Insurance is a pretty big topic really, which is why we will be breaking it down into several smaller, more manageable guides over the following pages. In fact it is such a big topic that there are probably a few types of insurance you don’t even know about.
Essentially, any time you have any risk of loss, chances are good you can insure against it. So car insurance is an obvious one, since driving is one of the riskier things we do in our day to day lives. We also have insurance in case we are victims of crime or against any other unfortunate event which befalls us.
Understanding How Insurance Works
Everyone knows how insurance works; you pay a premium set by the insurance company (hopefully you shop around for the best deal first of course) and if some predefined event happens they pay out some amount, generally enough to cover all or most of the loss incurred.
But understanding how the insurance companies calculate risk and hence premiums is helpful as it may save you money later.
Risk Vs Reward
The insurance company makes money when the bad event doesn’t happen. So if you don’t have a car accident they don’t have to pay out. They keep your premium and that is their profit (after overheads are paid).
If you do crash, get robbed or have a fire etc… The insurance company has to pay out. They still keep your premium, but the cost of the pay out may be more than your premium and in that instance they make a loss on your account.
Of course they have thousands of customers and as long as on average the amount they take in premiums is more than they pay out in claims they should make a profit. The first step is figuring out how risk your account is.
Risk is worked out using statistics for the most part. Hypothetically, if you have a 10% chance of making a claim each year, and the cost of a claim would be £1,000 then your insurance company would expect to pay out £1,000 every ten years, or £100 a year on average.
In this instance they would have to charge you £100 plus some amount to cover their overheads and hopefully leave enough for their profits.
In the real world your claim amount would be much harder to predict. Taking car insurance as an example – you could have a small bump which costs £200 to fix or you could write off someone’s Ferrari worth £200,000. And on top of that you could get sued for a few more thousand too.
This is why insurance companies look for any type of correlation they can to accurately assess not only how likely you are to claim but how large a claim might be. If you live in an area with a lot of crime your house insurance will be higher, if you drive a faster car your car insurance will be higher…
Even having the wrong job can cost you money if for instance Engineers tend to have more expensive car accidents than HR Managers they will pay a higher premium accordingly.
Other Things That Affect Insurance
As we mentioned above, on top of the expected average cost, the insurance company has to add some amount to cover their overheads and their profit. This is why medium to smaller companies often have lower premiums than the big ones who advertise on TV all the time. Someone has to pay for those adverts. Company X may not be on comparison websites but they pay a lot to advertise that fact instead!
Another factor is variance
Ok, so in our example above, you might expect on average to claim £1,000 every ten years, but what if you have a run of bad luck? You could end up claiming £2,500 in that ten year period!
Insurance is a game of risk and it is possible for an insurance company to have an ‘unlucky’ year where they actually lose money or at least fail to make a profit. The larger the company the better their risk is spread, and hence the more they can risk squeezing their margins.
As a result, you often find very small, specialist companies are not actually as competitive, particularly if you are a high risk customer (such as a teenaged driver). You should of course shop around, but you will often find it is the medium sized companies that you have never heard of who work out cheapest.