The key role of insurance is to help people financially protect themselves against life's uncertainties, such as natural disasters, a car accident or an illness while on holidays.
How does insurance work?
Insurance works by pooling together the resources of a large number of people who have similar risks to make sure that the few people who experience loss are protected.
When take out an insurance policy and pay an insurance premium, you are putting a little of your own money into that pool.
If your property is accidentally lost, stolen, damaged or destroyed, and you have a general insurance policy that covers the property for those risks, you can make a claim and draw on that pool of money to help pay for repairs or replacements costs.
This may allow you to avoid paying the full cost of replacing, repairing, rebuilding or restoring valuable things if they are lost, stolen, damaged or destroyed. It also means you could avoid ending up with a large debt or liability.
When you pay an insurance premium, you will have access to the pool of money only if you claim a loss that is covered by your insurance policy.
It is possible that a person who has paid an insurance premium for many years might never make a claim.
When you buy an insurance policy, your insurer promises it will pay you for the type of loss stipulated in the policy – such as an accident, theft, loss or catastrophe – by funding repairs or replacement of items, up to the limit of your policy, or sometimes by providing a cash settlement.
Each insurer’s policies have different rules about what the policy will cover. Exclusions may apply, so you should read your policy carefully and seek advice if you’re not sure what your policy will cover.
What is underwriting?
Underwriting is the way an insurer works out how much to charge for each risk they cover for each person who buys an insurance policy and under what terms.
When preparing a policy, insurance underwriters will calculate:
- How much they will agree to pay for a loss
- Under what circumstances they will make a payment
- How much the premium will be
Underwriters think about a number of different things when working out the price of a particular risk for insurance. For example, car insurance premiums may vary depending on the age, sex and driving record of the main drivers, as well as the location, type and age of the car.
Each insurer has its own set of underwriting guidelines to help determine whether or not they should accept the risk of a particular situation.
In some cases, an insurer may decide it won’t cover a particular risk while other insurers may do so.
Underwriting involves working out a premium that is low enough to attract a good number of buyers, and high enough so that there will be enough money in the pooled funds to pay all the claims that might be made, plus make a profit for the insurer's shareholders.
What is reinsurance?
Reinsurance is like insurance for insurers. It can be used to cover different risks for insurers. For example, insurers may use reinsurance to make sure they can pay a large number of claims if there is a big disaster, such as a cyclone or flood. This is usually called catastrophe cover.
Insurers may also use reinsurance if they have claims from policyholders that are higher than a certain value, which has been agreed beforehand with the reinsurer.
Reinsurance involves a number of insurers, often from different geographic regions, that pool together to share their exposure to risk.