Like banking, stock brokerage, credit card issuance or mortgage lending, insurance is a financial business.
The broad purpose of financial service companies is to assist people in meeting their financial needs. The financial need met by insurance is to protect insurance buyers from the financial impact of devastating, unforeseen events.
People who own real estate, businesses, automobiles or a wide variety of other valuable property are subject to the risk posed by a sudden, unexpected catastrophe — such as a fire, theft, hurricane, tornado, accident or lawsuit.
Faced with this ever-present risk, property owners have two choices: They can retain the risk, meaning that if a catastrophe occurs they will themselves pay for all the damage, or they can transfer the risk to an insurance company, meaning that the insurance company will pay for covered damage.
The policyholder pays a certain sum — the premium on the insurance policy — in return for which a property/casualty insurance company agrees to indemnify (protect) the insured party from the cost of unforeseen events according to the terms of the insurance policy.
Insurance premiums are pooled together and invested in bonds, stocks and other investment vehicles that earn income. Premiums and the income they earn constitute the funds out of which insurance companies pay the claims of policyholders and the insurer’s cost of doing business.
A frequent misconception about property/casualty insurance is that the business makes very high profits. In fact, the property/casualty insurance business has been consistently less profitable than many other types of businesses.
Another similarity between insurance and other businesses is that the price charged for the company’s product is directly related to the price at which the business purchases the raw materials used in the product. If the price of beef or bread goes up, then the price of hamburgers also must rise.
Similarly, if the price of car repairs or home constructions or settling lawsuits rises, the cost of automobile or fire or liability insurance must rise. There have been major increases in the cost of items purchased by insurance claims payments.
A third similarity between insurance and other businesses is that competition keeps prices down. Consumers usually will seek the best deal they can find on any product or service, whether it is airline fares or television sets or insurance. Sellers who offer lower prices for identical products receive more business.
Competition among America’s nearly 3,500 property/casualty companies has always been keen and has meant that prices for property/casualty insurance policies are kept in line with costs.
Determining the price of an insurance policy is an enormously complex process. A crucial variable in the price of insurance is risk. Risk is calculated mathematically by insurance professionals known as actuaries. The greater the likelihood (risk) of an insured event occurring, the more likely it is that the insurance company will have to pay a claim.
Thus, insurance companies must charge higher premiums for greater risk, so they will have sufficient reserves available to pay all claims of that type.
Insurance companies do not create risk. The risk is out there in the real world; it is this existing risk that insurance companies measure. Likewise, insurance companies have little control over the ever-increasing cost of goods and services that cause the total dollars paid out for insurance claims, and insurance premiums as well, to rise.
In effect, insurance companies really are messengers to society about the cost of risk.
Nothing is more important to the long-term success of any business than satisfied customers. To hold down the price of insurance, it is necessary to hold down the costs of what insurance pays for.
That is why the insurance industry continually devotes substantial resources to supporting programs and proposals aimed at reducing the costs of risk.
Among these efforts are: requiring stronger bumpers on cars, increasing seat belt use, keeping drunk drivers off the road, equipping cars with better theft protection devices, encouraging competition in the car parts industry, urging use of smoke detectors and changing some of the rules governing lawsuits to reduce costs and inefficiencies in the court system.
Public support for these and other risk and cost-controlling efforts is vitally needed to help contain the cost of property/casualty premiums.