How Insurance Turns Small Premiums Into Big Protection

Published Date: 05/28/2024

Insurance is one of those things everyone has and everyone pays for — yet few people truly understand how it actually works. Why do premiums rise every year? How can insurers afford to pay massive claims after disasters? And where does your money go after you write that check?



In a recent episode of Insurance Hour, host Karl Susman broke down these questions in plain language, using a memorable analogy involving Abraham Lincoln’s log cabin to explain the financial mechanics that keep the insurance system — and much of our economy — functioning. From risk pooling and investing premiums to reinsurance and loss prevention, this article explores how a small premium becomes a powerful financial safety net.

The Origins of Insurance and the Lincoln Log Cabin Example

At its core, insurance is about managing risk. Centuries ago, it began as protection against one of humanity’s oldest threats: fire.

Susman reminded listeners that the Hartford Insurance Company famously insured Abraham Lincoln’s log cabin — not for lawsuits or liability, but simply against the risk of it burning down. To explain how insurance works, he modernized that idea with a simple example.

Imagine Abe’s cabin costs $1,000 to rebuild. Abe pays an insurance company $5 a year, and the company guarantees that if the cabin burns down, it will pay the full $1,000. On its face, that sounds impossible. How could a company collect $5 and pay out $1,000?

The answer lies in how insurers spread and manage risk.

How Risk Pooling Makes Insurance Possible

The most fundamental principle of insurance is risk pooling.

Abe’s cabin isn’t the only one insured. Hundreds or thousands of other cabin owners are also paying $5 each into the same pool. If only a few cabins burn down in a given year, the total premium collected is more than enough to rebuild them.

This idea — many paying for the losses of a few — is what transforms individual uncertainty into collective financial stability.

But insurers must be strategic about how they structure that pool. As Susman explained, companies don’t insure every log cabin in one small neighborhood. If a single fire wipes them all out, the losses would be catastrophic. Instead, insurers diversify geographically, spreading policies across cities, regions, and even states.

It works the same way as a diversified investment portfolio: by spreading exposure, insurers reduce the chance that one event destroys the entire pool at once.

How Insurance Companies Invest Your Premium

Once premiums are collected, insurers don’t let that money sit idle.

“They don’t stuff your premium under a mattress,” Susman joked. “They invest it.”

When you pay your premium, a large portion goes into reserves — funds set aside to pay future claims. While that money waits, insurers invest it in conservative, highly liquid assets such as government bonds, blue-chip stocks, and short-term securities.

The returns generated from these investments create additional income that helps offset claim costs and stabilize premiums.

“If insurance companies couldn’t invest your premium dollars,” Susman explained, “they’d have to raise rates dramatically. Investment income is part of what keeps premiums reasonable.”

Strict state regulations govern how insurers invest. They are prohibited from taking excessive risks with policyholder funds and must balance safety, liquidity, and yield at all times.

What Reinsurance Is and Why It Protects Policyholders

One of the least understood — yet most important — parts of the insurance system is reinsurance.

“Think of reinsurance as backup coverage,” Susman said. “It’s how carriers make sure they can pay even the biggest claims.”

Using Abe’s example again, suppose his insurer takes $2.50 of the $5 premium and pays it to a reinsurer. If Abe’s cabin burns down, the insurer and the reinsurer split the $1,000 cost.

This layered protection spreads risk across dozens of companies worldwide. Many of the largest reinsurers are based in Switzerland, Germany, and the United Kingdom, and they help underwrite parts of nearly every major U.S. insurance program.

When disaster strikes — whether it’s California wildfires, Florida hurricanes, or overseas earthquakes — the financial burden is shared globally, not absorbed by a single company.

“Reinsurance protects you,” Susman emphasized. “It ensures your insurance company has enough money — even after a catastrophe — to pay your claim.”

Reinsurance is expensive, and those costs flow back into premiums. But without it, insurers would not be able to survive large-scale loss events.

How Catastrophic Losses Drive Premium Increases

Today’s insurance market is under immense pressure from the growing frequency and severity of catastrophic losses.

From wildfires and floods to severe storms, insurers are paying out more than ever before. Each major event forces companies to reassess risk models, hold larger reserves, and purchase additional reinsurance — all of which increases operating costs.

“We’re seeing catastrophic events weekly, if not more,” Susman said. “Insurance companies must prepare for the worst. The last thing anyone wants is an insurer that can’t pay its claims.”

State regulators monitor insurer solvency closely and require companies to maintain specific levels of liquid capital — cash or near-cash assets — to ensure claims can be paid immediately after disasters. These rules are what keep the system from collapsing during widespread loss events.

Why Loss Prevention Is Critical to the Insurance System

The final — and most proactive — pillar of insurance is loss prevention.

“The ideal customer,” Susman said, “is one who pays premium all day long and never files a claim.”

Insurers invest heavily in helping policyholders reduce risk because avoiding claims benefits everyone. Fewer losses mean lower costs for insurers and fewer disruptions for policyholders.

Using the log cabin analogy, Susman highlighted practical examples of loss prevention:

• Installing spark arrestors to prevent chimney embers from igniting roofs
• Creating defensible space to slow wildfire spread
• Using deadbolt locks and alarm systems to deter theft

These steps may seem small individually, but across millions of properties they significantly reduce claims and help stabilize premiums over time.

Why Even a Covered Loss Is Still a Loss

A common misconception is that filing a claim should feel like “getting something back” after years of paying premiums. Susman strongly rejected that idea.

“Some people say, ‘I’ve been paying premiums all these years — it’s about time I got something back.’ But that’s not how insurance works.”

Insurance is not a savings account or an investment. It is a risk-transfer tool that you hope you never need to use. Even when a claim is fully covered, it still brings stress, disruption, and lost time. Whether it’s a car accident or home damage, claims interrupt life.

That’s why both insurer and policyholder share the same goal: preventing losses whenever possible.

How All the Pieces Work Together

So how does a small monthly premium become a powerful financial safety net?

• Risk is pooled across thousands of policyholders.
• Exposure is diversified so one event doesn’t trigger total collapse.
• Premiums are conservatively invested to grow reserves.
• Reinsurance is purchased to protect against catastrophic losses.
• Loss prevention programs reduce the number and severity of claims.

Together, these layers allow the system to withstand everything from a kitchen fire to a statewide disaster.

Why Understanding Insurance Matters More Than Ever

Natural disasters are becoming more frequent. Construction costs are rising. Reinsurance is more expensive. That makes understanding how insurance truly works more important than ever.

When premiums increase, it’s easy to assume greed or inefficiency. But much of the increase reflects real-world economics: higher losses, greater risk, and stricter solvency requirements.

“The concepts we use today are the same ones used for Lincoln’s log cabin,” Susman said. “They’ve just evolved with time. At the end of the day, insurance is still about one thing — making sure that when something bad happens, there’s money there to help you recover.”

The Human Side of Insurance and Risk

Insurance may appear to be all about numbers, data, and financial models — but at its core, it’s about people. Every premium and every claim connects back to one promise: helping individuals and families rebuild when life takes an unexpected turn.

The next time you open a renewal notice and see your premium, remember you’re not just paying for a policy. You’re participating in a system of shared protection that has safeguarded families, businesses, and even presidents since the days of Abraham Lincoln.

And that, as Karl Susman reminds us, is the real magic of insurance.