CHAPTER 2

INTRODUCTION TO INSURANCE

WHAT IS INSURANCE ?

1. The business of insurance is related to the protection of the economic values of assets.
Every asset has a value. The asset would have been created through the efforts of the
owner. The asset is valuable to the owner, because he expects to get some benefits from
it. The benefit may be an income or some thing else. It is a benefit because it meets some
of his needs. In the case of a factory or a cow, the product generated by is sold and
income generated. In the case of a motorcar, it provides comfort and convenience in
transportation. There is no direct income.

2. Every asset is expected to last for a certain period of time during which it will perform.
After that, the benefit may not be available. There is a lifetime for a machine in a factory
or a cow or a motorcar. None of them will last forever. The owner is aware of this and he
can so manage his affairs that by the end of that period or lifetime, a substitute is made
available. Thus, he makes sure that the value or income is not lost. However, the asset
may get lost earlier. An accident or some other unfortunate event may destroy it or make
it non-functional. In that case, the owner and those deriving benefits therefrom, would be
deprived of the benefit and the planned substitute would not have been ready. There is an
adverse or unpleasant situation. Insurance is a mechanism that helps to reduce the effect
of such adverse situations. Thus, Insurance is a mechanism of protection against such
financial losses.

PURPOSE & NEED OF INSURANCE

1. Assets are insured, because they are likely to be destroyed, through accidental
occurrences. Such possible occurrences are called perils. Fire, floods, breakdowns,
lightning, earthquakes, etc, are perils. If such perils can cause damage to the asset, we say
that the asset is exposed to that risk. Perils are the events. Risks are the consequential
losses or damages. The risk to a owner of a building, because of the peril of an
earthquake, may be a few lakhs or a few crores of rupees, depending on the cost of the
building and the contents in it.
2. The risk only means that there is a possibility of loss or damage. The damage may
or may not happen. Insurance is done against the contingency that it may happen.
There has to be an uncertainty about the risk. Insurance is relevant only if there are
uncertainties. If there is no uncertainty about the occurrence of an event, it cannot be
insured against. In the case of a human being, death is certain, but the time of death is
uncertain. In the case of a person who is terminally ill, the time of death is not uncertain,
though not exactly known. He cannot be insured.
3. Insurance does not protect the asset. It does not prevent its loss due to the peril. The
peril cannot be avoided through insurance. The peril can sometimes be avoided, through
better safety and damage control management. Insurance only tries to reduce the impact
of the risk on the owner of the asset and those who depend on that asset. It only
compensates the losses - and that too, not fully.
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4. Only economic consequences can be insured. If the loss is not financial, insurance
may not be possible. Examples of non-economic losses are love and affection of parents,
leadership of managers, sentimental attachments to family heirlooms, innovative and
creative abilities, etc.

THE HUMAN ASSET

1. A human being is an income-generating asset. One's manual labour, professional
skills and business acumen are the assets. This asset also can be lost through
unexpectedly early death or through sickness and disabilities caused by accidents.
Accidents may or may not happen. Death will happen, but the timing is uncertain. If it
happens around the time of one's retirement, when it could be expected that the income
will normally cease, the person concerned could have made some other arrangements to
meet the continuing needs. But if it happens much earlier when the alternate
arrangements are not in place, there can be losses to the person and dependents. Insurance
is necessary to help those dependent on the income.

2. A person, who may have made arrangements for his needs after his retirement, also
would need insurance. This is because the arrangements would have been made on the
basis of some expectations like, likely to live for another 15 years, or that children will
look after him. If any of these expectations do not become true, the original arrangement
would become inadequate and there could be difficulties. Living too long can be as much
a problem as dying too young. Both are risks, which need to be safeguarded against.

INSURANCE OF INTANGIBLES

The concept of insurance has been extended beyond the coverage of tangible assets.
Exporters run the risk of losses if the importers in the other country default in payments
or in collecting the goods. They will also suffer heavily due to sudden changes in
currency exchange rates, economic policies or political disturbances in the other country.
These risks are insured. Doctors run the risk of being charged with negligence and
subsequent liability for damages. The amounts in question can be fairly large, beyond the
capacity of individuals to bear. These are insured. Thus, insurance is extended to
intangibles. In some countries, the voice of a singer or the legs of a dancer may be
insured.

