Definition of insurance is easy enough to be found in Wikipedia, dictionaries and Google searches.  We have often heard people talk about being safe because of being insured.  There are many ways to tell a story, for us to understand why insurance is a small but  very critical part of doing business.

This story is one approach of many to come from me in future postings.

To begin with, a single cigarette butt could spark a fire that destroy an entire building, a town and a forest.  Such is the nature of tiny, rare, very difficult to predict and catastrophic impact of risk.  A small neglect, can lead to another and another and cause huge losses and damages as we too often seen in numerous costly incidences ranging from bad financial loans, to oil spillages, building & bridge collapses, ravaging fires, and fatal motor vehicle, airplane, sea vessel’s accidents. 

In the ancient history of civilizations, insurance begin with people’s need for security and fear for uncertainties. The commitment of “one for all and all for one” is the most basic principle of insurance.  A person naturally tried satisfy his need for security by himself; and then seek support from his family, his group of neighbors, his circle of friends, the group he work for and so on. 

In a world where we increasingly work in highly specialized areas, the value of business is increasingly concentrated in a particular niche segment.  With that,  insurance has grown to become a crucial tool to diversify risks and provide an opportunity for a business to continue to be in operation, in case of a big loss.

Henry Ford of Ford Motor was once said to have heard a visitor to New York express wonder at the sight of the magnificent city with its soaring buildings. Ford’s reply, acknowledge the significance of insurance: “This has only been made possible by the insurers,” he said. “They are the ones who really built this city. With no insurance, there would be no skyscrapers. No investor would finance buildings that one cigarette butt could burn to the ground.”

Origins of Insurance

In different forms, insurance had used for more than 2,000 years prior, by the Chinese, Babylonian, Greek, Roman and Arab traders to face the treacherous open seas and long caravan journeys.

Insurance’s principal of indemnity was documented in the Code of Hammurabi of the Kingdom of Babylon circa 1,700 BC.

The oldest insurance policy for shipping was written in 1343 in Genoa. After marine insurance, insurance against fire hazards was developed following series of serious fires striking London in 1666 and Hamburg, German between 1672 and 1676.

As the industrial age and global trade expanded ,  the world economy experience many challenges that  made commercial insurance business what as what it is today.

Development of insurance

In the early years, insurers worked without statistics, rates, or calculations of probability, relying solely on their personal assessment, judgment and experience of risks. Each time there is a loss, an Insurer had to ask himself fearfully whether he had taken on too much risk. To seek peace of mind, an Insurers began to transfer part or all of the risk to another Insurer willing to accept it, in a practice now known as Reinsurance and Coinsurance

Actuarial science as a means of assessing risks and setting insurance rates was first recorded in London in 1706. With  better understanding of risks, several innovations emerges:

• Reinsurance aimed at balancing portfolios on a larger international scale;
• Addition of new classes of insurance to address specific business needs;
• Creation of social insurance plans for protection against health issues and natural catastrophic events.

Growth of Insurance

Insurance’s rapid growth of in the last 100 years can be explained in the context of economic development:

• Transformation of technology from assembly lines, air travels to digital devices.
• Formation of large community cities.
• Change in ways of thinking from local settings to global context.

Economic development forced businesses and people to adopt a more independent, responsible attitude to life.  Insurance as we know it today, come about by the increased need for security and certainty , brought about by the industrial, global trades and information age.

Rules of Large Numbers and Probability

To set premium rates, insurers must be able to predict future losses.  However, it is impossible to predict when a loss will hit any one individual, or the extent of the loss will cause.  To be able to insure, Insurer grouped policy holders under assumptions such as :

• Each is exposed to the same types of risk
• Each loss is a separate event.
• A loss comply to the rule of large numbers.

Using principle of large numbers, proven by Jakob Bernoulli in 1713, Insurers are able to predict with significant accuracy extend of annual loss to be expected from a group. The larger the group, the closer an average loss will be to a definite value.

Insurers make extensive use of statistics to calculate the expected losses and distribute them over the individual premiums.   The laws of probability make it possible to apply past data to the present and to predict future trends. The projected losses are then distributed among those insured, thereby determining the premium.

There is however a big difference between prediction and reality, which causes  Insurers and Reinsurer to be wary of underwriting and actuarial risk, especially against rare extreme risk which may put them out of business very quickly.