What is Insurance

Insurance is a means of providing protection against financial loss in a great variety of situations. For example, life insurance helps replace income lost to a family if a wage-earning parent dies. Health insurance helps pay medical bills. Fire insurance pays all or part of the loss if a homeowner's house is destroyed by fire. Automobile insurance helps cover the costs of damages resulting from a car accident. People also can buy insurance to cover unusual types of financial losses. For example, athletes can insure their bodies against injury.

Insurance works on the principle of sharing losses. People who wish to be insured against particular types of losses agree to make regular payments, called premiums, to an insurance company. In return, these people receive a contract, called a policy, from the company. The company promises to pay them a certain sum of money for the types of losses stated in the policy. The individuals paying premiums are called policyholders. The amount of money paid by the insurance company to the policyholders is known as the benefit or the claim.

The insurance company uses the premiums to buy stocks, bonds, mortgages, government securities, and other income-producing investments. The company pays benefits from the premiums it collects and from the investment income the premiums earn. Insurance works because policyholders are willing to trade a small, certain loss-the premiums-for the guarantee that they will be indemnified (paid) in case of a larger loss.

Although a policyholder may never receive benefits from an insurance company, the premiums have not been wasted. Insurance gives policyholders a feeling of security. Policyholders know they will be indemnified if a loss should occur. They can therefore own property, drive a car, operate a business, and engage in many other activities without worrying about the financial losses that might result.

Insurance works well only when the possible losses to the insured person can be estimated. Insurance companies take advantage of the laws of probability. These laws enable an insurance mathematician called an actuary to determine the likelihood that an event will occur. Laws of probability are based on the law of large numbers. As the number of auto insurance policyholders increases, for example, an insurance company can use this law to predict with ever-greater accuracy the number of policyholders who will be in an accident.

Insurance generally covers only situations involving pure risk-that is, situations in which only losses can occur. Such situations include fire, flood, and accidents. Insurance does not cover gambling and other speculative risks, in which either losses or gains may result.