Introduction to Insurance

IRDA 50 Hours refreshers

IRDA – 50 hours Training Nov’08For Internal Circulation Only

Agenda

• In this session you will:– Review the basic concepts of life insurance– Show the different kinds of risks– Distinguish between a risk and a peril– Show the ways of managing risks– Outline the need for insurance as a risk sharing device– Outline the importance of insurance on society and economy

What is Insurance?

• Insurance is related to the protection of the economic value of assets.

• Every asset is created through the efforts of the owner.

• As asset provides benefits to the owner and so it is valuable.

Anything that has a monetary value

What is an asset?

ASSET

Assets

These assets serve 2 main purposes

These assets serve 2 main purposes

For Generating Income

Eg. Factory

For Generating Income

Eg. Factory

For Comfort or Convenience

Eg. Your car or House

For Comfort or Convenience

Eg. Your car or House

Assets have a specific lifespan

• Assets have a specific lifespan, but it is possible that during the lifespan, the asset may:

Be Destroyed

Be Destroyed

Become non-functional

Become non-functional

• How is this likely to affect the owner of the asset?• The destruction of the asset or the asset becoming non-functional

will cause a loss to the owner.

Insurance is a promise to pay a certain sum to the owner or beneficiary of the asset, if such loss occurs.

Insurance is a promise to pay a certain sum to the owner or beneficiary of the asset, if such loss occurs.

Origins of Insurance

• Insurance has existed in some form or the other since 3000 BC• The origins can be traced to Lloyd’s Coffee House (London)• Traders who gathered in Lloyds coffee house agreed to share losses to

their goods being transported by ships.• These losses occurred due to pirates or bad weather.

Origins of Insurance in India

• Insurance in India began with the Oriental Life Insurance Co. Ltd. in.• 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

Purpose & Need of Insurance

• Assets are lost or damaged due to accidental occurrences called Perils

PERILSPERILS

FLOOD

FIREEARTHQUAKE

LIGHTNING

BREAKDOWNS

OLD AGE

EPIDEMIC

ILLNESS

Need and purpose of Insurance

• The damage that are caused due to these perils is the “Risk” that the asset is exposed to.

Peril

Cannot be prevented

Asset

The RISK can be insured against.

The RISK can be insured against.

Damage/ Financial Loss

• Peril is the Risk that every asset is exposed to• Peril cannot be prevented• The financial loss due to the damage can be compensated by taking

proper insurance• Non financial loss is not covered by insurance

Purpose & Need of Insurance

Insurance only compensates the monetary loss but cannot protect the asset against the Peril

Insurance only compensates the monetary loss but cannot protect the asset against the Peril

Classification of Risks

• Risks can be classified on many basis:On the extent of

damage likely to be caused

On the extent of damage likely to be

caused

Financial and Non-FinancialFinancial and Non-Financial

Dynamic & StaticDynamic & Static

Fundamental and Particular

risks

Fundamental and Particular

risks

Pure and Speculative Risks

Pure and Speculative Risks

Critical or Catastrophic

Critical or Catastrophic ImportantImportant

Those which may lead to the

bankruptcy of the owner

Those which may lead to the

bankruptcy of the owner

May upset family or business finances

badly, requiring a lot of time to recover

May upset family or business finances

badly, requiring a lot of time to recover

Dynamic- Caused by perils which

have national consequence, like inflation.

Dynamic- Caused by perils which

have national consequence, like inflation.

Static- caused by perils which have

no consequence on the national

economy, like a fire or theft.

Static- caused by perils which have

no consequence on the national

economy, like a fire or theft.

Financial- which may result in financial loss.

Financial- which may result in financial loss.

Non- Financial- Which may not

result in a financial loss.

Non- Financial- Which may not

result in a financial loss.

Fundamental Risks- are those that affect large

populations. Eg- a train crash

Fundamental Risks- are those that affect large

populations. Eg- a train crash

Particular Risks- affect only specific

persons.Eg. A theft in a persons house.

Particular Risks- affect only specific

persons.Eg. A theft in a persons house.

Pure Risk Not under the

control of the person.

Pure Risk Not under the

control of the person.

Speculative- which is

somewhat under the control of the

person. For example- Gambling.

Speculative- which is

somewhat under the control of the

person. For example- Gambling.

Insurance as a risk-sharing device

• People exposed to the same risk come together.• If any one ‘member’ suffers a loss, the same will be shared by others • The person who lost will be compensated for the loss.

Larger Impact reduced to smaller manageable impacts

Unfortunate Few

Fortunate Many

The loss of the unfortunate

few is shared by the

fortunate many.

The loss of the unfortunate

few is shared by the

fortunate many.

Insurance is a business of sharing

• 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.

• How can insurance help in mitigating the financial loss?

Risk Sharing

• 100 airline • companies come• together to form an • insurance pool

Insurance Pool

Risk Sharing

Shared by

many airlines

Risk of 1 airline

Basic Principles

• There are certain principles which make it possible for insurance to remain a fair arrangement:– The occurrence has to be random– The occurrence has to Accidental– Not the deliberate creation of the Insured person.

How is the loss determined?

• The manner in which the loss is to be shared can be determined before-hand.

• It would be proportional to the risk that each person in the group is exposed to.

• This would be indicative of the risk that he is exposed to.

• Each persons share may be collected from the members after the loss has occurred or in advance.

The Human Asset

• Human life is also an income generating asset.

• This can also be affected by death or sickness or accidents leading to

disability.

• Accidents may or may not happen, but death is certain.

• Only the time of death is not certain.

Insuring Human Life

• There are two major concerns when it comes to insuring human life…

– Living too Long

– Dying too soon

• Life Insurance helps to take care of both these concerns.

