The basics of
Insurance is one of the ways that businesses and individuals reduce the financial impact of a
risk occurring. While an insurance policy does not remove a risk, it does provide the policyholder with some
security should the worst happen.
Insurance works like this. A business that provides insurance – known as the ‘insurer’ – agrees
to take on the risk on behalf of the business or individual concerned – known as the ‘insured’. It does this
by providing the insured with an insurance contract, sometimes called a ‘policy’. In this contract the
insurer will state what risks it has agreed to insure against and how much it will pay if the risk happens so
that insured is put back into the same position as if the risk had not happened. The policy may also include
a list of things that are not insured against, known as ‘exclusions’. So for example, if someone buys
insurance in case their car is stolen, the insurance may have an exclusion if the insured was careless and
left the keys in the car, making it easy for the car to be stolen. In return, the insurer receives a fee from
the insured, and this is called the insurance ‘premium’.
The insurer will collect premiums on a number of policies and pool these funds together which it
then invests to make the pot of money grow. Should any insured person make a claim on a policy, the insurer
will pay out on that claim from the pool of funds. The insurer is in business to make a profit and will be
hoping that the total premiums it receives in any one year together with any money it can make by investing
the money will exceed the total claims it has to pay out.
Insurers in Australia and in most countries are very closely supervised to make sure that they
do keep enough money to pay all their claims.
To be included in an insurance policy, a risk must be capable of being measured in monetary
terms. It must also be something that is not certain to happen. So to take a very simple example, you cannot
insure against the risk that the sun is going to set. That is a certainly going to happen and it is not
something for which you can buy insurance. Also the insured person must have a direct interest in any loss –
you cannot take out life insurance on the life of a complete stranger for example.
The insurer will look at all the circumstances surrounding a risk before deciding whether or not
to provide insurance cover against it, and this whole process is called ‘underwriting’. Underwriters are the
specialists employed by the insurer to carry out this task and they will want to understand a number of
things about the risk such as how likely is it to happen, what steps are already taken to reduce the risk and
what are the financial consequences of it happening.