What is insurance?

In simple words, we will be covering and explaining the need and working of the insurance industry

You may have come across this wonderful Cred advertisement where Kumar Sanu sings you this beautiful insurance pitch. If you have been wondering how Kumar Sanu’s firm makes money from selling insurances then you have reached the correct article. In simple words, we will be covering and explaining the need and working of the insurance industry, which may be boring to outsiders but is a brilliant business model to shareholders.

The history of the insurance business

The early beginnings of the insurance business can be traced back to ancient Babylon, Chinese and Indian traders using methods to transfer or distribute risk as long as the 2nd and 3rd millennia BC. Concepts of insurance have been also found in 3rd century BCE Hindu scriptures such as Dharmasastra, Arthashastra, and Manusmriti. However, the ancient history of the insurance business in detail deserves a separate video on its own.

Much later in 17th century London, maritime travel was still a difficult venture, and shipowners regularly found their ships attacked by pirates, losing out a lot on economic damages. This was a regular phenomenon for many shipowners who needed to send their ships to different lands for trading spices, commodities, and colonization.

This was when Edward Lloyd started an insurance scheme for ships in his London coffee shop, where shipowners could pay a premium to Lloyd’s business in return for compensation in case of damages to the ship. Lloyd’s insurance business took off and still exists today in the name of Lloyd’s of London.

How exactly does insurance work?

We can take a simple example to understand the business model, assume two students Ram and Shyam. Shyam tells Ram – “you can pay me 10 rupees to insure you against you losing your notebook. If you lose your notebook I’ll get you a notebook of 25 rupees“. Ram agrees. He pays 10 rupees to Shyam to ‘insure’ his notebook. This means that if Ram loses his notebook, Shyam will get him a new book.

Now, you might be thinking, that sounds very unprofitable for Shyam in case the scenario of Ram losing the notebook does happen, even though that’s an unlikely occurrence. But the brilliance of Shyam is, he provides the same condition to many other students who give 10 rupees to Ram to insure their notebooks.

Say 20 students insure their notebooks and one student lost their notebook. He will have to shell out 25 rupees from his revenue to buy a notebook for that student. That isn’t a problem however since he has a pool of (20 students * 10 rupees =) 200 rupees and he’ll have to shell out (1 student * 25 rupees =) 25 rupees only.

This is the same fundamental logic that massive insurance companies use for their businesses too, which ensures constant cash flow inwards. To sum it up simply, insurance is the practice of pooling funds from many insured entities to pay for the losses that some insured entities may incur.

While companies don’t insure notebooks, they do insure

  • Life
  • Health
  • Motor
  • Home
  • Fire
  • Financial instruments (like the credit default swap)

While pretty much anything can be technically insured, the things that are most commonly insured are the ones that are the closest to people’s hearts and people’s pockets, which makes it easier for the insurance companies to target a larger audience.