HOW INSURANCE WORKS

1. The mechanism of insurance is very simple. People who are exposed to the same
risks come together and agree that, if any one of them suffers a loss, the others will share
the loss and make good to the person who lost. All people who send goods by ship are
exposed to the same risks, which are related to water damage, ship sinking, piracy, etc.
2. Those owning factories are not exposed to the above risks, but they are exposed to
different kinds of risks like, fire, hailstorms, earthquakes, lightning, burglary, etc. Like
this, different kinds of risks can be identified and separate groups made, including those
exposed to such risks. By this method, the heavy loss that any one of them may suffer (all
of them may not suffer such losses at the same time) is divided into bearable small losses
by all. In other words, the risk is spread among the community and the likely big impact
on one is reduced to smaller manageable impacts on all.
3. If a Jumbo Jet with more than 350 passengers crashes, the loss would run into several
crores of rupees. No airline would be able to bear such a loss. It is unlikely that many
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Jumbo Jets will crash at the same time. If 100 airline companies flying Jumbo Jets, come
together into an insurance pool, whenever one of the Jumbo Jets in the pool crashes, the
loss to be borne by each airline would come down to a few lakhs of rupees. Thus,
insurance is a business of 'sharing'.
4. There are certain principles, which make it possible for insurance to remain a fair
arrangement.
 The first is that it is difficult for any one individual to bear the consequences of
the risks that he is exposed to. It will become bearable when the community
shares the burden.
 The second is that the peril should occur in an accidental manner. Nobody should
be in a position to make the risk happen. In other words, none in the group should
set fire to his assets and ask others to share the costs of damage. This would be
taking unfair advantage of an arrangement put into place to protect people from
the risks they are exposed to. The occurrence has to be random, accidental, and
not the deliberate creation of the insured person.
 The manner in which the loss is to be shared can be determined before-hand. It
may be proportional to the risk that each person is exposed to. This would be
indicative of the benefit he would receive if the peril befell him.

4. The share could be collected from the members after the loss has occurred or the likely
shares may be collected in advance, at the time of admission to the group. Insurance
companies collect in advance and create a fund from which the losses are paid.

5.The collection to be made from each person in advance is determined on assumptions.

While it may not be possible to tell beforehand, which person will suffer, it may be
possible to tell, on the basis of past experiences, how many persons, on an average, may
suffer losses. The business of insurance is nothing but one of sharing.

The following two examples explain the above concept of insurance.

Example-1 In a village, there are 400 houses, each valued at Rs.2,00,000. Every year, on
the average, 4 houses get burnt, resulting into a total loss of Rs.8,00,000. If all the 400
owners come together and contribute Rs.2,000 each, the common fund would be
Rs.8,00,000. This is enough to pay Rs.2,00,000 to each of the 4 owners whose houses got
burnt. Thus, the risk of 4 owners is spread over 400 houses - owners of the village.

Example-2 Suppose there are 10000 employees in a big organization each aged 35 and
having similar prospects of longevity. Suppose experience shows that over a year, 2
persons in a thousand among a group of this type die. While it is not possible to say
which persons in the group will die during a year, it is fairly certain that twenty
individuals in the group will die during a year. Assume that the economic value of the
loss suffered by the family of a deceased member is Rs. 10,00,000/-. If every one of the
10000 members of the group were to pay a relatively small contribution of Rs. 2000/- out
of the total contributions of Rs. 2,00,00,000/-, the dependents of the 20 deceased
members could be compensated. This co-operative venture of sharing the loss implies
payment of a price of Rs. 2000/- per members for buying security against the risk of
premature death.

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THE BUSINESS OF INSURANCE
Insurance companies are called insurers. The business of insurance is to
(a) bring together persons with common insurance interests (sharing the same risks),
(b) collect the share or contribution (called premium) from all of them, and
(c)pay out compensations (called claims) to those who suffer.

The premium is determined on the same lines as indicated in the examples above, but
with some further refinements.

Classification of Insurance Business:

The insurance is broadly classified as
(i) Life Assurance Business, and
(ii) General Insurance or Non-life Insurance Business.

