What is Insurance?
Insurance means protection against future losses arising from unexpected possible risks. Technically, insurance is a course of action through which an individual manages the potential risk and transfers it efficiently to the structure that is capable of handling it. Though insurance neither reduces the severity of risk for an individual or organization nor does it reduce the probability of an occurrence of an event in the future, it compensates for the financial loss related to the event.
Table of Content
- 1 What is Insurance?
- 2 Features of Insurance
- 3 Requirements for Insurable Risk
- 4 Comparison Between Insurance and Gambling
- 5 Types of Insurance Companies
- 6 Important Aspects of the Insurance Market
- 7 Alternatives to Traditional Insurance
- 8 Miscellaneous Functions of Insurance Company
An individual can get protection in exchange for a particular amount called a premium. The minimum amount promised by the insurer at the time of maturity of the policy is called the sum assured. An organization that provides insurance policies to people is called an insurer and a customer who buys these policies from the insurer is known as an insured or policyholder. The insurer must communicate all features, terms, and conditions of the policy to the insured. On the other hand, the insured should go through all terms and conditions before buying the policy.
The concept of insurance in India dates back almost 200 years. The ancient writings, such as Manusmrithi, Yagnavalkya (Dharmasastra), and Kautilya (Arthasastra) describe the act of resource pooling by the community and its redistribution amongst the affected at the time of famines and floods. This in its raw form is the underlying principle of modern-day insurance.
In the past, the insurance practices in India were heavily influenced by countries, such as England. Marine trade loans and carrier contracts are some of the earliest forms of insurance contracts. However, the business of life insurance started with the establishment of Oriental Insurance Company in Calcutta. General Insurance in India was born with the establishment of Triton Insurance Company Ltd., in 1850 in Calcutta by the British rulers.
In 1993, a committee under the chairmanship of R.N. Malhotra, the Former Governor of the Reserve Bank of India (RBI), was set by the government to propose recommendations for reforms in the insurance sector. The committee submitted its report in 1994 recommending that the private sector should be permitted to enter the insurance industry. In addition, the committee recommended that foreign companies should be allowed in India preferably through joint ventures with Indian partners.
In 1999, IRDA was formed as an autonomous body for regulating and developing the insurance industry as recommended by the Malhotra Committee. It was incorporated as a statutory body in April 2000. IRDA finally opened up the market in August 2000 with the invitation for the application for registration. Since then, IRDA frames various regulations for the insurance industry. These regulations can be related to the registration of companies for carrying on insurance business, protection of policyholders’ interests, and so on.
Features of Insurance
Insurance protects individuals against potential financial loss that may cause due to the occurrence of uncertain events. Suppose an individual is the sole breadwinner for a family. His/her untimely death can create financial hardship for his/her family members. In such a case, an insurance policy can compensate the family members with the insured amount.
Similarly, an organization can go for an insurance policy to get protection against various tangible risks, such as fire, spillage, or various other accidents. Therefore, the main feature of any insurance policy is to provide financial security to the insured and his/her family even after the insured’s death.
In addition, the following are some other important features of insurance:
- Sharing of risk
- Co-operative device
- Value of risk
- Payment at contingency
- Amount of payment
- Insurance differs from charity
As a tool, insurance shares the financial losses of an insurer, that occurred due to some specific course of events. These events may include death in the case of life insurance; marine perils in the case of marine insurance; fire in the case of fire insurance; and other events in general insurance like theft in burglary insurance, accident in motor insurance, etc.
Co-operative device
It is one of the most important features of every insurance plan. Insurance is a device that works in the cooperation of a large number of people who agree to share the financial loss arising due to a particular insured risk. The underlying principle behind using insurance as a cooperative device is that it helps in pooling funds from a large number of people and compensating for losses incurred by some people within the pool.
Value of risk
While insuring an entity, the risk is assessed to determine the consideration or premium that is charged by the insured. The premium, in other words, denotes the value of risk. The higher the risk, the higher would be the premium amount.
Payment at contingency
The insurance amount is paid to the insured if the contingency occurs. For example, general contracts are usually contracts of uncertainty where events like fire or marine perils may or may not occur. Therefore, the payment is made only if these events or contingencies occur.
