Final answer:
Insurance companies can pay out large benefits due to risk pooling among many policyholders, actuarial fair pricing of premiums, and their ability to negotiate lower service rates due to a large client base. Not every insured individual will use their benefits, creating a surplus that covers those who do need to make large claims.
Step-by-step explanation:
An insurance company can pay a large benefit to an individual without having collected that amount in premiums from that specific individual because the risk is spread across a large group of policyholders. The concept is known as risk pooling, where premiums are collected from all insured parties and placed into a pool. Companies calculate the likelihood of events occurring across this group, setting premiums accordingly to cover the expected payouts, which creates an actuarially fair insurance policy. Not every policyholder will claim benefits; in fact, most will contribute more in premiums than they receive. This surplus helps cover the costs for those who do experience the insured event and need to claim benefits.
The calculation of premiums and payouts is based on probability and statistics, a work done by professionals called actuaries. They assess the risk of potential claims and set premium prices to ensure the company can cover these claims while also earning a profit. To tackle inefficiencies like moral hazard, where insured individuals may take greater risks because they have coverage, insurance companies may include deductibles and co-pays in their policies.
Because insurance companies serve a large number of clients, they have strong negotiating power with service providers. They can secure service rates lower than an individual could, leading to economies of scale. This negotiation prowess saves money for the company and benefits the consumer by providing more value for the premiums paid and making it feasible for the company to pay out large benefits when needed.