Insurance is a financial arrangement whereby a party (the insured) which faces a monetary risk if a particular event occurs passes that risk to an insurer in return for the payment of a premium.
A common example is motor insurance. A motorist faces several risks, including the theft of their vehicle and damage caused to their vehicle. The motorist will choose to insure themselves against some or all of these risks and approach an insurer. The insurer will quote a premium to insure the nominated risks for a period of usually twelve months. Once insured, the motorist can make a claim against the insurer if any of the nominated risk events occurs. An insurance policy will set out the exact circumstances in which a claim will be paid, and the way in which the amount of the claim will be determined. In the event of theft, the payment would usually be the market value of the vehicle. In the case of damage to the vehicle the payment will usually cover the necessary repairs, up to the market value of the vehicle. Other forms of insurance include building, marine, aviation and business. A special case is life insurance where the insured’s dependants receive a claim payment on the death of the insured.
Insurance is usually provided by either a mutual organisation, or an insurance company. In a mutual, the insured parties pool their risks together. In an insurance company the risks are passed to the company’s shareholders. In either case, the insurer must hold reserves of capital to provide a level of certainty that it will be able to meet all future claim payments arising from the risks it has insured.
In setting the amount of premium to charge the insured, the insurer will assess the size of the risk taking into account the nature of the insured, and then incorporate an allowance for the insured’s overheads, and a contribution to the insurance company’s profits. Insurers employ actuaries to do much of the work in determining the premium for each insured.