Insurance

Insurance is defined as a cooperative device to spread the loss caused by a particular risk over a number of persons who are exposed to it and who agree to ensure themselves against that risk. Risk is the uncertainty of a financial loss. Insurance is also a social device to accumulate funds to meet the uncertain losses arising through a certain risk to a person insured against the risk.¹

The modern industrialized society is exposed to various kinds of uncertainties and risks, which are of different degrees and range from the unavoidable to those assumed by choice. The annual losses to individuals and businessmen from premature deaths, fire, water, accident, windstorm, sea perils, earthquakes, floods, dishonesty, negligence, unemployment, lighting, etc are beyond estimation and indicate the importance of recognizing and meeting them intelligently. In order to avoid or minimize these losses, man has devised various plans to protect himself against these unexpected and unfortunate calamities. Insurance is one such method. Insurance, therefore, denotes a contract where by one party (insurer), in consideration of money payment called premium, undertakes to indemnify another party (insured) against any loss or pay to that party an agreed sum of money on the happening of a certain event. The insurance is based upon the principles of cooperation and probability.²

Insurance companies bear risk in return for a fee called the premium. Thus, insurance companies are risk bearers. They accept or underwrite the risk in return for an insurance premium.³

There are two parties to an insurance contract:

• Insurer/assurer/underwriter and
• Insured /assured /beneficiary.

The document laying down the terms of the contract is called (the insurance) policy. The property which is insured is the subject matter of insurance. It may be insured against loss arising from uncertain events/causalities/perils in the form of destruction of, or damage to, the property, death, or disablement of a person. The insured’s interest in the subject matter of insurance is known as insurable interest. ⁴

1.1a Function of Insurance

The functions of insurance can be studied into two parts:

1. Primary Functions
2. Secondary Function

Primary Functions:

i. Insurance provides certainty: Insurance provides certainty of payment for the risk of loss. There are different types of uncertainty in a risk. The risk will occur or not, when will it occur, and how much loss will be there? In other words, there is the uncertainty of the happening of time and the amount of loss. Insurance removes all these uncertainties, and the assured is given the certainty of payment of loss. The insurer charges a premium for providing the said.⁵

ii. Insurance provides protection: The main function of insurance is to provide protection against the probable chances of loss. The insurance guarantees the payment of loss and thus protects the assured from.⁶

iii. 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 share is obtained from each and every insured in the shape of a premium, without which the insurer does not guarantee protection.⁷

Secondary Function:

Besides the above primary functions, the insurance works for the following functions:

i. 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. The reduced premium will stimulate more business and more protection to the masses. ⁸

ii. It provides capital: The insurance provides capital to society. The accumulated funds are invested in productive channels. The scarcity of capital in society is minimized to a greater extent with the help of investment in insurance. ⁹

iii. It 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. ¹⁰

iv. It helps economic progress: The insurance by protecting society from huge losses of damage, destruction and death provides an initiative to work hard for the betterment of the masses. The next factor, the capital, is also immensely provided by the masses which is then invested and facilitates the economic progress of the country. ¹¹

Definition of Insurance

The definition of insurance can be made from two points:

1. Functional Definition and
2. Contractual definition

Functional Definition: –

Insurance is a cooperative device to spread the loss caused by a particular risk over a number of persons, who are exposed to it and who agree to insure themselves against the risk. Thus, the insurance is

a) a cooperative device to spread the risk;
b) the system to spread the risk over a number of persons who are insured against the risk;
c) the principal to share the loss of each member of the society on the basis of probability of loss to their risk; and
d) the method to provide security against losses to the insured.¹²

Contractual Definition:–

Insurance may be defined as a contract consisting of two parties where one party (the insurer) agrees to pay to the other party (the insured) or his beneficiary a certain sum upon a given contingency (the risk) against which insurance is sought.¹³

Characteristics of Insurance

The insurance has the following characteristics, which are generally observed in case of life, marine, fire, and general

