Basic Concepts of Insurance

 Basic Concepts of Insurance
 Basic Concepts of Insurance

Insurance is an economic institution that allows the transfer of financial risk from an individual to a pooled group of risks by means of a two-party contract. Insurance markets can exist because of the law of large numbers, which states that, for a series of independent and identically distributed random variables (such as automobile insurance claims), the variance of the average amount of a claim payment decreases as the number of claims increases. However, natural hazards-such as earthquakes, floods, and hurricanes—are classified as catastrophic risks. There is a high probability that many structures would be damaged or destroyed at the same time.

One way that insurers reduce the magnitude of their catastrophic losses is by employing high deductibles. The use of coinsurance, whereby the insurer pays a fraction of any loss that occurs, produces an effect similar to a deductible. Another way of limiting potential losses is for the insurer to place caps on the maximum amount of coverage on any given piece of property. An additional option is for the insurer to buy reinsurance.

Basic Concepts of Insurance

Insurance is based on the concept of risk pooling or risk sharing of losses. Basically under this concept, all individuals suffering a similar risk, place an agreed sum into a pool and the monies collected are used to indemnify any contributing individual against any loss arising out of the risk. The pool can either be managed by the individuals or paid to and managed by a company. In the former, the plan is known as mutual insurance while in the latter, the company managing the pool is known as a stock life insurance company.

For example, supposing in a certain typhoon prone community, there are 2000 houses, each worth $100000 and each is exposed to the same probability of being destroyed by a typhoon. In a particular year, if the statistics indicate that two of the houses will be destroyed by typhoon, this means that each house owner is relatively safe as he only faces a 0.1% chance that his house will be destroyed. However, should he be so unlucky as to constitute the 0.1%, his loss will be devastating. However, by setting up a common fund of $200000 to be used to compensate any two houseowners hit by typhoon, each house owner gains the assurance that any loss arising from the risk is minimised. Further, to accumulate this fund, each household only needs to contribute an affordable premium of $100. Each house owner therefore, pays a premium of $100 to buy peace of mind.

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Human beings are exposed to different kinds of risks, Such as loss of property by fire, untimely death, and loss in accidents. They are uncertain. It is impossible to eliminate financial loss arising from an uncertain event with the help of insurance. Thus, insurance is a financial mechanism to reduce or eliminate the financial loss due to risk .However, it can neither eliminate nor reduce the risk, but only provides protection against them .Insurance is a way of sharing a risk among the peoples.

The nature of insurance can be expressed clearly by an example. Suppose there are 20,000 houses in a village each values Rs: 200000. On the basis of experience it is ascertained that four houses are destroyed by fire each year. Thus, it is clear that fire will catch in four houses next year. But, it cannot be ascertained as to which house will catch house. 

Nobody knows who those unfortunate individuals will be. One cannot foretell when and who would suffer loss. But everyone is afraid of the risk to which they are exposed. That is, everyone is likely to suffer from a loss of Rs: 200000 which is a big burden for an individual. They can find a method of providing protection against this risk by establishing a common fund to which each contributes Rs: 80 very years. The four unfortunate householders can be compensated by the created fund. It is in this cooperative measures that insurance originated. In fact, the most important from of risk transfer is insurance. 

Insurance protects a person and his dependents from loss arising from future uncertain events such as fire, flood, accidents, early death, etc. It should be remembered that the loss cannot be eliminated by insurance but it spreads over a large number of persons. The function of insurance is to distribute the loss of few persons into many persons. We have to make the idea that the insurance is a process of sharing risks.

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