How do insurance companies make money?

The world is full of randomness. However, humans hate randomness and nasty surprises and much prefer predictability. Insurance companies help reduce risk across the entire population and reduce the number of surprises. It reduces the vagaries of life and enables us to be less stressed.

Example of Auto Insurance

Let us take the case of auto insurance which pays for damages caused in an accident. Suppose one out of 1000 becomes a victim of an accident in a year. If you get into an accident, you have to pay Rs 100,000 in damages and if you don’t get into an accident, you pay nothing. You never know if you will be the one who falls victim to an accident this year. There can be many unforeseen events. If you get into an accident, you won’t have 100,000 to pay. Everyone is worried that they might be the same. To reduce the risk, you start pooling your money with 999 other people and each of you decides to pay Rs 100 every year. The pool now has 1000 * 100 = 100,000. Statistically, one in 1000 will be the victim of an accident and whoever is involved in that accident will pay that pool money.

What does the insurance company do?

Now you have bought peace of mind for Rs.100. Now, you are losing Rs 100 in the best case and worst case scenario. In other words, you can go about your activities without worrying about random occurrences. Since, it is not easy to create a pool of money with such a large number of people, specialized companies come into play. Insurance companies are just companies that pool money and make sure that the right people get the money.

Basic Work of Insurance Company

They have two primary functions:

To assess risk (evaluating whether 1 in 1000 or 1 in 300 will be the victim of an accident this year)
Fraud Detection – Making sure that the person who gets the pool money really was in an accident.

Doing both of these activities gives them benefits. Instead of taking Rs 100 from each person, he will deposit Rs 110.