How does insurance work?

How does insurance work?

When you take out an insurance policy, you pay a premium to the insurance company. If you never make a claim, you never get any of the money back; instead it's pooled with the premiums of others who have taken out insurance with a particular firm. 
That may not sound like a good deal, but the idea behind insurance is that everyone pays into a pot of money, knowing that only some of them will ever need to make a claim. If you have to make a claim (perhaps because your washing machine has flooded your kitchen and damaged your floor), the money comes from the pool of your and other policyholders' premiums.  

How are premiums calculated?

Insurers are professional risk takers, which means they know the probability of different types of risk happening so they can calculate the premiums needed to create a fund large enough to cover likely loss payments. 

Clearly, only a proportion of policyholders will make a claim in any one period. So, an insurer will take two important factors into account when calculating the premium it will charge. Firstly, how likely it is in general terms that someone will need to claim and secondly, whether the person who wants to take out the policy is a bigger or smaller risk than the 'average' policyholder. 
Take three examples. In motor insurance, a young person with a high-powered car, or a driver with a long history of accidents will pay a higher premium than a mature and experienced driver with a car with a smaller engine who has not had an accident before. 
Similarly, the owner of a fish and chip shop will pay a higher premium for his or her fire insurance than, say, the owner of an office. The risk is greater, so the premium is higher. 
Someone who is young, fit and in a risk-free job will find it easier to buy life insurance and will pay lower premiums than someone who has a heart condition or is in a risky occupation. 
The level of premium is also affected by the insurance company's desire to target a particular section of the market. So, if an insurer wants to encourage younger drivers to buy insurance from it, it may decide to undercut the premiums charged by some of its rivals.