The Concept of Insurance - Insurance

Nearly everybody is aware of insurance, and knows what it can do for them in some basic sense. Despite this, most people can not offer a full explanation of how insurance works. They understand that they make a monthly payment to the insurer, and in exchange they will receive compensation in the event that something goes wrong which the insurer has previously agreed to pay for. Despite this, they don't understand the fundamental way in which an insurer operates.
Insurance is a method of managing risk, both on the part of the insured agent and the insuring agent. The insured passes their risk onto the insurer. In exchange for taking on the risk, the insurer demands payment from the insured.

An insurer will choose its premiums based on the risk of an event, in combination with its cost. As an example, if the risk of an event occurring is 1 in 1,000 every day, and the cost of the event is $1,000, than the insurer could expect to break even if they charged a premium of $1 a day. Since the insurer is in the business of earning a profit, they will tend to charge as much more than this as the market is willing to spend.
The insured will choose to interact with an insurer because they perceive the risks and potential losses to be too great. Using the example above, an individual could potentially try to "insure" themselves by saving $1 a day rather than paying a premium to an insurance company. However, after a period of 500 days, the individual would have a 1 in 2 chance of having already experienced the event. This would mean that 50 percent of the time they would have saved $500 and not experienced the event. By the same token, 50 percent of the time they would have already spent a thousand dollars, and already be in debt by at least $500. On top of this, they would owe interest on the debt. For this reason, it is a rational decision for the individual to pay the premium to the insurance company, rather than save their money in order to guard against the event.
The process of insurance is obviously quite a bit more complicated than this, of course. There are many circumstances in which the risks can not be accurately assessed, for example. Generally speaking, an insurer will use the law of large numbers in order to determine what its likely losses are. At the same time, they will tend to assess the individual risk of each applicant separately, which can be somewhat difficult.