INTRODUCTION TO INSURANCE
WHAT IS INSURANCE
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. It is a benefit because it meets
some ofhis needs. The benefit may be an income or in some other form. In
the case of a factory or a cow, the product generated by it is sold and
income is generated. In the case of a motor car, it provides comfort and
convenience in transportation. There is no direct income. Both are assets
and provide benefits
Every asset is expected to last for a certain period of time during which it
will provide the benefits. After that, the benefit may not be available.
There is a life-time for a machine in a factory or a cow ora motor car.
None of them will last for ever. The owner is aware of this and he can so
manage his affairs that by the end of that period or life-time, a substitute is
made available. Thus, he makes sure that the benefit is not lost. However,
the asset may get lost earlier. An accident or some other unfortunate event
may destroy it or make it incapable of giving the benefits. An epidemic
may kill the cow suddenly. In that case, the owner and those enjoying the
benefits therefrom, would be deprived of the benefits. The planned
substitute would not have been ready. There is an adverse or unpleasant
situation. Insurance is a mechanism that helps to reduce the effects of
such adverse situations. It promises to pay to the owner or beneficiary of
the asset, a certain sum if the loss occurs.
The Brief History of Insurance
The Greeks had started benevolent societies in the late 7th century AD, to take care of
the funeral and families of members who died. The friendly societies of
England were similarly constituted. The Great Fire of London in 1666, in
which more than 13000 houses were lost, gave a boost to insurance and
the first fire insurance company, called the Fire Office, was started in
The origins of insurance business as in vogue at present, is traced to the
Lloyd’s Coffee House in London. Traders, who used to gather in the Lloyd’s
coffee house in London, agreed to share the losses to their goods while
being carried by ships. The losses used to occur because of pirates who
robbed on the high seas or because of bad weather spoiling the goods or
sinking the ship. In India, insurance began in 1818 with life insurance
being transacted by an English company, the Oriental Life Insurance Co.
Ltd.. The first Indian insurance company was the Bombay Mutual
Assurance Society Ltd, formed in 1870 in Mumbai. This was followed by
the Bharat Insurance Co. in 1896 in Delhi, the Empire of India in 1897 in
Mumbai, the United India in Chennai, the National, the National Indian
and the Hindusthan Cooperative in Kolkata
Later, were established the Cooperative Assurance in Lahore, the Bombay
Life (originally called the Swadeshi Life), the Indian Mercantile, the New
India and the Jupiter in Mumbai and the Lakshmi in New Delhi. These
were all Indian companies started as a result of the swadeshi movement in
the early 1900s. By the year 1956, when the life insurance business was
nationalised and the Life Insurance Corporation of India (LIC) was formed
on 1 September 1956, there were 170 companies and 75 provident fund
societies transacting life insurance business in India. After the amendments
to the relevant laws in 1999, the L.I.C. did not have the exclusive privilege of doing life insurance business in India. By 31.8.2007, sixteen new life
insurers had been registered and were transacting life insurance business
PURPOSE & NEED OF INSURANCE
Assets are insured, because they are likely to be destroyed or made non-
functional before the expected life time, 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, the contents
in it and the extent of damage.
The risk only means that there is a possibility of loss or damage. The damage may or may not happen. The earthquake may occur, but the
building may not have been affected at all. Insurance is done against the
possibility that the damage may happen. There has to be an uncertainty
about the risk. The word ‘possibility’ implies uncertainty. 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. The person is
insured, because of the uncertainty about the time of his death.. In the
case of a person who is terminally ill, the time of death is not uncertain,
though not exactly known. It would be ‘soon’. He cannot be insured.
Insurance does not protect the asset. It does not prevent its loss due to the
peril. The peril cannot be avoided through insurance. The risk can
sometimes be avoided, through better safety and damage control measures.
Insurance only tries to reduce the impact of the risk on the owner of the
asset and those who depend on that asset. They are the ones who benefit
from the asset and therefore, would lose, when the asset is damaged.
Insurance only compensates for the losses – and that too, not fully.
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.
HOW INSURANCE WORKS
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 ships are exposed to the same risks, which are related to water damage, sinking of the vessel, piracy, etc. Those owning
factories are not exposed to these risks, but they are exposed to different
kinds of isks like, fre, 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 in the group may suffer (all of them may not
suffer such losses at the same time) is divided into bearable small losses
by all the others in the group. 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. Insurance helps to spread the costs or risks.
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 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’.Itmakes an unbearable loss, bearable.