• The risks in the case of a human being are related to:

– Early death

– Living too long

– Disabilities

– Sickness, unemployment, etc.

Human Life Value (HLV)

• The income generating capacity of a human being depends on his/ her skills:

• These skills are assets. • The value of these assets can be measured by considering the amount

of income that is generated by the person concerned.

manualmanual professionalprofessional problem solving

problem solving

entrepreneurial, etc

entrepreneurial, etc

HLV provides scientific ways to determine the asset value of the human life and therefore, the amount of life

insurance required

HLV provides scientific ways to determine the asset value of the human life and therefore, the amount of life

insurance required

Insurance of Intangibles

• The concept of insurance has been extended beyond the coverage of tangible assets.

Exporters may suffer losses, due to defaults from importers

from other countries.

Exporters may suffer losses, due to defaults from importers

from other countries.

Doctors and other

professionals run the risk of being charged

with negligence and subsequent

liability for damages.

Doctors and other

professionals run the risk of being charged

with negligence and subsequent

liability for damages.

They may suffer heavily due to sudden changes in

currency exchange rates, economic policies or political

disturbances in the other country.

They may suffer heavily due to sudden changes in

currency exchange rates, economic policies or political

disturbances in the other country.

All these are

dynamic risks and can be insured

Insurance of Intangibles

• In some countries, the voice of a singer or the legs of a dancer may be insured. These are assets which produce the income and provide living to the owners.

• The object insured is intangible, but it is linked to a financial loss, and therefore becomes insurable.

• Indian non-life insurers are perhaps, considering the feasibility to insure such risks.

The business of insurance

• Insurance companies are called the insurers.

• They bring together persons with common interests (sharing the same risks)

• Collect the share of contribution (called premium)

• Pay out compensation (called claims)

Insured

Insurer

Trustee

• The insurer is in the position of a trustee because:– 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. – The management of the insurance business requires care to prevent

entry of people whose risks are not of the same kind.– The management also has to ensure that no payments are made for

claims on losses that are not accidental.

Underwriting of Risks

• Underwriting includes assessing the risk- 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 great

care.

Reinsurance

• Insurance companies are taking risks and 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.

• Insurers normally are financially sound enough to be able to pay claims.

• However a catastrophic 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.

• To protect themselves from such situations, they reinsure the risk with other insurers.

• If there is a claim, the burden is shared by the primary insurer and the reinsurers.

Classification of Insurance business- India

Insurance BusinessInsurance Business

Life Insurance

Life Insurance Non- Life InsuranceNon- Life Insurance

firefire MarineMarine Miscellaneous

Miscellaneous

Covers Fire

Related Risks

Covers transport related

risks and ships

Covers liability, fidelity, motor, crop,

personal accident,

etc.

Covers death and disability

The law of large numbers

• The premiums payable by an individual for insurance is based on expectations of the losses.

• These expectations are based on studies of occurrences in the past, and the use of statistical principles.

• In statistics there is a “Law of Large Numbers”.

• If a coin is tossed, the chance of it coming down as a head or tail is half.

• If the same coin is tossed 10 times, we cannot say for sure that heads will come 5 times.

• If the coin is tossed 1 million times, the number of heads will be closer to half a million. The variation will also be less as a percentage.

So, the larger the number of risks included in the pool, the better the chances that the assumptions regarding the

probability of the risk will be accurate.

So, the larger the number of risks included in the pool, the better the chances that the assumptions regarding the

probability of the risk will be accurate.

Business of Insurance

• Insurance is nothing but the business of sharing of risk.

• It spreads the losses of an individual over the group of individuals who

are exposed to similar risks.

• People who suffer loss get relief because the loss is made good.

• People who do not suffer the loss are relieved because they were

spared the loss.

Insurance as a social security tool

• When a breadwinner of the family dies, the income of the family dies as well.

• The economic condition of the family is thus affected.• The family may be pushed into the lower strata of society, which creates

a cost for the society.• Insurance prevents this by stepping in and providing the family with the

sum assured.• It is the responsibility of the state to provide social security to its

members.• Insurance is one of the instruments provided for this purpose.

Thus, insurance helps provide social security.Thus, insurance helps provide social security.

Role of Insurance in Economic Development

• It relieves the worry of the insured there by increasing the individual’s productivity

• It mobilizes money from people's homes for nation building

• Acts as an Anti-inflationary Force-inflation happens when lot of spending takes place from income

Difference between Life Insurance and Hire purchase

• In a hire purchase scheme, the product is purchased immediately, but payments are made in installments.

• In the event of death, the installments are not excused, they are still payable.

• In Life insurance, premium payments cease on death, there is nothing outstanding.

THERE IS NO FINANCIAL ARRANGEMENT THAT CAN EQUAL THE BENEFITS OF LIFE INSURANCE.

THERE IS NO FINANCIAL ARRANGEMENT THAT CAN EQUAL THE BENEFITS OF LIFE INSURANCE.

Advantages of Life Insurance

• Life insurance has no competition from any other business.• It offers quick settlement of claims in the event of death.• It encourages financial discipline, as premiums are required to be paid

regularly.• Creditors cannot claim life insurance money. The money can be

protected against attachment by courts.• Marketability and liquidity are better. A life insurance policy is property

and can be transferred or mortgaged. Loan can be taken against it.

A Recap

• Insurance helps to reduce the adverse effects that perils have on assets.

• Insurance can be taken on assets and human life.• Insurance is based on the concept of sharing of risks.• Insurance is of two main types- Life Insurance and General Insurance• It is based on the law of large numbers.• It plays an important role in economic development and is a very good

way to provide social security.

Thank You!