How does the insurance device work ?

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aAbuDaggY.BassemDr.
AbuMandeelAhmedAmani
(EBUS3306)InsuranceandRiskofFundamentals
2017.Dec,8
ce work indoes the insurance deviowH
Trust Company?

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Our world is full of randomness. Risk has become a part of our survival instinct. This
world is full of hidden gambles, which do not work in our interests. Consequently,
keeping this randomness in check makes good business sense. I strongly believe that
insurance is the best choice to reduce life's randomness and risk. Insurance plays an
important role in the economy, supporting economic activity by helping organizations
and individuals to manage their risks. Given the importance of this role, insurers have
the potential to affect company's financial stability.
An insurance policy is a contract or a promise between the insured (you), and the
insurer (the insurance company). The insurance company collects a premium from
you for the issued policy and agrees to pay for any covered losses you suffer. It seems
like a simple business model for earning money, but can be quite complicated.
Insurance companies are like any other business in the world. They have to make a
profit to stay in business. There are two basic strategies for insurance companies to
make profit. In this report, I will attempt to sum up the framework of insurance
company to make profit by raising two main questions:
1. How does the insurance company make profit operationally?
2. How does the insurance company make profit financially?
Therefore, I can safely say that insurance company makes profit by using many
functions and strategies operationally:
Underwriting policy:
It begins with the formulation of the company's underwriting policy. It
establishes the framework within which the underwriter make decisions. The
policy specifies the headlines of insurance. Consequently, performing under
writing effectively helps the company greatly to make profit. Thus,
underwriting must develop a keen sense of judgment good knowledge of the
hazards associated with various types of coverage. This definitely associated
with risk reduction through pooling.
Risk reduction through pooling:
Insurance depends on the principle of pooling of funds and thereby sharing the
risks. This is evident in this example:
Let us supposethat there is only one building type (Total number 1,000) in the
city, and all have the same costof $ 10,000.
Approximate fire accidents in a year (10 out of 1,000 no. of houses)
Total number loss = 10 * 10,000 = $ 100,000
Contribution from each house owner = 100,000 / 1,000 =$ 100
(For no profit or loss to anyone)

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Hence, the 1,000 house owners pool$ 100 for insurance to avoid a common
risk, which is mainly the damage by fire.
Therefore, insurance companies take a small premium ( $ 100 ) for very high
house value ( $ 10,000 ). They can add their own profit margin of 10 – 20 %
and take between 110 - 120 $
Underwriting policy involves the process ofdetermination risks. Insurance
company determines risks using the "Law of Large number ". This means that
greater number of exposures, greater the accuracy and creditability of
predictions and lesser the deviation.
In the previous example, the probability of house fires = number of house fires
/ Total number of houses.
10 / 1000 = 0.01
So, the premiums is = 0.01 value of one house $ 100.
If we expand this city problem to whole world with different types of houses
sizes, complex localities, nearness to hazard. (Warehouses have more chances
of fire), there may be million of houses, go downs and thereby accurate
probabilities and accurate premium numbers (satisfying law of large numbers)
can be calculated.
How does the insurance company make profit financially?
Firstly: Underwriting income:-
Underwriting income is the first strategy used to make profit in insurance
company. It is mainly the differences between amount of money collected from
the insured (you) in form of premiums and the money given to the one
claiming in the hour of need.
This picture can present a clear machinery of making profits from underwriting
income.

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Secondly:Investment income:
This is related to an important question that raised up in my mind when I
attempted to understand the insurance device. The big question is what they do
of all the premium money that they have collected from the insured. The
answer was definitely is investment! In fact, Insurance companies believe they
can make a profit from investing the money they receive before having to pay
claims.
Profit from investment: From the premiums, they receive from people who buy
insurance policies to be insured. Insurance companies make investments in
different assets that would yield profits for them eventually. Such investments
are mostly real estate, government bonds, treasury bills and private equity.
For example, Insurer (A) may collect $ 1,000,000 in premium for policies
issued or renewed in a given year. If they pay less than $ 1,000,000 in claims,
they have made a profit. If they pay more than $ 1,000,000 is paid in claims,
they suffer a loss. Insurers have a unique way to earn massive amount of
additional profits.
Unlike, many other types of business, insurance companies collect huge sums of cash
throughout the year and may not have to pay on claims on these policies for many
years.
By a way of conclusion, I can sum up the process ofmaking profits in insurance
company by this simple formula:
Insurance Company's Profit = Premium Collected + Income from
Investments - Underwriting Expenses - Claims Settled
Premium Collected:
The amount the insured party pays to the company
Income from Investments:
The collected premium is invested by the insurance companies in various financial
instruments and they earn interest income from them.
Underwriting Expenses:
This includes administrative costs like sales, marketing, agent commissions etc.
Claims Settled:
Every insurance company needs to settle claims like:
Health Insurance: paying hospitals
Motor Insurance: paying garages
Life Insurance: upon death or maturity

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