What is Insurance and how does it Work?

by Free Insurance advice on January 9, 2012 · 0 comments

in Insurance in Nigeria, Insurance Terms and Terminologies

What is Insurance and how it Works?


Life is full of risks. Risk and are incidental to life. Man may meet untimely death. He may suffer from accident, destruction of property, fire, floods, earthquakes and other natural calamities. Whenever there is , there is risk as well as insecurity. People always want to avoid the financial consequences of these risks e.g replacing personal property that is lost or damaged. Insurance exists because risk exists. Insurance cannot remove the risk or the likelihood that one might become a victim of risks, but it ensures the transfer of all or some of the financial impact.


defines insurance as a “system under which the , for a consideration (usually agreed upon in advance) promises to reimburse the insured or to render services to the insured in the event that certain accidental occurrences result in losses during a given period”

Wikipedia defines Insurance as ‘a contract in writing under which one party agrees to indemnify the other party against a loss or damage suffered by it on account of an uncertain future, in return for a consideration called ‘premium’

It is a contract between two parties (insurance company (A) and the insured or policyholder (B) in which the risk is transferred to the insurance company in exchange for the payment (in advance) of a token called Premium with the insurance company agreeing to make good the loss to the policy holder whenever he suffers any loss

Insurance is a form of ; a risk- transfer mechanism. It is a method of coping with risk. Its primary function is to substitute certainty for as regards the economic cost of loss-producing events and the aim is to compensate the owner against the losses arising from a variety of risks which he anticipates to his life, property and business. It is a means of pooling of risks, under which a group of people who are subject to an insurable risk contribute regularly to a fund. The fund so created is utilized to compensate those members of the group who actually suffer a loss due to some unexpected calamity. Thus the loss of a few is shared by all the members on an equitable basis


How Insurance works?

When individuals or companies purchase insurance policies, all the money from the premium is what is called the insurance pool. This fund is used to compensate those members of the group who suffer loss due to unexpected calamity. Insurance companies use statistical laws (Law of Large Numbers) to predict what percentage of insured people or businesses will actually suffer a loss and file a claim. The law of large numbers states that if you repeat a random experiment, such as tossing a coin or rolling a die, many, many, many times, your outcomes should on average be equal to the theoretical average. When applied to insurance, the more members in an insured group, the more likely it is that the number of actual losses will be very close to the number of expected losses. Insurance companies have over the years developed statistics for each different types of risks covered to help them predict the likely losses. Therefore, in order to afford to cover the financial losses of its customers, insurance company needs a very large base of members.


Practical Example

Let us assume a Secondary school with 100 students. Every year for the past 10years, only one student has had an injury, resulting in about N5, 000 in medical expenses. Without insurance, every family would need to save N5, 000 to cope with the likelihood that their ward would be the victim. Hence, at the end of the year, 99 families whose kids would not have been injured would have paid nothing (and have N5,000 left in savings), but one family would have paid N5,000 (and have nothing left).

With insurance, the families can join together to spread out the risk. They can create an insurance fund totaling N5, 000 if all 100 families would pay N50 each at the beginning of the school year. This N5, 000 would then go to the family of the child involved in an accident.

By spreading the risk, each family only has to save N50 instead of N5, 000. However, some could argue that the N5, 000 will be avoided if it is not your child who is a victim. Instead of having to cough out the full N5,000, most people would rather risk losing N50 for a likelihood to avoid N5,000 in medical bills.

Ideally, the premium contribution of each student is supposed to be commensurate with the risk brought to the pool because they do not bring the same (equal) risk to the pool as some live in some risk prone areas and engage in high risk activities. This would involve having more detailed information on each student’s risk exposure to allow for differentiated premium to be paid.

To read more about paying insurance premiums, click the link below:


How Does my Insurance company determine the premium I pay?





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