Depending on how old you are, either you are already enrolled in some insurance program(s) or you will in the near future. Vehicle insurance is mandatory in India and so you don’t have a choice there. Besides, there are life insurance programmes and insurance schemes for your home, expensive articles and a number of confusing kinds of all these. This is first in our series on personal finances and it answers the question, how insurance works?
How Insurance Works? Plus an Introduction to Risk Pooling.
Consider, for instance, you may your home and everything inside of it to an accidental fire. It might not happen but the associated risk is too high to leave it on chance. Fortunately, people in your neighbourhood also share a similar exposure to the same risk. So, people in your neighbourhood come together to create a fund to compensate when someone loses their home to fire. This fund is pooled through premiums paid by individual participants. Your premium depends upon your individual exposure to the risk and the compensation that you would want to be paid in case of a fire incident. We call such an arrangement risk pooling and this is how insurance works.
You toss a coin 100 times and it won’t turn tail all of the 100 times. Most likely, the tail will appear for around 50 times only (if not 50 exactly).
Participants pay a premium, either a one-time or at regular intervals, to fund a scheme with an insurance company. This fund is then used to compensate participants in case of a loss due to a specified risk. The fund works best when the number of claimants is small and the compensation amounts are reasonable. But there might as well be a disaster that may unexpectedly increase everyone’s exposure to the specified risk. The small fund cannot be expected to compensate for everyone’s loss in such cases. For this, the insurance companies generally require you to agree to a set of terms and conditions. These conditions help protect the company against too many claims for compensations.
Insurance Practices are Centuries Old.
There are accounts of similar practices from the Roman Empire.
In the Roman Empire, there are accounts of private citizens coming together to form burial associations. There were an admission fee and a monthly premium that the members were required to pay to the association. In return, the association provided for their members a proper funeral on their death and some payment to their family.
How Insurance Benefits Society?
Individually, you might not be able to pay for health treatments if you were to get diagnosed with a fatal disease. It is a huge loss if you lose your home to a fire accident or damage your car in a road accident. You may never experience these losses in your life. But what if you do get diagnosed with a disease? Or lose your home to a fire? The associated cost is huge and you will find it difficult to get back with life for some time after the incident. Other people are exposed to common risks and risk pooling helps us share the cost to our exposure to these risks. Insurance practices help individuals deal with unpredictable accidents. It is also a wonderful example of collaboration and shared responsibility in our society.