When you take out an insurance policy, you get asked all sorts of questions. Your age. Your address. Your health status. What you had for breakfast this morning. Your dog’s name.
Maybe not the last two, but you get the point. It feels like insurers want to know everything about us before providing cover for whatever it is we’re trying to insure. But what’s with all the questions?
To understand why they want to know the ins and outs of our personal life, we must first understand what insurance actually is, how risk is calculated, and the problem it attempts to solve.
Put simply, insurance is formed when a group of individuals come together to pool (or mitigate) their risk. Now let’s explore exactly how that works with an example...
Imagine that you own a ship that travels from the UK to the US every year. You carry £100,000 worth of cargo. From previous experience, you know that there is roughly a 1% chance you might come into trouble along the way which will cause the loss of your entire cargo.
Of course, it’s unlikely to happen. But you still don’t want to take the risk. So you decide to pool your risk with 100 other ship owners that have the same type of ship. You each put in £1,000 every year, creating a pot of £100,000 to cover one ship’s cargo.
The law of averages says that one of you (1% of 100) will come into trouble every year – but it won’t matter, because the pot of money will cover it. So in effect, each captain pays £1,000 every year to insure £100,000 worth of cargo.
Several years later, it’s plain sailing. Your original predictions were spot on, and the law of averages turned out to be correct. Only one ship owner claims each year and all the cargo is safe. Everyone’s happy.
Now, a bunch of other ship owners want to secure their cargo too. But the problem is, they have different ships. Some are older, rustier, poorer quality and therefore more likely to encounter a problem.
Existing policy holders are like, “hang on sailor, this isn’t fair”. They make the argument that the new ships pose a bigger risk than the existing fleet. And if they join, this would increase the 1% chance of a ship's cargo being lost.
But instead of making the existing 100 ship owners pay more, you come up with a better way to manage the new ships. You already know that ships more than five years old are more likely to come into trouble. So, you decide to start asking new ship owners how old their ship is.
The older the ship, the higher the risk. The higher the risk, the higher the premium.
And that, in a nutshell, is what we call underwriting. The process of making sure that everyone pays a fair price for the risk they bring. This means that more people can come together to pool their risk.
Seems fair enough, right?