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The Basis of Insurance

Life insurance is among the largest and most important industries in the United States and worldwide for that matter. There are five categories when it comes to insurance policies: fire, marine, casualty, surety, and life. In combination, these five forces control billions and billions of dollars in assets and collect more than fifteen billion dollars per year in premiums. It is extremely rare to come across a business, or even a family home, that doesn’t have some form of protection in regard to insurance, especially life insurance.

The main purpose of insurance is to offset the possibility of loss resulting from a number of potential tragedies that expose themselves to a person or his/her property. When it comes to the question of what risk entails, it is defined in The Dictionary of Insurance Terms, published by the Chamber of Commerce in the United States, as “a chance of loss.” Webster defines risk in the same way. Another term commonly used in insurance parlance is “hazard.”

It would help in the understanding of insurance however, if we would distinguish between these three terms: “risk,” “chance of loss,” and “hazard” independently of one another.

In the abstract, risk is defined as uncertainty, with reference to the uncertainty of financial loss and has little to do with the loss itself. Risk principally has to do with the uncertainty of a loss, with the degree of risk measured by the probable variation of actual experience from expected experience.

Chance of loss is best described as a fraction or percentage. It indicates the probable number and severity of losses out of a given number of exposures. If you flip a coin, your chance of loss is ½, or 50 percent. In this case, calculating the chance of loss is easy. When it comes to life insurance, the task is not as simple. With situations involving loss by fire, windstorm, and other perils, we cannot rely solely on logic; instead, we have to collect a mass of statistical data.

For instance, if we are interested in the probability of a loss to our house by fire, we would have to collect all the statistics we can find concerning fires. We would need to know how many fires occurred during a given time and how many houses were exposed to fire losses during that period. The same principal is used in determining the chance of death at any given age. If we find out that out of 1,000 persons alive at the age of 75, only 911 live to reach their seventy-sixth birthday, we can express the chance of death during the seventy-fifth year as the fraction 89/1,000, or 8.9 percent—this percentage can now be used to determine what type of life insurance is necessary.

Looking at the term “hazard,” we are considering perils, the things that ostensibly cause loss. It is necessary, however, to go behind the perils to find the real cause. The fire that breaks out in the garage, for example, is the peril; but the pile of oily rags which is left lying around is the cause of the fire and thus is the real cause of the loss. Hazard may be defined as a condition that may create or increase the chance of loss arising from a given peril. Things like carelessness, bad highways, and dangerous employments are hazards, for they are conditions that increase chance of loss.

With these definitions in mind, life insurance provides a mechanism for the sharing of losses, as well as for performing other important social functions. The most important goal is to prevent the losses before they occur. All in all, it is certainly in one’s best interests to understand life insurance basics, investigate the risk of losses, and choose wisely amongst the various types of life insurance.

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