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How motor insurance works – A short story

motor insurance

Motor insurance is one the most popular forms of insurance all over the world. This is mainly because it is a legal requirement in most countries to have valid auto insurance for every vehicle on the road. Motor insurance works based on the fundamental principles of insurance. If you have been wondering how an insurance company is able to pay you for the value of your car yet you only gave them a small proportion of this value in premiums, here is how auto insurance works.

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Let’s say you are living in a city called Maishani which has ten thousand cars. The average value of each car in Maishani is about half a million shillings. Let us further say every year, ten cars crash beyond repair, and their owners must get new cars. In the same period, about one thousand cars experience crashes that require an average of fifty thousand shillings to fix. Therefore, car owners in Maishani collectively require five million shillings to buy new cars, and five million shillings to repair damaged cars every year. If all the drivers in Maishani had a meeting and decided to contribute (pooling of risk) towards a fund where anyone who loses their car can get compensation, it would be the beginning of insurance. The most basic way that they would calculate each person’s contribution (premiums) to this fund would be by dividing the annual demand for car replacements and repairs, among the number of motorists in Maishani. Based in this model, if each driver contributes one thousand shillings, the city will afford to replace all cars lost to accidents and it would be able to pay the bills of all repairs needed after accidents.

However, the fund would need managers to collect the money and to administer it (a motor insurance provider). This means that the drivers would need to make additional payments to cater for the fund managers, their offices, and their equipment. The company would also require inspectors (investigators) because in the city, some motorists may try to get compensation based on false claims.

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Apart from these costs, the fund needs to prepare for increased claims as younger drivers get to the road. In addition, it needs to decide whether it should pay people whose cars are damaged by riots, something that happens frequently in Maishani. In this case, the fund managers can propose that apart from the basic cover, the fund will replace cars lost to riots if the owner is willing to pay five hundred shillings in addition to their base premiums. To ensure that every driver is careful, the company can also propose that every driver will meet some of the cost of repairs after every accident (Excess). So drivers may be required to pay the first ten thousand shillings of the cost of repairs to the car.

Knowing Maishani, it may be impossible to get all the people to agree. So the government of Maishani passes a law making it illegal to drive a car that does not have insurance. It also decides that instead of the people forming a revolving fund, it will licence private companies that can take premiums and offer compensation to Maishani residents based on an agreement (insurance policy). In other words, Maishani now has a fully-fledged Motor Insurance company operating using the modern principles of insurance.

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