applicant,
how much premium the insured should pay for the particular amount of coverage
When underwriting an applicant, an insurance underwriter will, therefore, attempt to protect the
insurance company’s book of policies from risks that could cause a loss. As such, it is feasible
that an applicant who presents too high of a risk to the insurer, may be denied issuance of
insurance policy altogether.
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Insurance – How it works
Example of Underwriting in Case of Life Insurance:
There are numerous factors considered when underwriting a life insurance policy. First, an
underwriter will need to determine the probability of an applicant’s life lasting as long, or even
longer, than the “average” life expectancy for an individual of that particular age and gender.
In this estimate of life expectancy, if the applicant were to live as long or longer than anticipated
based on the mortality table, then the funds that the insured has paid into the policy in the form
of premiums will typically create enough of an investment for the insurer to take on the risk.
This means that even after the insured has passed away, the total amount of premium that he
or she paid into the policy over time – combined with such funds’ invested return – will be more
than what the insurer will pay out in the form of a death benefit on the policy, resulting in a profit
to the insurance company.
Given this, life insurance underwriters will also analyze factors that could possibly cause an
applicant to pass away prior to their average life expectancy. Such factors could include a family
history of certain health issues such as cancer or stroke, as well as external factors such as
working in a dangerous occupation.
2. Documentation Process
Once the insurance company chooses to issue a policy and the terms and conditions are
agreeable to both the parties, an insurance contract is entered into between the parties. This
contract is commonly referred to as the insurance policy.
Insurance contract document is a legal document that spells out the conditions, features,
coverage and limitations of an insurance product.
Some of the insurance terms and their meaning in the contract are:
Bound: Once the insurance product or contract has been accepted it is called “bound”.
This process is called the binding process.
Insurer: A person or company that acknowledge the risk and compensate the losses to
the insured in the event of occurrence in return of premium paid i.e. an insurance
company
Insured: person or entity compensated for loss by an insurer as per terms of contract
Insurance Rider: Additional benefits linked to an insurance policy that modifies the
policy’s scope or terms.
Insurance Umbrella Policy: When coverage contract lacks with scope of cover, an
umbrella policy may be obtained to extend the cover losses above the limit of an
insurance agreement.