Insurance is a legal relationship between you and the insurance company whereby you pay a minimal amount of money in order for this company to support or compensate you for any loss you may incur. This contract is represented by a policy. The company pools clients’ risks to make payments more affordable for the insured.
Insurance makes people feel comfortable. They know that should anything go wrong, there will always be another person to cater for the expense of the damage.
Why do you need insurance?
It is a financial safety net. Also, it ensures that you are not compelled to meet all the costs if something bad happens. It also assists you and your family to rebuild your lives in case of an unfortunate event like a fire outbreak, theft, legal disputes, or car accident.
Key Terms and Concepts in Insurance
⦁ Insurance
This is a contract or policy that shifts the risk of a loss to an insurance company. The person or group who buys the insurance is called the policyholder or the insured.
⦁ The insured
This is the entity, person, or group that is protected by the insurance. They give money to the insurance company, known as the premium, in exchange for a promise of protection.
⦁ Insurance firms
They provide cover to individuals who incur losses as a result of certain risks.
⦁ Risks
These are those events that lead to loss such as, accidents, theft, and disability.
⦁ A premium
It is a periodic contribution towards an insurance company for a financial agreement with this company to cover a client’s losses in case of an unfortunate event.
Each insurance type has its unique factors that influence the premium amount. These factors considered are
- age, gender, health status of people (life and health insurance),
- vehicle type and condition (auto insurance),
- property value (property insurance),
- business size, and industry (business insurance).
⦁ The sum insured
This refers to the amount of money covered by insurance.
⦁ A policy
It refers to an official document. It contains details of an understanding between an insurance firm and a party seeking insurance. Also, It outlines different terms and conditions like protected risks, coverage period, policy limits, premiums, limits, deductibles, exclusions and limitations in a very clear manner. The policy is provided to the policyholder ( the insured) once the initial payment is made.
⦁ Policy beneficiaries
These are those who receive compensation from insurance companies. In the event the insured person is to incur an unfortunate loss, it is him or her who will be compensated.
⦁ The grace period
It is a period allowed between the date of signing the contract and the date of payment of the first premium. At this time, the policy is in force. This period is usually a maximum of thirty (30) days.
⦁ A cover note or binder
This is a written assurance by the insurance company that it is ready to secure a person or entity as it awaits the signing of the policy.
⦁ Consequential loss
This is the financial burden (like money) that businesses lose when its operations are impaired by a covered risk.
⦁ Insured risk
It refers to any loss incurred has to be demanded by the insured and paid by the insurance company. This demand is known as a claim.
⦁ Insurance agents
They are people who act as middlemen between customers and insurance firms to offer policies. Their commission is calculated according to the total value of the policies they successfully sell.
⦁ Insurance brokers
These are people who assist individuals in obtaining insurance. They work to bring people to the right insurers, assess the market, negotiate with the insurers on behalf of their clients and advise on the best insurer to purchase coverage from. These people earn a commission called brokerage as a reward for their services.
Principles of Insurance
The principles provide a guide when forming insurance contracts between the insurance companies and the policy holders.. These principles include:
1. Insurable Interest
Insurance claims may only be made when it can be proven that the insured risk has led to a direct monetary loss, not just due to the occurrence of the risk. For instance, Mr. John cannot be allowed to insure his neighbors property. This is because he will not lose anything if the property is destroyed. This principle hinders individuals from deliberately causing harm to the property or lives of others with an aim of seeking a compensation.
The basic assumption of life insurance implies that people do care about protecting their own lives. Likewise, it is assumed that one can have an insurable interest in the lives of their spouse and children. In view of this, there is sufficient insurable interest that allows the husband to take a policy on the life of the wife. Or, the father to take one on the life of the child.
2. Indemnity
The insurance company is only required to provide the necessary sum of money to replace the property which was lost or damaged. This principle seeks to ensure that the insured person is placed in exactly the same financial position that he would have been if the loss had not happened.
