Purpose and Need of Insurance

The business of insurance is related to the protection of the economic value of assets. Every asset has value. The asset would have been created through the efforts of the owner, in the expectation that, either through the income generated there from or some other output, some of his needs would be met. In the case of a factory or a cow, the production is sold and income generated. In the case of a motorcar, it provides comfort and convenience in transportation. There is no direct income. There is normally expected life time for the asset during which time it is expected to perform. The owner, aware of this, can so manage his affairs that by the end of that life time, a substitute is made available to ensure that the value or income is not lost. However, if the assert gets lost earlier, being destroyed or made non functional, through an accident or other unfortunate event, the owner and those deriving benefits there from suffer. Insurance is mechanism that helps to reduce such adverse consequences.


Assets are insured, because they are likely to be destroyed or made non-functional through an accidental occurrence. Such possible occurrences are called perils. Fire, floods, breakdowns, lightning, earthquakes, etc, are perils. The damage that these perils may cause the asset, is the risk.

The risk only means that there is possibility of loss or damage. It may or may not happen. There has to be uncertainity about the risk. Insurance is done against the contingency that it may happen. Insurance is relevant only if there are uncertainties. If there is no uncertainty about the occurrence of an event, it cannot be insured against.

There are other meanings of the term ‘risk’. To the ordinary man in the street risk means exposure to danger. In insurance practice risk is also used to refer to the peril or loss producing event. For example, it is said that fire insurance covers the risks of fire, explosion, cyclone, flood etc. again, it is used to refer to the property covered by insurance. For example, a timber construction is considered to be a bad risk for fire insurance purpose. Here the term risk refers to the subject matter of insurance.

Conceptually the mechanism of insurance is very simple. People who are exposed to the same risks come together and agree that, if any one of the members suffers a loss, the others will share the loss and make good to the person who lost. All people who send goods by ship are exposed to the same risk related to water damage, ship sinking, piracy, etc. those owning factories are not exposed to these risks, but they are exposed to different kinds of risks like, fire, hailstorms, earthquakes, lightening, burglary, etc. like this, different kinds of risks can be identified and separate groups, made including those exposed to such risks. By this method, the risk is spread among the community and the likely big impact on one is reduced to smaller manageable impacts on all.


The manner in which the loss is to be shared can be determined before hand. It may be proportional to the likely loss that each person is likely to suffer, which is indicative of the benefit he would receive if the peril befell him. The share could be collected from the members after the loss has occurred or the likely shares may be collected in advance, at the time of admission to the group. Insurance companies collect in advance and create a fund from which the losses are paid.

A human life is also an income generating asset. This asset also can be lost through unexpectedly early death or made non-functional through sickness and disabilities caused by accidents. Accidents may or may not happen. Death will happen, but the timing is uncertain. If it happens around the time of one’s retirement, when it could be expected that the income will normally cease, the person concerned could have made some other arrangements to meet the continuing needs. But if it happens much earlier when the alternate arrangements are not in place, insurance is necessary to help those dependent on the income.

In the case of a human being, he may have made arrangements for his needs after his retirement. Those would have been made on the basis of some expectations like he may live for another 15 years, or that his children will look after him. If any, of these expectations do not become true, the original arrangement would become inadequate and there could be difficulties. Living too long can be as much a problem as dying too young. These are risks which need to be safeguarded against. Insurance takes care.

Insurance does not protect the asset. It does not prevent it loss due to the peril. The peril cannot be avoided through insurance. The peril can sometimes be avoided through better safety and damage control management. Insurance only tries to reduce the impact of the risk on the owner of the asset and those who depend on that asset. It compensates, may not be fully, the losses. Only economic or financial losses can be compensated.

The concept of insurance has been extended beyond the coverage of tangible assets. Exporters run the risk of the importers in the other country defaulting as well as losses due to sudden changes in currency exchange rates, economic policies or political disturbances. These risks are now insured. Doctors run the risk of being charged with negligence and subsequent liability for damages. The amounts in question can be fairly large, beyond the capacity of individuals to bear. These are insured. Thus, insurance is extended to intangibles. In some countries, the voice of a singer or the legs of a dancer may be insured; even through the advantages of spread may not be available in these cases.

Satisfaction of economic needs requires generation of income from some source. If the property, which is the source of such income, is lost fully or partially, permanently or temporarily, the income too would stop. The purpose of insurance is to safeguard against such misfortunes by making good the losses of the unfortunate few, through the help of the fortunate many, who were exposed to the same risk but saved from the misfortune. Thus the essence of insurance is to share losses and substitute certainty by uncertainty

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There are certain basic principles which make it possible for insurance to remain popular and a fair arrangement. The first is the fact that people are exposed to risks and that the consequences of such risks are difficult for anyone individuals to bear. It becomes bearable when the community shares the burden. The second is that no one person should be in a position to make the risk happen. In other words, none in the group should set fire to his assets and ask others to share the costs of damage. This would be taking unfair advantage of as arrangement put into place to protect people from the risks they are exposed to. The occurrence has to be random, accidental and not the deliberate creation of the insured person.