Primary Functions of Insurance
1. Risk transfer: Insurance is a risk transfer mechanism, whereby the individual or the business enterprise can shift some of the uncertainty of life on to the shoulders of others in return for a known premium, usually a very small amount compared with the potential loss; the cost of that loss can be transferred to an insurer. Without insurance, there would be a great deal of uncertainty experienced by an individual or an enterprise, not only as to whether a loss would occur, but also as to what size it would be if it did occur.
2. The common pool: The insured’s premium is received by the insurer into a fund or pool for that type of risk, and the claim of those suffering losses are paid out of this pool. An insurance company will pay its motor claims out of the monies it has received from those because of the large number of clients in any particular fund or pool. The insurance company can predict with reasonable accuracy the amount of claims likely to be incurred in the coming year. There will be some variation in claims costs from year to year and the premium includes a small margin to build up a reserve upon which the company draws in bad years. Therefore, subject to the limitations of the type of cover brought, the insured will not be required to make further contributions to the common pool after the loss.
3. Equitable premiums: The contributions paid to the fund should be fair to all the parties participating. In fixing the level of premium for each case,
- He must try to ensure that the level of contribution made to the fund by a particular policyholder is equitable compared to the contributions of others, bearing in mind the likely frequency and severity of claims which may be made by that policyholder.
- The level of premium fixed must be relatively competitive, otherwise the insurer will go out of business due to lack of new orders.
To summarise, the primary function of insurance is to provide a risk transfer mechanism by means of a common pool into which each policy holder pays a fair and equitable premium, according to the risk or loss he or she brings to the pool.
Subsiding Functions
a. Security
b. Loss Prevention: Fire Surveyors are trained to identify sources of potential risk in the production process, storage of materials and the use of electricity, etc. They make recommendations which will limit the incidence of loss from these sources to a minimum.
- Theft Surveyors: Make recommendations for the protection of property against thieves. The protective devices installed on their recommendation will deter many casual thieves, thereby reducing the number of losses.
- In a similar manner, the Liability Surveyor will endeavour to advise the businessman or employer in ways to prevent claims from the public due to their operators or products or from employees, due to usage conditions of work.
- Loss control: The various surveyors mentioned above are concerned not only with preventing loss (which can never be achieved fully due to human limitations), but also with the limitation or control of losses which do occur. For example, the Fire Offices Committee (FOC) lays down rules and regulations as to the buildings, design of fire doors, sprinkler installations and alarm systems, so that fire which start may be contained for sufficient time to enable the public fire service to get to the scene and extinguish the blaze before it becomes a major disaster.
- Loss Adjusters: The investigation of losses, their causes and the values involved, is often a highly technical process which requires very quick action after the loss in order to assess these factors accurately and take steps to minimize further loss. These experts contribute greatly to the limitation of the cost of loss, by knowing how best to bring a business on its feet again quickly, where to purchase or hire temporary plant, where to dispose or salvage at the best price, and so on.
- Social benefits: When the multiplier effect of the reduced income of a group of workers is taken into account, society at large in that locality may suffer if a firm goes into liquidation after an uninsured loss. But where the full consequential loss (i.e. loss of profits, temporary loss of job by workers, etc) insurance has been arranged, the aid which insurance provides in monitoring industry in an area stabilizes the economy and in aggregate helps to stabilize the national economy through the continued sources of rates and taxes.
- Savings: Another benefit which stems from the provision of life assurance cover, is the use of endowment assurances as a means of saving e.g. for retirement, house purchase mortgage and children’s education. As these contracts are long term, the temptation to end the contract early has financial penalties by way of surrender values below the value paid in. The saver is therefore more inclined to keep on paying the premium, compared with saving in a bank or building society.
- Investment funds: insurers, as custodians of premiums paid, invest these funds so that they are available when required, be it in the case of property claims, liability claims or life assurance.
Characteristics of insurance risk
- Financial value: The risk must involve a loss that is capable of financial measurement. Insurance is concerned only with situations where monetary compensation is given for a loss. This feature of the insurable risk is easily identified in, for example, damage to property where the level of compensation can be equated with the cost of pains. Where someone is injured by you in, for example, a motorcar accident then the court will decide how much the injured person should receive in compensation. This amount is the financial measure of your risk.
- Homogeneous exposure: There must be a large number of similar, homogeneous risks before any one in that number is capable of being insured. The first is that the measurement of risk by probabilities and statistics relies on reasonable experience of past events. Statistics have been compiled by most insurance companies on common risks such as fires, explosion, motor accidents, theft, injuries and deaths. The second is that if there were only three or four exposures, then each one would have to contribute a very high amount if losses were to be met from these contributions. On the other hand, if there were thousands of similar exposures then the contributors could be compensated very small amount as only a few would be unfortunate enough to suffer a loss and hence refuse it to be met from the contributions. The insurance of household contents against fire is an example homogeneous exposure, whereas the insurance a concert privatisation is not.
- Pure risks only: Insurance is concerned only with pure risks. Speculative risks, where there is the possibility of some pain, cannot be insured.
- Particular and fundamental risks: Particular risks are generally insurable provided they satisfy the other criteria of insurable risks. Fundamental risks however do not present such a straightforward picture. The widespread, indiscriminate nature of the effect of most fundamental risk has resulted in them, traditionally, being uninsurable and insurers are very careful in selecting those for which they wish to provide cover. Fundamental risks that arise out of the nature or society we live in are largely uninsurable and those that arise due to some physical occurrence base their insurability on the circumstances. As a result war and changing customs are largely uninsurable. Fundamental risks due to some may be insurable but this could depend for example, on the geographical location or the object being insured.
- Fortuitous: the loss must be entirely fortuitous as far as the person seeking insurance is concerned. It is not possible tom insure against an event that will occur with certainty, as in such a case, there would be no risk, no uncertainty of loss. The frequency and severity of any risk must be completely beyond the control of the person insuring. In case of life, even though death is certain but the timing is not certain, hence fortuitous.
- Insurable interest: One of the basic doctrines of insurance is that the person insuring must be the one who stands to suffer come financial loss if the risk materialises.
- Against public policy: It is a common principle in law that contracts must not be contrary to what society considers the right and moral thing to do. This applies to insurance contracts in the same way, and one form of risk that is not insurable is one that is against public policy. It would not be acceptable to society at large if a person could burn down his own factory or shop in order to recover insurance money intended to penalize the person and while insurance may be available to meet the losses following, say, a motor accident it is not possible to provide insurance to who was found guilty of some offence.
- Reasonable premium: The premium must be seen to be reasonable in relation to the likely financial loss.
- Catastrophic: The risk to be insured must not be catastrophic in nature.
