Unit 3 - Introduction to Insurance Risk and Insurance.

Definition and Basic Characteristics of Insurance - Requirements of an Insurable Risk -

Adverse Selection and Insurance - Insurance vs. Gambling - Insurance vs. Hedging - Types
of Insurance - Essentials of Insurance Contracts. Indian Insurance Industry - Historical
Framework of Insurance, Insurance sector Reforms in India. IRDA - Duties and powers of
IRDA - IRDA Act 1999. (Theory).
Definition and Basic Characteristics of Insurance

Insurance is a mechanism by which the person exposed to the potential risk, arising
out of the events beyond his control, transfers the financial loss; in part or in full to a third
party.

The party which transfers the potential loss is termed as the „Insured‟ and the party
which indemnifies or undertakes to compensate the other party of such potential loss is
termed as „Insurer‟.

The Insurer provides the coverage for the potential financial loss for a fee or a
consideration which is called the „Premium‟.

Insurance is a special type of contract between the Insurer (the Insurance Company) and
the Insured (the client) wherein:

 The client agrees to pay a premium to the Insurance Company. Such premium may be
a fixed amount payable as a single payment or it may be paid as periodical payments.
This will depend upon the type of Insurance and the terms thereof.

 In lieu of the payment of such premium the Insurance Company agrees to make some
payment to the client or bear the costs of the client due to financial loss incurred on
the occurrence of certain events.

Insurance & basic characteristic of insurance

Insurance

A contract (policy) in which an individual or entity receives financial protection or

reimbursement against losses from an insurance company. The company pools clients' risks
to make payments more affordable for the insured.
Four basic characteristic of insurance

• Pooling of Losses.
• Payment of Accidental Losses.
• Risk Transfer.
• Indemnification.

Pooling of Losses

Pooling is the spreading of losses incurred by the few over the entire group, so that in
the process, average loss is substituted for estimator.

Pooling indicates,
• The sharing of losses by the entire group.
• Prediction of future losses with some accuracy based on the law of large numbers.

Payment of Accidental Losses

A second characteristic of private insurance is the payment of accidental losses. An

accidental loss is one that the unforeseen and unexpected and occurs as a result of chance. In
other words, the loss must be accidental. The law of large numbers is based on the
assumption that losses are accidental and occur randomly. For example, a person may
commit suicide. The loss would be accidental insurance policies do not cover intentional
losses.

Risk Transfer

Risk transfer is another essential element of insurance. With the exception of self-
insurance, a true insurance plan always involves risk transfer. Risk transfer means that a pure
risk is transferred from the insured to the insurer, who typically is in a stronger financial
position to pay the loss than the insured. From the viewpoint of the individual, pure risks that
are typically transferred to insurers include the risk of premature death, poor health,
disability, destruction and theft of property, and liability lawsuits.
Indemnification

A final characteristic of insurance is indemnification for losses. Indemnification

means that the insured is restored to his or her approximate financial position prior to the
occurrence of the loss. Thus, if your home burns in a fire, a homeowner‟s policy will
indemnify you or restore you to your previous position. If you are sued because of the
negligent operation of an automobile, your auto liability insurance policy will pay those sums
that you are legally obligated to pay. Similarly, if you become seriously disabled, a disability
income insurance policy will restore at least part of the lost wages.

Other Characteristics of Insurance

• It is a contract for compensating losses.

• Premium is charged for Insurance Contract.
• The payment of Insured as per terms of agreement in the event of loss.
• It is a contract of good faith.
• It is a contract for mutual benefit.
• It is a future contract for compensating losses.
• It is an instrument of distributing the loss of few among many.
• The occurrence of the loss must be accidental.
• Insurance must be consistent with public policy.

Benefits of Insurance

• Risk transfer.
• Protection.
• Assured profit.
• Benefits to consumers.
• Insurance serves as a basis of credit.
• Investment.
• Insurance encourages savings.
• Capital formation.
Requirements of an Insurable Risk

• Large Number of Exposure Units.

