Insurance serves as an excellent risk-management and wealth-preservation tool, but what is it exactly? This brief article is meant to give you an insight about insurance products. It is time to learn a crucial component of the actuarial profession!

 

Insurance is a contract between an individual (the policyholder) and an insurance company, which provides that the insurance company will cover some portion of a policyholder’s loss as long as the policyholder meets certain conditions specified in the insurance contract. In exchange, the policyholder pays a premium (pays what? bear with me) to obtain insurance coverage. If he/she experiences a loss, such as a car accident or a house fire, the policyholder files a claim for reimbursement with the insurance company.

Let me provide you with an example. Suppose you have a homeowner’s insurance policy. You pay $1,000 per year in premiums for a policy with a face value of $200,000, which is the estimated coverage in case of a loss. If your house burns to the ground, you file a claim for $200,000 with your insurance company. With the money you receive, you can rebuild your house.

 

So what is 'Premium'?

 

A premium is the specified amount of payment required periodically by an insurer to provide coverage under a given insurance plan for a defined period of time. In other words, the premium is what the policyholder pays to have the coverage.

 

 

Insurance Premium

 

The owner usually pays a fixed premium amount in exchange for the insurance company's guarantee to cover economic losses incurred under the scope of the agreement. Premiums are based on both the risk associated with the insured and the amount of coverage desired.

 

What about 'Deductible'?

 

A deductible is the amount of money an individual pays for expenses before his insurance plan starts to pay. The policyholder will pay a deductible to cover part of the loss, and the insurance company will pay the rest.

 

To understand insurance deductibles, imagine your deductible is $300, and you incur medical expenses for $2,000. You pay the $300 deductible, also called the out-of-pocket cost, and your insurer pays the remaining $1,700. However, if your entire medical bill is $300, you would pay the entire amount and your insurer would pay nothing. Insurance deductibles do not just apply to health insurance. Car insurance, homeowners insurance, renters insurance and other types of insurance policies also have deductibles. Going back to the house fire example, assume you have a $1000 deductible. After the company approves the claim for $200,000, you pay your $1,000 deductible, and the insurance company covers the remaining $199,000 of your loss.

 

What is a 'Cap'?

 

An Insurance cap is a limit to the amount of money the policyholder has to pay out of pocket for any one accident or in any one year (or possibly over different timeframes, depending on the contract). For example, if the cap is $10, and the loss was $15, the insurer would only pay $10. However, if the loss was $9, then the insurer would pay the full $9. In the house fire example, assume there is a cap of $150,000, and the loss was $200,000. Therefore, the insurer would have to pay $150,000.

 

What is 'Reinsurance'?

 

Reinsurance is insurance for insurance companies. Insurance companies sometimes want to decrease their risk resulting from an insurance claim. Basically reinsurers insure the insurers. The advantage for insurers of employing reinsurance services is that the insurer bears less volatility, has a greater spread and can write larger premiums on their books. These factors should add up to larger profitability. Reinsurance allows the spread of risk. Instead of a primary insurer going bust due to a catastrophic event losses get spread around so that each participant bears a little of the pain. Reinsurance lets insurers cover their risks by recovering some or all of the amounts they pay to claimants.

 

Suppose an insurer wants to transfer $500,000,000 worth of risk. Reinsurance company A might take $250,000,000 worth, reinsurance company B might take $ 150,000,000 worth and reinsurance companies C and D might handle $ 50,000,000 worth.

 

Insurers may underwrite policies covering a larger quantity or volume of risks without excessively raising administrative costs to cover their solvency margins. In addition, reinsurance makes substantial liquid assets available for insurers in case of exceptional losses.