What is ‘insurance’ and how does it work?

Insurance is a social device for spreading the chance of financial loss.

In purchasing insurance, a person agrees to share a risk with a larger group of people. Doing this reduces the individual financial responsibility during a covered loss. In other words: a large, uncertain loss is traded in this way for a small, certain loss. This smaller certain loss is the premium.

Who can purchase insurance?

To be insurable, a risk must involve the possibility of loss only, and not gain. And the applicant must have a legitimate interest in the preservation of the life or property insured. This is the “Insurable Interest”.

How do insurance companies know what to charge?

The law of “Large Numbers” is one of the primary factors which allow insurance companies to predict the expected loss within a group. The basic principle of this law states: the larger the number of separate risks of a like nature combined into one group, the more predictable the number of future losses of that group within a given time period. The large the group, the more closely the predicted experience will approach the actual loss. Insurance companies can only predict the number of losses expected for a group, not for each individual.

Why should my premium go up if I have never had a claim?

Insurance companies collect premium to cover expenses, profits, and the cost of expected losses. The expected losses are based upon the past experience of the average risk. The fact that some people never experience a loss is immaterial, for they are balanced by other people who are involved with a loss.