On the other hand, the life insurance contract is usually a contract of certainty, where the contingency of death or the expiry of the term will surely occur. In such insurance contracts, the payment is certain.
Amount of payment
It depends upon the value of the loss that occurred due to the certain insured risk. However, the maximum amount of payment depends upon the amount insured at the time of insurance by the insured.
Insurance differs from charity
Insurance is not charity as it provides security and safety to an insured in turn of fixed premium paid by him/her. Charity, on the other hand, is given as an act of goodwill. It does not provide security and safety to the donor. Insurance is a business industry that provides insurance services by charging a nominal premium.
Requirements for Insurable Risk
Insurable risk can be defined as conditions and circumstances of the insurance seeker that match the terms of the insurer to accept and underwrite risks. There are broadly two conditions of risks that make them insurable:
- An insurer should be able to measure the risk and loss associated with and ascertain the cost in terms of premium.
- The risk should be similar to the risk of those pooling with the insurer to fulfill their protection need.
The decision of whether a risk is insurable or not is taken by the insurer. Therefore, insurable risk perceives the situation from the insurer’s point of view. The insurer has to fulfill the needs of other insurance seekers who have pooled with the insurer; therefore, him/her can’t underwrite the risk with unlimited liability. Owing to this fact, the insurer sets certain requirements or standards per which they determine the acceptability of the risk.
These requirements or standards include:
Risk should be quantifiable
The risk that cannot be quantified; cannot be insured. When an insurance seeker or the applicant approaches the insurer with a set of risks, the insurer asks for various details that help him/her determine the insurability of the risk. If the insurer can underwrite the risk within the guidelines to identify the risk, it is likely to get insured.
The similarity of the nature of risk with the risk of other people availing insurance
The second condition is that the risk should be similar to the risk of those people who are already in the process of availing the insurance coverage from the insurer. When the nature of the risks is similar for a large number of people, it is possible to determine a methodology to provide insurance. It also enables the insurer to decide on the premium factor.
Acceptability of insurance by the insurer as well as the applicant
It becomes easy for the insurer to provide services to a large number of people in which each person has a similar kind of risk. If the premium charged is suitable for the applicant and the insurer, the risk can be insured. In short, any risk can be insured; however, it should be quantifiable and there should be sufficient demand for insurance for such kind of risk.
Comparison Between Insurance and Gambling
Risk is often in the form of uncertainty, which may result in loss or profit. To minimize the uncertainty and negative consequences of the risk, people buy insurance. As mentioned earlier, insurance does not decrease the severity of risk rather it reduces the probability of financial loss in certain events like fire, death, accident, marine peril, etc. However, these events may or may not occur and the payment is made only if these events or contingencies occur. Due to this, many people consider that buying insurance is the same as gambling where there is no certainty of payment. However, there is a significant difference between the two.
| Parameter | Insurance | Gambling |
|---|---|---|
| Nature of risk | Insurance is ‘pure’ risk as it deals with the possibility that particular events, like accidents or fire, which are covered under an insurance contract, will occur. Therefore, in the case of insurance, the insured understands that he/she will get the insurance payment only if the insured entity meets with the risk. | The risk associated with gambling is a ‘hypothetical’ risk as it offers an opportunity for gain as well as for loss. So, the gambler may hope to win the gambling amount. |
| Coverage | The major aim of insurance is to re-establish the insured to his/her original position. Insurance does not cover the possibility of making a profit, which is in the case of gambling. | A gambler gambles with the hope of gaining something or earning a profit. |
| Objective | As an industry, insurance aims at increasing the economic productivity of a country. It minimizes the probability of financial loss by eliminating worry and increasing initiatives. It generates a pool of insurance funds that are used to support projects necessary for economic growth. | Gambling does not increase the economic productivity of a country. |
| Purpose | Insurance buyers are risk avoiders. People buy insurance to reduce exposure to large losses. | Gamblers are risk seekers. They take risks to earn profit. |
Types of Insurance Companies
Insurance means the assurance of financial aid when there is any contingency. It is a promise made by an insurance service provider to cover an individual against loss in exchange for a premium. Life is always uncertain and these uncertainties can cause losses for which an individual may not be prepared. The insurance service provides the guarantee that the individual will be compensated for those losses. Insurance services are broadly classified into two types—general insurance and life insurance.
