Insurance: An Overview

Saima Rizvi (2005)

1.1 Introduction to Insurance

Insurance is defined as a cooperative device to spread the loss caused by a particular risk over a number of persons who are exposed to it and who agree to ensure themselves against that risk. Risk is the uncertainty of a financial loss. Insurance is also a social device to accumulate funds to meet the uncertain losses arising through a certain risk to a person insured against the risk.1Insurance

The modern industrialized society is exposed to various kinds of uncertainties and risks, which are of different degrees and range from the unavoidable to those assumed by choice. The annual losses to individuals and businessmen from premature deaths, fire, water, accident, windstorm, sea perils, earthquakes, floods, dishonesty, negligence, unemployment, lighting, etc are beyond estimation and indicate the importance of recognizing and meeting them intelligently. In order to avoid or minimize these losses, man has devised various plans to protect himself against these unexpected and unfortunate calamities. Insurance is one such method. Insurance, therefore, denotes a contract whereby one party (insurer) in consideration of money payment called premium, undertakes to indemnify another party (insured), against any loss or pay to that party an agreed sum of money on the happening of a certain event. The insurance is based upon the principles of co-operation and probability.2

Insurance companies bear risk in return for a fee called premium. Thus, insurance companies are risk bearers. They accept or underwrite the risk in return for an insurance premium.3

There are two parties to an insurance contract:

      • (i) Insurer/assurer/underwriter and
      • (ii) Insured /assured /beneficiary.

The document laying down the terms of the contract is called (insurance) policy. The property which is insured is the subject matter of insurance. It may be insured against loss arising from uncertain events/causalities/perils in the form of destruction of, or damage to, the property or death, disablement of a person. The interest which the insured has in the subject matter of insurance is known as insurable interest.4

1.1.1 Function of Insurance

The functions of insurance can be studied into two parts:

      • I) Primary Functions
      • II) Secondary Function

Primary Functions:-

i) Insurance provides certainty: Insurance provides certainty of payment for the risk of loss. There are different types of uncertainty in a risk. The risk will occur or not, when will it occur, how much loss will be there? In other words, there is the uncertainty of happening of time and amount of loss. Insurance removes all these uncertainties and the assured is given certainty of payment of loss. The insurer charges premium for providing the said certainty.5

ii) Insurance provides protection: The main function of the insurance is to provide protection against the probable chances of loss. The insurance guarantees the payment of loss and thus protects the assured from sufferings.6

iii) Risk sharing: The risk is uncertain, and therefore, the loss arising from the risk is also uncertain. When risk takes place, the loss is shared by all the persons who are exposed to the risk. The share is obtained from each and every insured in the shape of premium without which the insurer does not guarantee protection.7

Secondary Function:-

Besides the above primary functions, the insurance works for the following functions:

i. Prevention of loss: The insurance joins hands with those institutions which are engaged in preventing the losses of the society because the reduction in loss causes the lesser payment to the assured and so more saving is possible which will assist in reducing the premium. Lesser premium invites more business and more business causes lesser share to the assured. The reduced premium will stimulate more business and more protection to the masses.8

ii. It provides capital: The insurance provides capital to society. The accumulated funds are invested in productive channels. The scarcity of capital of the society is minimized to a greater extent with the help of investment in insurance.9

iii. It improves efficiency: The insurance eliminates worries and miseries of losses at death and destruction of property. The carefree person can devote his body and soul together for better achievement. It improves not only his efficiency, but the efficiencies of the masses are also advanced 10

iv. It helps economic progress: The insurance by protecting society from huge losses of damage, destruction, and death provides an initiative to work hard for the betterment of the masses. The next factor, the capital, is also immensely provided by the masses which is then invested and facilitates the economic progress of the country.11

1.1.2 Definition of Insurance

The definition of insurance can be made from two points:-

    • i) Functional Definition and
    • ii) Contractual definition

Functional Definition:-

Insurance is a co-operative device to spread the loss caused by a particular risk over a number of persons, who are exposed to it and who agree to insure themselves against the risk. Thus, the insurance is a) a cooperative device to spread the risk; b) the system to spread the risk over a number of persons who are insured against the risk; c) the, principal to share the loss of each member of the society on the basis of probability of loss to their risk; and d) the method to provide security against losses to the insured.12

Contractual Definition:-

Insurance may be defined as a contract consisting of two parties where one party (the insurer) agrees to pay to the other party (the insured) or his beneficiary, a certain sum upon a given contingency (the risk) against which insurance is sought.13

1.1.3 Characteristics of Insurance

The insurance has the following characteristics which are generally observed in case of life, marine, fire, and general insurance:-

