Basic Concepts of Insurance

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Basic principles of insurance.

Insurance is a form of protection against the financial losses resulting from certain events.

Insurance does not protect you from the event itself! Fire insurance will not, of course, keep your house from burning, nor will life insurance enable you to live longer. But fire insurance will, if your house burns down, compensate you for the loss of your home, and life insurance can provide your dependents with an income if you die.

Fire insurance and life insurance are the branches of insurance that concern most of us. These two illustrate the important principles which underlie all types of insurance.

Because insurance is one of our largest businesses, we ought to be familiar with its basic principles because of its value to us as individuals.

Basic Concepts of Insurance

1. Principle of division of risk.

All insurance is based upon a principle called division of risk. This means simply that, if a loss to an individual or to several individuals is shared by a large number of individuals, the loss will not be an excessive burden on anyone. We can illustrate this concept and show how it works by the following general but simple example:

Suppose that 1000 people seeking protection from a common danger, such as fire, pay $1 per week into a fund.  The  total yearly contribution to this fund will be $52,000. It is understood that we will use this fund to pay the losses incurred by any of the contributors due to fire. Thus if one of the participants suffers a loss, say of $5000, we will pay him $5000. In doing this, we have actually divided his loss among 1000 persons so that each individual’s share is only $5.

It is obvious that the larger the group of participants, the larger will be the total fund provided to meet the risks, and the greater will be the division of risk. As we said before, all insurance ?fire, life, health, accident, public or personal liability, and so forth ?is based upon this concept of division, or distribution, of risk. Insurance companies are formed to receive the money paid into funds like the one in our illustration. These companies will invest the money received so that it will increase by earning interest. The insurance company will also pay the losses whenever they occur.

2. Issuance of a contract (Policy)

Another basic concept of insurance is that there is always a contract issued. Every person who is insured or who buys insurance receives from the insurance company a contract called a policy. We often call the person who buys insurance the insured, and the company the insurer. These two, the insured and the insurer, are the ones who are required by the insurance policy to do certain things.

The insured agrees to make a specified payment called premiums, and the insurer agrees to pay for certain losses if they occur, up to an agreed amount which is called the face of the policy.

3. Insurance for protection, not for profit

The third principle upon which insurance of all kinds is founded is that insurance exists for the protection of the insured, not for his profit. Therefore, when a loss occurs, only the amount of the loss will be paid if this amount is not greater than the face of the policy. If the loss is greater than the face of the policy, the company will pay only the face. It will not pay the total loss. The excess of the loss over the face must be borne by the insured.


    Business Mathematics (Part 2) by W. M. Spangler, M.A. ©1973, 1954 Intext, Inc.

    Scranton, Pennsylvania, USA