Once I read a story which explained very well of how insurance works.
Long ago, there was a village with 100 households. They were all padi farmers. Not far from the village lived a gang of robbers that came down from the mountain on the last day of each year. The robbers would target at the village and shot an arrow. Whichever house nearest to the fallen arrow would be required to give the robbers 100 sacks of rice. 100 sacks was in fact all the padi harvested in a year, living the family nothing to live by for the following year!
One day, a wise man from the nearby village heard about the ill-fated village and decided to pay the village a visit. He shared with them an idea of how every one can help each other to reduce the loss to the minimal. The brilliant idea was for each household to contribute a sack of rice at the end of the year. 100 household would mean 100 sacks of rice. At year end, no one should be in fear anymore of losing his fortune for a year!
This concept is similar to life insurance. Every policyholder does contribution from his premium to form an insurance pool. Should any of the policyholder pass on, the money from the pool is used for compensation.
Technical definition would be:
Insurance provides financial protection against a loss arising out of happening of an uncertain event. A person can avail this protection by paying premium to an insurance company.
A pool is created through contributions made by persons seeking to protect themselves from common risk. Premium is collected by insurance companies which also act as trustee to the pool. Any loss to the insured in case of happening of an uncertain event is paid out of this pool.
Insurance works on the basic principle of risk-sharing. A great advantage of insurance is that it spreads the risk of a few people over a large group of people exposed to risk of similar type.
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