    • i. Sharing of risk: Insurance is a mechanism adopted to share the financial losses that might occur to an individual or his family on the happening of a specified event. The loss arising from these events if insured are shared by all the insured in the form of premium. Hence, the risk is transferred from one individual to a group.14
    • ii. Co-operative device: Insurance is a co-operative device under which a group of persons who agree to share the financial loss may be brought together, voluntarily or through publicity or through solicitations of the agents. An insurer would be unable to compensate for all the losses from his capital. So, by ensuring a large number of persons, he is able to pay the amount of loss. Like all co-operative devices, there is no compulsion here on anybody to purchase the insurance policy.15
    • iii. Value of risk: The risk is evaluated before insuring to charge the amount of share of an insured, herein called, consideration or premium. There are several method of evaluation of risks. If there is an expectation of more loss, the higher premium may be charged. So, the probability of loss is calculated at the time of insurance.16
    • iv. Payment at contingency: The payment is made at a certain contingency insured. If the contingency occurs, payment is made. Since the life insurance contract is a contract of certainty, because the contingency, the death or expiry of the term, will certainly occur, the payment is certain. In other insurance contracts, the contingency is the fire or the marine perils etc, may or may not occur. So, if the contingency occurs, payment is made, otherwise, no amount is given to the policyholder.17
    • v. Amount of payment: On the occurrence of the contingency, the insurer is legally bound to make good the financial loss suffered by the insured. The amount of payment depends upon the value of loss that occurred due to the particular insured risk, provided insurance is there up to that amount. In life insurance, the purpose is not to make good the financial loss suffered. The insurer promises to pay a fixed sum on the happening of an event. It is immaterial in life insurance what was the amount of loss at the time of contingency. But in the property and general insurance, the amount of loss, as well as the happening of loss, is required to be proved.18
    • vi. Huge number of insured persons: To make the insurance cheaper, it is essential to ensure a larger number of persons or property because the lesser would be cost of insurance and so, the lower would be premium. In order to function successfully, the insurance should be joined by a large number of persons.19
    • vii. Insurance is not a gambling: The uncertainty is changed into certainty by insuring property and life because the insurer promises to pay a definite sum at damage or death. Insurance is just the opposite of gambling. In gambling, by bidding the person exposes himself to the risk of losing, in the insurance, the insured is always opposed to risk, and will suffer loss if he is not insured.20
    • viii. Insurance is not charity: Charity is given without consideration but insurance is not possible without premium. It provides security and safety to an individual and to the society although it is a kind of business because in consideration of premium it guarantees the payment of loss.21
    • ix. Investment portfolio: Since insurers collect premiums initially and make payment later when (e.g., the insured person’s death) or if (e.g., an automobile accident) an insured event occurs, insurance companies maintain the initial premiums collected in an investment portfolio, which generates a return. Thus, the insurers have two sources of income; the insurance premium and the investment income, which occurs over time.22

1.1.4 Principles of Insurance

The insurance is based upon i) Principles of Co-operation and ii) Principles of Probability

    • i. Principal of Co-operation: Insurance is a co-operation device. If one person is providing for his own losses, it cannot be strictly an insurance because in insurance the loss in shared by a group of persons who are willing to co-operate. The co-operation took another form where it was agreed between the individual or the society to pay a certain sum in advance to be a member of the society. The society by accumulating the funds guarantees payment of a certain amount at the time of loss to any member of the society. The accumulation of funds and charging of the share from the member in advance became the job of one institution called the insurer. Now it became the duty and responsibility of the insurer to obtain adequate funds from the member of the society to pay them at the happening of the insured risk. Thus, the shares of loss took the form of premium. Today, all the insured give a premium to join the scheme of insurance. Thus, the insured are co-operating to share the loss of an individual by payment of a premium in advance.23
    • ii. Theory of Probability: The loss in the shape of premium can be distributed only on the basis of the theory of probability. The chances of loss are estimated in advance to affix the amount of premium. Since the degree of loss depends upon various factors, the affecting factors are analyzed before determining the amount of loss. With the help of this principle, the uncertainty of loss is converted into certainty. Therefore, the insurer has to charge only so much of amount which is adequate to meet the losses. The probability tells what the chances of losses are and what will be the amount of losses.24

1.1.5 Benefits of Insurance

Insurance is the instrument of security, saving and peace of mind. It provides several benefits by paying a small amount of premium to an insurance company as:25

    • i) Safeguards oneself and one’s family for future requirements.
    • ii) Peace of mind in case of financial loss. The knowledge that insurance exists to meet the financial consequences of certain risks provides a form of peace of mind.
    • iii) Encourages saving.
    • iv) Tax deductions.
    • v) Protection from the claim made by creditors.
    • vi) Security against a personal loan, housing loan or other types of loan.
    • vii) It provides a protection cover to industries, agriculture, women and children.

