Insurance is a pooling of risks to enable people to share
risks. In life, everyone including businessmen, faces risks, resulting in
losses.
1. Those who wish to insure against loss in the event of
a risk materializing, will contribute periodical payments called premiums to a
central pool which is managed by an insurance
company. The individual premium is small relative to the
amount insured.
2. Any loss due to the
insurer's risk materializing will be compensated for out of the common pool.
The amount of compensation will be just enough to indemnify or restore
the insured to the position he was in immediately before
the loss. The indemnity will not exceed the amount originally insured for.
3. The insurance company
will have to study the risk involved for each insurance proposal. It will
consider all factors that may make the insured risk more likely to happen. The
basic principle is: The higher the risk, the higher the premium charges.
4. The premium finally
payable by the insured can be calculated based on:
(a) the insured
value of the property
(b)
the tariff rate or the rate of premium quoted by the insurance company
Illustration
Amer studying the
risks involved for a certain proposal for fire insurance, the insurance company
quoted a rate of 20 cents per $100. Suppose the value of property was $100,000,
the total amount of insurance premium payable would be:
Rate
quoted to insure property against fire 20
cents per $100
Insured
value of property $100,000
Amount
of premium payable 0.20
x 100 000 = $200
100
5. The premium payable ($200
per year) is so small compared to the amount of possible compensation payable,
i.e. $100,000. This is because the total number of people who face the risk of
loss due to fire is very great. It incorporates all owners of properties in the
country. Therefore, the number of those who are willing to contribute to the
central pool is very great. Consequently, the central pool is very big even
though each insured pay a small premium. But only a small percentage of the
total population who buys fire insurance will eventually suffer a loss. So, it
is possible to pay the few unfortunate from the central pool. It is a case of
the fortunate many (who did not suffer any loss due to fire) who help the
unfortunate few (who did suffer a loss due to fire). This is the whole
principle of 'pooling of risks'.
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