There are certain principles, which make itpossible forinsurance to remain
a preferred and 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 loss. This would be
taking unfair advantage of an arrangement put into place to protect people
from the accidental risks they are exposed to. The occurrence has to be
random, accidental, and not the deliberate creation of the insured person.
THE HUMAN ASSET
A human being is an income generating asset. One’s income generating
ability depends on one’s skills, (manual, professional, problem solving,
entrepreneurial, etc). These are the assets. The value of the asset can be
measured by considering the income that is generated by the person
concerned. The concept of Human Life Values, provides scientific ways
to determine the asset value of the human life and therefore, the amount of
life insurance required.. These techniques, like other techniques related
to selling, will have to be learnt on the job.
These assets 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. Ifithappens 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 ithappens much earlier
when the alternate arrangements are not in place, there can be losses to
the person and dependents. Those dependent on the income are helped to
overcome their difficulties, by insurance
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 be able to look after the
aged parents. 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 takes care.
Thus, the risks in the case of a human being are related to
Living too long
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 from the risks. The premium is determined on the same lines as
indicated in the examples above, but with some further refinements.
In India, insurance business is classified primarily as life and non-life or
general. Life insurance includes all risks related to the lives of human
beings and general insurance covers the rest. General insurance has three
classifications viz., Fire (dealing with all fire related risks), Marine (dealing
with all transport related risks and ships) and Miscellaneous (dealing with
all others like liability, fidelity, motor, crop, engineering, construction,
aviation, personal accident, etc). Personal accident and sickness insurance,
which are related to human beings, is classified as ‘non-life in India, but
is classified as ‘life’, in many other countries. What is ‘non-life’ in ndia is
termed ‘Property and Casualty’ in some other countries.
In India, the IRDA has, in 2005, issued Regulations enabling micro
insurance (broadly meaning insurance for small Sums Assured, like 5 to
50 thousands) to be done by both life and general insurers on the basis of
mutual tie-ups. Apolicy may be issued by a life insurer covering both life
and non-life risks, but premnium on account of the non-life business will
be passed on to a general insurer and the claim amount collected from the
The insurer is in the position of a trustee as it is managing the common fund, for and 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 ofrisk. 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
Insurance companies are talking risks. They have to pay claims as and when they occur. They cannot be sure when the claim will occur and how
big the claim may be. This is so because of the very nature of perils. Insurers
normally are financially sound enough to be able to pay claims. But there
are limits. An event like the tsunami or a hurricane may generate claims
amounting to crores of rupees, which may put a very heavy strain on the
reserves of the insurer. Insurers protect themselves from such situations, which may be beyond their capacity, by reinsuring the risk with other insurers. If there is a claim, the burden is shared by the primary insurer and the reinsurers.
PRINCIPLES OF LIFE ASSURANCE
LIFE INSURANCE CONTRACTS
Alife insurance policy promises that the insurer will pay to the policyholder
a certain sum of money if the person insured dies or any other specified
contingency happens. It is a contract, within the meaning of the Indian
ContractAct, 1872. Acontract is an agreement between two or more parties
to do, or not to do, so as to create a legally binding relationship.
contract must have the following essentials
• Offer and acceptance
• Capacity to contract
• Consensus ‘ad idem’ (genuine meeting of minds)
• Legality of object or purpose
• Capability of performance
• Intention to create legal relationship
Insurance is a contract between the insurer and the policyholder. The
policyholder can be different from the person whose life is insured, as
will be seen later. Insurance is a specialised type of contract. Apart from
the usual essentials of a valid contract, insurance contracts are subject to
two additional principles viz. Principle of Umost Good Faith and the
Principle of Insurable Interest. These apply to all insurances, both life
PRINCIPLE OF UTMOST GOOD FAITH
Commercial contracts are normally subject to the principle of :caveat emptor”
i.e. “let the buyer beware”. It is assumed that cach party to the contracto
examine the item or service, which is the subject matter of the conte
Each party can verify the correctness of the statements of the other nt
There is no need to take the statements on trust. Proof can be asked for.
In the case of insurance contracts, this principle does not apply. Most of the facts relating to health, habits, personal history, family history etc.
which form the basis of the life insurance contract, are known only to the
proposer. The insurer cannot know them, if the proposer does not disclose
them. The underwriter can ask for a medical report. Yet there may be
certain aspects, which may not be brought out even by the best medical
As the underwriter knows nothing
and the man who comes to him to ask for insurance knows everything, itis
the duty of the assured to make a full disclosure to the underwriter., without
being asked, of all material circumstances. This is expressed by saying
that it is a contract of utmost good faith”.
