Insurance – Definition, Principles and Functions

Life is a roller coaster ride and is full of twists and turns. Insurance policies are a safeguard against the uncertainties of life. As in all insurance, the insured transfers a risk to the insurer, receiving a policy and paying a premium in exchange. The risk assumed by the insurer is the risk of death of the insured in case of life insurance. Insurance policies cover the risk of life as well as other assets and valuables such as home, automobiles, jewelry etc. On the basis of the risk they cover, insurance policies can be classified into Life Insurance and General Insurance. Life insurance products cover risk for the insurer against eventualities like death or disability. General insurance products cover risks against natural calamities, burglary, etc.

functions of Insurance

Insurance is system by which the losses suffered by a few are spread over many, exposed to similar risks. With the help of Insurance, large numbers of people exposed to a similar risk make contributions to a common fund out of which the losses suffered by the unfortunate few, due to accidental events, are made good. Insurance is a protection against financial loss arising on the happening of an unexpected event. Insurance policy helps in not only mitigating risks but also provides a financial cushion against adverse financial burdens suffered.

Insurance is defined as a co-operative device to spread the loss caused by a particular risk over a number of persons who are exposed to it and who agree to ensure themselves against that risk. Risk is uncertainty of a financial loss. Insurance is also defined as a social device to accumulate funds to meet the uncertain losses arising through a certain risk to a person injured against the risk. Insurance provides financial protection against a loss arising out of happening of an uncertain event. A person can avail this protection by paying premium to an insurance company. A pool is created through contributions made by persons seeking to protect themselves from common risk. Any loss to the insured in case of happening of an uncertain event is paid out of this pool.

Life insurance has come a long way from the earlier days when it was originally conceived as a risk-covering medium for short periods of time, covering temporary risk situations, such as sea voyages. As life insurance became more established, it was realized what a useful tool it was for a number of situations that includes temporary needs, threats, savings, investment, retirement etc. Insurance is a contract between two parties whereby one party agrees to undertake the risk of another in exchange for consideration known as premium and promises to pay a fixed sum of money to the other party on happening of an uncertain event (death) or after the expiry of a certain period in case of life insurance or to indemnify the other party on happening of an uncertain event in case of general insurance. The party bearing the risk is known as the ‘insurer’ or ‘assurer’ and the party whose risk is covered is known as the ‘insured’ or ‘assured’.

The definition of insurance can be seen from two view points:

  • Functional Definition – Insurance is a co-operative device of distributing losses, falling on an individual or his family over large number of persons each bearing a nominal expenditure and feeling secure against heavy loss.
  • Contractual DefinitionInsurance may be defined as a contract consisting of one party (the insurer) who agrees to pay to other party (the insured) or his beneficiary, a certain sum upon a given contingency against which insurance is sought.

Principles of Insurance

Insurance is based upon two basic principles.

  1. Principles of Co-operation: Insurance is a co-operative device. If one person is providing for his own losses, it cannot be strictly insurance because in insurance the loss is shared by a group of persons who are willing to co-operate.
  2. Principles of Probability: The loss in the form of premium can be distributed only on the basis of theory of probability. The chances of loss are estimated in advance to affix the amount of premium. Since the degree of loss depends upon various factors, the affecting factors are analyzed before determining the amount of loss. With the help of this principle, the uncertainty of loss is converted into certainty. The insurer will not have to suffer loss as well as gain windfall. Therefore, the insurer has to charge only so much of amount which is adequate to meet the losses.

The insurance, on the basis of past experience, present conditions and future prospects, fixes the amount of premium. Without premium, no co-operation is possible and the premium cannot be calculated without the help of theory of probability, and consequently no insurance is possible.

Functions of Insurance

The functions of Insurance can be bifurcated into Primary functions and Secondary functions.

1. Primary Functions of Insurance

The primary functions of insurance include the following:

  1. Provide Protection: The primary function of insurance is to provide protection against future risk, accidents and uncertainty. Insurance cannot check the happening of the risk, but can certainly provide for losses of risk. Insurance is actually a protection against economic loss, by sharing the risk with others.
  2. Assessment of risk: Insurance determines the probable volume of risk by evaluating various factors that give rise to risk. Risk is the basis for determining the premium rate also.
  3. Collective bearing of risk: Insurance is a device to share the financial loss of few among many others. Insurance is a mean by which few losses are shared among larger number of people. All the insured contribute premiums towards a fund, out of which the persons exposed to a particular risk are paid.
  4. Savings and investment: Insurance serves as a tool for savings and investment, insurance is a compulsory way of savings and it restricts the unnecessary expenses by the insured. For the purpose of availing income-tax exemptions, people invest in insurance also.

2. Secondary Functions of Insurance

The secondary functions of insurance include the following:

  1. Prevention of Losses: Insurance cautions individuals and businessmen to adopt suitable device to prevent unfortunate consequences of risk by observing safety instructions; installation of automatic sparkler or alarm systems, etc. Reduced rate of premiums stimulate more business and better protection to the insured.
  2. Small capital to cover large risks: Insurance relieves the businessmen from security investments, by paying small amount of premium against larger risks and uncertainty.
  3. Contributes towards the development of large industries: Insurance provides development opportunity to large industries having more risks. Even the financial institutions may be prepared to give credit to sick industrial units which have insured their assets including plant and machinery.
  4. Source of Earning Foreign Exchange: Insurance is an international business. The country can earn foreign exchange by way of issue of insurance policies.
  5. Risk Free Trade: Insurance promotes exports insurance, which makes the foreign trade risk free with the help of different types of policies under marine insurance cover.