1.1.6 Role and Importance of Insurance

The role and importance of insurance can be divided into: –26

    • i) Uses to individual
    • ii) Uses to a special group via to business or industry.
    • iii) Uses to society.

Uses of Individual:

    1. Insurance provides safety and security.
    2. It affords peace of mind.
    3. It protects mortgaged property.
    4. It eliminates dependency
    5. Life insurance encourages savings.
    6. Life insurance provides profitable investment.
    7. Life insurance fulfills the needs of a person like family needs, old age needs and some special needs like the need for education, marriage, need for settlement of children, etc.

Uses to business:-

    1. Uncertainty of business losses is reduced.
    2. Business efficiency is increases with insurance.
    3. Enhancement of credit
    4. Business continuation.
    5. Welfare of employees.

Uses to society:-

    1. Wealth of the society is protected.
    2. The economic growth of the country.
    3. Reduction in inflation.

1.2 Kinds of Insurance

Insurance occupies an important place in the modern world because the risks, which can be insured, have increased in number and extent owing to the growing complexity of the present-day economic system. It plays a vital role in the life of every citizen and has developed on an enormous scale leading to the evolution of many different types of insurance. Infact, now days almost any risk can be made the subject matter of contract of insurance. The different types of insurance have come about by practice within insurance companies, and by the influence of legislation, controlling the transacting of insurance business.27

Broadly insurance can be classified into the following categories:-

1. Classification on the basis of nature of insurance.

    • a) Life insurance.
    • b) Fire insurance.
    • c) Marine insurance.
    • d) Social insurance.
    • e) Miscellaneous insurance.

2. Classification from business point of view.

    • a) Life insurance.
    • b) General insurance.

3. Classification from risk point of view.

    • a) Personal insurance.
    • b) Property insurance.
    • c) Liability insurance and
    • d) Fidelity guarantee insurance.

1. Classification on the basis of nature of insurance

Life Insurance: Life insurance is different from other insurance in the sense that, here, the subject matter of insurance is life of human being. The insurer will pay the fixed amount of insurance at the time of death or at the expiry of certain period. At present, life insurance enjoys maximum scope because the life is the most important property of the society or an individual. Each and every person requires insurance. This insurance provides protection to the family at the premature death or gives adequate amount at the old age when earning capacities are reduced. Under personal insurance a payment is made at the accident. The insurance is not only a protection but is a sort of investment because a certain sum is returnable to the insured at the death or at the expiry of the period. Fire, Marine, and Miscellaneous insurance would be discussed under the head of general insurance.28

Social Insurance: The social insurance is to provide protection to the weaker section of the society who is unable to pay the premium for adequate insurance. Pension plans, disability benefits, unemployment benefits, sickness insurance and industrial insurance are the various forms of social insurance. With the increase of the socialistic idea, the social insurance is an obligatory duty of the nation. The Government of a country must provide social insurance to its masses.29

2. Classification from a business point of view

From the business point of view insurance can be divided into two categories —life insurance and general insurance. Life insurance has already been discussed, so the next category is the general insurance segment.

    • General Insurance: The general insurance includes property insurance, liability insurance and other forms of insurance. Fire and marine insurance are strictly called property insurance. Motor, theft, fidelity and machine insurances come under liability insurance to a certain extent. The strictest form of liability insurance is fidelity insurance, whereby the insurer compensates the loss to the insured when he is under the liability of payment to the third party.30

(A) Property insurance: Under the property insurance, property of a person/ persons is insured against a certain specified risk. The risk may be tire or marine perils, theft of property or goods, damage to property at accident.

      • a) Marine insurance: Marine insurance provides protection against losses in marine perils. The marine perils are a collision with rock or ship attack by enemies, fire and captured by pirates, etc. These perils cause damage, destruction or disappearance of the ship and cargo and non-payment of freight. So, marine insurance insures ship, cargo, and freight.31
      • b) Fire insurance: Fire insurance covers risks of fire. In the absence of fire insurance, the fire waste will increase not only to the individual but to the society as well. With the help of fire insurance, the losses arising due to fire are compensated and the society is not losing much.32
      • c) Miscellaneous insurance: The property, goods, machines, furniture, automobile, valuable articles, etc. can be insured against damage or destruction due to accident or disappearance due to theft. There are different forms of insurances for each type of the said property whereby not only property insurance exists but liability insurance and personal injuries are also insured.33

(B) Liability insurance: The general insurance also includes liability insurance whereby the insured is liable to pay the damage of property to compensate for the loss and personal injury or death. This insurance is seen in the form of fidelity insurance, automobile insurance and machine insurance.34

