What is Insurance?

Insurance is a mechanism by which risk is transferred by a person or business to an insurer, which reimburses the insured person or business for covered losses and provides for the sharing of losses among all insureds. This sharing is possible because the insurer collects a pool of all of the premiums paid by customers into a fund from which it pays losses.

How Does Insurance Benefit Society?

Paying Losses

The major benefit of insurance is indemnifying insureds for covered losses. Through indemnification, individuals and businesses are able to maintain their economic position and avoid becoming a burden on others. For example, when a family’s house is destroyed by fire and the loss is covered under an insurance policy, the family will be less dependent on relatives or government organizations for lodging or other continuing expenses.

Reducing Uncertainty

Another benefit of insurance, which is closely related to paying for losses, is the reduction of uncertainty that insurance protection provides. An individual or a family will have increased peace of mind knowing that the possible financial consequences of losses arising from the ownership of a home or a car will be covered by insurance.

Insurers are interested in lowering the costs of losses and, therefore, promote a variety of risk control activities to their insureds by providing premium reductions for those insureds who practice risk control. These risk control activities can either lower the frequency of potential accidents by preventing losses from happening (loss prevention) or reduce the severity of accidents that occur despite loss prevention activities (loss reduction).

Satisfying Legal Requirements

Insurance is often used or required to satisfy legal requirements. In many states, for example, owners of automobiles must prove that they have auto liability insurance before they can register their autos. All states have laws that require employers to pay for job-related injuries or illnesses of their employees, and employers generally purchase workers compensation insurance to meet this financial obligation.

The insurance mechanism, therefore, includes three essential components: Risk, Transfer, Pooling - Insurance is a contract that transfers the risk of financial loss from an individual or business to an insurance company. The company collects small amounts of money from its clients and pools that money together to pay for losses.

The premium is the basis of your "insurance payment". An insurance premium may then be taxed, or services fees may sometimes be added to it depending on the local insurance laws, and the provider of your contract. 

The deductible is a specific amount the policy-holder must pay out-of-pocket before the insurer pays a claim. Deductibles serve as deterrents to large volumes of small and insignificant claims.

The core components that make up most insurance policies are the deductible, policy limit, and premium.