Insurance Definition and Overview

Definition of Insurance

• Insurance can be defined from multiple disciplines, including law, economics, history, actuarial science, risk theory, and sociology.
• Insurance is the pooling of fortuitous losses by transferring risks to insurers, who agree to indemnify insureds for such losses or provide other pecuniary benefits.

Law of Large Numbers in Insurance

• The law of large numbers states that the average of a large number of independent, identically distributed random variables tends to fall close to the expected value.
• This principle is used to show that the entry of additional risks to an insured pool tends to reduce the variation of the average loss per policyholder around the expected value.
• As the number of policyholders increases, the probability that the actual loss per policyholder will equal the expected loss per policyholder is higher.
• This means that there are returns to scale in insurance production, making it easier to establish the correct premium and reduce risk exposure for the insurer as more policies are issued.

Basic Characteristics of Insurance

Pooling of Losses

• Pooling involves the grouping of a large number of exposure units to provide a substantially accurate prediction of future losses.
• The primary purpose of pooling is to reduce the variation in possible outcomes, thereby reducing risk.
• 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.

Payment of Fortuitous Losses

• A fortuitous loss is one that is unforeseen and unexpected by the insured and occurs as a result of chance.
• The law of large numbers is based on the assumption that losses are accidental and occur randomly.

Principle of Insurable Interest

• Insurable interest is the legal right to insure arising from a financial relationship recognized under the law, between the insured and the subject matter of insurance.
• The insured must have a pecuniary or monetary interest in the property, which they have insured.
• If the insured has no insurable interest over the life or property they insure, the insurance contract is considered unenforceable.

Principle of Utmost Good Faith

• The principle of utmost good faith stems from the doctrine of "Uberrimae Fides".
• It implies that in a contract of insurance, the concerned contracting parties must rely on each other's honesty.
• There must be a positive duty to voluntarily disclose, accurately and fully, all facts material to the risk being proposed, whether requested or not.
• Any concealment of necessary facts is deemed intentional and will make the policy void.

Principle of Indemnity

• Indemnity is the protection or security against damage or loss, providing financial compensation to place the insured in the same pecuniary position after the loss as enjoyed just before it.
• The principle of indemnity ensures that the insurer is liable to pay up to the amount of loss, but not more than that.
• The two fundamental purposes of the principle of indemnity are:
  • To prevent the insured from profiting from a loss.
  • To reduce moral hazard, preventing dishonest policyholders from deliberately causing the loss to collect the insurance proceeds.
• Exception to the principle of indemnity: life insurance, where the value of life is determined by qualitative factors and is subject to one's opinion.