It is utterly unthinkable to estimate the value of a human life or even his/her physical well-being in terms of money. However, when it comes to life insurance, it clearly states the amount of money that will be paid out to the beneficiaries of the insured person in the unfortunate event that he/she dies, suffer misfortune, or gets an injury.
3. Subrogation
Subrogation means that once you are fully compensated, any remaining property belongs to the insurance company. This principle works alongside the principle of indemnity to prevent someone from benefiting from a loss.
If Mary’s car is involved in a severe accident and her insurance company fully reimburses her for the car’s total worth, the leftover parts or scrap metal from the car becomes the insurance company’s rightful property.
Kindly note that this principle does not apply to life insurance, as there is no property to subrogate in that case.
4. Utmost Good Faith (Uberrima Fides)
Under the principle of utmost good faith, policyholders are expected to disclose all relevant information regarding the property or life being insured. If this is not done then there are likely to be consequences of having the contract nullified and no form of compensation is offered. If someone has a terminal illness, they must promptly disclose it to the insurer.
What is the function of the insurance?
- To guard against potentially unfavorable occurrences in the future. It is a prevention against bearing the cost of loss.
- To share the financial losses of a few among many others. All the insured contribute the premiums towards a fund, out of which the person exposed to a particular risk is paid. It’s a collective bearing of risk.
- To evaluate various factors that give rise to risk and determine the probable volume of risk. This is the basis for determining the premium rate
- To caution people and businessmen to adopt suitable methods to prevent the unfortunate consequences of risk. For example, observing safety instructions like the installation of alarm systems, etc. This makes the insurance companies reduce the amount of premiums you pay, which is saving you money.
How insurance works
A company, the insurer, offers a guarantee for a certain risk that may or may not occur, and then another party, the insured, pays the insurer in exchange for protection against that risk.
For instance, there are two people – Mike and Andrew. Mike says to Andrew, “I’m traveling to a remote area and won’t need a phone. Well, I’ll leave you my phone and give you ten dollars to make sure it is kept safe. If I lose or damage my cell phone, then you must go out and buy me a new one”. Mike believes that Andrew probably won’t lose his phone. If Andrew agrees, then that’s insurance right there.
When Mike returns and finds that Andrew hasn’t lost his (Mike’s) phone, Andrew will be ten dollars richer. If Andrew finds 100 more people who are willing to give him 10 dollars each to cover their phones, he’ll have 1,000 dollars. If one of those 100 people loses their phone and Andrew pays 100 dollars as compensation, he still has 900 bucks.
The law of large numbers
Insurance companies use the law of large numbers to operate. This means that they need a large group of people who face similar risks spread out over a certain area. In this way, the risks are not all placed in one location but are evenly distributed.. This law assists these companies in estimating the future number of losses and persons who will require insurance.
The idea behind this is that only a few people in the group will suffer a loss. This assists it in determining how much money people should be willing to pay in order to be insured. Everyone in the group pays premiums into a common pool. This is called “pooling of risks.”
If someone suffers a loss, the money to fix it comes from the pool. The losses of the few are spread out among all the contributors, so each person only bears a small portion of the total loss. The whole group shares the loss. This is why individuals don’t feel the full burden of this loss. The insurance company manages and controls this pool. These companies make money because they evaluate the risk and decide whether it is worth the gamble.
Conclusion
Insurance is a contract where you pay a fee to an insurance company for financial protection. Its role is to serve as a risk mitigation mechanism, help to allocate the price of risks among a large number of people, assess the probability and impact of risks, and encourage people to practice safety. It is based on four important principles, which include insurable interest, indemnity, subrogation, and utmost good faith which are the foundation of insurance agreements. You should know these terms alongside others like premiums, policyholders, and beneficiaries to appreciate the intricacies of such contracts.
As insurance companies work by spreading the risks and applying the law of large numbers. This means the losses are distributed among the members of the group. No particular person within the group is likely to be a victim of colossal loss due to misfortune. These are some insurance basics you’ve learnt about to make smart financial decisions and manage risk effectively.
