Knowing The Function of Insurance

The term insurance is generally interpreted as coverage.  This coverage is based on an agreement between two parties, namely the party who is obliged to pay dues or premiums and the other party who is obliged to provide full guarantees to the payer of dues, if something happens to the payer of his dues or belongings in accordance with the  agreement made.

          From the term, insurance serves as a mechanism or way to transfer risk from an individual or business entity to the insurance company. In insurance, this individual or business entity is referred to as the insured or policyholder, while the insurance company is referred to as the insurer.  The provisions of the agreement related to insurance between the insured party and the insurer are stated in an insurance policy.

In the context of this risk transfer, when the insured risk occurs, the party who will indemnify or bear the financing is the insurance company. This risk transfer scheme will certainly ease the burden on the insured because there is no need to be confused about thinking about or seeking financing for the risks experienced. That is, insurance will provide peace of mind or peace of mind for the insured.

          For example, an entrepreneur insures his shop building at the risk of fire and earthquake. When the risk of fire or earthquake damage occurs, losses arising from fires or earthquakes will be replaced by insurance companies so that entrepreneurs are helped financially and can immediately focus on recovering their business.

          For more details, let's get to know what the functions of insurance are at least three main functions of insurance that we need to understand, namely:

1. Risk Transfer Mechanism        

The function of the risk transfer mechanism is a mechanism or way of transferring the risk of financial loss of property caused by a danger (peril) from an individual or business entity to an insurance company. For the transfer of these risks, individuals or business entities will pay a certain amount of premiums (certainty) to the insurance company. The amount of this premium is generally much smaller compared to the potential loss value experienced by individuals or business entities.

 Without diverting risk through insurance, individuals or business entities will face uncertainty. Not only uncertainty over the potential losses that will be experienced, but also uncertainty over how much potential loss will be suffered when a peril actually occurs. This uncertainty will indeed make individuals or business entities not calm in running their business.

In the practice of life or health insurance, the risk of death or illness will be borne by the insurance company through payment of sum insured for the risk of death and reimbursement of medical expenses for the risk of illness. That is, this risk transfer mechanism will make individuals who have life insurance and their families calm (peace of mind) because when the insured dies, the family left behind will get a sum insured that can be used to meet the needs of the family. Meanwhile, the transfer of risk to health insurance will make individuals calm because the burden of medical expenses will be replaced or covered by the insurance company.  The reason is, death and illness  cannot be predicted when it  occurs but both will definitely occur so the risk needs to be transferred.

2. The Common Pool

In addition to functioning as a risk transfer mechanism, insurance has also a function of raising funds. Premium received by insurance companies from the insured or policyholders will be collected in a fundraiser called The Common Pool. Considering that there are very many types of insurance, then this fundraising activity will be grouped according to the same type of insurance so that the insurance company has several common pools.

Through the collection of these funds, insurance companies can carry out the function of transferring risk through payment of claims. If there is a claim that must be paid by the insurance company, the claim money will be taken from the type of insurance (class of business) that experiences the claim, not from other types of insurance. In order to manage the smooth payment of claims, the insurance company will reserve a certain amount of funds from each common pool.

In this common pool mechanism, the element of mutual cooperation is very thick because each insured will pay premium money to the insurance company. Furthermore, the insurance company will manage the premium money and will distribute or pay it to the insured who has suffered a disaster or loss. Not all insured will get claim rights if they do not have the prerequisites to make a claim. When buying vehicle insurance for example, we will not file a claim until the coverage period ends if indeed the insured vehicle does not suffer damage covered by insurance.

 Another example is bpjs health insurance mandatory health insurance. The government requires all levels of Indonesian society to be participants and must pay dues every month. Furthermore, the participants' dues will be collected and managed by BPJS Kesehatan to cover medical expenses for sick participants.

3. Equitable Premiums

The next main function of insurance is as a means to guarantee a balance between premiums and claims (equitable premiums). In carrying out this function, the insurance company will calculate the premium burden to be paid by the insured based on the risk profile faced. Thus, the amount of premiums and the value of claims between accounts for the same type of insurance will most likely not be the same. For example, property insurance between buildings that are in disaster-prone and non-disaster-prone areas, the calculation of premium values and claims will be different. 

The function of equitable premiums is really to ensure that the insured pays a premium according to his risk profile. If the risk profile is low, the insured will be charged a cheap premium. And if the risk profile is high, the insured will be charged a high premium. 

Another example is two buildings that are to be insured for fire risk as follows:

a.    Building A has an area of 1,500 m2 with specifications of brick walls reinforced with concrete construction, roof tiles, and is above the ground covering an area of 2,500 m2.

b.    Building B has an area of 900 m2 with specifications of walls made of wood, roofs from shingles, and its location is adjacent to mini gas stations or stalls that sell retail gasoline.

Of the two figures above, of course building B has higher hazards compared to   building A.  Hazards are circumstances that can affect the occurrence or frequency of losses after the severity of the loss (severity of losses) if it occurs.