Meaning and Nature of Insurance

Every economic activity, including the banking activity discussed so far in this chapter, is exposed to risk — a fire may destroy a warehouse, a ship carrying cargo may be lost at sea, a person may fall seriously ill or die unexpectedly. Insurance is the mechanism society has developed to deal with exactly this problem.

Insurance is a contract, called a policy, under which one party (the insurer) agrees, in exchange for a payment called the premium, to compensate another party (the insured) for a specified financial loss that may occur due to an uncertain event. The essential idea underlying insurance is risk pooling and risk transfer: a large number of people who are each exposed to a similar risk contribute a small, affordable premium into a common fund, and whichever few among them actually suffer the loss in a given period are compensated out of that common fund. In this way, an uncertain and potentially devastating loss for one individual is converted into a small, certain and manageable cost — the premium — shared across the whole group.

It is worth being precise about what insurance does and does not do. Insurance does not prevent a loss from occurring at all; a fire may still break out, and a person may still fall ill. What insurance does is spread the financial burden of that loss across many contributors instead of letting it fall entirely on the one unlucky individual it happens to. This is why insurance is best understood as a risk-transfer and risk-sharing mechanism rather than a risk-prevention one, and why it works reliably only when it is based on a large enough pool of similar risks for the law of averages to operate predictably — a small handful of policies would not let an insurer estimate its likely claims with any confidence. …