Definition
Insurance may thus be considered as a process by which the losses of a few, who are unfortunate to suffer such losses, are shared amongst those exposed to similar uncertain events / situations.
How Insurance Works
There is however a catch here.
- Would people agree to part with their hard-earned money, to create such a common fund?
- How could they trust that their contributions are actually being used for the desired purpose?
- How would they know if they are paying too much or too little?
Obviously, someone has to initiate and organize the process and bring members of the community together for this purpose. That 'someone' is known as an 'Insurer' who determines the contribution that each individual must make to the pool and arranges to pay to those who suffer the loss.
The insurer must also win the trust of the individuals and the community.
1. How insurance works
a) Firstly, these must be an asset which has an economic value. The ASSET:
- May be physical (like a car or a building) or
- May be non-physical (like name and goodwill) or
- May be personal (like one's eyes, limbs and other aspects of one's body)
b) The asset may lose its value if a certain event happens. This chance of loss is called as risk. The cause of the risk event is known as peril.
c) There is a principle known as pooling. This consists of collecting numerous individual contributions (known as premiums) from various persons. These persons have similar assets which are exposed to similar risks.
d) This pool of funds is used to compensate the few who might suffer the losses as caused by a peril.
e) This process of pooling funds and compensating the unlucky few is carried out through an institution known as the insurer.
f) The insurer enters into an insurance contract with each person who seeks to participate in the scheme. Such a participant is known as insured.
2. Insurance reduces burdens
Burden of risk refers to the costs, losses and disabilities one has to bear as a result of being exposed to a given loss situation/event.
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There are two types of risk burdens that one carries - primary and secondary.
a) Primary burden of risk
The primary burden of risk consists of losses that are actually suffered by households (and business units), as a result of pure risk events. These losses are often direct and measurable and can be easily compensated for by insurance.
Example 1
When a factory gets destroyed by fire, the actual value of goods damaged or destroyed can be estimated and the compensation can be paid to the one who suffers such loss. If an individual undergoes a heart surgery, the medical cost of the same is known and compensated. In addition, there may be some indirect losses.
Example 2
A fire may interrupt business operations and lead to loss of profits which also can be estimated, and the compensation can be paid to the one who suffers such a loss.
b) Secondary burden of risk
Suppose no such event occurs and there is no loss. Does it mean that those who are exposed to the peril carry no burden? The answer is that apart from the primary burden, one also carries a secondary burden of risk.
The secondary burden of risk consists of costs and strains that one has to bear merely from the fact that one is exposed to a loss situation. Even if the said event does not occur, these burdens have still to be borne.
Let us understand some of these burdens:
i) Firstly, there is physical and mental strain caused by fear and anxiety. The anxiety may vary from person to person, but it is present and can cause stress and affect a person's wellbeing.
ii) Secondly when one is uncertain about whether a loss would occur or not, the prudent thing to do would be to set aside a reserve fund to meet such an eventuality. There is a cost involved in keeping such a fund. For instance, such funds may be held in a liquid form and yield low returns.
By transferring the risk to an insurer, it becomes possible to enjoy peace of mind, invest funds that would otherwise have been set aside as a reserve, and plan one's business more effectively. It is precisely for these reasons that insurance is needed.