2 Concepts of Insurance – Functional and Contractual [Explained]

Concepts of Insurance

Insurance is a contract between two parties where you as a policyholder agree to pay premiums regularly or periodically and the insurer or insurance company in return gives you an assurance to protect you financially in outlined unexpected events.

The concept of insurance had been in practice for a long time ago but it was not as effective as nowadays. Usually, the concepts of insurance are two – functional and contractual concepts.

Functional Concept

The functional concept of insurance is the oldest concept of insurance. It is the practice people were used to following at the beginning of the insurance popularity.

According to the functional concept, insurance is a cooperative device through which risk is distributed among a large number of people. This is a traditional concept and is based on practical theory.

During the initial phase of the insurance industry, individuals would collaborate with each other to obtain mutual benefits. They would contribute a modest sum of money to a shared fund, and if an unforeseen event such as an accident or financial loss occurred, the affected party would receive compensation from this fund.

The principle underlying this idea is the concept of mutual cooperation for the sake of shared benefits.

Insurance serves as a collaborative social mechanism that brings together a considerable number of individuals who contribute a fair amount to reduce or eradicate the financial impact on any member in the event of accidents or other tragedies.

The functional concept of insurance was popular when the insurance industries were not fully developed. And, it is useful for people who have minimum income and are not able to bear the unexpected loss.

However, under the functional basis, every member of the group had to be truthful and share accurate and right information on the happening of themselves. No one was allowed to be compensated for fake reasons.

Contractual Concept

Compared to the functional concepts of insurance, the contractual concept is the modern concept of insurance.

Insurance operates on a contractual basis, meaning that it involves an agreement between an insurer and the insured party. The insurer (insurance company) assumes the responsibility of compensating the insured or their nominee for any financial loss resulting from unforeseen events as specified in the contract.

To this concept, insurance is a more legal term. It is a legal contract between an insurer (insurance company) and the insured (individual or policyholder or a business).

The gradual development of business activities created complexity in insurance. Hence, the functional concept become insufficient and the contractual concept came into existence.

Under this concept, the insurer and insured come into a written agreement for the payment of premiums and compensation of loss. Where, the premium is the amount the insured pays periodically to the insurer, which is commonly called the insurance premium.

In other words, under the contractual concept, Insurance can be described as a mutual agreement between two parties, namely the insurer and the insured, in which the insurer undertakes to pay a specified sum of money to either the insured or their beneficiary in the event of a particular contingency, commonly referred to as the “risk,” against which the insurance policy has been obtained.

Difference Between Functional and Contractual Concepts of Insurance

The followings are the main difference between contractual and functional concepts of insurance.

  • The initial form of insurance is the functional concept whereas the modern or developed form of insurance is a contractual concept.
  • The contractual concept is more legal than a functional concept.
  • In functional concepts, there is mutual consent between a group (s) of people. Whereas, in the contractual concept, there is mutual consent between the insurance company and the individual or business.
  • The main objective of the functional concept is to share the risk, whereas, the main objective of the contractual concept is to minimize the risk.

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