The different kinds of insurance companies are:
General Insurance or Non-life Insurance
General insurance is a contract between a policyholder and a general insurance company where insurance coverage is taken for non-life assets. Through general insurance, a person can protect himself/herself against loss caused due to damages caused to his/her assets. General insurance can provide coverage against risks pertinent to crops, homes, motors, equipment, shops, offices, and travel.
Health insurance also comes under the general insurance category. In this way, general insurance typically comprises any insurance but coverage against life. It is called property and casualty insurance in the U.S. and non-life insurance in Continental Europe.
A general insurance company provides coverage against risk in consideration of a premium paid by the policyholder. For example, National Insurance Company is a public sector company while Bajaj Allianz General Insurance is a private sector company that provides general insurance in India.
Types of General Insurance
The different types of general insurance are explained as follows:
- Crop insurance
- Motor insurance
- Home insurance
- Travel Insurance
- Health Insurance
- Fire insurance
- Marine insurance
- Inland marine insurance
Crop insurance
Under this type of general insurance, farmers can protect their crops against the risk of damage caused due to unfavorable weather, pests, fire, etc. The government at national and state levels runs various crop insurance schemes to protect the financial interests of farmers.
Motor insurance
In India, the Motor Vehicles Act, of 1988 makes it mandatory for vehicle owners to buy motor insurance. On buying a new vehicle, a person needs to buy insurance to get the vehicle registered with the Regional Transport Office.
Thereafter, every year, the person has to renew his/her motor insurance, to cover risks. Also, there are provisions of penalties if a vehicle owner does not renew his/her policy. Motor insurance can also cover damages caused to the third party in an accident.
Home insurance
Like any other tangible asset, a person can also insure his/her house against damages caused by fire, theft, terrorist activities, riots, and natural calamities such as floods, hurricanes, and thunderstorms.
The home insurance industry is still at a nascent stage in India and the percentage of people opting for home insurance is far less than that of homeowners. However, with the rise of the home loan market in India, the demand for home insurance is also growing. This is because banks and housing finance institutions make home insurance mandatory for homeowners before granting loans.
Travel Insurance
As travel also involves a certain degree of risk, travel insurance is one of the fastest-growing industries in India. More and more travelers, especially people traveling abroad, are opting for travel insurance to cover their baggage against the risk of loss, theft, robbery, etc.
Health Insurance
Inflation and ever-rising costs of quality healthcare signify the importance of health insurance. In India, a large number of people in urban areas are now aware of the benefits that health insurance offers. Due to multiple reforms in the insurance sector in India, there is a wide range of health insurance plans covering accidents to critical illnesses, for different age groups.
Considering the high-risk profile and special requirements of senior citizens, the Insurance Regulatory and Development Authority (IRDA) has issued specific guidelines for insurance companies to offer specific health insurance plans for senior citizens.
Before that, insurance companies used to avoid senior citizens because of higher chances of health disorders and related expenditures. The premium paid towards health insurance is eligible for tax exemption to the limit of ₹15,000 a year, under section 80D of the Income-tax Act Further, senior citizens can claim exemption of up to ₹20,000 a year, under this provision.
Fire insurance
Fire insurance is a form of insurance that protects the properties of people against the damage caused due to fire. When any kind of infrastructure or property is covered by fire insurance, the insurance policy will compensate for the loss if the property is damaged or destroyed by fire.
Marine insurance
Marine insurance covers the loss or damage to ships, cargo, and terminals. It also covers the damage to any transport by which property is transferred, acquired, or held between the point of origin to the point of final destination. There are two broad categories of marine insurance:
- Ocean marine insurance: The ocean marine insurance may comprise the following:
- Hull: This covers physical damage to vessels, including their machinery and fuel but not their cargo.
- Cargo: This covers the loss, damage, or theft of commodities while in transit.