Life Insurance Business (Insurance act,1938):

It is the business of effecting contracts of Insurance upon human life, including any
contract whereby the payment of money is assured on death (except death by accident
only) or the happening of any contingency dependent on human life and any contract
which is subject to the payment of premiums for a term dependent on human life and
shall be deemed to include —
(a) The granting of disability and double or Triple Indemnity accident benefits, if so
provided in the Contract of insurance,
(b) The granting of annuities on human life, and
(c) The granting of Superannuation Allowance and annuities payable out of any fund
applicable solely to the relief and maintenance of persons engaged or who have been
engaged in any particular profession, trade or employment or of the dependents of such
persons.
It is insurance on human life including insurance whereby the payment of money is
assured on natural death and accidental death or on happening of any contingency
dependent upon human life. Insurance only for death due to an accident does not fall
within the ambit of Life insurance.
Although the primary function of Life Insurance is to provide protection to the family
against loss of income on the death of the breadwinner, different forms of life insurance
have been devised to meet diverse financial needs.

Non-Life Insurance or General Insurance:

Any insurance, which does not qualify for calling as Life Insurance is termed as Non-life
or General Insurance and includes insurance of property, interest liability and personal
accident excluding natural death. Even tho
ugh conventional classification of General Insurance has been, in the past in the three
branches — (i) Fire Insurance,
(ii) Marine Insurance and
(iii) Miscellaneous (accident) Insurance,
in modern times it is classified as follows:
(i) Insurance of person — Personal Accident and Sickness Insurance are included under
this classification.
(ii) Insurance of Property — Buildings, machinery, aircrafts, steamers, stock of business,
cash, securities come under the heading property and therefore Fire Insurance, Marine
Hull Insurance, Marine Cargo Insurance, Burglary Insurance, Engineering Insurance,
Crop Insurance and Aviation hull Insurance fall under this classification.
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(iii) Insurances of interest — Fidelity guarantee insurance and the Guarantee Insurance
fall under this classification.
(iv) Insurances of Liability — Public (third party) liability insurance, Professional
Indemnities fall under this classification.

Comparison of Life Assurance with other forms of Insurances:

While the basic concept of insurance is of spreading the loss over many, the basic
principles of insurable interest and utmost good faith apply equally to all classes of
insurance; Life Assurance differs from other forms of insurance in following way:

(i) RISK IS CERTAIN UNDER LIFE ASSURANCE: Each person has to die sooner or
later. Risk of death is certain under Life Assurance. However, under non-life Insurances
risk is not certain. Therefore, the mathematical value of risk under life Assurance can be
found out with more degree of accuracy.
(ii) LIFE ASSURANCE IS A LONG TERM CONTRACT:
Since Life Assurance Contracts are long-term contracts, Service to the Policyholders
assumes great importance. Minimum atleast 5 years contract as per the regulatory norm.
Investment of funds and interest yield are also, therefore, vital. Non-life Insurances are
one-year contracts except in health maximum 3 years contracts have been allowed. In
vehicle insurance some 3 and 5 years contracts have been allowed recently.
(iii) DIFFICULTY IN DETERMINING VALUE OF HUMAN LIFE: It is not difficult to
determine value of the subject matters of insurance under non-life insurances like
properties, machines etc. but it is difficult to determine the value of human life which is
subject matter of Insurance under Life Assurance Contracts.
(iv) CONTRACTS OF INDEMNITY: While non-life Insurances are contracts of
indemnity (except personal accident policies) , Life Assurance and personal accident
insurances are not.
(v) PRINCIPLE OF SUBROGATION: Under non-life insurance, when the insurer makes
good the loss, suffered by a person, he acquires the rights and remedies of that person.
This does not apply to life Insurance.
(vi) The right to renew the life policy on payment of requisite premium is automatic
throughout the period agreed in the policy at the outset. The insurer has no right to refuse
renewal if the premium is paid at the right time. General Insurance policies are usually
annual contracts, to be renewed every year. Each renewal constitutes a new contract.
Both the insured and the insurer have the option to renew or not to renew the policy.
(vii) Utmost good faith has to be observed by parties in both types of insurance but in
life insurance once the contract is entered into the insured generally has no duty to report
any changes affecting the risk insured. In general insurance the duty of utmost faith arises
at every renewal. Under certain policies, policy conditions require disclosure of material
changes in risk, even during the currency of the policy.
(viii)The premium under the life insurance contract remains constant throughout the
period of the policy. The premium under general insurance contracts may vary at each
renewal depending upon the changed nature of the risk or experience. The premium may
be increased or decreased according to circumstances.

