Well some of us may think that there’s nothing
more boring than attending an insurance conference.
And we may well be right, but if we look back
to see how the industry began, it isn’t
as dull as it might first appear.
From swashbuckling pirates to a ferocious
fire that ravaged the world’s greatest city,
insurance has had a colorful past.
But how do those grey suits who sell insurance
really make money, and how do the inner workings of one of the most complicated fiscal models really work?
If these questions whet your curiosity, then
Continue reading.
Well, insurance is a financial vehicle that
helps spread risk.
By taking a risk from an individual, and spreading that risk around a community, the individual is able to go about their personal or business life without crumbling from financial ruin.
In the simplest terms, let’s look at two
people.
One is named Bob and the other Jim.
Bob says to Jim, #I’ll give you ten dollars,
but if I lose my cell phone, you’ll have
to buy me a new one.
If Jim agrees, then that’s insurance right
there.
Insurance companies make money because they evaluate the risk and decide whether it is
worth the gamble.
Jim believes that Bob probably won’t lose
his phone and he’ll therefore be ten dollars
richer.
If Jim finds 100 more people who are willing
to give him 10 bucks each to cover their phones, he has 1,000 dollars.
If one of those 100 people loses their phone
and Jim pays 100 dollars as compensation,
he still has 900 bucks.
This insurance idea has been floating around
since the ancient Chinese and the Babylonians
spread their shipping risks.
But it wasn’t until around the 17th century
in London that modern insurance really took
off.
Merchant marine men and traders often hung
out in coffee shops in the business district
of London, and while drinking copious amounts
of coffee, the idea of modern day insurance
was born.
Lloyds of London, the heart of worldwide insurance, was developed inside one of these coffee houses and here’s how it worked.
First, you have the client.
Say the client has a ship that he is nervous
about losing to pirates offshore, or perhaps
the vessel will be destroyed in bad weather.
The client approaches an insurance broker.
The broker looks at the ship, or pays someone
to look at the ship, and they decide how much
the total value of that ship is worth.
The broker then assesses the risk.
He asks the client where he is traveling to
and what cargo he will be carrying.
With all this information, he draws up an
insurance policy which he shows to the third
person in the chain - the underwriter.
For a cheaper premium, the underwriter may
exclude a few risks.
And for a few more bucks, he may include some extra risks.
Now there are normally lots of underwriters
approached, but one will be the lead, and
the lead underwriter, like Jim, will normally
take the largest proportion of the risk and
sign his name first on the policy document.
He is known as the underwriter, as he writers
his name under the risk on the insurance policy.
The lead underwriter makes the major decisions when it comes to accepting the policy, and will be the main man to agree to any claims on the policy.
Once the terms of the policy are agreed to,
it is made legal, and the client is happy
and the ship sets sail - but not before paying
the insurance premium to the broker, who will
take about 10%, and pass the rest on to the
underwriter.
But what should happen if pirates board the
ship, steal the cargo, and burn it at sea?
Well, the client (if he is still alive, if
not, a representative of the client) will
speak to the insurance broker and the broker
will visit with the lead underwriter and tell
him the bad news.
The rest of the underwriters (there may well
be as many as 20 on a big policy) are told
the news and then the broker must negotiate
the best claim settlement for the client or his or her representatives.
The underwriters pay the money to the broker,
who passes it on to the client, without deducting any cut.
The broker makes his money once the premium
is paid, and will help negotiate the best claims for his
clients through gentlemanly honor and the prospect of future business.
Now it may not be all bad news for the Underwriter.
If he is wise and not greedy, he may have
reinsured the policy.
Reinsurance puts the underwriter in the position of the client.
The underwriter sells the policy onto another
underwriter or firm of underwriters, while
retaining a share of the premium.
Confused yet?
Think back to Jim and his phone insurance.
If Jim resold his 10 dollar phone policy for
9 dollars, rather than the 10 he received,
then he gets to keep a dollar each for each
of his 100 clients, meaning he has 100 dollars
completely risk free.
Similarly, much of the modern day insurance
that flows through Lloyds of London is reinsured out of the building to smaller insurance companies all across the world.
So what starts as a simple agreement between
the client and the broker (or Jim and Bob)
is spread across a business community who
each stand to profit from the premium or take
a cut of any losses.
This is how insurance works – by the spreading
of risk over communities.
So that is how maritime insurance was born.
It was developed through the need of ship-owners to carry on in business should they lose everything whilst at sea.
But what about property insurance?
Well around the same time, 1666, the great
fire of London devastated the city where modern day insurance was born, and famous architect Sir Christopher Wren, in his great London redevelopment project in 1667, made sure to include an insurance office in his new plan. Now property insurance is commonplace with most homenowners having a policy in place.
Also medical, life, travel, car, and dental
insurance are all commonly held policies.
Even pet insurance is a major insurance business nowadays.
Over time the business model has evolved.
Modern day insurance companies are fiercely
competitive, which is good for you, the client,
as polices are priced at their lowest possible
point.
Companies now look to write as many polices
as possible to create a financial pool.
They take the premium from thousands of policies, and invest that money in another financial product.
So the insurance underwriter may pay out more
claims than they make in policy premiums.
But they have invested all those premiums in a high interest investment scheme, so they make their money outside of the original insurance
product.
Insurance in this example is a way of creating
cash flow to be used in more lucrative investments.
Thanks for reading, and, as always, don’t
forget to share and sign up.
See you next time!
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