- Freight: This covers the policyholder against loss of the freight money in case the shipowner cannot complete his contract of carriage because of unavoidable peril.
- Hull: This covers physical damage to vessels, including their machinery and fuel but not their cargo.
Inland marine insurance
This is a broad type of coverage for shipment that does not involve ocean transport. This type of insurance covers articles in transit by all forms of land and air transportation. In addition, it includes property held by bailees and floaters that cover expensive personal items such as fine art and jewellery.
Life Insurance
As the term suggests, life insurance covers the risk of life. A life insurance policy is a contract between the insured person and the life insurance company to provide a pre-determined sum of insurance to the nominee/s in case of injury or death of the policyholder.
Life insurance is expected to provide financial security to the dependents of the policyholder. The insured amount should be sufficient to replace the income of the policyholder. However, there is no compulsion to equate one’s income to the sum insured under the policy. For example, Life Insurance Corporation is a public sector company, while Aegon Religare Life Insurance is a private sector company that provides life insurance in India.
In India, life insurance policies can be of five types:
- Term insurance policy
- Whole life insurance policy
- Endowment policy
- Unit Linked Insurance Plan (ULIP)
- Group insurance policy
Term insurance policy
Under this type of insurance policy, one is expected to pay the premium amount against consideration of a certain sum of insurance coverage. The premium amount is treated as expenditure because a term insurance plan does not give any returns or money back. Term insurance plans can be taken for a period ranging from 5 to 30 years.
Whole life insurance policy
A life insurance policy that protects the insured for the entire life is called a whole life insurance policy.
Endowment policy
Under an endowment policy, the policyholder receives the whole of his/her money paid as the premium amount back after the expiry of a pre-determined policy period. In the case of death of the policyholder, his/her nominee receives the full sum insured under the plan.
Unit Linked Insurance Plan (ULIP)
As the term suggests, ULIPs are purchased in units. The price per unit is announced by an insurance company as per the Net Asset Value (NAV). ULIPs provide the dual benefit of life insurance and investment. The amount of premium paid towards a life insurance plan is invested in equity markets, which work on the principle of risk and rewards.
Group insurance policy
These policies are taken for a group of people. Generally, organizations provide group insurance policy benefits to their employees. Governments also provide group insurance schemes to citizens. The recently launched Pradhan Mantri Jan Dhan Yojana is an example of a group insurance scheme.
Important Aspects of the Insurance Market
- Number of private players
- Unit-linked insurance plans (ULIPs)
- Innovative distribution channels
- Competition
- Insurance density
Number of private players
In India, the number of private players was 10 in FY01 and by the end of FY08, there were 18 life insurance companies operating in the country. Subsequently, Aegon Religare Life Insurance Company Limited, HSBC, Oriental Bank of Commerce, Life Insurance Co. Ltd., and DLF Pramerica Life Insurance Company Limited were given the Certificate of Registration by the Authority.
There was an increase in growth by 65% in the number of offices of life insurers in FY08 as calculated in the beginning and at the end of the year. LIC offices increased by 10%, while the private sector offices became double in number.
Unit-linked insurance plans (ULIPs)
Various ULIPs were introduced by private players. Some individuals were willing to opt for these plans for purely investment purposes. This helped private players to compete against LIC also. These plans became popular as they were of interest to people.
The success of private players was based on these ULIPs, which were able to generate a high income for the respective company. Even today, ULIPs continue to dominate and the income coming from ULIPs remains large.
Innovative distribution channels
New and innovative ideas introduced in distribution channels made it easier to introduce products in those segments which were not covered earlier.
Moreover, all insurance companies started training programs for staff members, especially advisors. This helped in better productivity through a better customer approach. SBI Life developed a website and invited people to interact through the website.
Competition
There was fierce competition in the insurance business. LIC introduced new products like ‘Jeevan Anurag’ and ‘Jeevan Nidhi’ insurance policies. LIC also depended upon ULIPs, which grew by 29.76% (y-o-y) in FY06. To face the competition posed by private firms, LIC focussed more on ULIPs and made several sales.
