Why an Insurance Policy Is Necessary?

WHAT IS AN INSURANCE POLICY?

Insurance policy is a contract between the insurer and the insured, known as the policyholder, which determines the claims which the insurer is legally required to pay. In exchange for an initial payment, known as the premium, the insurer promises to pay for loss caused by perils covered under the policy language.

I would like to cite an example that will explain the main purpose of an insurance policy.

An individual has $35,000 worth of assets, but there is a possibility that he may lose $10,000. For example, his car is stolen, or a storm may damage his house. If the individual doesn’t buy the insurance, then he may be at a risk of losing the money and left with$25,000.

What happens if the insurance is bought?

Suppose now the person decides to buy insurance worth $10,000. But he has to pay a premium of $100 every month.

There can be 2 cases:

1. If the loss does not occur, then he would be left with $34,900.we can understand this with the use of equation also.

Worth of assets=$35,000

Premium paid=$100

The person is left with=$35,000-$100 = $34,900

1. 2.  If the loss occurs, then also he would be left with $34,900.This can also be understood with the help of an equation.

Worth of assets=$35,000

Premium paid=$100

Lose occurred=$10,000

Value of the insurance bought=$10,000

The person is left with after the loss occurred= $35000+$10000-$10000-$100=$34,900

From the above 2 cases, we get to know that the consumer ends up with the same wealth no matter what happens. Therefore, he is fully insured against the loss.

This example is successful in making us understand the importance of buying an insurance policy.

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