The first requirement of an insurable risk is a large number of exposure units.
Ideally, there should be a large group of roughly similar, but not necessarily identical,
exposure units that are subject to the same peril or group of perils. For example, a
large number of frame dwellings in a city can be grouped together for purposes of
providing property insurance on the dwellings.

The purpose of this first requirement is to enable the insurer to predict loss
based on the law large numbers. Loss data can be compiled over time, and losses for
the group as a whole can be predicted with some accuracy. The loss costs can then
the spread over all insured in the underwriting class.

• Accidental and Unintentional Loss.

A second requirement is that the loss should be accidental and unintentional;
ideally, the loss should be accidental and outside the insured‟s control. Thus, if an
individual deliberately causes a loss, he or she should not be covered for the loss.

• Determinable and Measurable Loss.

A third requirement is that the loss should be both determinable and
measurable. This means the loss should be definite as to cause, time, place and
amount. Life assurance in most cases meets this requirement easily. The cause and
time of death can be readily determined in most cases, and if the person is insured, the
face amount of the life assurance policy is the amount paid. Some dishonest claimants
may deliberately fake sickness or injury to collect from the insurer. Even if the claim
is legitimate, the insurer must still determine whether the insured satisfies the
definition of disability stated in the policy.

• No Catastrophic Loss.
The fourth requirement is that ideally the loss should not be catastrophic. This
means that large proportion of exposure units should not incur losses at the same time.
 As we stated earlier, pooling is the essence of insurance. If most or all of the
exposure units in a certain class simultaneously incur a loss, then the pooling
technique breaks down and becomes unworkable. Premiums must be increased to
prohibitive levels, and the insurance technique is no longer a viable arrangement by
which loses of the few are spread over the entire group.

• Calculable Chance of Loss.

A fifth requirement is that the chance of loss should be calculable. The insurer
must be able to calculate both the average frequency and the average severity of
future losses with some accuracy. This requirement is necessary so that a proper
premium can be charged that is sufficient to pay all claims and expenses and yield a
profit during the policy period.

• Economically Feasible Premium.

A final requirement is that the premium should be economically feasible. The
insured must be able to pay the premium. In addition, for the insurance to be an
attractive purchase, the premiums paid must be substantially less than the face value,
or amount, of the policy. To have an economically feasible premium, the chance of
loss must be relatively low.

Adverse Selection and Insurance

Adverse selection is common in the insurance industry, where there is excessive

information imbalance. It is also a case where the buyer is the one with more information
than the seller. Insurance companies need the information to price their premiums and
determine the terms of their policies.

They can not afford to charge low premiums to high-risk takers because that would
lose them money. This is why life insurance companies will charge smokers more than non-
smokers. Smokers are more liable to get life-threatening diseases and are more at risk of
dying early than non-smokers.
Insurance vs. Gambling

Insurance is often erroneously confused with gambling. There are two important
differences between them. First, gambling creates a new speculative risk, while insurance is
a technique for handling an already existing pure risk. This, the you bet $300 on a horse race,
a new speculative risk is created, but if you pay $300 to an insurer for fire insurance, the risk
of fire is already present and is transferred to the insurer by a contract. No new risk is created
by the transaction.

The second difference between insurance and gambling is that gambling is socially
unproductive, because the winner‟s gain comes at the expense of the loser. In contrast,
insurance is always socially productive, because neither the insurer nor the insured is placed
in a position where the gain of the winner comes at the expense of the loser. The insurer and
the insured both have a common interest in the prevention of a loss. Both parties win if the
loss does not incur. Moreover, consistent gambling transactions generally never restore the
loser to the former financial position. In contrast, insurable contract restore the insured
financially in whole or in part if a loss occurs.

Insurance vs. Hedging

The concept of hedging is to transfer the risk to the speculator through the purchase of
future contracts. An insurance contract, however, is not the same thing as hedging. Although
both techniques are similar in that risk is transferred by a contract, and no new risk is created,
there is some essential difference between them. First, an insurance transaction involves
transferring insurable risks because the requirement of an insurable risk can generally be met.
However, hedging is a technique for handling typically uninsurable risks, such as protection
against a decline in the price of agriculture products and raw materials.

