Human life is full of risks and uncertainty. Each and every step of
life is full of risks. We cannot eliminate risk. However, we can make provision
for financial security against risk. Insurance is the means to get financial
security against risk. Insurance is a way of reducing uncertainty of occurrence
of an event. Insurance is an investment, from which we get return just when
certain misfortune happened from predetermined occurrence.
Insurance has wide scope and areas nowadays. So there is no single definition
of insurance. Insurance can be defined from the viewpoints of several
disciplines. The definition of insurance can be expressed from the viewpoints
of law, economics, history, and sociology and risk theory. However, it is
better to define the insurance from common viewpoint.
Basic characteristics of
insurance:
There are four major characteristics of insurance. Overall
definitions of insurance can be expressed based on those characteristics.
According to the preceding definitions, insurance typically includes the
following characteristics:
Pooling
of losses: Pooling is the spreading of misfortunes
caused by the couple of over the whole group, so that in the process, average
loss is substituted for actual loss. It is the heart of insurance.
Payment
of accidental losses: An accidental loss is one
that is unforeseen and unexpected and occurs as a result of chance. It is the
second characteristics of insurance. The law of large numbers is based on the
assumption that losses are accidental and occur randomly for example, a person
may be hit by a car in the road and break a leg. The loss would be fortuitous.
Only such accidental losses are paid in insurance.
Risk transfer: Actually,
insurance is a risk transfer business, in which a particular risk of an insured
is transferred to the insurer. Risk transfer is known that the actual risk is
transferred from the insured to the insurer, whose financial position is
stronger to pay the loss than the insured. Particularly, the pure risks of
individual and organizations that are transferred to insurance company include
the risk of premature death, poor health, disability destruction and accidental
loss of property and liability lawsuits. Risk transfer is an essential element
of insurance.
Indemnification: Indemnification
is one of the most important characteristics of insurance. Insurance should provide
somebody with protection, especially financial protection against possible
loss, damage or liability.
It should be noted that insurer indemnify the losses from risk only
in specific situation. If the loss occurred because of the negligent operation
of the owner, the insurance company will not legally be liable to indemnify the
losses. However, the insured may be indemnified under some policies such as
auto-liability insurance policy, disability-income insurance policy. This will
restore at least part of the lost wages.
Requirement of an
insurance risk
From the viewpoint of the insurer, there are some major requirements
of an insurance risk:
Large
number of exposure units: There must be a large
number of exposure units. A large group of roughly similar is essential, but
they need not necessarily identical. But the exposure units should be subjected
to the same types of risks. It is the first requirement of an insurable risk.
Main objective of this first requirement is to collect small premiums forming a
big pool of fund enough to indemnify the losses. Secondly, large number of
insured is required to enable the insurer to predict loss based on the law of
large number. Loss data can be complied over time and losses for the group can
be predicted with some accuracy. Then the loss costs can be spread over all
insured parties. For example, a large number of vehicles in a city can be
grouped together for purposes of providing vehicle insurance.
Accidental
loss: The loss must be accidental and
unintentional. It means the intentional losses should not be paid. It is
another important requirement of an insurable risk. If an individual
deliberately causes a loss, she or he should not be indemnified for the loss.
Thus, the cause of loss should be out of control of the insured. The
requirement of accidental loss is for two reasons:
If intentional losses are paid, moral hazard
will be substantially increased and insurer will have to face serious financial
problem. The premiums must rise as a result. This will decrease the consumers’
purchasing the insurance, which again leads increase in premium. In this way,
the insurer comes to the bankruptcy, lack of number of insured and greater
number of claims.
The loss should be accidental rather than
intentional. A deliberately caused loss is not a random event because the
insured knows when the loss will occur. In this way, the prediction of future
loss based on the random occurrence of events may be highly inaccurate if
intentional loss occurs.
Economically
feasible premium: the premium must be economically
feasible. It means the insurer must be able to pay the premium. In addition,
for the insurance to be an attractive purchase, the premium that must be paid
is substantially less than the face value, or amount of the policy. For
example, an old man of 99 years wants to enter into a life policy, the insurer
can issue a Rs. 100000 life insurance policy, but the pure premium will be
about Rs. 95000 as risk is very high. An additional amount for expenses will
have to be added. The total premium will exceed the face amount of the
insurance. Such policy is neither economically feasible nor attractive.
Therefore, there is less chance of entering into an insurance contract with
that old man.
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