Definition and purpose of insurance

Summary

Insurance is a risk-management arrangement in which one party (the insurer) agrees, for a fee (a premium), to compensate another party (the insured/policyholder) if a specified loss, damage, or injury occurs. The transaction is formalized in an insurance policy, which sets out the conditions under which compensation will be paid, and the loss must be reducible to financial terms. The purpose of insurance is to protect against contingent or uncertain financial loss by pooling funds from many insured entities. Instead of bearing a potentially large loss alone, the policyholder accepts a guaranteed, relatively small payment (the premium), while the insurer promises to cover losses that fall within the policy’s scope. Typically, the insured must have an insurable interest in what is being insured, established through ownership, possession, or a pre-existing relationship.

Key Points

• 1

  Insurance provides financial protection against specified, uncertain losses in exchange for a premium.

• 2

  The insurance policy defines the covered events and the circumstances under which the insurer will pay.

• 3

  Insurance works by pooling funds from many policyholders to reduce the impact of losses on any single party.

• 4

  An insurable interest is usually required so the insured has a stake in the loss being covered.