1. Sharing of risk: Insurance is a mechanism adopted to share the financial losses that might occur to an individual or his family on the happening of a specified event. The loss arising from these events, if insured, is shared by all the insured in the form of a premium. Hence, the risk is transferred from one individual to a group.¹⁴
2. Co-operative device: Insurance is a co-operative device under which a group of persons who agree to share the financial loss may be brought together, voluntarily or through publicity or through solicitations of the agents. An insurer would be unable to compensate for all the losses from his capital. So, by ensuring a large number of persons, he is able to pay the amount of loss. Like all cooperative devices, there is no compulsion here for anybody to purchase the insurance policy.¹⁵
3. Value of risk: The risk is evaluated before insuring to charge the amount of share of an insured, herein called consideration. There are several methods of evaluation of risks. If there is the expectation of more loss, a higher premium may be charged. So, the probability of loss is calculated at the time of insurance. ¹⁶
4. Payment at contingency: The payment is made at a certain contingency insured. If the contingency occurs, payment is made. Since the life insurance contract is a contract of certainty, because the contingency, the death or expiry of the term, will certainly occur, the payment is certain. In other insurance contracts, the contingency is the fire or the marine perils etc, may or may not occur. So, if the contingency occurs, payment is made, otherwise, no amount is given to the policyholder.¹⁷
5. Amount of payment: On the occurrence of the contingency, the insurer is legally bound to make good the financial loss suffered by the insured. The amount of payment depends upon the value of loss that occurred due to the particular insured risk, provided insurance is there up to that amount. In life insurance, the purpose is not to make good the financial loss suffered. The insurer promises to pay a fixed sum on the happening of an event. It is immaterial in life insurance what was the amount of loss at the time of contingency. But in the property and general insurance, the amount of loss, as well as the happening of loss, is required to be proved.¹⁸
6. Huge number of insured persons: To make the insurance cheaper, it is essential to insure larger number of persons or property because the lesser would be cost of insurance and so, the lower would be In order to function successfully, the insurance should be joined by a large number of persons. ¹⁹
7. Insurance is not a gambling: The uncertainty is changed into certainty by insuring property and life because the insurer promises to pay a definite sum at damage or death. Insurance is just the opposite of gambling. In gambling, by bidding, the person exposes himself to the risk of losing; in the insurance, the insured is always opposed to the risk and will suffer loss if he is not insured.²⁰
8. Insurance is not charity: Charity is given without consideration, but insurance is not possible without premium. It provides security and safety to an individual and to the society although it is a kind of business because in consideration of premium, it guarantees the payment of loss.²¹
9. Investment portfolio: Since insurers collect premiums initially and make payment later when (e.g., the insured person’s death) or if (e.g., an automobile accident) an insured event occurs, insurance companies maintain the initial premiums collected in an investment portfolio, which generates a return. Thus, the insurers have two sources of income; the insurance premium and the investment income, which occurs over time.²²

Principles of Insurance

The insurance is based upon i) Principles of Cooperation and ii) Principles of Probability

i. Principal of Co-operation: Insurance is a co-operation device. If one person is providing for his own losses, it cannot be strictly insurance because in insurance the loss is shared by a group of persons who are willing to cooperate. The co-operation took another form where it was agreed between the individual or the society to pay a certain sum in advance to be a member of the society. The society by accumulating the funds guarantees payment of a certain amount at the time of loss to any member of the society. The accumulation of funds and charging of the share from the member in advance became the job of one institution called the insurer. Now it became the duty and responsibility of the insurer to obtain adequate funds from the member of the society to pay them at the happening of the insured risk. Thus, the shares of loss took the form of a premium. Today, all the insured give a premium to join the scheme of insurance. Thus, the insured are cooperating to share the loss of an individual by payment of a premium in advance.²³

ii. Theory of Probability: The loss in the shape of a premium can be distributed only on the basis of the theory of probability. The chances of loss are estimated in advance to affix the amount of premium, Since the degree of loss depends upon various factors, the affecting factors are analyzed before determining the amount of loss. With the help of this principle, the uncertainty of loss is converted into certainty. Therefore, the insurer has to charge only so much of the amount which is adequate to meet the losses. The probability tells what the chances of losses are and what will be amount of losses.²⁴

Benefits of Insurance

Insurance is the instrument of security, saving, and peace of mind. It provides several benefits by paying a small amount of premium to an insurance company as:²⁵

• i) Safeguards oneself and one’s family for future requirements.
• ii) Peace of mind in case of financial loss. The knowledge that insurance exists to meet the financial consequences of certain risks provides a form of peace of mind.
• iii) Encourages saving.
• iv) Tax deductions.
• v) Protection from the claim made by creditors.
• vi) Security against a personal loan, housing loan, or other types of loan.
• vii) Provides a protection cover to industries, agriculture, women, and children.

Role and importance of Insurance

The role and importance of insurance can be divided into:-²⁶

• i) Uses for individual
• ii) Uses to a special group via business or industry.
• iii) Uses to the society.

Uses of Individual:

1 . Insurance provides safety and security.
2. It affords peace of mind.
3. It protects mortgaged property.
4. It eliminates dependency.
5. Life insurance encourages savings.
6. Life insurance provides profitable investment.
7. Life insurance fulfills the needs of a person like family needs, old age needs, and some special needs like the need for education, marriage, the need for settlement of children, etc.

Uses to business:-

1. Uncertainty of business losses is reduced.
2. Business efficiency increases with insurance.
3. Enhancement of credit.
4. Business continuation.
5. Welfare of employees.

Uses to society:-

1. Wealth of the society is protected.
2. Economic growth of the country.
3. Reduction in inflation.

For citing this article use:

• Rizvi, S. (2005). Insurance as an investment option in privatization era.