Fundamental Characteristics of Insurance

There are basically 4 fundamental characteristics of insurance, which is established on the following essential principles:

  • Principle of risk transfer

  • Principle of indemnity
  • Principle of pooling losses
  • Payment of fortuitous (unintentional) losses

Principle of Risk Transfer


In its most basic make-up, insurance has two elemental characteristics:
  • Transferring or shifting risk from a financially weaker party e.g. individuals, to one who is financially stronger, e.g. insurers.
  • The sharing of losses among members in the pool on some equitable basis.

Risk transfer is a basic characteristic of insurance, which is why loss-transfer technique in risk management frequently uses insurance as a tool. Unless the case is self-insurance where the individual or organization retains the risk, all insurance devices engage the principle of risk transfer. In effect, risk transfer involves the transfer of a pure risk from the insured to the insurer, who is financially well endowed to withstand risk of loss if the insured event occurs.

From the individual standpoint, pure risks that are frequently transferred to the insurers cover the risk of premature death, deterioration of health, disability, damage and loss to property, and liability lawsuits. For a business, it could be the loss of a keyman due to similar events, causing a loss of profits and the other risks associated with operating a business. 

Principle of Indemnity


It is important to note that the purpose of insurance is not for the insured to make a profit when the insured event happens. This is the primary position the principle of indemnity is footed on. In essence, the principle of indemnity asserts that an insured may not be paid an amount in excess of the loss incurred by him in the event the insured peril occurs.

Indemnification henceforth is the restoration of an insured person to his or her approximate financial position prior to the occurrence of the loss. If for instance, the insured's car met with an accident, the insurer will pay a sum approximately equal to the repair bill of the damaged car.

In the case of life insurance, the insured is paid on the sum insured stated in the policy when the insured event, say death, occurs, because life insurance is not a contract of indemnity but a valued contract. It is a well-established and accepted insurance principle that an individual has unlimited insurable interest in his own life, and henceforth is entitled to insure himself for any sum that the insurer is willing to give cover.
 

Principle of Pooling Losses


In addition to eliminating risk at the level of the individual through transfer, insurance can help to reduce risk for those that participate in the pool. The principle of sharing or pooling losses is central to insurance. Essentially, pooling in insurance is averaging of losses incurred by individuals over the whole group, so that in the process, average loss is swapped for actual loss.

Pooling also involves the grouping of a large number of exposure units so that the law of large numbers can work to furnish a materially precise prediction of future losses. The law of large numbers says that the greater the number of exposures, the more closely will the actual results approach the probable results that are expected from an infinite number of exposures. Preferably, there should be a large number of homogeneous exposure units - i.e. units that are similar but not necessarily identical. Hence, pooling implies two key sub-principles:
  • The sharing of losses by the whole group
  • Forecast of future losses with some exactness based on the law of large numbers. 

Principle of Payment of Fortuitous (Unintentional) Losses


If a loss-bearing event can be foreseen to be happening in definite term, it is not an insurable event. The only exception is perhaps is death. Even then, the event is insurable because the exalt timing of death is generally not determinable. A fortuitous loss is one that is unforeseen and unexpected and occurs as a matter of chance. This is to say that the loss to be insurable must occur accidentally or unintentionally -  such events happen randomly based on the law of large numbers. Example, a lorry skidded on a slippery road and knock into the shopping mall, the event would be considered a fortuitous event. If a plane crash due to bad weather, the incident is fortuitous.


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