FAQs: Basics of Insurance

1. Define insurance

Ans. Insurance can be defined both from an economic perspective and from a legal perspective.

From an ECONOMIC PERSPECTIVE, insurance is a financial intermediation function by which individuals exposed to a specific financial contingency each contribute to a pool from which covered events suffered by participating individuals are paid.

From a LEGAL PERSPECTIVE, insurance is an agreement by which one party, the policy owner, pays a stipulated consideration called the premium to the other party called the insurer in return for which the insurer agrees to pay a defined amount of money or provide a defined service if a covered event occurs during the currency of the policy.

2. What are the basic characteristics of insurance?

Ans: The basic characteristics of insurance are.

• Pooling of losses
• The law of large numbers
• Payment of fortuitous losses
• Risk transfer
• Indemnification

1. Pooling of losses: Pooling of risks, or the sharing of losses is the heart of insurance. Pooling is spreading of losses incurred by the few over the entire group, so that, in the process, average loss is substituted for actual loss.

It implies.

(i) the sharing of losses by the entire group; and
(ii) prediction of future losses with some accuracy based on the law of large numbers.

2. The law of large numbers: Many lines of insurance risk reduction are based on the law of large numbers. It states that the greater the number of exposures, the more closely will the actual results approach the probable results that are expected from an infinite number of exposures.

3. Payment of fortuitous losses: Payment is made for losses that are unforeseen and unexpected and occurs as a result of chance. This means the loss must be accidental.

4. Risk transfer: In this, a pure risk is transferred from the insured to the insurer who typically is in a stronger financial position and is willing to pay the loss than the insured (e.g., risk of premature death, poor health, destruction or theft of property)

5. Indemnification: This means the insured is restored to his or her approximate financial position prior to the occurrence of the loss

3. Write a brief note on the Law of Large Numbers

Ans: Many lines of insurance risk reduction are based on the law of large numbers. The law states that the greater the number of exposures, the more closely will the actual results approach the probable results that are expected from an infinite number of exposures. If there are a large number of exposure units, the actual loss experience of the past may be a good approximation of future losses. To charge premium that will be adequate for paying all losses, expenses and margin for profit, this concept is important to insurer because he can predict future losses with a greater degree of accuracy as the number of exposures increases.

4. What do you mean by Risk Transfer?

Ans. In this, a pure risk is transferred from the insured to the insurer, who typically is in a stronger financial position and is willing to pay for the loss than the insured (e.g., risk of premature death, poor health, destruction or theft of property).

5. What do you mean by Indemnification?

Ans. Indemnification means the insured is restored to his or her approximate financial position prior to the occurrence of the loss.

6. What are the requirements of an insurable risk?

Ans. Insurers normally insure only pure risks. However, all pure risks are not insurable. From the viewpoint of the insurer, the requirements of an insurable risk are:

• There must be a large number of exposure units;
• The loss must be accidental and unintentional;
• The loss must be determinable and measurable;
• The loss should not be catastrophic;
• The chance of loss must be calculable;
• The premium must be economically feasible.

7. How does insurance differ from gambling?

Ans. Insurance is often confused with gambling. But there are two important differences between them.

1. Gambling creates a new speculative risk, while insurance is a technique for handling an already existing pure risk.

2. Gambling is socially unproductive, because the winners gain comes at the expense of the loser. In contrast, insurance is always socially productive, because neither the insurer nor the insured is placed in a position where the gain of the winner comes at the expense of the loser. The insurer and the insured both have a common interest in the prevention of a loss. Both parties win if the loss does not occur.

3. Gambling transactions never restore the losers to their former financial position. In contrast, insurance contracts restore the position of insureds financially in whole or in part if a loss occurs.

8. How does insurance differ from speculation?

Ans. Insurance is different from speculation. Insurers insure pure risks. Pure risk is defined as a situation in which there are only the possibilities of loss or no loss, while speculation deals with speculative risk. Speculative risk is defined as a situation in which either profit or loss is possible.

2. The law of large numbers, which is the basic characteristic of insurance, can be applied more easily to pure risks than to speculative risks. Based on this, insurers predict future loss experience.

3. Finally, society may benefit from a speculative risk even though a loss occurs, but it is harmed if a pure risk is present, and a loss occurs.

9. How does insurance differ from hedging?

Ans. Though both insurance and hedging techniques are similar in that risk is transferred by a contract, and no new risk is created, there are major differences between them.

First, an insurance transaction involves the transfer of insurable risks, because the requirements of an insurable risk can generally be met. Second, insurance can reduce the objective risk of an insurer by application of law of large numbers.

However, hedging is a technique of handling risks that are typically uninsurable, such as protection against decline in the price of agricultural products and raw materials.In contrast, hedging typically involves only risk transfer, not risk reduction. The risk of adverse price fluctuations is transferred to speculators who believe that they can make a profit because of superior knowledge of market conditions. The risk is transferred, not reduced, and prediction of loss generally is not based on the law of large numbers.

10. Differentiate between Life and Non-Life insurance

Ans. LIFE INSURANCE is a branch of private insurance and includes the following four classes of insurance coverage:

1. Death: called life insurance / assurance
2. Living a certain length of time: called endowments, pensions and annuities.
3. Incapacity: called disability and long-term care
4. Injury or incurring a disease: called health insurance, accident insurance, and medical expense insurance.

NON-LIFE INSURANCE is also a branch of private insurance and includes the following coverage:

1. Property losses: damage or destruction of homes;
2. Liability losses: payments due to professional negligence;
3. Workers compensation and health insurance in some countries.

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