How do insurance companies pay out big claims, when their customers only pay small premiums?

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If you’re wondering how your monthly premium can be less than your phone bill, but cover you for more than the cost of a brand-new car, you’re not the only one. So, how does it all add up? Because of a clever concept called ‘risk pooling’.

What is ‘risk pooling'?

Risk pooling's history goes back millennia. Over 5,000 years ago, shippers protected their crew and cargo from being lost at sea by pooling their supplies. In other words, they spread their men and supplies across multiple different ships. This meant the risk of losing them at sea was lowered, because it was spread out more evenly.

In the insurance world, a ‘risk pool' specifically refers to the grouping together of money from each individual policy holder's premium, to form a collective pool of funds.

When someone makes a claim, it then gets paid out from this pool.

Why do insurance companies use risk pooling?

If insurance companies were at risk of paying out more in claims than they receive in premiums, insurance quite simply wouldn't exist. That's why risk pooling is such a common concept in the insurance industry; because it's a highly effective way to lower risk.

Pooling evenly distributes the risk across all the individuals getting insurance from the same company, and makes it less likely that any one claim will be too large for the insurance company to pay out. Pooling can be beneficial for customers, too. It helps make insurance more affordable for everyone in the pool. And the bigger the pool, the more predictable and secure the insurance premiums.

Why do some people never make an insurance claim?

In insurance, the concept of risk pooling relies on the fact that some people will never make a claim. There are several reasons this might happen. One of the most obvious is that some people are lucky enough to live long and healthy lives. Another reason is that some people cancel their policy or benefit before they had the chance to make a claim. A person could choose to cancel their cover because:

An inheritance or asset sale provides the funds they need to cover any future medical costs on their own; or

They don't need as much insurance as they once did (for example, because they've paid off their debts or their children have left home); or

Their premium price has gone up and they can no longer afford it; or

They've found a better deal with another insurance company; or

They simply don't believe they need it anymore.

If some customers never make a claim, where does all the premium money go?

This is where the concept of risk pooling comes into play. When an individual customer's premium money goes into the pool, it then gets used to pay out all claims – not just their own. And since they themselves haven't had to claim, their premium funds end up being used to pay other customers' claims. 

To put it simply, the money received from customers who don't claim, is used to pay out the customers who do claim.

Why should I have to pay for other people's claims, if I haven't made a claim myself?

At first glance, the idea of risk pooling might seem a little unfair. But it's important to understand that your premium isn't really paying for other people's claims. It's actually paying for the risk that you yourself could have to make a claim someday.

See, any potential future claim you make will likely exceed the cost of all the premiums you've paid put together. And that's why the risk pool is so essential – and so brilliant. It's the source of the extra funds needed to cover your claim, above and beyond your premium payments.

Why should you buy insurance, instead of just saving your own money to pay for your claims?

You wouldn't be the first person to choose to save for a rainy day, rather than purchase cover.

But before you do, there are a few key risks to take into account:

  • Life doesn't wait, and there's every chance a claim event could happen before you've had enough time to save for it; or

  • Your insurance savings could end up redirected to other expenses, like car trouble or a wedding, which could leave you without the funds you need for a claim; or

  • In the event of a relationship split, your savings could end up divided, and insufficient to cover a claim; or

  • You could use all your savings on one insurance claim, leaving no funds left over for a potential second claim in the future.

Insurance can be hard to unpack, and easy to misunderstand

We hope life treats you well, and that you never have to experience an event that shows you just how important insurance really is. But for those customers who are struck by tragedy, having a policy that delivers against its promises is invaluable. And the relief and gratitude that brings is priceless.

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