What is insurance?
Insurance is ,a legal contract
that protects people from the financial costs that result from loss of life,
loss of health, lawsuits, or property damage. Insurance provides a means for
individuals and societies to cope with some of the risks faced in everyday
life.
For example, you have insurance for your house in case it burns down. If
that happens, you get money from the insurance company to house your family and
rebuild (or replace) your home. You can purchase insurance for a wide variety
of perils - fire, theft, natural disasters (floods, earthquakes, etc.),
property damage, personal injury claims, and so forth.
People purchase contracts of
insurance, called policies, from a variety of insurance organizations. Almost
everyone living in modern, industrialized countries buys insurance.
For instance, laws in most states require people who own a car to buy
insurance before driving it on public roads. Lenders require anyone who
finances the purchase of a home or car with borrowed money to insure that
property. Business partners take out life insurance on each other to make sure
the business will succeed even if one of the partners dies.
Types of coverage
In a simplified format, there are two basic types of coverage: first party
coverage, and third party coverage.
What is "first party" coverage?
A "first party" policy is one that protects you in case you
suffer damage or loss. Thus, a home insurance policy is usually a "first
party" policy .You, as the homeowner, are the first party (you own the
home) and you are the person who can receive benefits under the policy.
Most often first party policies provide property damage coverage and
medical coverage to you, the policyholder.
What is "third party" coverage?
Contrast "first party" coverage with "third party"
coverage, which usually protects you against claims brought by others.
The person making the claim
sometimes is referred to as a "third party claimant." Typical
examples of third party coverage are automobile liability policies that offer
protection when you are in an auto accident.
Not only do they provide medical coverage for you (first party coverage),
but they also "cover you" if an inured party brings a claim against
you for careless driving.
Another example of "third
party" coverage is the liability coverage in your homeowner's policy -
coverage that protects you if somebody is injured while on your property.
Insurance
Terms
Insurance makes up part of the
broader financial services industry (see Finance). In the United States in the
late-1990s, more than 5500 insurance companies offered a wide range of policies
and services. Some large companies sell virtually every type of insurance
available in the marketplace. Smaller companies may specialize in a specific
geographic region or type of insurance. In 1997 more than 300 Canadian
companies sold some form of insurance.
II.
REASONS FOR INSURANCE
In life, losses are sometimes unavoidable. People may become ill and lose
income or savings to pay off medical bills. Individuals or their relatives may
die of illness or accidents. People’s homes or other property may suffer damage
or theft. People also may accidentally cause injury to others or damage to the
property of others.
No one knows in advance when a loss will occur or how serious that loss
will be. The uncertainty surrounding potential losses is known as risk.
Insurance offers a way for people to replace risk with known costs—the costs of
buying and maintaining insurance policies.
If the accident injures someone, the costs of medical care could be much
higher. Through the mechanism of insurance, however, the car owner can share
the risk of an accident with others who face the same risk.
Insurance pools (combines) risks shared by many people, thereby reducing
the risks faced by a group. People pay to buy insurance coverage (protection
from risk). In exchange, all policyholders (people who own insurance policies)
receive a promise that the group of policyholders—as represented by the
insurance organization—will pay when any policyholder experiences a covered
loss.
The reduction in risk brought by insurance relies on a mathematical concept
called the law of large numbers. That law states that the ability to predict
losses improves with larger groups. Using calculations based on statistics,
experts known as actuaries can accurately predict the losses of a large
population, even without knowing when or how any one individual will experience
loss.
speculative risk and pure risk
Insurers distinguish between two types of risk: speculative risk and pure
risk. Speculative risk offers both the potential for gain and the potential for
loss. People who invest in the stock of companies, for example, take
speculative risk. An increase in stock prices produces a gain, while a decline
in stock prices produces a loss.
Pure risk, by contrast, creates the potential only for loss. Although pure
risks do not necessarily result in losses, they never result in gains.
Historically, insurance dealt only with pure risks, and most people still
buy insurance to cover pure risks. No one, for instance, experiences a gain
when they go a full year without an auto accident. However, some insurance
companies now help businesses finance large losses including those incurred on
speculative risks, such as the international exchange of currency.
Also, in the 1990s financial markets and some professions outside
insurance, such as the field of environmental impact and damage assessment,
began to expand into risk management for the first time.
III. THE IMPORTANCE OF INSURANCE
Insurance benefits society by allowing individuals to share the risks faced
by many people. But it also serves many other important economic and societal
functions. Because insurance is available and affordable, banks can make loans
with the assurance that the loan’s collateral (property that can be taken as
payment if a loan goes unpaid) is covered against damage.
This increased availability of credit helps people buy homes and cars.
Insurance also provides the capital that communities need to quickly rebuild
and recover economically from natural disasters, such as tornadoes or
hurricanes.
Insurance itself has become a significant economic force in most
industrialized countries. Employers buy insurance to cover their employees
against work-related injuries and health problems. Businesses also insure their
property, including technology used in production, against damage and theft.
Because it makes business operations
safer, insurance encourages businesses to make economic transactions, which
benefits the economies of countries. In addition, millions of people work for
insurance companies and related businesses. In 1996 more than 2.4 million
people worked in the insurance industry in the United States and Canada.
Insurance companies perform a type of monetary redistribution—they collect
premiums and eventually redistribute that money as payments. Depending on the
type of insurance, redistribution can take anywhere from a few months to many
decades.
Because of this delay between collecting and paying out funds, insurance
companies invest their funds to bring in extra revenues. Such investments help
businesses and governments finance their operations, and profits from those
investments support the operations of insurance companies. With these
investment earnings, insurance companies can keep rates much lower than would
otherwise be possible.
Not all effects of insurance are positive ones. The possibility of earning
insurance payments motivates some people to attempt to cause damage or losses.
Without the possibility of collecting insurance benefits, for instance, no one
would think of arson, the willful destruction of property by fire, as a
potential source of money.
IV. RISK ASSESSMENT
To help individuals and businesses manage risk, providers of insurance must
have ways of determining what kinds and degrees of risk different people and
businesses face. To do this, insurers rely on the basic principle of grouping
together similar risks. By examining the risks faced by a variety of
individuals and businesses, insurers can establish common risk profiles
(patterns of characteristics).
With this information, an insurer can quickly determine what kind of
insurance to offer someone applying for a policy, and how much it will cost to
insure that person’s risks.
Every insurer employs underwriters to assess the insurance risk posed by
applicants for insurance, and to group applicants into classes based on similar
risk profiles. For example, companies that insure cars and their drivers
categorize teenage drivers as a class separate from older drivers.
Studies have shown that teenagers have many times more crashes than other
age groups.
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