Insurance involves transferring risk from the buyer to the seller. In return for taking on the risk of some specific bad thing happening to the policy holder, the policy holder agrees to give the insurer a predetermined series of payments.
If the bad thing actually happens, the insurer is responsible for compensating the policy holder for the damage. If it doesn’t, the insurer gets to keep the policy holder’s money.
To create a successful business that provides value through insurance, you need to:
- Create a legal agreement that transfers the risk of some specific bad thing happening from the policy holder to you.
- Calculate the likelihood of that bad thing actually happening, using available data.
- Collect the agreed-upon series of premium payments over time.
- Pay out legitimate claims upon the policy when the bad thing happens.
Insurance is valuable to the buyer because it protects them from risk. For instance, if your house burns down, you likely don’t have enough money in the bank to purchase a new one. But by purchasing homeowners’ insurance, you transfer this risk to the insurer.
If your home is destroyed, the insurance company will compensate you and allow you to buy a new home. If your home is not destroyed, the insurance company gets to keep the premium payments.
Offering insurance is effective because it spreads risk over a large number of people. If an insurer writes policies for millions of homes, it’s highly unlikely that all of them will burn down at the same time. This means that only a certain number of claims will need to be paid at a given time. As long as the insurer brings in more premium payments than it pays out in claims, the insurer if profitable. Car insurance, medical insurance, and life insurance work the same way.
Insurers are concerned about avoiding bad risks, maximizing premium payments, and minimizing payments on claims. As such, they must be careful to avoid fraud. This can be done by preventing illegitimate claims as well as by not cheating customers by collecting premium payments without paying legitimate claims. If an insurer doesn’t pay legitimate claims, they may end up in court as policy holders use the legal system to defend their insurance contract.
To learn more about insurance as a form of value, check out The Personal MBA by Josh Kaufman.
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