Page 247 - DMGT303_BANKING_AND_INSURANCE

Banking and Insurance

Notes According to Britannica Encyclopaedia, "Insurance may be described as a social device whereby
a large group of individuals through a system of equitable contributions may reduce or eliminate
certain measurable risks of economic loss common to all members of the group."
In legal terms, insurance is a contractual agreement whereby one party agrees, for a consideration
called premium, to compensate another party for losses. Thus, an insurance transaction involves
the following:
Insurer: The party agreeing to pay for the losses of the insured.
Insured: The party who insured his risk with the insurer.

Premium: The payment to the insurer received from the insured for indemnifying the losses.
Policy: It is the contract between the insurer and insured that sets the contractual obligation
between the two.

Exposure to loss: The insured's possibility of incurrence of loss is called the insured's exposure
to loss.

12.5 How Insurance Works

The mechanism of insurance is very simple. People who are exposed to the same kind of risks
come together and agree that, if any one of them suffers a loss, the others will share the loss and
make good to the person who lost. All people who send goods by ship are exposed to the same
risks, which are related to water damage, ship sinking, and piracy etc. Those owning factories
are not exposed to these risks, but they are exposed to different kinds of risks like fire, hailstorms,
earthquakes, lightning, burglary etc.
Like this, different kinds of risks can be identified and separate groups made. By insurance, the
heavy loss that anyone or few of them may suffer is divided into bearable small losses by all. In
other words, the risk is spread among the community and the likely big impact on one or few is
reduced to smaller manageable impacts on all.

There are certain principles also, which make it possible for insurance to remain a fair
arrangement. The first being sharing of risk as it is difficult for any one individual to bear the
consequences of the risks that he is exposed to. It will become bearable when the community
shares the burden.
The second is that the peril should occur in an accidental manner. Nobody should be in a
position to make the risk event occur. In other words, none in the group should set fire to his
assets and ask all others to share the costs of damage as this would be taking unfair advantage of
an arrangement which is their to protect people from the risks they are exposed to. The occurrence
of loss has to be random, accidental, and not the deliberate action of the insured person(s).

The manner in which the loss is to be shared can be determined beforehand. It may be proportional
to the risk that each person is exposed to. This would be indicative of the benefit he would
receive if the peril befell him. Insurance companies collect the share of people to the pool in
advance and create a fund from which the losses can be paid.

The collection to be made from each person in advance is determined on some assumptions.
While it may not be possible to tell beforehand, which person will suffer, it may be possible to
tell on the basis of past experiences, how many persons, on an average, may suffer losses. The
following illustrations make the concept of insurance clear.

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