GIM1110 | Economic basis of insurance: risk and premiums

Although complicated in practice the insurance mechanism is essentially quite simple. An insured person may pay £500 to his insurer for comprehensive cover for his car. He may not see a penny for his £500, and indeed he hopes not to do so. However, his insurer may have to pay say £15,000 if the policyholder writes off his car, and possibly £1 million or more in the event of an accident involving traumatic personal injury. Similarly, private individuals may insure their house against fire and other perils, or personal belongings against theft. A private policyholder pays a (relatively) small certain sum, a premium, for protection from the financial loss which may arise from the specified peril and which might otherwise be difficult or impossible to bear. Thus even at the level of the private individual the availability of insurance may encourage economic activity in the form of the purchase of a car or a house. A manufacturer may similarly insure a factory against damage or destruction by fire or some other peril, and may in addition take out loss of profits insurance against the possibility of interruption of the manufacturing process by the peril. Again the availability of insurance may be one factor in deciding to invest in plant or premises, by eliminating a degree of uncertainty from the potential costs. From this perspective Vaughan (GIM1090) gives the following definition of insurance:

‘From an individual point of view, insurance is an economic device whereby the individual substitutes a small certain cost (the premium) for a large uncertain financial loss (the contingency insured against) which would exist if it were not for the insurance.’