The law imposes a greater duty on the parties to an insurance contract
than in the case of other commercial contracts, to disclose relevant
information. This duty is one of utmost good faith or Uberrimae Fides.
It is the duty of the proposer to make a full disclosure to the insurer. The
implication is that, in the event of failure to disclose material facts, the
contract can be held to be void ab initio.
All risks are not insurable. Otherwise, an insurance contract would be no
different from a wagering contract or betting. It was explained earlier
that speculative risks are not insurable. A wagering contract is speculative
in nature and is illegal in terms of Section 30 of the Indian Contract Act.A
subject matter of a valid contract has to be legal. What distinguishes an
insurance contract fromawagering contract and makes it non-speculative,
is that the insured musthave an insurable interestin the subject of insurance.
In simple terms, it means that the proposer must have a stake in the
continuance of the subject matter insured and could suffer a loss, if the
risk occurs. What is insured is the financial or pecuniary interest in the
subject matter of insurance. The insured must be in a relationship with the subject matter of insurance, whereby he benefits from it’s safety and well-being and would be prejudiced by its loss or damage.
FEATURES OF INSURABLE INTEREST
In the case of life insurance policies, insurable interest must exist at the
inception of the policy. There is no requirement for insurable interest at
the time of a claim under the life insurance policy. In the case of Marine
a ib policies insurable interest must exist at the time of the claim. This implies
that there need not be insurable interest at the inception of the policy.
When an importer asks for insurance cover on goods which he has ordered,
he is still not the owner and therefore, has no insurable interest. In other
insurances, insurable interest must exist at the time ofinception as well as
at the time of claim.
PRINCIPLE OF INDEMNITY
Insuranceis meant to compensate losses. By implication, the mechanism
of insurance cannot be used to make a profit. This broadly is the Principle
of Indemnity. The amount paid out as a claim cannot exceed the amount
of loss incurred. Insurance should place the insured in the same financial
position after a loss as he enjoyed before it, not better.
There is a link between indemnity and insurable interest. It is the interest
of the insured in the subject matter of insurance, that is insured. Therefore,
the amount of claim cannot exceed the extentof interest. In the case of life
insurance however, because the insurable interest (on own life) is assumed
to be unlimited, the principle of indemnity does not apply. In health
insurance covers, which are part of general insurance, the principle of
indemnity will apply.
Because of the principle of indemnity, there could be difficulties in settling
claims in general insurance. Assessments of losses made by qualified
surveyors, are often disputed. The damaged parts that have been replaced,
called salvage, may have some resaleable value. The insurer may have
the option to settle the claimby way of repair, reinstatement or replacement.
In the case of liability or damages (for pain and mental agony etc.), the level of indemnity is vague and indeterminable. Such problems do not exist in life insurance.
The life insurance business deals with risks relating to life of human beings.
The circumstances (perils) that create the loss or damage (risks) are mainly
two, death and old age. Insurance does not prevent either. It can mitigate
the consequences in those circumstances.
Human beings also run the risk of sickness (medical costs can be very
burdensome), accidents (causing disability) and unemployment. These
are insurable in non-life insurance. Sickness and accident risks, including
disability, are insurable as supplementary benefits, also called riders, under
life insurance policies. These are explained in the chapter on life insurance
As a rule, risks are managed in three ways, viz.,
Prevention or Avoidance
Death and Old Age are not preventable at all. Accidents, sickness and
unemployment are also perhaps not avoidable despite being careful.
Accidents may be caused by someone else being negligent. Surroundings
can create sickness. Economic conditions lead to unemployment…
Retention of the risk is an alternative. This is possible by having one’s
own resources to take care of the needs, like puting aside savings to be
used for the rainy day’. Big organisations like the State Road Transport
Corporation or the Railways may find it cheaper to bear the risks
themselves, as they have the benefit of large numbers. One might think of
joint families as systems that can manage the risks themselves. Strictly,
however, inajoint family system, there is sharing by others in the family.
That is the principle of insurance.
The third option is the transfer of the risk to another person.One common
‘transfer’ is when the State, being a welfare State, takes over the
responsibility for medical care of its citizens, or pays benefits to the elderly
and the unemployed. This happens in some countries in Europe, USA
and Canada. Insurance is a mechanism for transfer.