Understanding Financial Stability
Insurance companies promise more benefits than they take in premiums. If you have a $200,000 home insurance policy that covers insurable events affecting your residence, it is possible you will pay a low premium relative to the benefit. Let’s assume that you only pay $150 per month for this benefit. This means that your benefit will be paid for very little premiums. Even though you might only have to pay two premiums before you file a claim, even though it amounts to $300 in premium payments you still get your full benefit amount if you are eligible for the insurable event. You are not the only policyholder who is in this fortunate position. There are hundreds of thousands of policies out there, each worth billions of dollar, with policyholders paying small premiums.
You might wonder how insurance companies can avoid financial collapse and still provide all the insurance benefits for such low premiums. Insurers can be financially stable and pay claims in three important ways.
- Understanding the risk
- Spreading risk
- Reserves
Understanding Risk
An insurance company must understand risk and underwrite policies to determine how much risk they will be exposed. This allows them to price the policy fairly, so those with higher risk pay a higher premium while those with lower risk pay a lower price. This helps insurance companies gauge how many policies will be subject to a claim. Not every policyholder will be able to file a claim. This means that there are a few policies where the insurance company collects only premiums. These premiums pay for many claims that are experienced by policyholders who have insurable events.
Spreading risk
Insurance companies can spread their risk over a large number of clients to ensure enough premiums to earn a profit and preserve reserves. The percentage of policyholders that must collect money from an insurance policy is much lower than the amount who actually pay it. This process is known as the Law of Large Numbers, and has been used by insurance companies and groups for many years.
Setting Aside Reserves
Insurance companies must have reserves, which are funds that are regularly set aside by the company to cover any claims they receive. These reserves can be used to pay any claim that is received. These reserves are separate from any other expenses of the insurance company and mandatory contributions are made to them.
Insurers have an accurate idea of how many claims they will face over time, thanks to their underwriting efforts as well as actuarial data. They also know what amount they should reserve for future claims.
Security Checking for Your Insurance Company
You can find out how financially sound an insurer is by checking their rating on A.M. Best. A.M. Best, an insurance rating agency, evaluates the financial strength and assigns them a letter score that reflects how strong they are.
Their ability to pay claims is what determines their financial strength. Before assigning a rating, they compare all the insurers, examine income statements and balance sheets, and review industry trends.
It doesn’t matter how cheap a quote an insurer might give you, it is important that you research their financial stability before taking out a policy. It is worthless to pay premiums to an insurer year after year that doesn’t meet their obligations to you.
