About Insurance and Its Characteristics

Valid until 31 January 2015 (unless noted)

Insurance is one method of risk transfer, especially for the pure risk. Insurance is a contract agreement between the insured and insurance company (insurer), where the insurer is willing to provide compensation on the loss experienced by the insured, and the insurer obtain insurance premium from insured as a reward. Four things that are required in the transaction of insurance are: (1) Contract agreement / policy, (2) The premium payment, (3) insurance (benefit) is paid in case of loss as mentioned in the contract, (4) Gathering (pool) resources by the insurance company is required to pay indemnity. Insurance business is based on the principles to gather (pool) resources, not to gather risk. Through the premium received by the insurance company, the company can gather resources, so that it can reduce the probability can not meet its obligations. Merging risks to reduce the inability to pay obligations requires a low (or negative) relations, so that the risk will eliminate each other. Risks that can be covered by insurance can be quite varied. Here are some examples of risks : risk of accident (ex: car insurance), risk of death (life insurance), risk of not being paid by banks (deposit insurance), and the risk of fire or property damages (property insurance).

There are two problems that are inherent in the insurance contract, the moral hazard problem and adverse selection. Moral hazard is a behavior that is not careful (careless). Insurance tends to encourage the occurrence of moral hazard. As an example, eg I was very careful in running the car on the road. Then I buy car insurance. After the purchase of car insurance, I will feel that insurance company have to protect me when the accident occurred. Therefore I do not become more carefully when I am driving a car. I become more careless. After the purchase of car insurance, I will feel that insurance company have to protect me when the accident occurred. Insurance companies will suffer a loss because of the change of my behavior, that I am a carefull driver when buying car insurance, changes to careless driver when I already get car insurance.

Adverse selection problem can be described as following... Who tends to buy insurance, the person who has careless or careful behavior? Careless person tend to buy insurance, because he / she feels need protection because of his / her careless behavior. Careful person tend to be more careful in the purchase of insurance, because the need for protection (insurance) is not equal to the needs for protection of the careless person. Once again the insurance companies will be in disadvantaged situation because they have a lot of careless people.

Both behaviors (moral hazard and adverse selection) would increase losses for insurance companies, which ultimately will lead insurance companies to increase insurance premiums. High insurance premiums that will be the second problem. Careful people increasingly not become interested in buying insurance, because premiums are too high. Ultimately, insurance companies have only careless customers, and the premium becomes too high. Insurance companies in the end can not survive in a situation like this. Insurance companies can prevent or reduce such risk through several mechanisms, such as with a different premium burden. Customers who are more "risky" must pay more high in premium. However both of problems are inherent in the insurance business.