Difference between Assurance and Insurance

The two terms assurance and insurance have often been used interchangeably and treated
as synonyms, but a fine distinction between the two concepts is required for a better
understanding of the subject of insurance.
Assurance is used in those contracts which guarantee the payment of a certain sum on the
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happening of a specified event, which is bound to happen sooner or later. Life Policies
are contracts of assurance. Under life policies, the insurer is required to pay the fixed
amount agreed upon in advance in the event of death or on the expiry of the period of the
policy.
Insurance contracts are contracts of indemnity under which the insurer, in consideration
of a sum of money, undertakes to compensate the insured for the loss suffered by him due
to the happening of a specified event such as accident in case of accident insurance,
illness in case of health insurance, destruction of property in case of fire insurance,
damaging of goods in case of marine insurance, and so on. In such events, there is
absolute uncertainty. The time of occurrence as also the severity of the loss caused by the
occurrence of the event are uncertain. Thus, insurance refers to those risks which are
contingent in nature as fire, marine or accident.

LIFE INSURANCE
Life Insurance is a co-operative risk-sharing plan, based on the incentives of individual
thrift and initiative. It spreads losses of an individual over the group of individuals who
are exposed to similar risks. People who suffer loss get relief because their loss is made
good. People who do not suffer loss are relieved because they were spared the loss.

Through Life Insurance, people are able to set aside portions of their income during their
earning years, to make provisions for the time when their incomes cease, because of early
death, retirement, etc. Thus, Life Insurance makes it comparatively easy for people to
provide against these uncertainties of life a task generally impossible for an individual to
accomplish alone.

LAW OF LARGE NUMBERS - SCIENTIFIC BASIS OF LIFE INSURANCE.

According to this law, the average of the results obtained from a large number of trials
will move closer to the expected result as more and more trials are performed. Let’s
explain this through a popular example. When you flip a coin, the chances of it landing
head upwards are 50%, as the coin has two sides and it could show either head or tail. By
this logic, a person flipping a coin six times should get tails at least three times, but when
a coin is flipped just six times, the person may get five tails in a row. But flip that coin 60
times, and the number of tails would be closer to the 50% mark. As you increase the
number of trials of an event, the number of occurrences of that event get closer and closer
to the average chance of the event taking place.
Why do insurers apply this law?
Insurance is about covering risks and not certainties. But even while covering an
uncertain event, it is important for the insurer to know the probability of that risk actually
becoming a reality, to be able to price the product right. Insurers rely on the law of large
numbers to predict the risks. An insurer can predict the chances of a specific risk taking
place more accurately through this law. For example, as the number of people in a group
(who want an insurance cover against a common risk such as car theft) increases, the
real-life instances of that disaster come close to the expected average of that event
occurring. In other words, the deviation of the actual event from the expected average
will reduce, as the number of people in the pool increases.
So, larger the sample size, the greater is the predictability for insurance when doing the
premium rating. By having a larger pool, the insurer can accurately predict the
probability of an event and price the policy accordingly. When it works perfectly,

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insurance companies run a stable business, consumers pay a fair and accurate
premium, and the entire financial system avoids serious disruption.
To insure a single life against death for Rs. One crore during a given year is clearly a
gamble. If the number of persons insured is increased to one hundred, the element of
uncertainty is still present to a large extent. If the number of lives insured were so large as
to make the application of the law of averages virtually perfect, practically all uncertainty
as to the amount of loss during given period would be removed. When the insurance
protection is offered by an organization, it becomes a business instead of speculation.
Whereas, if an individual assumes a single risk, he either loses or gains thereby the whole
amount, making the transaction highly speculative. The company which assumes a large
number of risks runs its business on a non-speculative basis. During a given year, an
individual either dies or he survives the year. The result is a 100% loss or a 100% gain, if
one wagers upon the one life. But when we take one hundred thousand of such lives of
the same age and like physical condition, the variation in the result will be 2% usually.

