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Define and Explain What is Insurance

Define Insurance

The insurance can be defined as “a process by which one party (the insurer) undertakes to provide, within the regulatory framework of a contract, a benefit in case of occurrence of a risk to another party (the Insured), subject to the payment of a premium or contribution. The insurer then realizes the pooling of risks by using the law of large numbers and the laws of statistics “.

To use less technical language and to quote a statute of Queen Elizabeth of England, one can say that “insurance has been established so that the loss weighs slightly on a lot, rather than heavily on little”.

What is Insurance?

The insurance is, by definition, a system that can protect an individual, association or business against the financial and economic consequences of the occurrence of a risk (= random event) particular.

The means employed by the insurance authorities to protect them against this risk is to associate them with a community of persons (the insured), which contributes to being able to compensate those of its members who would suffer material damage or tangible assets if the risk is realized.

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The parties involved in an insurance deal

From the above definition of insurance, it appears that four parties come into play in an insurance transaction:

The Insured

This is the person at risk

The beneficiary

This is the person who must collect the benefit of the insurer

The subscriber

This is the person who signs the insurance policy

The insurer

It is the legal entity that accepts the assumption of the risks, collects the contributions and settles the claims. 

NB: In the case of individual non-life insurance, the insured person, the beneficiary and the subscriber are often the same people.

The elements of an insurance transaction

Still, on the basis of our definition of the insurance operation, five related concepts deserve to be explained:

The risk

The notion of “risk” refers to several definitions. “Risk” can mean: 

1) the insured object (a building, an automobile,): this is referred to as “object risk”, 
2) a category of insurable events of the same nature
3) a harmful event (illness, fire, theft, death, death, disability, etc. this is called “risk-cause” or peril. 

The last meaning of the word “risk” is, in the field of insurance, the most important. The risk is then the damaging event against the arrival of which one seeks to guard and thus corresponds to the event insured. 

For a risk to be insurable, it must necessarily satisfy three conditions: 

1) It must be future (if the damaging event has already occurred, no longer speak of risk) 
2) It must be uncertain : The uncertainty must be either in the occurrence or not of the event for example (one should not be able to predict whether the insured person will be sick,) or in his or her date of occurrence or ( It should not be possible to predict the date of death of the person who has taken out a life insurance policy). 
3) The risk must be independent of the will of the insured. 

However, these conditions are necessary, but not sufficient for a risk to be insurable. Indeed, for an insurable risk to exist, there must also be an insurance market, that is, there must not only be demand from individuals, businesses or communities, but there must also have an offer from insurers. 

In order for insurers to accept a risk (understood in the second sense of the term as a “class of insurable events of the same nature”)

Two other conditions must be met:

  1. The insurer must have sufficient financial capacity to take care of the claims that will arise in this category of risks.
  2. The legal conditions for to ensure the risk: The risk must be linked to a licit activity. It would, therefore, be formally prohibited to carry out a clandestine activity, for example, in trafficking in arms or drugs.

The Insurance Premium

The premium is the contribution paid by the insured to the insurer in exchange for the guarantee granted to him to be compensated (according to the contractual conditions) in the event of the risk for which he has insured. It is payable at the start of the insurance operation or the insurance year. 

The premium corresponds mainly to the cost of risk to which should be added the operating costs of the insurer (distribution and management) and any taxes.

It is, therefore, the product of a complex calculation which relies above all on the preliminary estimate of the loss ratio. 

To do this, statistical tools are used which determine more or less precisely the probability of realization of the guaranteed events.

The Contribution

The contribution, which is a term synonymous with premium but used in the mutual sector, can be either fixed or variable: 

1) If fixed, the contribution cannot be changed during the validity of the contract without the subscriber’s consent and Regardless of the insurer’s performance. 

2) If the contribution is variable (as in the case of a mutual company, for example), the payment of the contribution may give rise to either a supplementary reminder of a contribution (if the losses cost more than expected), or to a refund called “rebate” (otherwise). 

NB: In the case of life insurance, the contribution is always fixed. 

The contributions collected must be sufficient to cover the cost of the claims occurring during the year,

The mutuality

All the persons insured against the same risk and who contribute to face its consequences constitute a mutuality. Insurance is, therefore, the organization of solidarity between the insured people against the occurrence of the same type of event. 

According to this principle, if the risk worsens, the tariff of the contracts increases, if the risk decreases, the tariff decreases. If insured persons “defraud” (by not declaring the gravity of their risks or by exaggerating the importance of a disaster, for example), the entire community will be penalized. The idea of compensation within the mutuality implies that all the members of this mutuality should be treated on an equal footing that is to say with equity.

The insurer’s benefit: indemnity and lump sum

The insurer’s undertaking in the event of a risk is to pay a benefit in the form of money intended for: 

– either the subscriber or the insured 
– or to a third party 
– or to the beneficiary (in the case of Life insurance). 

The financial benefits of the insurer can be of 2 kinds. They may take the form of;

  1. Compensation: benefits are determined after the occurrence of the accident according to its size (this type of benefit paid by an insurer to an insured person who is the victim of an accident of the road, for example). 
  2. Lump-sum benefits: these benefits are determined at the time of the contract, before the occurrence of the loss. This may involve the payment of capital, an annuity or an amount of a certain amount per day. It is this type of benefit that delivers an insurer mainly under a contract of life insurance or death insurance. 

About the author

Salman Qureshi

Salman Qureshi is an Accountant by profession & he loves to write on Commerce & Management Sciences Subject to assist Students. Hope you guys will like his effort.

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