Each blow you receive has a chance of striking a certain part of your body. I think the ratios are that your body receives 30% of the hits, legs 10%, head 15%, hands 5%, feet 5%, and shield 35%. Each section has an individual armour rating based on what you're wearing. If you do not have a piece of armour, it counts as zero. The average armour rating displayed in the Character panel is the statistical average armour rating of your body (body*30% + legs*10% + ...).
Mathmatically, I don't know what the armour rating does. I think it absorbs an amount of damage. But higher is better!
