Insurance companies promise much more in benefits than they collect in premiums. For instance, if you have a $200,000 limit on your home insurance policy for insurable incidents affecting your dwelling it is likely you pay a very low premium in relation to the benefit. For the sake of this example, let’s say you pay only $150 a month for the benefit. That means that you will pay very little in premiums over the course of the year in exchange for your benefit. You might even pay only two premiums before you have a claim and even though that amounts to only $300 in premium payments, you will still be entitled to your full benefit amount if your insurable event qualifies you. And you aren’t the only policyholder in that lucky position. Hundreds of thousands of policies are out there worth billions of dollars, and each with the policyholders paying very, very small premiums.
This might make you wonder how insurance companies avoid financial collapse while guaranteeing all these insurance benefits in exchange for such small premiums. There are three very important ways that insurers remain financially stable and pay claims:
- Understanding risk
- Spreading risk
- Setting aside reserves
In understanding risk, an insurance company must underwrite policies so that they understand exactly how much risk the policy will expose them to. This helps them price the policy fairly so that those who present more risk pay a higher premium and those who represent less risk pay a lower premium. It also helps the insurance company gauge about how many of their policies will have a claim. After all, not every policyholder will have a claim on their policy. That means there is a certain percentage of policies on which the insurance company simply collects premiums. It is these premiums that pay for many of the claims experienced by the small percentage of policyholders with insurable incidents.
By spreading out their risks over a large pool of paying clients, insurance companies are able to secure enough in premiums to make a profit and save reserves. After all, the actual percentage of policyholders who must collect money from their insurance policy is relatively small compared to the number who pay for it. This process is referred to as the Law of Large Numbers and it has been utilized by insurers and groups for years.
Setting Aside Reserves
In order to pay the claims that they do receive, insurance companies must set aside funds on a regular basis into what are called reserves. When a claim comes in these reserves can be tapped to satisfy the contract that each policyholder has with his or her insurance company. The reserves are kept separate from all other insurance company expenses and contributions to them are mandatory.
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Because insurers have a good idea of the number of claims they will face over the years, thanks to their underwriting efforts and actuarial data, they know what amount to set aside in reserves.
Checking on the Security of Your Insurance Company
In order to determine just how financially sound your insurer is, you should begin by looking up their rating on the A.M. Best website. A.M. Best is an insurance rating agency that evaluates the financial strength of insurers and assigns them a letter grade that represents just how strong they are.
The financial strength is based on their ability to pay claims. They compare each insurer with others, check balance sheets and income statements, review industry trends and take other qualitative data into consideration before assigning their rating.
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