What is Insurance?
Insurance is a contract between two parties. One party is the insured and the other party is the insurer. Insured is the person whose life or property is insured with the insurer. That is, the person whose risks are insured is called insured. Insurer is the insurance company to whom risk is transferred by the insured. That is, the person who insures the risk of insured is called insurer.
Thus insurance is a contract between insurer and insured. It is a contract in which the insurance company undertakes to indemnify the insured on the happening of certain event for a payment of consideration. It is a contract between the insurer and insured under which the insurer undertakes to compensate the insured for the loss arising from the risk insured against.
Definitions of Insurance
Some definitions of insurance are given below:
According to Gosh and Agarwal, “insurance may be defined as a co-operative form of distributing a certain risk over a group of persons who are exposed to it’
According to Mc Gill, “Insurance is a process in which uncertainties are made certain”.
In the words of Jon Megi, “Insurance is a plan wherein persons collectively share the losses of risks”.
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.
Benefits of Insurance
Benefits to Individual
- Insurance provides security & safety: Insurance gives a sense of security to the policy holder. Insurance provide security and safety against the loss of earning at death or in old age, against the loss at fire, against the loss at damage, destruction of property, goods, furniture etc. Life insurance provides protection to the dependents in case of death of policyholders and to the policyholder in old age. Fire insurance insured the property against loss on a fire. Similarly other insurance provide security against the loss by indemnifying to the extent of actual loss.
- Encourage Savings: Life insurance is best form of saving. The insured person must regularly save out of his current income an amount equal to the premium to be paid otherwise his policy get lapsed if premium is not paid on time.
- Providing Investment Opportunity: Life insurance provide different policies in which individual can invest smoothly and with security; like endowment policies, deferred annuities etc. There is special exemption in the Income Tax, Wealth Tax etc. regarding this type of investment
Benefits to Business or Industry
- Shifting of Risk: Insurance is a social device whereby businessmen shift specific risks to the insurance company. This helps the businessmen to concentrate more on important business issues.
- Assuring Expected Profits: An insured businessman or policyholder can enjoy normal expected profits as he would not be required to make provisions or allocate funds for meeting future contingencies.
- Improve Credit Standing: Insured assets are easily accepted as security for loans by the banks and financial institutions so insurance improve credit standing of the business firm
- Business Continuation: With the help of property insurance, the property of business is protected against disasters and chance of closure of business is reduced
Benefits to the Society
- Capital Formation: As institutional investors, insurance companies provide funds for financing economic development. They mobilize the saving of the people and invest these saving into more productive channels
- Generating Employment Opportunities: With the growth of the insurance business, the insurance companies are creating more and more employment opportunities.
- Promoting Social Welfare: Policies like old age pension scheme, policies for education, marriage provide sense of security to the policyholders and thus ensure social welfare.
- Helps Controlling Inflation: The insurance reduces the inflationary pressure in two ways, first, by extracting money in supply to the amount of premium collected and secondly, by providing funds for production narrow down the inflationary gap.
Functions of Insurance
The functions of insurance can be studied into two parts:
Primary Functions
- Insurance provides certainty: Insurance provides certainty of payment at the uncertainty of loss. The uncertainty of loss can be reduced by better planning and administration. But, the insurance relieves the person from such difficult task. Moreover, if the subject matters are not adequate, the self provision may prove costlier. There are different types of uncertainty in a risk. The risk will occur or not, when will occur, how much loss will be there? In other words, there are uncertainty of happening of time and amount of loss. Insurance removes all these uncertainty and the assured is given certainty of payment of loss. The insurer charges premium for providing the said certainty.
- Insurance provides protection: The main function of the insurance is to provide protection against the probable chances of loss. The time and amount of loss are uncertain and at the happening of risk, the person will suffer loss in absence of insurance. The insurance guarantees the payment of loss and thus protects the assured from sufferings. The insurance cannot check the happening of risk but can provide for losses at the happening of the risk.
- 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 risk-sharing in ancient time was done only at time of damage or death; but today, on the basis of probability of risk, the share is obtained from each and every insured in the shape of premium without which protection is not guaranteed by the insurer.
Secondary functions
- 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 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 cause lesser share to the assured.
So again premium is reduced to, which will stimulate more business and more protection to the masses. Therefore, the insurance assist financially to the health organisation, fire brigade, educational institutions and other organisations which are engaged in preventing the losses of the masses from death or damage. - Provides Capital: The insurance provides capital to the society. The accumulated funds are invested in productive channel. The dearth of capital of the society is minimised to a greater extent with the help of investment of insurance. The industry, the business and the individual are benefited by the investment and loans of the insurers.
- 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.
- Helps Economic Progress: The insurance by protecting the society from huge losses of damage, destruction and death, provides an initiative to work hard for the betterment of the masses. The next factor of economic progress, the capital, is also immensely provided by the masses. The property, the valuable assets, the man, the machine and the society cannot lose much at the disaster.
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.
