Insurance as a Transfer System

Insurance as a Transfer System

Insurance is a system that enables a person, family, or business to transfer the costs of losses to an insurance company. The insurance company, in turn, pays for covered loses and, in effect, distributes the costs of losses among all insureds (that is, all insureds share the cost of a loss).

Thus, insurance is a system of both transferring and sharing the costs of losses.

Transferring the Costs of Losses

By transferring the costs of their losses to insurance companies, insureds exchange the possibility of a large loss; insureds exchange the possibility of a large loss for the certainty of a much smaller, periodic payment (the premium that the insured pays for insurance coverage).

This transfer is accomplished through insurance policies.

An insurance policy is a contract that states the rights and duties of both the insured and the insurer regarding the transfer of the costs of losses.

A loss exposure, or simply an exposure, is any condition or situation that presents the possibility of a loss.

It is not necessary for a loss to occur for a loss exposure; simply there should be a possibility of a loss.

Sharing the Costs of Loses

As a system of sharing, insurance involves the “pooling” by the insurance company of the premiums paid by the Insureds and payment of claims from such pool.

Insurance Companies estimate future losses and expenses to determine how much they must collect from insureds in premiums.

One popular method that Insurance Companies use for predicting future losses is the mathematical principle The Law of Large Numbers.

The law of large numbers is a mathematical principle stating that as the number of similar but independent exposure units increases, the relative accuracy of predictions about future outcomes (losses) based on these exposure units also increases.

An Exposure Unit is a measure of loss potential and is used in pricing insurance.

FUNDAMENTALS OF INSURANCE

FUNDAMENTALS OF INSURANCE

CHAPTER 1: Insurance: What is it?

Insurance can be described as follows:

• A transfer system, in which one party – the insured – transfers the chance of financial loss to another party – the insurance company or the insurer.

An insured is a person, a business, or an organization whose property, life, or legal liability is covered by an insurance policy.

An insurer is an insurance company.

• A business, which includes various operations that must be conducted in a way that generates sufficient income to pay claims and provide a reasonable profit for its owners.

• A contract between the insured and the insurer that states what potential costs of loss the insured is transferring to the insurer and expresses the insurer’s promise to pay for those costs of loss in exchange for a stated payment by the insured.

FUNDAMENTALS OF INSURANCE