A second difference between insurance and hedging is that insurance and hedging can
reduce the objective risk of an insurer by applying the law of large numbers. As the number
of exposure units increases, the insurer‟s prediction of future losses improves because the
relative variation of actual loss from expected loss will decline. Thus, many insurance
transactions reduce objective risk. In contrast, hedging typically involves only risk transfer,
not risk reduction. The risk of adverse price fluctuation is transferred because of superior
knowledge of market conditions. The risk is transferred, not reduced, and prediction of loss
generally is not based on the law of large numbers.

Types of Insurance

Insurance in India is mainly of two types viz. Life Insurance and Non-Life Insurance
which is termed as General Insurance. These are described as follows:

1. Life Insurance
Under Life Insurance the Insured pays the premium at specified times and in turn the
Insurance Company undertakes to pay the specified fixed amount to the legal recipients in the
event of death of the Insured. Thus life insurance is a mechanism whereby the life of the
Insured is insured.

2. General Insurance
Insurance other than Life Insurance falls under the category of General Insurance. The
different types of General Insurance are fire, marine, Motor Vehicle, accident and other types
of non-life insurance.

Essentials of Insurance Contracts

Following are the essentials fo insurance contracts,
• Nature of contract.
• Utmost good faith.
• Insurable interest.
• Indemnity.
• Causa proxima.
• Contribution.
• Risk must be attached.
• Mitigation of loss.
• Subrogation.
• Terms of policy.
Nature of contract

Nature of contract is fundamental principle of contact of insurance. A contact of

insurance comes into existence when there is an offer and acceptance. It has to satisfy all the
essential elements of a simple contact.
 Age of majority according to law.
 Sound mind.
 Premium is the consideration.
 Object of the contract must be lawful.
 Free consent.

Utmost good faith

Both parties should disclose all material facts and figures relating to the insurance
contact.
• Life insurance : Age, income, education, occupation, health, family size.
• Fire insurance: Inflammable materials, nature and its use, fire detection etc.
• Motor insurance: Type of car, value and details etc.

Insurable interest

Insurable interest is a fundamental principle of insurance. It is necessary for a valid

contract of insurance. It means that insurable interest must be a monetary interest. The
insured must have an insurable interest in the subject matter of insurance.

• In life insurance at the time of taking policy.

• In fire insurance both at the time of taking policy and as well as the time of loss.

Indemnity

A contract of insurance is a contract of indemnity. All contract of insurance except

life, personal accident and sickness insurance are contracts of indemnity. This means that the
assured, in case of loss against which the policy has been insured, shall be paid the actual
amount of loss not exceeding the amount of the policy.
Methods of Indemnity
• Cash payment.
• Repairs.
• Replacement.

Causa Proxima

It is a rule of law that in actions on fire policies, full regard must be had to the causa
proxima. If the proximate cause of the loss is fire, the loss is recoverable. If the cause is not
fire but some other cause remotely connected with fire, it is not recoverable, unless
specifically provided for.

Contribution

According to this principle, in case of double insurance, the insurers are to share the
loss in proportion to the amount assured by each of them. In order to apply the right to
contribution between two or more companies, the following factors must exist.

• The subject matter of insurance must be the same.

• The event insured must be the same.
• The insured must be the same.

Risk must be attached

A contract of insurance can be enforced only if the risk has been attached. Premium is
the consideration for the risk run by the insurance company. Risk or loss must be available to
create the insurance contract.

Mitigation of loss

Mitigation of loss is applied in valid insurance contract. In the event of some mishap
of the insurance property, the insured must make necessary effort to safeguard his remaining
property and minimize the loss.
Subrogation

The term subrogation means the transfer of all the rights and remedies available to the
insured in respect of the subject matter to insurer after indemnity has been affected.

Term of Policy

An insurance policy specifies the terms or period of time it covers: often the nature of
risk against which insurance is sought determines the life of the policy. A life insurance
policy may cover a specified number of years or the balance of the insured life.

