How Does Insurance Work?: How Insurance Started, How Your Premiums Are Set, and What Happens to the Profits

March Madness is in full swing, and the hectic 3-week betting bonanza will leave some of us with empty pockets and others with some extra cash to spend.

Maybe you decided to fill out a bracket this year, and maybe you threw 10 bucks into a pot with 10 other people. You, my friend, were doing exactly what insurance companies do.

You calculated your probability for winning — 10% — and decided that risking $10 for a potential $90 gain was worth it.

Insurance companies do the exact same thing.

The first type of insurance was… what?

So, where did insurance start?

Take a guess. Here are just some of the different kinds of insurance available today:

• Agriculture insurance
• Aviation insurance
• Builder's risk insurance
• Burial Insurance
• Car insurance
• Cyber-Insurance
• Divorce insurance
• Earthquake insurance
• Flood insurance
• Health insurance
• Home insurance
• Landlords' insurance
• Legal expenses insurance
• Liability insurance
• Life insurance
• Mortgage Insurance
• Pet insurance
• Pollution insurance
• Property insurance
• Renters' insurance
• Shipping insurance
• Travel insurance
• Vehicle insurance
• Weather insurance
• Zombie fund

We can all safely take Zombie fund out of the race, but can you guess which one of these insurances started the entire concept of insurance?

You’re probably thinking along the lines of

• health,
• life, or
• home insurance.

But actually… drum roll please…

It all started with burial insurance.

It wasn’t the fear of dying that started this new money pooling trend, but rather the fear of a funeral that wasn’t grandiose enough.

Funeral societies were formed in Egypt, Greece, and the Roman Empire. In today’s terminology, the members basically paid a subscription to be a part of the club. That money was then paid out for extravagant funerals that the members alone couldn’t have paid for.

After that, cargo insurance began. This type of insurance helped to cover ships and ship merchandise. Just like the burial insurance, all of the members paid into the fund to be a part of the club.

Then came fire insurance in 1543 in Germany, and 40 years later,  life insurance was introduced in England. It took another 200 years before England saw the first life insurance society, called Equitable. You may recognize that name — Equitable still exists today.

How do insurance companies set the monthly premiums?

Life insurance companies relied on mortality tables that showed the probability of death based on a variety of factors like age and sex, and that determined the premiums, or monthly payments.

Here’s an example of a mortality table:

Fast forward into the early 1800s, and the modern insurance industry formed. Better statistics and risk information helped the insurance companies to thrive, and here we are today in the 21st century with nearly 6,000 insurance companies.

How do insurance companies make money?

Insurance is now a staple in our budgets — health and car insurance are legally required by the government, and you can’t mortgage a home without home insurance. Odds are that most of us, if not all of us, are paying into one or more different types of insurance.

You’re investing in it, but do you know how it works?

It can get really confusing really fast, but we’ve decided to break it down to bare bones so that we can all walk away feeling like we truly get it.

So, here’s how it works. Let’s use health insurance as our example.

You give birth very prematurely, and your tiny baby requires 24-hour monitoring in a neonatal intensive care unit.

When all is said and done, your medical bills are right at $100,000. How does the insurance company afford that cost let alone make money?

As you saw before with the mortality table, insurance companies work with probabilities. So, let’s just say that there is a 1% chance of this medical crisis.

The insurance company has 100 “members,” and each member pays in $1050 for the year. The insurance company now has $105,000.

The unlucky 1 gets the $100,000 for the treatment, and there’s $5,000 left over.

So… what happens to that $5,000?

Nowadays, most insurance companies invest profits or simply keep it for themselves. However, this wasn’t always the case.

Enter: mutual insurance.

A mutual insurance company is owned entirely by its policyholders. That means that all profits are distributed back to the policyholders in some way or another.

This mutual insurance concept started in England in the late 1600s to cover losses due to a fire. It took another 50 years or so before this concept spread to the US with good ole’ Benjamin Franklin. Franklin started a house fire “contributionship,” and now, there are 52 prevalent mutual insurance companies in the US.

You’ve probably heard of some of them — Liberty Mutual, Mutual of Omaha, and State Farm Insurance are a few examples.

How do I make sense of all this?

Insurance can be confusing, and sometimes we question its merits, but it did rise out of necessity. When all is said and done, almost all of us would be seriously in trouble if an expensive crisis came from left field.

And, while insurance can be confusing for most of us, there are a select few of us who have spent our lives understanding it to help others. Let us take the confusion out of insurance, and we’ll see what potential risks we can protect you from.

Want some help with your insurance? Have some unanswered questions? Feel like you may not be completely covered?