Insurance and Its Purposes

Insurance and Its Purposes 

        Insurance is a form of risk management primarily used to hedge against the risk of a contingent loss. It can also be defined as the equitable transfer of the risk of a loss, from one entity to another, in exchange for a premium. An insurer is a company selling the insurance, in which they use an insurance rate, or a factor used to determine the amount, called the premium, to be charged for a certain amount of insurance coverage.  

        The insurance industry typically follows seven principles for risks that each serve a different purpose. These principles are:

1. A large number of homogeneous exposure units. The vast majority of insurance policies are provided for individual members of very large classes. The existence of a large number of homogeneous exposure units allows insurers to benefit from the so-called “law of large numbers,” which in effect states that as the number of exposure units increases, the actual results are increasingly likely to become close to expected results.
2. Definite Loss. The event that gives rise to the loss that is subject to insurance should, at least in principle, take place at a known time, in a known place, and from a known cause. Ideally, the time, place and cause of a loss should be clear enough that a reasonable person, with sufficient information, could objectively verify all three elements.
3. Accidental Loss. The event that constitutes the trigger of a claim should be fortuitous, or at least outside the control of the beneficiary of the insurance. The loss should be ‘pure,’ in the sense that it results from an event for which there is only the opportunity for cost.
4. Large Loss. The size of the loss must be meaningful from the perspective of the insured. Insurance premiums need to cover both the expected cost of losses, plus the cost of issuing and administering the policy, adjusting losses, and supplying the capital needed to reasonably assure that the insurer will be able to pay claims.
5. Affordable Premium. If the likelihood of an insured event is so high, or the cost of the event so large, that the resulting premium is large relative to the amount of protection offered, it is not likely that anyone will buy insurance, even if on offer.
6. Calculable Loss. There are two elements that must be at least estimable, if not formally calculable: the probability of loss, and the attendant cost.
7. Limited risk of catastrophically large losses. The essential risk is often aggregation. If the same event can cause losses to numerous policyholders of the same insurer, the ability of that insurer to issue policies becomes constrained, not by factors surrounding the individual characteristics of a given policyholder, but by the factors surrounding the sum of all policyholders so exposed.

        With these seven principles of risk, insurance companies have a purpose. There are many different kinds of insurance with different companies, so finding the best one for you can be the hard part.