Historical Framework of Insurance

• In 1818 the first insurance company was established in the name of Oriental life
insurance company at Calcutta.
• The Bombay life Assurance company – 1823
• Madras Equitable Life Assurance Society – 1829
• Triton Insurance Company – 1850 – First General Insurance Company.
• Premium – Before 1871 insurance premium was 15% higher than the Europeans.
• Bombay Mutual Life Assurance Society is the first company to charge the same
premium in India.

Life Insurance

• In 1912 the first attempt made at regulation of the insurance business through The
Indian Life Assurance Companies Act.
• In 1928 Act came into existence. Then Insurance Act reviewed and a comprehensive
Legislation was enacted and called as Insurance Act 1938.
• In 1956 the nationalization of Life insurance business took place. At that time in India
there were 245 Indian and Foreign insurance societies were working. To enact this
245 societies amalgamated and then nationalized.
• LIC formed by an Act of parliament with a capital contribution of Rs 5 Crores.
General Insurance

• Triton Insurance company is the first general insurance company in India which was
established in 1850.
• In 1907 the Indian Mercantile Insurance Ltd was established to transact all classes of
general insurance business.
• In 1957 code of conduct was framed by General Insurance Council.
• In 1968 the Insurance Act amended to regulate investments and set minimum
solvency margin and the tariff advisory committee.
• In 1972 the general insurance business Act framed by amalgamating 107 insurers and
grouped into four companies.
• New India Assurance Company Ltd.
• Oriental Insurance Company Ltd.
• United India Insurance Company Ltd.
• National Insurance Company Ltd.

Insurance Sector Reforms

Malhotra Committee

In 1993 Malhotra Committee was formed to evaluate the Indian insurance industry
and recommend its future directions.

Objectives
• Reforms in the Indian financial sector.
• Bringing more efficient and competitive financial system which suitable for the
requirements of the economy.

Members
• Former Finance Secretary.
• RBI Governor.
• RN Malhotra.
Recommendation

• Government stake in the insurance companies to be brought down to 50%.

• All the insurance companies should be given greater freedom to operate.
• Private companies with a minimum paid up capital of Rs 1 billion should be allowed
to enter the industry.
• No company should deal in both life and general insurance through a single entity.
• Foreign companies may be allowed to enter the industry in collaboration with the
domestic companies.
• Postal life insurance should be allowed to operate in the rural market.
• Only one state level life insurance company should be allowed to operate in each
state.
• The insurance Act should be changed.
• An insurance regulatory body should be set up.
• Controller of insurance should be made independent.

INSURANCE REGULATORY DEVELPMENT AUTHORITY ACT

(IRDA) 1999

This Act was passed by Parliament in Dec.1999 & it received presidential acceptance
in Jan.2000. The aim of the Authority is “to protect the interest of holders of Insurance
policies to regulate, promote and ensure orderly growth of Insurance industry & for matters
connected therewith or incidental thereto.”

Features of Authority

• Corporate body by the aforesaid name which means it will act as group of persons, called
members, who will work jointly not as an individual person like Controller of Insurance.
• Having perpetual succession which means any member may resign or die but the
Authority will work.
• A common seal with power to enter into a contract by affixing a stamp on the documents.
• Sue or be sued means the Authority can file a case against any person or organization and
vice versa.
Composition of Authority

The Authority shall consist of nine persons as per details given below:
• Chairperson.
• Not more than 5 whole time members.
• Not more than 4 part time members.
These persons shall be appointed by the Central Govt. from amongst persons of
ability, integrity & standing who have knowledge or experience in life Insurance, general
Insurance, actuarial science, finance, economics, law accountancy, administration or other
discipline which would in the opinion of the Central Govt. be useful to the Authority.
(Section 4)

Duties

The Authority shall have the duty to regulate, promote and ensure orderly growth of
the Insurance business and reinsurance business subject to the provisions of any other
provisions of the act.