FOUNDATION OF UNDERWRITING PRACTICE

1. Accumulation of fund From the above, it is clear that an Insurance Organization

needs a combination of many lives into a group to keep the business successful and non-
speculative. Insurance in its various forms is meant to give financial protection against
different types of risks or contingencies faced by the individuals. The main difference
between life and other forms of insurance is that, in the latter, the contingency insured
against may or may not, happen and in good number of cases does not occur. In Life
Insurance the contingency against which protection is granted namely death, may not
happen in the first year. But each passing year increases the probability, until it becomes
a certainty, because death eventually embraces everyone. It is therefore, necessary, if a
Life Insurance Policy is to protect the insured during the whole of his or her life, not only
to provide against the risk of death each year, but also to accumulate enough fund for the
purpose of meeting an absolutely certain claim. In the context of accumulating this fund,
the Insurance Companies have to take into account several characteristics that
differentiate one life from another. Lives assured at the younger ages live much longer
before a claim is made on their policies, than those who take the insurance cover at the
older ages. It is therefore necessary, in the interests of equity that the premiums charged
should increase with the increase in age at entry.
2. The insurer as trustee .The insurer is in the position of a trustee as it is managing the
common fund, forbid on behalf of the community of policyholders. It has to ensure that
nobody is allowed to take undue advantage of the arrangement. That means that the
management of the insurance business requires care to prevent entry (into the group) of
people whose risks are not of the same kind as well as paying claims on losses that are
not accidental. The decision to allow entry is the process of underwriting of risk.
Underwriting includes assessing the risk, which means, making an evaluation of how
much is the exposure to risk. The premium to be charged depends on this assessment of
the risk. Both underwriting and claim settlements have to be done with great care.
3.Differentiate between policyholders according to the benefit Various types of
policies are issued covering different sets of contingencies. Some insuring against risk of
death for a certain number of years only, while others cover for whole life. Some
contracts provide for payment of premiums for a limited number of years and others for
the entire duration of the policy. Some policies offer payment of entire sum insured on
the happening of the contingency, while others provide for the payment of that sum in a
fixed number of years or installments. Here again, in the interests of justice and fair play
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among different groups of policyholders, it is incumbent on the insurer to determine the
premium rates not only with reference to the age of the insured at entry, but also
according to the nature of different benefits offered.
4. Scientific principles in the determination of their premium rates. The insurers
cannot handle these complex terms justly, unless they follow some scientific principles in
the determination of their premium rates. Some types of Life Insurance Policies
(popularly known as Endowment) offer payment of sum assured in the event of death
during the term of the policy or survival to the end of the term. It is, therefore essential
that there be an accurate determination of the liability involved and that an adequate
premium be charged which is equitable as between ages and types of policies. These
reasons make it essential for the Insurers to compute their premiums on the basis of tables
of mortality and morbidity, based on experience which will show the probability of death
or disability at any age.

