Insurance provides financial protection against a loss arising out of happening of an uncertain event. A person can avail this protection by paying premium to an insurance company.
A pool is created through contributions made by persons seeking to protect themselves from common risk. Premium is collected by insurance companies which also act as trustee to the pool. Any loss to the insured in case of happening of an uncertain event is paid out of this pool.
Insurance works on the basic principle of risk-sharing. A great advantage of insurance is that it spreads the risk of a few people over a large group of people exposed to risk of similar type.
Definition
Insurance is a contract between two parties whereby one party agrees to undertake the risk of another in exchange for consideration known as premium and promises to pay a fixed sum of money to the other party on happening of an uncertain event (death) or after the expiry of a certain period in case of life insurance or to indemnify the other party on happening of an uncertain event in case of general insurance.
The party bearing the risk is known as the 'insurer' or 'assurer' and the party whose risk is covered is known as the 'insured' or 'assured'.
Concept of Insurance / How Insurance Works
The concept behind insurance is that a group of people exposed to similar risk come together and make contributions towards formation of a pool of funds. In case a person actually suffers a loss on account of such risk, he is compensated out of the same pool of funds. Contribution to the pool is made by a group of people sharing common risks and collected by the insurance companies in the form of premiums.
Lets take some examples to understand how insurance actually works:
| Example 1 | Example 2 |
| SUPPOSE | SUPPOSE |
| UNDERLYING ASSUMPTION All 1000 house owners are exposed to a common risk, i.e. fire | UNDERLYING ASSUMPTION All 5000 persons are exposed to common risk, i.e. death |
| PROCEDURE All owners contribute Rs. 300/- each as premium to the pool of funds  Total value of the fund = Rs. 3,00,000 (i.e. 1000 houses * Rs. 300) 5 houses get burnt during the year Insurance company pays Rs. 40,000/- out of the pool to all 5 house owners whose house got burnt | PROCEDURE Everybody contributes Rs. 1200/- each as premium to the pool of funds Total value of the fund = Rs. 60,00,000 (i.e. 5000 persons * Rs. 1,200) 50 persons die in a year on an average Insurance company pays Rs. 1,00,000/- out of the pool to the family members of all 50 persons dying in a year |
| EFFECT OF INSURANCE Risk of 5 house owners is spread over 1000 house owners in the village, thus reducing the burden on any one of the owners. | EFFECT OF INSURANCE Risk of 50 persons is spread over 5000 people, thus reducing the burden on any one person. |