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. The process of insurance is obviously quite a bit more complicated than this, of course. 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.
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