Insurance is a very common term used in our day-to-day life. Ideally, insurance is a form of risk management and this is clearly defined in law and economics. It might be hard to digest that insurance falls under risk management but a simple definition of the term will certainly help you to understand this. The basic explanation for insurance includes the fact that it is used to evade risk which can arise due to any unexpected losses. In another version of explanation, insurance is also put together as an unbiased transfer of risk from one entity to the next, which involves exchange of payment.
There are several common terms which are used in the context of insurance such as the company putting forth the insurance is known as the insurer; the person buying the insurance is called as the insured and the chargeable fees for a certain amount of insurance coverage which is known as the premium. Based on the type of strategy which the insured undertakes to buy, he/she receives a contract which is named as the insurance policy.
Insurance is aptly categorized under the label of risk management and risk sharing. In order to understand the ‘risk sharing’ aspect of insurance, you need to comprehend the fact that the premiums and losses of all policyholders in a particular group are calculated on the basis of a predetermined formula and thus the risk factor clearly stands as shared.
In simpler terms, insurance can be co-related to risk sharing as it is the fact that several people pay to overcome the losses which has been incurred by a few and the core idea behind this strategy is that it is truly unpredictable. Treating insurance as a means of investment is not a great idea. The prime problems dealt with insurance mainly include fake losses and losses being exaggerated. The core reason for the cause of these problems is the fact that insurance companies try to sell their policies only to the low risk part of the population. Insurance may also lead to failure of coverage which may result even if the insurance is appropriately priced to loss probability. This is because either low risk may arise which adds up little money to the pool, poor people are treated as low risks who would not dare to participate and the same poor people can become high risks as they are unable to participate in this as they cannot afford the premium.
Thus, in all, it can be rightly concluded that insurance is definitely a form of risk sharing and it is this aspect which adds up to the positive qualities of an insurance policy.