Insurance as a Risk Transfer Mechanism
Three important principles from the foundation for the risk transfer mechanism of Insurance:
Sharing the losses of the Unfortunate Few by Many
A large amount of people who face the same risks have been grouped together and the risk suffered by a few is spread over this group. A fund is created by which all those who face a similar risk will drop a small sum of money. This fund will be sufficient to make over the economic loss suffered by few.
The probability Theory is a mechanism for measuring the likelihood of an occurrence. This likelihood is measured on a scale from 0 to 1, where 0 represents impossibility and 1 denotes certainty. Where the probability lies on the range from 0 to 1 is an indicated of how likely the event is.
Utilizing the Law of Probability, the likelihood of future events are estimated based on the Knowledge of what has happened in the past under similar conditions.
For example, consider that there are 10,000 houses in a township. The value of each house is Rs. 5laKhs (each has a similar exposure to risk). In the past, there have been two fire accidents every year, on an average, and the damage was to the tune of Rs. 4laKhs in most of the cases. In such a situation. each of the owners of the 10,000houses can contribute Rs.80 each, creating a pool of Rs.8laKhs, which can be distributed to the unfortunate two affected houses owners.
Law of Large Numbers
This mathematical law is extremely useful for an insurer. It states that, as the number of exposure units increases, the more closely the actual experience will approach the expected (the probable) experience. The larger the sample, the greater would be the likelihood that the frequency of occurrence will coincide with the average frequency that can be established by theoretical calculation.
A coin has two sides and each side has an equal chance (50:50) of falling face up when it is tossed. If the coin tossed 100 times, the outcome may be that the coin landed on its head 60 times. As we continue tossing the coin, the more the number of times it is tossed, the closer the outcome will be to 50:50 The larger the number of trials, the closer the actual experience will be to the probable experience.
Consider again the example given earlier for insuring a township of houses against fire. As the number of houses under observation increases, the greater is the degree of accuracy the insurer will have in predicting the proportion of a houses that will burn.
The law of large numbers has dual application in insurance. The insurer must have a sufficiently large volume of historical data so that the prediction can be more accurate. Once the estimate is worked out, a large number of contracts must be entered into, to avoid possible losses due to small numbers.
Equality of Risk
The loss incurred by the unfortunate few people is paid out of the common fund created by contributions from the individuals or the enterprises In the group. This contribution, in Insurance terminology, is called ‘Premium’. Equity demands that each member of the group should contribute a premium which should be appropriate with the risk that individual or business brings into the fund. The risk is not uniform in quality or quantity. This process of fixing the appropriate contribution adequate to meet the risk is done on the basis of Actuarial or Mathematical Principles.
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