LEVEL PREMIUM CONCEPT

1. Now let us examine how the Life Insurance Premiums are computed. The simplest
way to understand this is to look at fire insurance first. Only a few houses in each
community are damaged or destroyed by fire each year. The annual rate of destruction
can be determined from past experience, so that it is possible to estimate the yearly cost
that all must pay in order that those who suffer loss can be compensated.
2. The same principles apply to Life Insurance. But while a house may never catch fire,
everyone must some day die. Moreover, the risk of a house catching fire does not, as a
rule increase with the age of the house. But the risk of dying does increase, as one grows
older. To provide life Insurance for only one year at a time, the premium would have to
be increased each year to meet the increased risk - which is not the case with fire
insurance. It is not very satisfactory to buy life long protection if the cost increases each
year. It is particularly unsatisfactory in the later years of life, when the yearly cost
increases to a point where many people cannot afford to carry life insurance that they still
need and want.
3. Life Insurance companies follow a system of level annual premium i.e the premium
once determined at the inception of the contract according to the age of the proposer at
the commencement of policy will remain unchanged throughout the policy term and same
premium is charged every year. Though the premiums are based on mortality risk which
increases as the age increases. Thus a person who is aged 18 years is less likely to die
then a person aged 28,38,48 and so on. With the increase in age every year mortality risk
increases and logically speaking the premium should increase every year but increasing
the premium every year has several drawbacks and not possible practically to underwrite
every year and determine the premium. Instead insurers calculate the total risk for the
term of insurance and charge premium for the average risk throughout the term of the
policy.
4. Keeping the premium the same from year to year, instead of increasing it with age,
involves the collection during the earlier years of a sum over and above that is required to
pay the current cost of insurance or to cover the risk at that particular age. It means in
initial years of the policy the insured will be paying the premium which is more than the
premium required to cover the risk at that age. This overcharge accumulates and will be
drawn upon during the later years when the same level annual premium becomes
insufficient to meet the current mortality cost.
5. This overcharge, or unearned premium, is called the policy reserve. When combined
with reserves on a large number of policies, it represents the sum that, together with the
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future premiums to be paid by that group of policyholders will just enable the company to
meet its claims on all lives insured in the group, assuming that deaths occur according to
the mortality table used. This method of accumulating a reserve fund is fundamental to
any sound plan of permanent Life Insurance.
6. The chief significance of the level premium concept lies in the fact that the redundant
premium in the early years of the contract creates a fund, which is held by the Insurer for
the benefit and to the credit of the policyholders. Earnings ( interest) are generated by
investing the fund. The accumulated fund, increased by interest earnings, is used to pay
the benefit provided under the contract.
7. Experience has shown the desirability of a level annual premium. Mathematically, it
is possible to consider a Life Insurance Policy as composed of a series of one year
renewable term assurances and to make each year's premium just cover the cost of current
protection. Under this plan, since the rate of death increases with increasing age, the
premium will gradually increase with age and so will become more and more
burdensome and eventually becomes prohibitive. As a result the healthy member of the
group will withdraw, pushing the cost of insurance still further. Therefore, it is desirable
to charge a uniform or level annual premium as contrasted with an increasing one. This
method has the advantage of the annual premium being moderate in amount, and the
same from year to year, with the result that policyholders remain satisfied and soon
become accustomed to its payment and are able to budget it.

INSURANCE V/s GAMBLING

1. What is gambling? It is nothing but betting on chance and is highly speculative.
Whatever one person wins from a wager is lost by the other wagering party. Before the
gambler wagers on the throw of the dice he could not have lost even one paisa whatever
the result. As soon as he has made a wager, he created a risk of loss to himself, where no
such risk had existed previously.
2. When we compare this wagering activity to Life Insurance, we will find a lot of
difference. In Insurance what one insured gains is not at the expense of another insured.
Basically, a group of people are coming together and contributing by way of premiums to
a fund. This creation of a fund helps in the payment of all claims. The purchase of
Insurance does not create a new and therefore non-existent risk or loss to the purchaser,
as is always true when one enters into a gambling agreement. Instead, the only intelligent
reason for purchasing insurance is that the purchaser faces an already existing risk of
economic loss.
3. Insurance and gambling are similar in only one respect. Both are wagering
agreements.(A wagering agreement is a promise to give money or money's worth upon
determination or ascertainment of an uncertain event.) In Insurance Contracts one party
promises to pay a given sum to the other upon the happening of a given future event. This
promise is conditioned upon the payment of or agreement to pay a stipulated amount by
the other party to the contract. This means that in either case, one party may receive
more, much more than what he paid or agreed to pay. At this point, the similarity ceases
between gambling and insurance.
4. Features common to Insurance and Gambling are:
a) Promise of payment on happening of certain event.(Wagering agreements.)
b) Amount receivable not commensurate with amount paid. (Aleatory Contracts).
The features differentiating insurance from gambling are:

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INSURANCE GAMBLING

Risk already exists. Risk not existent. It is created by means

No total loss. Entire group provides for of gambling.
themselves. One gains at the cost of the other. Total loss
It is based on mathematical prediction. to one.
It is highly speculative.

5. Life Insurance is essentially non-speculative. From the insured's point of view, Life
Insurance is the antithesis of gambling. Nothing is more uncertain than life, and Life
Insurance offer the only sure method of changing that uncertainty into certainty. Failure
of the head of a family to insure his or her life against the sudden loss of economic value
through death amounts to gambling with the greatest of life's values, and the gamble is a
particularly mean one since, in case of loss, the dependent family and not the gambler
must suffer the consequences. "He who does not insure gambles with greatest of all
values and if he looses, makes those dearest to him pay the price". (Prof. Huebner).

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