What is insurance: how do many people paying a little each cover one person's big loss?

There are a hundred cafés in a town. Each of them fears fire: there is flame, gas and electricity in the kitchen. Fires are rare, but if one happens, for a single café owner it means losing all their savings. Now imagine: the hundred owners agreed that each would put 500 000 soum a year into a common "pot". The pot collects 100 × 500 000 = 50 000 000 soum. If during the year a fire breaks out in one café and causes a loss of 40 000 000 soum, it is covered from this pot. Everyone lost a little, nobody was ruined completely. This is the core idea of insurance.

What is insurance?

Insurance is a promise to cover a loss when an unexpected event specified in a contract occurs, in exchange for an agreed fee. On one side stands the policyholder, who pays money and receives protection; on the other side stands the insurer (the insurance company), which collects the money and covers losses.

Key words:

• Insurance premium: the fee paid for protection. Do not be misled by the name: the customer does not receive it but, on the contrary, pays it.
• Insured event: an event specified in the contract that gives grounds for covering the loss.
• Policy: the document confirming that the contract has been concluded.

The scientific name for the idea we saw in the example above is risk pooling: a large risk that cannot be predicted for each individual participant turns into a small payment that can be calculated for the many. A real insurer, of course, does not just hold the pot: it calculates the risk, covers its own expenses and keeps reserves.

Where does the word come from?

As for the Uzbek word «sug'urta», we could not find a consistent, clear account of its origin in reliable dictionaries, so we will not guess here.

The path of the English word insurance, however, is known. According to the Online Etymology Dictionary, the verb "insure" is a spelling variant of "ensure" and comes from the Anglo-French word enseurer: en- "to make" and Old French seur "safe, sure". Literally: "to make sure". According to the same dictionary, the commercial sense "protection against loss in exchange for payment" is recorded in English from the 1650s; before that the word "assurance" was used in this sense.

The name captures the essence well: insurance does not eliminate risk, but it makes the future more certain.

Why it is needed: its function and purpose

The main purpose of insurance: to spread the large loss caused by an unexpected event among many people and so preserve the financial stability of an individual person or business. In practice it helps with the following:

1. So that one event does not destroy the whole business. If the café burns down, the owner finds the money to start again.
2. To make borrowing easier. If the property pledged as collateral is insured, the risk for the bank is lower.
3. For the family's peace of mind. Home, car or health insurance turns an unexpected large expense into a small payment known in advance.
4. To plan expenses. Instead of the uncertainty of "what if there is a fire?", the business has a definite figure: the annual premium.

Who it works with and who contributed

In insurance, agents and brokers work with customers, the actuary calculates risk and price, and the accountant reflects premiums and payments in the accounts.

To learn how insurance came about, here are the history articles: «Where did insurance begin: who paid the merchant whose cargo was thrown overboard?», «The coffee house and the fire: how did London turn insurance into a business?» and «Halley's table: how was the price of life insurance calculated?». The links are at the end of the page.

In the next lesson

In the second lesson we will look in more detail, using one example, at the parties to an insurance contract and its key terms.