How Does Insurance Work?

Insurance is basically its own world, with its own language. To outsiders, it can seem bewildering. But it’s really not that complex.

Basically, it all starts with actuaries. Think of them as the bookies of the insurance world. By using sophisticated mathematics, these human calculators determine the odds of future events happening.

Underwriters use actuaries’ predictions to assess different people's risk levels. They decide what people should be covered for, how much they should pay for that coverage and whether even to accept their application. The goal here is to reduce risk for insurers and applicants as much as possible.

Then agents and brokers draw up policies for each individual person or business based on those risk levels.

Finally, if something bad happens, claims adjusters step in to evaluate the damage and help those customers recoup their losses and move on with their lives.

That’s the gist of it. Odds, risks, policies, claims. Not that complicated.

Of course, there are also plenty of managers, marketers, IT folks, customer service representatives, etc., making it all work smoothly.

That’s the industry-level overview. At the individual level, when people purchase insurance, they get a policy, which functions like a contract: it states exactly what is covered and what isn’t.

To decide what’s covered and what’s not, insurance companies use the predictions that actuaries make about future events and the risk level of individuals and businesses determined by underwriters. Looking at the two together, insurance companies calculate the cost of a person’s policy premiums.

In broad strokes, the riskier it is to insure someone, the more that person’s policy will cost. The less risky, the less costly the policy. It’s all tied to the likelihood of a loss happening.

Once there’s a policy in place, the insurer collects regular payments for that policy, called premiums, and then pools that money. When someone makes an insurance claim, a claims representative first evaluates the damage or harm to determine if the person is covered for the claim. If the answer is yes, then the claims rep helps that person get reimbursed for the damages. Money for that reimbursement is taken from the collective insurance pool.

That’s the quick-and-dirty explanation. But to understand the bigger picture, you may wish to go back in time to when insurance started, to learn why it exists in the first place.