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How does Insurance work?

Last Updated: Oct 17, 2011 | 115 Views

Series – Basics of Insurance

Article length – 1275 words               Average time to read – 7 min & 10 secs!

  1. How will an insurance company pay my family so much money by collecting only a small amount from me every year?
  2. I pay only Rs. 5000 per year for a health insurance and how does the insurance company pay me Rs. 1,50,000 in case I incur such an expense due to hospitalisation?
  3. Are these businesses profitable or even sustainable?

These are some of the questions which come to everyone’s [more] mind while writing out a cheque to any insurance company. And yes, these questions are indeed something which needs to be answered. To answer the 3rd question first – yes these businesses are indeed very profitable but require very deep pockets and a relatively longer period of time to make money. It may take more than 10 years and maybe even more for some life insurance companies to even break-even – that is indeed a large period for anyone to seriously think of entering the business. Some of the retail non-life insurance portfolios are also not very profitable for the insurance companies and will take some time before these companies start making money. There are a variety of factors which impact this – the number of customers, the number of claims which have been processed and the type of costs incurred in acquiring the customers being some of the important factors.

Now coming back to topic of discussion – how does the concept of insurance work? Insurance is a great tool to mitigate risk and it will only work when there is a large pool of people participating in it. Also the claims should be as per chance as would happen under normal circumstances and no known risk should be ideally covered.

For the sake of an example, let us see how it would work for the people living in the island in the Pacific Ocean. Some statistics about the village were as follows:

Name of Island – Andawoman

No. of earning members – 5000

The village has 5000 adults some of whom earn a living through fishing. It was observed that when the earning member of the family died, the entire family was left stranded with no financial security and this was bad for entire village also. So a group of people got together and resolved to do something about it. They first collected data for the last 25 years and observed that 5 earning members on an average die every year which are totally unexpected – death due to old age not being considered and they were anyway not earning members of the family. On an average they observed that the income of a person is Rs. 6000 per month. So they launched an insurance plan named “Wizinsurance Super” whereby every member would need to pay Rs. 1,250 every year (annual premium) and in case they died due to any unnatural reason their family would receive Rs. 3,00,000 (sum assured) at one go which can take care of the future financial requirements of the family.

Some islanders immediately liked the idea and joined the plan. Some were sceptical initially but when they thought that they too could die in the high seas and their family would suffer, they too joined in. Some scoffed at the idea and said this is possible a scam and stayed out of it. So this is how the financials worked out in the first year:

Details of “Wizinsurance Super” plan

Sum Assured – Rs. 3,00,000

Annual Premium – Rs. 1,250

Term – 20 years

They did a grand launch of the plan in the festival grounds with the island’s beauty queen “Anaida” coming on stage and saying everyone who loves their dear ones should buy “Wizinsurance Super”. She also danced to a song and people were given caps with “Wizinsurance Super” written on it. The island’s most influential businessman was also roped in to give a speech on how great this plan was. Finally Anaida went around collecting name and addresses of everyone who wanted to buy this plan. Almost 1100 names were collected immediately.

So this is how it looked at the end of Year 1

No. of earning members in the village – 5,000

No. of people who purchased “Wizinsurance Super” – 2,000

Total premium collected in the first year – Rs. 25,00,000 (Rs. 1,250 x 2000 people)

No. of deaths that happened in the 1st year – 3 (the average of 5 was for the whole village)

Amount paid to 3 families – Rs. 9,00,000 (3,00,000 to each of the 3 families)

Profit of “Wizinsurance Super” – Rs. 16,00,000

Profit of “Wizinsurance Super” after expenses – Rs. 12,00,000

The family members who received the amount were very relieved and even their neighbours and relatives were very pleased to notice that even though there was a huge emotional loss due to the death in the family, at least they were financially secure. There were 3 more deaths in the village among people who had not taken the insurance plan and their families were really left stranded. Observing the benefits of this plan some 500 more villagers came and joined the scheme immediately. But there were another small lot of people who observed that they paid Rs. 1,250 but got nothing out of it – they were all healthy individuals and were very sure nothing could happen to them – so some 100 of them, who had paid the first year’s premium, opted out of the plan.

So Year 2 looked like this:

No. of earning members in the village – 5,000

No. of people who purchased “Wizinsurance Super” – 2,400

Total premium collected in the 2nd year – Rs. 30,00,000 (Rs. 1,250 x 2400 people)

No. of deaths that happened in the 1st year – 3 (the average of 5 was for the whole village)

Amount paid to 3 families – Rs. 9,00,000 (3,00,000 to each of the 6 families)

Profit of “Wizinsurance Super” – Rs. 21,00,000

Profit of “Wizinsurance Super” after expenses – Rs. 16,00,000

Total Profit in 2 year – Rs. 28,00,000

The insurance company went a step further to help the families of those who lost their earning members. They recruited them as insurance agents and paid them Rs. 3000 per month + Rs. 500 per policy sold. So they too were happy and were the perfect people to canvass and convince others to join in.

Eventually, the people who started the insurance plan became very rich and moved on to provide insurance plans to people in the other islands nearby.

Well, this is how things should ideally work out. In reality it could work out some other way also. If in the first year, if a boat had capsized in the sea and all 10 people on board were killed, the insurance company would have to shell out Rs. 30,00,000 against Rs. 25,00,000 collected as premiums and if for some unfortunate rea son, this happens 2 years in a row the  company would have gone bust and people would have paid for 2 years would have lost their money. If the company has deep pockets then they can sink in these losses and then start making money from the 3rd year onwards.

Also imagine a scenario where there are 2 insurance companies and they are competing for the same customer base and the new entrant drops the annual premium to Rs. 1000 per year as compared to Rs. 1,250 of “Wizinsurance Super”. Some customers would move there and new customers would be more difficult to add. OK, let’s leave this problem to the marketing and financial wizards to tackle – given the profits they made, surely they can afford to hire some smart guys!!!

So that how insurance companies work in the most basic form. There are more intricacies of course and we will tackle them in the later sections.

Deepak Yohannan
Deepak Yohannan is the CEO of MyInsuranceClub. He enjoys writing on Personal Finance and contributes regularly on sites like Reuters & Moneycontrol. He is a strong proponent of online insurance and is often found pointlessly babbling about it!

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