Insurance is all about spreading of risk and sharing of losses. It can only work in case of pure risk.
The dictionary defines insurance as “a contract (policy) in which an individual or entity receives financial protection, or reimbursement against losses from an insurance company, which pools client’s risks to make payments more affordable, in exchange for as premium.
There are few important points in this definition, which may escape attention at first glance. They are: (1) In the event of loss, the insurance company will only indemnify the insured to the extent of loss. (2) Insurance works on the concept of pooling in money. Therefore, we can also say that insurance is all about ‘spreading of risk and sharing of losses’. Assume that there are around 3,000 cars, each costing Rs 3 lakh and exposed to the same probability of meeting with fatal accident in a city. Past record suggests that each year, three out of the 3,000 cars meet with fatal accidents. This means that each car owner is relatively safe as he only faces a 0.1% chance of a fatal accident. However, should he be so unlucky as to be in the 0.1% bracket, his loss will be huge. By setting up a common fund of Rs 9 lakh to be used to compensate any three car owners who meet with an accident, each owner gains the assurance that any loss arising from the risk is minimized. To accumulate this fund, each car owner only needs to contribute an affordable premium of only Rs 300. Here it is important to note that insurances can only work in case of figure risk.
Pure risk is one where there are only two outcomes possible: (1) Loss (2) No loss/status quo. In our above example, either a car owner can meet with an accident or he may not meet with an accident. The third outcome, that is his car’s condition improving every year, is not possible.
On the other end, in case of a speculation and investment risks, there are three outcomes possible: (1) loss (2) no loss/status (3) gain. When we invest in stock market we can make money, loose money or there is no profit no loss situation. There is no formal insurance available to protect ourselves from losses suffered in speculative / investment risks. There are three kinds of pure risk. They are: (a) Personal Risk: Events which can affect our income generating capacity are personal risk, such as illness, disability death, loss of job, accident, among others. (b) Property Risk. Events which can cause loss or damage to our property are called property risks. Examples: fire, floods, theft, loss or damage to objects, and so on. (c) Liability Risk: This risk places liability on an individual for harm done to a third party due to neighbors like loss of limb of pedestrian while driving a car rashly, death of a maid servant at home due to electric shock or negligence by a professional, among others.
There is also another type of insurance covering loss of Rockets, space satellites and similar ones where the loss in the event of failure or loss is huge. Such are covered by 3 or 4 insurance companies and if one company issues a policy they can also reinsure with a few other insurance companies so that losses if any are shared by all in the proportion of insurance liability.
Insurance can be categorized into Life, General and Medical. Life Insurance is for an individual saving during his life time and after retirement gets large sum of money which he can invest and based on the returns of the amount live with peace during rest of his life. General Insurance is for Industrial damages while Medical is for Health insurance.