Role of Insurance
Everyone has a need for financial security. When tragedies strike, people want to have peace of mind knowing they are financially secure. Tragedies may hit at any time without advance notice. Insurance can provide financial security, so the uncertainty surrounding disaster is alleviated.
Insurance transfers an individual’s uncertainty of loss to the insurance company. Life and Health insurance protects against impairment to a person's greatest asset, his earning power, caused by injury, sickness, retirement and/or death.
What is an insurance contract?
An insurance contract is a legal agreement made between an insurance company and an individual. The insurance company, or insurer, collects a small amount of money, termed premium, from the insuredindividual. This premium is exchanged for the insurance company’s promise to pay benefits in the event of loss. The promise established by the insurance company is the legal agreement, termed insurance contractor insurance policy, between the insurance company and the individual who is covered by the policy, theinsured. The insurance company legally agrees to pay the insured in the event of a covered loss based on the terms and conditions in the policy. A loss is defined as an unintentional decrease in value of an asset. The insurance company must be notified of the loss. By notifying the insurance company, the insured is demanding payment of the benefits provided by the policy; this is the definition of a claim.
Nature of Insurance
The three most important principles of insurance are: risk pooling, the law of large numbers, andinsurable interest.
Risk Pooling/Loss Sharing
Risk is defined as the chance of a loss occurring. Risk pooling spreads risk by sharing the possibility of loss over a large number of people. It transfers risk from an individual to a group. For example, when several individuals contribute small amounts into a disability insurance plan, those amounts are pooled together to form a larger amount in order to provide support in the event that one of those individuals becomes disabled. The pool transfers each member's individual risk to the group and allows a large number of people to be insured for a small amount of money.
Law of Large Numbers
The second principle is the law of large numbers. To remain financially stable, insurance companies must have a general idea of how many losses will occur in a given year so that adequate funds can be set aside to cover claims. Instead of attempting to predict who will undergo loss, insurance companies use the law of large numbers to estimate how many losses will occur in a certain group of people over a certain period of time. Insurance companies employ actuaries, who are people who collect and analyze risk data. Actuaries take statistical data and determine the rate people will die, termed mortality, and the rate people will get sick, termed morbidity.
The law of large numbers states that as the group increases in size, it is easier to predict the number of future losses over a certain period of time.
Groups must consist of a large number of similar individuals in order to provide accurate mortality or morbidity rates. Also, it is important to be aware that the law of large numbers provides the best data when groups consist of similar risks. For example, a group of 100,000 non-smoking males age 30-35 provides much better loss predictions than a group of 100,000 males and females, of all ages, where some smoke and others don’t. Therefore, larger groups consisting of similar individuals provide more accurate mortality or morbidity projections.
Insurable Interest
The third principle is insurable interest. A party wishing to buy an insurance policy on another party, thepolicyowner, is required to have an insurable interest in the other party. Insurable interest states that an individual must have a valid concern for the continuation of the life or well being of the person insured. The continued livelihood of the insured must have significant value over the insured's illness or death. Insurable interest must exist in order for a policy to pay benefits.
Insurable interest in life insurance policies is present in the following:
- The purchaser is also the person insured under the policy
- Marriage or blood relationship
- Business partners
- Creditor-debtor relationship
Insurable interest must be shown when an individual applies for a life or health insurance policy. When the insured becomes sick, injured or dies, insurable interest does not need to be shown. Once insurable interest is established between the purchaser of the policy and the person insured by the policy, the individual who receives the benefits does not need to prove an insurable interest.
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