Concept Of Insurance

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Insurance has been defined by various experts in different ways. Willett, for example has defined it as "that social device for making accumulations to meet uncertain losses of capital which is carried out through the transfer of risks of many individuals to one person or to a group of persons". Pfeffer was of the view that "insurance is a device for the reduction of the uncertainty of one party, called the insured, through the transfer of particular risks to another party, called the insurer, who offers a restoration, at least in part, of economic losses suffered by the insured".

Insurance is based on the concept of risk pooling or risk sharing of losses. Basically under this concept, all individuals suffering a similar risk, place an agreed sum into a pool and the monies collected are used to indemnify any contributing individual against any loss arising out of the risk. The pool can either be managed by the individuals or paid to and managed by a company. In the former, the plan is known as mutual insurance while in the latter, the company managing the pool is known as a stock life insurance company.
For example, supposing in a certain typhoon prone community, there are 2000 houses, each worth $100000 and each is exposed to the same probability of being destroyed by a typhoon. In a particular year, if the statistics indicate that two of the houses will be destroyed by typhoon, this means that each house owner is relatively safe as he only faces a 0.1% chance that his house will be destroyed. However, should he be so unlucky as to constitute the 0.1%, his loss will be devastating. However, by setting up a common fund of $200000 to be used to compensate any two houseowners hit by typhoon, each house owner gains the assurance that any loss arising from the risk is minimised. Further, to accumulate this fund, each household only needs to contribute an affordable premium of $100. Each house owner therefore, pays a premium of $100 to buy peace of mind.
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