How does Insurance Work? (Simplified)
First things first, before we get to how insurance works, what is this insurance?.
Insurance is simply a tool used to protect you, your family, or your business against financial disaster due to unforeseen circumstances.
If we think about it, insurance has been there since time immemorial. The concept has been practiced without it being known as insurance.
Let us think about a village setup. Everyone in the village owns a hut, including you. The main nightmare your village has been facing is the huts catching fire because of the dry thatched roofs. So what do you and your fellow smart villagers do?
Every month, out of the income you make, you, together with each family in the village, sets a fraction of that amount aside to contribute to a pool of funds put in a pot that is guarded by the village chief. Because there is a large number of families, the amount contributed is usually significant.
If unfortunately, your hut catches fire, you go to the chief to report the incident. He, therefore, assesses the level of damage of your hut then takes money from that pot to give you to rebuild it. This is to take you and your family back to the position you were in before the hut caught fire.
Let’s say you did not contribute to this fund, you will have to dig into your savings (which may not be enough) or you may have to borrow from your neighbors and friends or move back in with your parents because of financial distress.
In the best-case scenario, your hut does not catch fire. The beautiful thing is that you are still comfortable in your hut (yaaaay) and the amount of money you contributed does not go to waste because it has helped your neighbor whose hut has caught fire.
So whether your hut catches fire or not, it is a win-win situation.
Money you contribute every month = premium
Chief guarding the money pot = insurance company
Money you received when your hut caught fire = claim proceeds
Fast forward to the present-day scenario. As long as you are on this earth breathing, you face a risk, your loved ones face a risk. This could be a risk of getting an illness or premature transition especially if you have loved ones depending on you.
If you have assets, you face a risk of the asset stolen or even destroyed and this will definitely cost you money.
We, therefore, pay premiums to an insurance company in the promise that if something were to go wrong, you will get paid. Insurance is to take you back to the position you were in before the unforeseen circumstance occurred.
Now that is insurance in a nutshell.