IPT02220 - The Insurance Industry: What is insurance? Spreading the risk

Insurance, in effect, is a mechanism for spreading risk.

A simple example will demonstrate how this works:

• There are 100 people engaged in furniture repair businesses.
• Each of them has things they want to insure, premises, tools, equipment and furniture under repair, valued at £10,000.
• Experience suggests that, on average, every two years one business will suffer a major fire, and will lose everything.
• These businesses have clubbed together to insure themselves (in technical terms they form a mutual insurer), which costs £500 a year to run.
• Every two years the ‘furniture mutual’ will have to pay out £10,000 against claims, and with their running costs (£500 x 2) this means a total cost of £11,000, or £5,500 a year.
• The cost is paid by the 100 businesses - that is to say, each pays a 1% share of £5,500 or £55 each.

This means that instead of running a risk of being wiped out by a fire, and having to safe- guard the future of the business by building up big cash savings, each business pays a relatively small premium confident in the knowledge that if disaster strikes there will be a pay- out, which will enable it to start again.