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How insurance works

Insurance is the main way for businesses and individuals to reduce the financial impact of a risk occurring.

Running a business of any kind involves a certain amount of risk. Whether it’s the risk of fire, the risk of damage to exported goods or the risk of natural disasters, all these incidents will have a financial impact on your business if they occur. This is what is being referred to when we use the term ‘risk’.

Most businesses take small steps to manage the effects of risk. For example, by installing smoke alarms and sprinkler systems to reduce the damage caused by fire or by installing security alarms to deter thieves.

However, business owners also want to protect themselves against the financial consequences of something untoward happening, and this is where insurance comes in. In effect, the business can transfer the risk away from themselves and on to someone else.

This transfer of risk is the basis of all insurance, and is something that Lloyd’s has been doing since the 17th century.

When things go wrong it can be expensive and so, for many of these eventualities, insurance is there to take the financial risk on our behalf.

A business that provides insurance agrees to take on risks on behalf of a company or individual, in exchange for a fee. It does this by providing the business or individual concerned with an insurance contract, sometimes called a ‘policy’.

This policy will cover a person or business for many of the costs they have to meet as a result of a risk occurring and provides the policyholder with some security should the worst happen.

The fee an insurer receives from a policyholder (in return for their policy) is called the insurance ‘premium’. This premium, and the terms and conditions of the policy, are based on the likelihood of the risk happening and its value.

The insurer collects premiums on a number of policies and pools these funds, which it then invests to increase the amount of money held. Should any insured person or business make a claim on a policy, the insurer will pay out on that claim from the pool of funds.

The insurer is in business to make a profit and will be hoping that the total premiums it receives in any one year, together with any money it can make through investments, will exceed the total claims it has to pay out.

Insurers are very closely supervised to make sure that they always have enough money to pay all their claims.

Here at Lloyd’s, the teams within the Corporation are responsible for making sure the level of capital is robust enough to ensure that policyholders are protected and all claims can be met.

Lloyd’s financial strength and ratings

Before deciding whether or not to provide insurance cover, the insurer will look at all the circumstances surrounding a risk, such as: the likelihood of it happening, the steps already taken to reduce the risk and the financial consequences.

This whole process is called ‘underwriting’. Underwriters are the specialists employed by the insurer to carry out this task.

The underwriters here at Lloyd’s are among the best in the world. They are experts at devising tailored and innovative solutions to new and complex problems.

Lloyd’s underwrites a wide range of businesses and projects all over the world. For example, oil rigs, transport networks, satellites, Wimbledon and The Oscars.

Reinsurance is an extension of the concept of insurance, in that it passes on part of the risk for which the original insurer is liable.

Due to the size and complexity of some risks, some insurers take out their own, additional insurance - as added protection for themselves. When insurers insure a risk again, it’s called reinsurance.

Reinsurance is a large, specialist area of insurance and makes up a significant part of all business carried out at Lloyd’s.

Reinsurance is important for four main reasons:

To protect an insurer against very large claims

Insurers spread the costs of paying out on large risks by reinsuring part of what they have agreed to insure with other reinsurers. This ‘spread’ means that the loss incurred by each individual insurer is not as severe.

To reduce exposure to ‘peaks and troughs’

Insurers want a balanced set of underwriting results each year, without peaks and troughs. Because reinsurance covers them against unusually large losses, this keeps a cap on the claims the insurer has to pay.

To obtain an international spread of risk

This is important when a country is vulnerable to natural disasters and an insurer is heavily committed in that country. Insurance may be reinsured to spread the risk outside the country.

To increase the capacity of the direct insurer

Sometimes, insurers want to insure a very large risk but are unable to do this on their own. By using reinsurance, the insurer can accept the whole risk and then reinsure the parts it cannot keep with other insurers.

Like the direct insurance market, reinsurance usually involves specialist brokers. The specialist reinsurance brokers here at Lloyd’s have expert knowledge of the market and the ability to access experienced reinsurance underwriters on behalf of their clients.