Principles of Insurance
Insurance is ultimately about risk transfer. One party (the insurer) agrees to take on the risk of another (the policyholder) in return for some benefit (premium).
Business insurance as we know it today began in Mr Edward Lloyd’s coffee house in London in the late 17th century. Ship owners, merchants and captains would meet to arrange insurance for their ships and cargo. In those times, when international shipping journeys were much longer and more perilous, those whose ships made it back to London made a large profit whereas those that did not return suffered a large loss.
It was not known which ships would return and which would not and therefore if the risk was shared between all ship owners then everyone shared a smaller amount of the loss, rather than a few suffering a large loss.
What are some of the underlying principles?
Unexpected event – The event that causes a loss needs to be unexpected, as in it is not known when or if the event will occur. For example if we use our Lloyd’s coffee house situation, if you knew your ship was about to sail into a very large storm and you decided to then purchase insurance, the event of damage by a storm would no longer be as unexpected.
Amount of Loss – It needs to be known what the potential loss will be. For Lloyd’s it would have been the cost to build a new ship and the cost of the cargo if it was totally damaged or lost.
Quantifiable risk – There needs to be enough information about the frequency of the type of events that might cause a loss. For Lloyd’s it would have been the number of ships that did not return to port compared with the total number of ships.
Sufficient pool of similar risks – There also needs to be a sufficient number of risks that are similar enough to each other so that the premium paid collectively can cover the events that cause loss to a few. For Lloyd’s all the ships paying premiums together shared the cost of the few ships that were lost.
Example of this in practice – Professional indemnity insurance
These principles can be applied to all types of insurance both business and personal. The premiums of many, pay for the claims of a few. Let’s look at how these principles are applied for professional indemnity insurance for a contractor:
- Unexpected event
It is not known which contractor will make a mistake in their work, which will cause the contractor’s client a loss.
- Amount of loss
From the history of claims and mistakes by contractors an insurer can estimate the average amount paid out in claims.
- Quantifiable risk
Again from the history of claims, insurers are able to build up a history of the frequency of such claims.
- Sufficient pool of similar
There are a large number of contractors with a similar risk exposure from providing professional services.
Because an insurance company has all these factors, when it calculates your premium it is factoring in the chance of you having a professional indemnity claim by the average cost of these types of claims. There is a large windfall or benefit to the person who has a claim and for many others they receive peace of mind that they have been protected against such a risk.
Disclaimer: There are other factors and policy exclusions that may influence whether a claim is covered by a policy or not. Policy coverage will solely be determined by the policy documents and policy wording, and no reliance can be placed on the content of this blog post whatsoever. The content and examples of this blog post are only given to provide a general understanding or to help explain a specific concept.