Insurance may be described as a social device whereby a large group of individuals or companies through a system of equitable contribution may reduce or eliminate certain measurable risks of economic cost resulting from the accidental occurrence of disastrous events. Its effect is to spread the cost which otherwise would fall upon an individual in an equitable manner over the members of a large group exposed to the same hazard. The theory behind Insurance is that members of an insurance scheme contribute to a central fund from which payments are made in case one of their members suffers loss by the occurrence of the risk [event] insured against. The payment - individual contribution to the pool is the premium.
Role of Insurance
Conventional insurance writers have observed that insurance has two basic roles.
- The transfer and shifting of risk from an individual to a group.
- The sharing of loss on an equitable basis by members of the group.
These roles constitute the Insurance mechanism. Insurance attempts to shift individual risk to a group and does so equitably should the risk attach. Arguably therefore, insurance is an economic device whereby the individual substitute a small certain cost for a large and uncertain financial loss in the future which could exist or arise but for insurance.
In practice the Insurance mechanism anticipates the possibility of organizing individuals into a homogenous group exposed to the same risk. Insurance companies employ two mechanisms to group individuals into homogenous groups.
- Law of large numbers, averages or probabilities
- Posterior or empirical probabilities.
Law of Large Numbers.
Is based on the likelihood of an event taking place and makes predictions on the likelihood of such event happening on the assumption that the happening of the event can be predicted with certainty. It operates on the premise that the observed frequency of nay event approaches the underlying probability as the number of trials approaches infinity. Hence the greater the number of exposure units [risks], the greater he certainty.
Posterial or Empirical Probabilities.
Under posterior or empirical probabilities, acturial scientists determine the probability of risk attaching by the reference to the past and prevailing circumstances. It has been observed that insurance in its fullest can only exist if the following elements are present :-
1) A person with an interest in something which can be valued (valuable), monetary or otherwise.
2) The thing in which he has interest is subject to loss by a peril.
3) A substantial number of other persons have an interest in similar things subject to loss by similar perils.
4) The chance of loss from the peril can be measured or measurable with some degree of certainty or accuracy.
5) The desire by enough persons or members of the group to share each others loss.
6) The loss or losses resulting from the insured risk must be definite and predictable in financial or pecuniary terms.
7) The loss must be tortuous or accidental.
8) The loss must not be catastrophic in aggregate.
9) The cost of insurance must be economically feasible (managerial premiums).