Insurance

Overview

At its essence, insurance is a method of shifting risk. Rather than having to face the full financial consequences of a rare but possibly huge loss by themselves, an individual or a business pays a regular, small, and foreseeable premium to an insurer, who then agrees to pay for a specified loss if it occurs. 

The insurer is able to make a profit since it spreads the risk among thousands or millions of customers, the majority of whom will not make a claim in any one year, and uses this spread to pay for the small number who do, it would be impossible for any single insurer to survive handling one person's house fire on its own, but when the risks are spread out over a large enough group of similar cases the figures become predictable. 

Main types

• Life insurance provides beneficiaries with a lump sum or a regular income should the policyholder die during the term of the policy, usually being used to secure a mortgage or to provide for any dependants. 
• General insurance protects against ordinary physical and financial risks, such as home insurance, motor insurance (which is legally required of drivers in the UK) and travel insurance, with the policies generally lasting for a fixed period and being renewed each year. 
• Health insurance pays for private medical treatment and, according to the policy, either supplements or replaces care from the NHS. 

How insurers make money

Insurers make money in two different ways. 

The first of these is underwriting profit, which is the amount by which the premiums received exceed the claims together with the costs that are paid out, provided that a well-managed insurer sets the prices of its policies so that, over time, the premiums are higher than the claims across the entire portfolio. 

The second, which is often greater, comes from the return on investment of the float: although insurers receive the premiums immediately, they do not have to pay out the claims for months or years, especially in the case of life insurance, and in the meantime the amount of premiums collected but not yet paid out can be invested in bonds, equities and property. That is the reason why big insurers have investment portfolios on a scale comparable to those of pension funds and are therefore often included with them as major institutional investors in the wider financial system.

Regulation

In the United Kingdom, there are two bodies which have the responsibility of regulating insurance companies, and these organisations carry out different functions. The Prudential Regulation Authority (PRA) looks after solvency by making sure that insurers keep adequate capital so that they can meet their obligations even in the case of a difficult, stressful situation. 

The Financial Conduct Authority (FCA), by contrast, is concerned with conduct and therefore monitors how insurers sell their policies, deal with claims and treat their customers. The core capital framework known as Solvency II has been updated since Brexit to produce a version suitable for the UK; this new version is generally referred to as Solvency UK, and the new system will become fully effective at the end of 2024, retaining the general risk-based approach but altering the specific rules to make them more appropriate for the UK market.

Risks and criticisms 

• It is a common problem that some policyholders have insurance which does not completely replace the items they would lose, for instance, the value of their possessions being less than the amount for which they are insured. 
• A major issue is the occurrence of claims disputes when there is a disagreement between the insurance company and the policyholder as to whether an event is covered or how much the loss is, this causing complaints to be sent to the Financial Ombudsman Service. 
• Moreover, in high-risk areas affordability is still an issue, flood risk being the most obvious example in the UK, and this has been addressed by Flood Re, a reinsurance scheme established in 2016 jointly by the government and the insurers, which reduces the amount that insurers can charge for the flood portion of home insurance in high-risk properties by spreading the costs across the broader market. Hundreds of thousands of households have benefited from the scheme since it was set up, but it is only a temporary measure and will be phased out by 2039, the pressure on it growing as more properties are designated as being at flood risk.