By; Sathi Khanam (Insurance Expert)
Written by; Shahriar Shovon (Article Writer)
There is no single definition of insurance. Insurance can be defined from the viewpoint of several disciplines, including law, economics, history, actuarial science, risk theory and sociology. But each possible definition will not be examined at this point. Instead, we will examine the common elements that are typically present in any insurance plan. However, before proceeding, a working definition of insurance-one that captures the essential characteristics of a true insurance plan- must be established.
After careful study, the Commission on Insurance Terminology of the American Risk and Insurance association has defined insurance as follows. Insurance is the pooling of fortuitous losses by transfer of such risks to insurers, who agree to indemnity insureds for such losses, to provide other pecuniary benefits on their occurrence, or to render services connected with the risk. Although this lengthy definition may not be acceptable by all insurance scholars, it is useful for analyzing the common elements of a true insurance plan.
Basic Characteristics of Insurance; Based on the preceding definition, an insurance plan or arrangement typically includes the following characteristics;
- Pooling of losses.
- Payment of fortuitous losses.
- Risk transfer.
Pooling of Losses; Pooling or the sharing of losses is the heart of insurance. Pooling is the spreading of losses incurred by the few over the entire group, so that in the process, average loss is substituted for actual loss. In addition, pooling involves the grouping of a large number of exposure units so that the law of large numbers can operate to provide a substantially accurate prediction of future losses. Ideally, there should be a large number of similar, but not necessarily identical, exposure units that are subject to the same perils. Thus, pooling implies the sharing of losses by the entire group and prediction of future losses with some accuracy based on the law of large numbers.
In addition, by pooling or combining the loss experience if a large number of exposure units, an insurer may be able to predict future losses with greater accuracy. From the viewpoint of the insurer, if future losses can be predicted, objective risk is reduced. Thus, another insurance characteristics often found in many lines of insurance is risk reduction based on the law of large numbers.
The law of large numbers states 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. However, for most insurance lines, actuaries generally do not know the true probability and severity of loss. Therefore, estimates of both the average frequency and the average severity of losses must be based on previous loss experience. If there are a large number of of exposure units, the actual loss experience of the past may be a good approximation of future losses. As we noticed earlier, as the number of exposure units increases, the relative variation of actual loss from expected loss will decline. Thus, actuaries can predict future losses with a greater degree of accuracy. This concept is important because an insurer must charge a premium that will be adequate for paying all losses and expenses during the policy period. The lower the degree of objective risk, the more confidence an insurer has that the actual premium charged will be sufficient to pay all claims and expenses and provide a margin for profit.
Payment of Fortuitous Losses;
A second characteristics of private insurance is the payment of fortuitous loss is one that is unforeseen and unexpected by the insured and occurs as a result of chance. In other words, the loss must be accidental.
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