Insurance Fundamentals Best Guide For 2015

DEFINITION OF INSURANCE:

Insurance is a financial device for transferring or shifting risk from an individual or entity to a large group with the same risk. This is accomplished through a contract, the insurance policy, with an insurance company. Under this arrangement, the individual, along with other insureds, pays a sum to the insurance company. In turn, the insurance company agrees to pay an amount of money (reimbursement) to the individual, or on behalf of the individual, if the events described in the policy occur.

Insurance is used to indemnify, or restore, a policyholder to a preloss condition. The individual accepts a known cost, the premium, in exchange for payment of a large, uncertain financial loss. The insurance company combines, or pools, a large number of similar units (homes, autos, businesses, etc.) and thus can predict losses within these units.

Although modern insurance transactions are somewhat different from those used by the river boatmen, the result is the same. The similarities are
• premiums are placed in a fund;
• payment from the fund is made for losses; and
• risks are shared equally. The characteristics of an insurance transaction are
• pooling of resources;
• accumulation of funds;
• distribution of funds to those who have losses;
• transfer of risk from one person to the group; and
• spread of risk among all members of the group.

COST AND BENEFITS OF INSURANCE:

The products and services the insurance industry provides offer many benefits to society. Today's insurance provides protection by reimbursing people when their property is damaged or they suffer some other loss. Insurance helps individuals and business owners resume their normal standard of living and operations, which also benefits society as a whole. The primary benefits of insurance include
• payment of losses;
• economic growth;
• credit support;
• loss prevention;
• peace of mind.

Payment of Losses:

If a business burns down and has no means to resume operation, it would mean financial hardship for the owner. But the negative impact would extend beyond the owner and affect
• employees (who now are unemployed)
• those from whom the business purchases raw materials, goods or services (who now must find a new customer)
• those to whom the business provides goods and services (who now must find another business to fill their needs). The proceeds of an insurance policy benefit everyone by restoring the insured person or organization to the same financial condition as before the loss and preventing the loss from rippling out and affecting others negatively

Economic Growth:

The insurance industry plays an important role in the nation's economy. It is second only to the commercial banking industry as a source of investment funds because insurance companies invest the billions of the premium dollars they receive annually in a wide range of investments. Insurance companies use premiums collected from policyholders to
• pay for claims
• pay for cost of doing business
• build cash reserves for future loss payments. Cash reserves are invested in federal and municipal bonds that are used to build roads, schools and utilities. Reserves are also invested in commercial developments and the stock market. These investments promote economic growth in communities and support the insurance company's requirement of maintaining sufficient capital reserves to pay future losses and earn a profit.

RISK:

Any introduction to insurance requires a clear understanding of the concept of risk. Many insurance professionals use the word risk to refer to an insured, a prospect for insurance or to the peril that is being insured. They will say that a particular person or property is a good risk or a bad risk, meaning that they have evaluated the underwriting characteristics of that person or property for a particular insurance policy. This usage differs from the strict insurance definition, which defines risk as the uncertainty regarding financial loss.

Loss and Exposure:

Loss is defined for insurance purposes as unintended, unforeseen damage to property, or the amount the insurance company is obligated to pay because of personal injury. Everyday wear and tear on clothing represents destruction or decline in value; however, for insurance purposes, it is not a loss because it is the expected or intended consequence of wearing the clothes. Smoke damage to clothing caused by a fire in the house, in contrast, would be considered a loss that a person could obtain insurance to offset. In the context of insurance, exposure is the possibility of a loss. It simply means the degree to which a person or property is vulnerable to risk or to the possibility of loss

The Law of Large Numbers: 

The mathematical principle of probability is called the law of large numbers. In insurance, a prediction must be made from past loss experience or statistical analysis of the number of losses to be expected within a group of exposures. The law of large numbers tells us that actual losses will be more accurate as the number of units of exposure increases.

This principle, known as the law of large numbers, states that as the number of observations of an event increase, the closer the predicted outcome will be to the actual outcome. Insurers know, within a very narrow margin, how many homes will be damaged each year by fire, although they do not know which homes will be damaged. This uncertainty introduces risk and makes it possible to insure homes against fire loss.

Assume 1,000 homes in an area are each worth $50,000. Also assume that statistics show that five of these homes can be expected to burn this year. If each of 1,000 homeowners contributes his or her share ($250) of the expected $250,000 loss into a fund at the beginning of the year, an adequate insurance pool will exist to pay for the losses if they occur.

Similarly, an insurer issues policies insuring against the same type of risk to a large number of homeowners. The insurer knows how many homes may be destroyed by fire in a single year, but not which homes will suffer the loss.

Common Loss Exposures: 

The probability that an event will occur is called a chance of loss or an exposure to loss. Listed below are the most common exposures to loss are
• personal
• property
• liability.

Personal Losses Illness, injury and premature death are all examples of personal loss exposures. Property Losses Car accidents, house fires and storm damage to businesses are examples of property loss. Property loss involves the destruction of personal or commercial property.
Liability Losses Liability loss exposure means the potential to become legally responsible for injuries of others or damages to someone else's property. For example, if your dog bites a small child, you may be liable for the child's injuries. Likewise, if you have a car accident and are held at fault, you may be required to pay for any injuries or damages that result.

Direct and Indirect Losses: 
Losses can be classified as either direct or indirect, with insurance policies designed to cover either or both types of loss. Direct loss refers to actual physical loss, destruction or damage to property—for instance, the loss caused by a fire as well as other damage for which the fire was the proximate cause, such as water damage from putting out the fire. Indirect loss is a financial loss incurred as a result of direct damage to property. For a business, this includes loss of profits, rent and continuing or extra expenses necessary to keep the business operating after a direct loss. In the case of a personal dwelling, indirect loss involves the possible loss of rent from a rental unit in the dwelling or the extra expenses the homeowner incurs from living in a motel while his or her home is being repaired after a direct loss.