(C) Other forms: Besides the property and liability insurances, there are certain other insurances which are included under general insurance. The examples of such insurances are export credit insurances, state employees’ insurance, etc, whereby the insurer guarantees to pay a certain amount at certain events. This insurance is extending rapidly these days.35

Kinds of insurance

3. Kinds of insurance from risk point of view.

    • a) Personal insurance: The personal insurance includes insurance of human/ life which may suffer loss due to death, accident and disease. Therefore, personal insurance is further sub-classified into life insurance, personal accident insurance and health insurance.37
    • b) Property insurance: The property of an individual and of the society is insured against the loss of fire and marine perils, the crop is insured against an unexpected decline in production, unexpected death of animals engaged in business, breakdown of machines and theft of the property and goods.38
    • c) Liability insurance: The liability insurance covers the risks of third party, compensation to employees’ liability of the automobile owners and reinsurance.39
    • d) Guarantee insurance: The Guarantee insurance covers the loss arising due to dishonesty, disappearance and disloyalty of the employees or second party failure causes to the first party. For example, in export insurance, the insurer will compensate the loss at the failure of the importers to pay the amount of debt.40

1.3 Types of insurance organizations

The insurance organization developed in different forms with the advancement of insurance practices. Some of the forms are discussed below:-

1. Self insurance: The plan by which an individual or concern sets up a private fund, out of which to pay losses is termed “Self insurance”. The person lays aside a periodically certain sum to meet the losses of any contemplated risk. While it may be called “self insurance”, it is not, as a matter of fact, insurance at all because there is no hedge, no shifting or distributing of the burden of risk among larger persons. It is merely a provision for meeting the contingency. Here the insured becomes his own insurer for the particular risk. But, it can be successfully worked only when there is a wide distribution of risks subject to the same hazard. It may be less expensive provided the amount of loss is tremendous. The fund, as it accumulates, belongs to the insured and he can invest it as he may deem prudent. He pays no commission to agents, no extra expenses for maintaining an office. So, on the one hand, the return of an investment will be higher and on the other, the cost of operation will be lesser.41

2. Individual insurer: An individual like other business can perform the business of insurer provided he has sufficient resources and talent of the insurance business. The individual organization has been rare in the field of insurance.42

3. Partnership: A partnership firm can also carry on the insurance business for the sake of profit. Since it is not an entity distinct from the persons composing it, the personal liability of partners in respect of the partnership debts is unlimited. In case of huge loss, the partners have to pay from their own personal funds and it will not be profitable for them to start an insurance business. These forms of insurance had completely disappeared with the advent of joint-stock companies.43

4. Joint-stock companies: The joint-stock companies are those which are organized by the shareholders who subscribe the necessary capital to start the business, are formed for earning profits for the stockholders who are the real owners of the companies. The management of a company is entrusted to a board of directors who are elected by the shareholders from among themselves. The company can operate insurance business and the policyholders have nothing to do with the management of the concern. They operate within the memorandum of association and articles of association framed by them. They used to distribute only 5 percent of the divisible profit to the shareholders and more than 95 percent of the divisible profit was distributed amongst the policyholders.44

5. Mutual companies: The mutual companies were co-operative associations formed for the purpose of effecting insurance on the property of its members. The policyholders were themselves shareholders of the companies. Each member was insurer as well as insured. They had power to participate in the management and in profit to the full extent. Whenever the income was more than the expenses and claims, it was accumulated in the form of savings and was entitled in reducing the rate of premium. Since the insured were insurers also, they always tried to reduce the management expenses and to keep the business at sound level.45

6. Co-operative insurance organization: Co-operative insurance organizations are those concerns which are incorporated and registered under Indian Co-operative Insurance Societies Act. These concerns are called ‘Co-operative insurance societies. These societies like mutual companies are non-profit organizations. The aim is to provide insurance protection to its members at the lowest reasonable net cost.46

7. Lloyd’s Association: The Lloyd’s association is an association of individual insurance known as ‘underwriters’. They are also termed as `Syndicates’ or Names’. Any insurer who wants to become a member of such association has to deposit a certain fee as a security for the regular payment of his liabilities. The association before enrolling the insurer as a member of the association will inquire about the financial position of the concern, business reputation and experience. The business is affected by the insurers called underwriters. The association is merely a controlling and guiding body. Marine insurance, war risk, election risk, export risk, etc. have been insured by Lloyd’s Association.47

8. State insurance: The Government of a nation sometime owns the insurance and runs the business for the benefit of the public. The state insurance is defined as that insurance which is under public sector, but more specifically, it can be stated that when governments have taken over the insurance business particularly life insurance.48

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