Insurance penetration: The main concept of insurance penetration is all about expanding business by private life insurance players in uncovered market segments. By applying new and innovative ideas to distribution channels, life insurance companies have been able to target markets that were not discovered earlier. This in turn contributed to an increase in the level of penetration.
The level of penetration has a strong positive correlation to the income levels of people. With its middle-class families with fairly good incomes, India has great potential for the insurance industry. Moreover, markets have become saturated in many developed economies and insurers all over the world are in search of a new and fresh market. Global insurance majors found India to be a good field where they can establish themselves.
Insurance density
The amount spent on insurance by an average consumer could be determined with the help of per capita income. Analysis of this measure shows that India is one of those nations, which spend the least while purchasing insurance. But the economic condition of people in India is improving day by day. This has led to a growth in per capita income in the last few years.
An increase in per capita income has resulted in people showing more interest and spending more on insurance. The total insurance spend of the country was US$ 9.1 in 2001. Over the next six years, the total amount rose to US$ 40.4.
Alternatives to Traditional Insurance
Over the years, many alternatives to traditional insurance have emerged. Some of these alternatives are self-insurance programs, captive insurers, risk retention groups, and risk-sharing pools. These alternatives have emerged due to various reasons, such as economies of scale, perceived failure of the commercial insurance market, escalating insurance costs, inability to obtain various types of liability insurance, etc.
Let us discuss some major alternatives to traditional insurance, as follows:
Self-insurance program
It is a risk management technique used by organizations, where a calculated amount of money is kept aside to bear a potential future loss. The technique uses actuarial and insurance information to calculate the amount that could be needed to cover uncertain future losses. Such programs are usually adopted by an organization as they help in achieving economies to a large extent.
Captive insurance
It is an alternate type of traditional insurance that is offered by captive insurance companies. These insurance companies are usually established by a parent group or company to cover risks to which the parent group or company is exposed. In this way, it is a kind of self-insurance for the parent group or company.
Captive insurance works as a cost-saving tool for large corporations as it helps parent companies in getting coverage for operations and liabilities in inexpensive ways. Companies opt for captive insurance as they get insurance benefits at relatively lower premium rates.
Risk-retention groups
Created under the federal Liability Risk Retention Act (LRRA), a Risk Retention Group (RRG) is an alternative risk transfer body. As an entity, RRG is owned by its members and retains the risk and financial output among its members only.
In other words, the members of the RRG are also the owners of the body and the membership is limited to the organisations or persons belonging to same businesses or activities. In this way, all the members of the RRG are exposed to similar kinds of risks and liabilities.
Risk-sharing pools
It is a risk-management technique mostly practised by insurance companies, where they come together to form a pool that may protect the insured (companies) against disasters such as floods, earthquakes, etc.
As the term suggests, a risk-sharing pool refers to the pooling of similar risks underlying insurance needs. It protects the members from increasing insurance rates and provides them with loss prevention services and savings. However, it is difficult to pool all risks effectively in one place.
Miscellaneous Functions of Insurance Company
Apart from the functions discussed in the previous sections, other miscellaneous functions are crucial for the successful operation of an insurance company. These functions supplement the primary and secondary functions that an insurance company already performs.
Let us discuss these functions as follows:
Legal functions
Insurance being a financial entity often requires legal advice and aid for adhering to regulatory requirements and attending cases of dispute in the court of law. A majority of insurers have a separate legal department as a part of their operational support functions.
This department provides legal assistance to the insurer in selecting and contacting outside attorneys for the insurer’s defense against suits by a policyholder on any kind of liability claim covered under the insurer’s policies as well as determining and drafting the legal language of the insurance contract.
Accounting functions
In an insurance company, the accounting department is responsible for the periodic filing of the insurer’s statutory financial statements. Accountants also develop budgets and analyze the expenses of the company.
In addition, in publicly traded companies, the accounting department has to prepare financial statements as per the Generally Accepted Accounting Principles (GAAP) and submit them to investors.
Engineering functions
In the running and operations of an insurance company, the engineering department is responsible for inspecting the business premises of the insurance company to ascertain their acceptability. Moreover, the engineering department is beneficial to the insured of the company as it makes recommendations for preventing losses.
