Search Knowledge Base

< Back
You are here:

Definition of Insurance

Source: Insurance, Banking & Negotiable Instruments Law Teaching Material

Insurance may be defined in various ways. Firstly, from the point view of an individual it may be defined as a risk transfer mechanism or an economic device whereby a person, called the insured/assured transfers a risk of a possible financial loss resulting from unforeseeable events affecting property, life or body to a person called the insurer for consideration. For instance, let us take a case of an owner of a motor vehicle, who always runs the risk of suffering a financial loss resulting from the loss or destruction of his property because of unforeseeable events such as fire, collision, overturning or even theft. Therefore, if the person purchases a motor insurance policy covering these risks from an insurer, it means that he transferred this possible financial loss to the insurer. 

Secondly, from the point of view of the insurer, insurance may be defined as a mechanism through which a risk is distributed among the group of persons who are exposed to the same type of risk, i.e., persons who bear the risk of suffering a financial loss as a result of events affecting property, life or body. We can further clarify this definition through the following example. 

Let us say that X insurance Company has, through its various branches, sold 200,000 fire insurance policies, i.e., policies that cover losses related to buildings(residential, or business…) so that the insurer will have to pay compensation to the insured or the beneficiary of the policy in case where such property is destroyed by fire or lightening. The money collected from the sale of these policies form the pool out of which compensation shall be paid to those persons who have suffered financial loss because of damage to the insured buildings houses or businesses. Let us say that in the given financial year 50,000 policyholders have sustained financial losses /or lost their properties because of various causes which are covered by the policy. So, the insurer according to the obligation it has undertaken pays compensation to these policy holders out of the pool mentioned above, i.e., the price collected by the insurer from the sale of the policies (premium). This in other words means that all 200,000-policy holders who have paid the premium have contributed to the compensation paid to those who have sustained losses. This also means that, the insurer has distributed the losses sustained by the 50,000 policyholders among the remaining 150,000 policyholders whose properties were not damaged or destroyed in the given year. 

Form the definitions provided above, we can understand that insurance is a cooperative economic device to spread the loss caused by a particular risk over a number of persons who are exposed to it and who agree to insure themselves against that risk. This means that insurance provides a pool to which many persons contribute a certain amount of money called the premium, and out of which the insurer compensates the few who suffer losses. This is always true in the case of property and liability insurance which cover contingencies  and given for a short period of time, usually a period of one year, but does not so fully apply to insurance of persons particularly life insurance(see Art 692) in which the policy usually becomes a claim ultimately. 

We can also understand that by insurance, the risk is transferred from the individual to the insurer who takes into account the total or probability of loss in a certain period, and then fixes the premium to be paid by each person insured. 

For example, in the case of motor vehicle insurance, if the total likely loss of Euro Trucker Trucks is 50 per year, valued Birr one million each and the total number of trucks expected to be on voyage per year is estimated to be 25,000 trucks, the premium for each truck will be 

                   50 x 1,000,000 = Birr 50,000,000 = Birr 2000 plus    

                    25,000                          25,000 

certain amounts of money, say Birr 500, for administration expenses and profit, i.e., Birr 2500. Thus, it can be seen that insurance is a device by which an insured person can protect himself from heavy loss likely to be caused by an uncertain event by paying a comparatively much smaller sum of money as premium. 

It has to be noted that insurance does not and cannot prevent loss of property, incurring civil liability, death, or injury or illness, rather it provides financial compensation for the effects of misfortune. In other words, we can say that insurance does not protect the insured property from loss or damage, or the insured from incurring civil liability or the insured person from death or injury or illness, but provides a financial compensation to the insured or the beneficiary who has suffered pecuniary losses as a result of loss or damage to property, or because he has incurred a civil liability or illness or death of the insured.  

Leave a Reply

This site uses Akismet to reduce spam. Learn how your comment data is processed.

Table of Contents