What is insurance?
Insurance enables those who suffer a loss or accident to be compensated for the effects of their misfortune. The payments come from a fund of money contributed by all the holders of individual insurance policies. In other words, individual risks are pooled and shared, with each policyholder making a contribution to the common fund.
The contribution is known as the premium. Premiums are paid to insurers - these are institutions which accumulate the money into the fund from which claims are paid. The loss is in fact paid for by the policyholder making the claim and by all the other policyholders who have not suffered in the same way.
Insurers are professional risk takers. They know the probability of different types of risk happening. They can calculate the premiums needed to create a fund large enough to cover likely loss payments. Clearly, only a proportion of policyholders will require compensation from the fund at any one time.
So two important factors arise when calculating the premium. Firstly, the general likelihood that a loss will occur. Secondly, whether the particular policyholder is above or below average in risk.
Take three examples. In motor insurance a young person with a high powered car, or a driver with a long history of accidents will pay a higher premium than a mature and experienced driver with a modest saloon who has been accident free.
Similarly, the owner of a fish and chip shop will pay a higher premium for his fire insurance than, say, the owner of an office. The risk is greater, so the premium is higher.
Someone who is young, fit and in a risk-free job will find it easier to buy life insurance, and will pay lower premiums than someone who has a heart condition or is in a risky occupation.
Two kinds of Insurance
There are two different kinds of insurance - life insurance and general insurance. With life insurance you don't renew your policy each year. Instead, you agree to pay a fixed premium for a set number of years. In other words you enter a long-term commitment when you buy a life insurance policy.
What is the Difference?
General insurance pays out;
- if a car has an accident or is stolen
- if a house catches fire or is burgled
- if a holiday has to be cancelled
- if someone is careless and damages other people's property.
- Most life policies, on the other hand, pay out when an event happens;
- when someone dies
- when someone survives beyond a specific date.
- Anyone can buy life insurance but, of course, the premium will depend on your age, your health, and your occupation.
Husbands and wives can insure each other's lives. However, you cannot insure the lives of other people unless you have a financial involvement in their life. This principle of insurance is called "insurable interest".
Insurable interest is a fundamental principle of insurance. It means that the person wishing to take out insurance must be legally entitled to insure the article, or the event, or the life. In other words, the happening of the event insured against, or the death of the life insured must cause the policyholder financial loss. Mr Smith would not be able to insure Mr Brown's house because its destruction would not cause Mr Smith financial loss. Similarly, you cannot insure the lives of other people unless you have a financial interest in the life being insured. The principle of insurable interest demonstrates the difference between insurance and a wager or bet.
Other principles apply to all kinds of insurance.
Insurance can provide compensation only for the actual value of property. It cannot cover the loss of sentimental value, for example. There must be a large number of similar risks so that the likelihood of a claim can be spread among other policyholders. It must be possible for insurers to calculate the chance of loss so that a premium can be set which matches the risk.
Losses must not be deliberate and not inevitable. Clearly, you could not buy fire insurance for a house which was already burning nor life insurance for someone on his or her deathbed.
Lastly, there are some risks which have financial implications so vast that they can be dealt with only by the state. These risks (mainly those arising from war or the major escape of nuclear or radioactive material) are normally not insurable.
Insurance takes the risk away from people's lives and businesses. It brings peace of mind to the policyholder. In return for paying premiums the policyholder knows that, if the unexpected happens, financial compensation will be available from the fund of premiums.