Principles Of Insurance

principles of insurance

Let’s to understand about principles of insurance!

1. Law of large numbers

Imagine that in a village there are 1000 persons who are all aged 50 and are healthy. Based on previous experience, it is expected that of these, 10 persons may die during the year. If the economic value of the loss suffered by the family of each dying person is taken to be Rs.20, 000, the total loss would work out to Rs.2, 00,000.

If each member contributes Rs.200 a year, this would be enough to pay Rs.20, 000 to the family of each of the ten persons who dies.

You would have wondered whether the prediction of number of actual deaths of ten is accurate. What would be the impact if the insurance company’s predictions about the risk turned out to be wrong or inaccurate and the number of deaths turns out to be 15 or 5?

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If the actual number of persons who die during a year were to be higher than ten, the amount collected would not be sufficient to compensate those who suffer the loss.

You need not worry too much about the accuracy of estimates. What saves the insurer is a wonderful principle of nature known as the law of large numbers. Simply put, it states that the more the number of members who are insured, the more likely it is that the actual result would be closer to the expected.

Example (principles of insurance)

Try this simple experiment. Toss one rupee coin. We all know that the theoretical probability that the outcome will be ‘heads’ is equal to ½. Does this mean that if you toss a coin four times you will always get two heads and two tails? When can you be hundred percent sure that you will get heads exactly half the time? The answer is, you would have to toss it a very large number of times. You would also notice that the more number of times you toss the coin, the more you would find that the result is coming closer to half.

Law of large numbers -Number of tosses of a coin

Insurance works on this law of large numbers. Insurance companies are able to make near accurate predictions about their risks because they typically spread that risk amongst thousands, even millions, of members who have signed contracts with them and who are their policy holders. This is the reason why when you purchase an insurance policy, the insurance company is able to give you an assurance that your losses would be compensated if they occur due to the insured event.

2. Insurable interest

Another important principle is insurable interest. Let us understand it with the help of a few examples.

Example 1 (principles of insurance)

Shri Manoj was staying with his wife and son. An insurance agent visited him offering health insurance. Manoj indicated that he wanted to take health insurance for all the members of his family. He also wanted to take a policy for his good neighbour.

The insurer said that Manoj can take a policy for his family but cannot take a policy for his neighbour. The reasons why the insurer refused to issue insurance policy to Manoj’s neighbour was because Manoj did not have an insurable interest in his neighbour’s health.

Insurable interest is the term we use to describe the relationship between the insured and the subject matter of insurance (in the above case it is the health of Manoj and his family on one hand and Manoj’s neighbour). This relationship gives Manoj a particular type of interest in the health of himself, his wife and child, whereby he benefits from the good health and suffers a financial loss by way of hospital expenses if one of the members of his family falls ill.

We buy insurance to ensure that the loss suffered is compensated for in some way. The position is not so in case of Manoj’s neighbour as Manoj does not suffer any financial loss due to his neighbour falling ill. Insurable interest exists when an insured person derives a financial benefit from the continued existence of the insured object or suffers a financial loss from the loss of the insured object. A person has an insurable interest in something when loss-of or damage-to that thing would cause the person to suffer a financial loss.

Example 2 (principles of insurance)

If the house you own is damaged by fire, you suffer a financial loss resulting from the fire. By contrast, if your neighbor’s house, which you do not own, is damaged by fire, you may feel sympathy for your neighbor but you have not suffered a financial loss from the fire. You have an insurable interest in your own house, but not in your neighbor’s house.

Imagine that you had insured your house. Later you sold the house to buy a bigger house. There was fire in the house after you sold the house.

Since you do not own the house anymore, you will not suffer any loss. Therefore, now you do not have any insurable interest in the house. Insurable interest should be there at the time the loss is suffered.

People have an insurable interest in their property to the extent of loss suffered, but not more. The principle of indemnity dictates that the insured is compensated for a loss of property, but is not compensated for more than what the property was worth.

A lender, who gives loan against the security of house, has an insurable interest on the property because if there is a loss to the house, he would suffer a loss by not getting back the money. However, the insurable interest of the lender is not in excess of the value of the loan.

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