The insurance is based upon (i) Principles of Co-operation and, (ii) Principles of Probability.
(i) Principles of Co-operation:
Insurance is a co-operation device. If one person is providing for his own losses, it cannot be strictly insurance because in insurance, the loss is shared by a group of persons who are willing to co-operate. In ancient period, the persons of a group were willingly sharing the loss to a member of the group. They used to share the loss to a member of the group.
They used to share the loss at the time of damage. They collected enough funds from the society and paid to the dependents of the deceased or the persons suffering property losses. The mutual co-operation was prevailing from the very beginning up to the era of Christ in most of the countries. Lately, the cooperation took another form where it was agreed between the individual and the society to pay a certain sum in advance to be a member of the society.
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The society by accumulating the funds, guarantees payment of certain amount at the time of loss to any member of the society. The accumulation of funds and charging of the share from the member in advance became the job of one institution called insurer.
Now it became the duty and responsibility of the insurer to obtain adequate funds from the members of the society to pay them at the happening of the insured risk. Thus, the shares of loss took the form of premium. Today, all the insured give a premium to join the scheme of insurance. Thus, the insured are co-operating to share the loss of an individual by payment of a premium in advance.
(ii) Principles and Theory of Probability:
The loss in the shape of premium can be distributed only on the basis of theory of probability. The chances of loss are estimated in advance to affix the amount of premium. Since the degree of loss depends upon various factors, the affecting factors are analysed before determining the amount of loss. With the help of this principle, the uncertainty of loss is converted into certainty.
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The insurer will have not to suffer loss as well have to gain windfall. Therefore, the insurer has to charge only so much of amount which is adequate to meet the losses. The probability tells what the chances of losses are and what will be the amount of losses.
The inertia of large number is applied while calculating the probability. The larger the number of exposed persons, the better and the more practical would be the findings of the probability. Therefore, the law of large number is applied in the principle of probability.
In each and every field of insurance the law of large number is essential. These principles keep in account that the past events will incur in the same inertia. The insurance, on the basis of past experience, present conditions and future prospects, fixes the amount of premium.
Without premium, no co-operation is possible and the premium cannot be calculated without the help of theory of probability, and .consequently no insurance is possible. So these two principles are the two main legs of insurance.