Duties & Powers

• Issue to the applicant (Insurance Company or Insurance Agent or Surveyors or Insurance

Brokers or Third Party Administrators) a certificate of registration, renew, modify,
withdraw, suspend or cancel such registration.
• Protection of the interests of the policyholders in matters concerning assigning of policy,
nomination by policyholders, insurable interest, settlement of insurance claim, surrender
value of policy and other terms and conditions of contracts of insurance.
• Specifying requisite qualifications, code of conduct and practical training for insurance
brokers, agents, third party administrator.
• Specifying the code of conduct for surveyors and loss assessors (Who assess the loss of
policyholder in case of General Insurance).
• Promoting efficiency in the conduct of insurance business.
• Promoting and regulating professional organizations connected with the insurance and re-
insurance business.
• Imposing fees and other charges on insurance companies, Agents, Insurance Brokers,
Surveyors and Third party Administrator.
• Calling for information from, undertaking inspection of, conducting enquiries and
investigations including audit of the insurers, intermediaries, insurance intermediaries and
other organizations connected with the Insurance business.
• Control and regulation of the rates, advantages, terms and conditions that may be offered
by insurers in respect of general insurance business not so controlled and regulated by the
Tariff Advisory Committee under section 64U of the Insurance Act, 1938 (w.e.f.,
1/1/2007 TAC has ceased to function).
• Specifying the form and manner in which books of account shall be maintained and
statement of accounts shall be rendered by insurers and other insurance intermediaries.
• Regulating investment of funds by insurance companies.
• Regulating maintenance of margin of solvency i.e., having sufficient funds to pay
insurance claim amount.
• To settle the disputes between insurers and intermediaries or insurance intermediaries.
• Supervising the functioning of the Tariff Advisory Committee.
• Specifying the percentage of premium income of the insurer to finance schemes for
promoting and regulating professional organizations referred to in clause (f).
• Specifying the percentage of life insurance business and general insurance business to be
undertaken by the insurer in the rural or social sector.

Objective of IRDA

• To protect the interest and fair treatment of the policyholder.

• To regulate the insurance industry in fairness and ensure the financial soundness of the
industry.
• To regularly constructing regulations to ensure the industry operates without any
ambiguity.

Indian Insurance Industry

The insurance industry of India has 57 insurance companies 24 are in the life
insurance business, while 33 are non-life insurers. Among the life insurers, Life Insurance
Corporation (LIC) is the sole public sector company. There are six public sector insurers in
the non-life insurance segment. In addition to these, there is a sole national re-insurer, namely
General Insurance Corporation of India (GIC Re). Other stakeholders in the Indian Insurance
market include agents (individual and corporate), brokers, surveyors and third-party
administrators servicing health insurance claims.

Market Size

In India, the overall market size of the insurance sector is US$ 280 billion in 2020.
The life insurance industry is expected to increase at a CAGR of 5.3% between 2019 and
2023. India‟s insurance penetration was attached at 3.76% in FY20, with life insurance
penetration at 2.82% and non-life insurance penetration at 0.94%.
The market share of private sector companies in the general and health insurance
market increased from 47.97% in FY19 to 48.03% in FY20. In the life insurance segment,
private players held a market share of 33.78% in premium underwritten services in FY20.
In FY21 (until February 2021), premium from new business of life insurance
companies in India stood at US$ 31.9 billion.
Gross premiums written of non-life insurers in India reached US$ 24.41 billion in
FY21 (between April 2020 and February 2021), from US$ 24.55 billion in FY20 (between
April 2019 and February 2020), driven by strong growth from general insurance companies.

Government Initiatives

The Government of India has taken number of initiatives to boost the insurance industry.
Some of them are as follows:

• Union Budget 2021 increased FDI limit in insurance from 49% to 74%.
• Under the Union Budget 2021, Finance Minister Ms. Nirmala Sitharaman announced
that the initial public offering (IPO) of LIC will be implemented in FY22, as part of
the consolidation in the banking and insurance sector. Though no formal market
valuation has been undertaken, LIC‟s IPO has the potential to raise Rs. 1 lakh crore
(US$ 13.62 billion).
• In February 2021, the Finance Ministry announced to infuse Rs. 3,000 crore (US$
413.13 million) into state-owned general insurance companies to improve the overall
financial health of companies.
• Under Union Budget 2021, fund of Rs. 16,000 crore (US$ 2.20 billion) has been
allocated for crop insurance scheme.