Introduction to Insurance:

Insurance Defined
Insurance can be defined in many different ways, from many different points of view. For example, from
an economic viewpoint, insurance is a system for reducing financial risk by transferring it from a
policyowner to an insurer. The social aspect of insurance involves the collective bearing of losses through
contributions by all members of a group to pay for losses suffered by some group members.
From a business viewpoint, insurance achieves the sharing of risk by transferring risks from individuals
and businesses to financial institutions specializing in risk. The insurer is not in fact paying for the loss.
The insurer writes the claim check, but is actually transferring funds from individuals.

who as part of a pool, paid premiums that created the fund from which the claims are paid.
Lastly, from a legal standpoint, an insurance contract (policy) transfers a risk, for a premium
(consideration), from one party (the policyowner) to another party (the insurer). It is a contractual
arrangement in which the insurer agrees to pay a predetermined sum to a beneficiary in the event of the
insured’s death. By virtue of a legally binding contract, the possibility of an unknown large financial loss
is exchanged for a comparatively small certain payment. This contract is not a guarantee against a loss
occurring, but a method of ensuring that payment is made for a loss that does occur.

How insurance work:

Brief History of Insurance:

The insurance sector in India has come a full circle from being an open competitive market
to nationalisation and back to a liberalised market again. Tracing the developments in the
Indian insurance sector reveals the 360-degree turn witnessed over a period of almost two
centuries.

A brief history of the Insurance sector

The business of life insurance in India in its existing form started in India in the year 1818
with the establishment of the Oriental Life Insurance Company in Calcutta.

Some of the important milestones in the life insurance business in India are:

• 1912: The Indian Life Assurance Companies Act enacted as the first statute to
regulate the life insurance business.
• 1928: The Indian Insurance Companies Act enacted to enable the government to
collect statistical information about both life and non-life insurance businesses.
• 1938: Earlier legislation consolidated and amended to by the Insurance Act with the
objective of protecting the interests of the insuring public.
• 1956: 245 Indian and foreign insurers and provident societies taken over by the
central government and nationalised. LIC formed by an Act of Parliament, viz. LIC
Act, 1956, with a capital contribution of Rs. 5 crore from the Government of India.

The General insurance business in India, on the other hand, can trace its roots to the Triton
Insurance Company Ltd., the first general insurance company established in the year 1850
in Calcutta by the British.
Some of the important milestones in the general insurance business in India are:

• 1907: The Indian Mercantile Insurance Ltd. set up, the first company to transact all
classes of general insurance business.
• 1957: General Insurance Council, a wing of the Insurance Association of India,
frames a code of conduct for ensuring fair conduct and sound business practices.
• 1968: The Insurance Act amended to regulate investments and set minimum
solvency margins and the Tariff Advisory Committee set up.
• 1972: The General Insurance Business (Nationalisation) Act, 1972 nationalised the
general insurance business in India with effect from 1st January 1973.
• 107 insurers amalgamated and grouped into four companies viz. the National
Insurance Company Ltd., the New India Assurance Company Ltd., the Oriental
Insurance Company Ltd. and the United India Insurance Company Ltd. GIC
incorporated as a company.

Insurance sector reforms:

In 1993, Malhotra Committee headed by former Finance Secretary and RBI Governor R.N.
Malhotra was formed to evaluate the Indian insurance industry and recommend its future
direction.

The Malhotra committee was set up with the objective of complementing the reforms
initiated in the financial sector. The reforms were aimed at "creating a more efficient and
competitive financial system suitable for the requirements of the economy keeping in mind
the structural changes currently underway and recognizing that insurance is an important
part of the overall financial system where it was necessary to address the need for similar
reforms…"

In 1994, the committee submitted the report and some of the key recommendations
included:

1) Structure

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

• Government should take over the holdings of GIC and its subsidiaries so that these
subsidiaries can act as independent corporations.
• All the insurance companies should be given greater freedom to operate.

2) Competition

• Private Companies with a minimum paid up capital of Rs.1bn 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.

3) Regulatory Body
 • The Insurance Act should be changed.
• An Insurance Regulatory body should be set up.
• Controller of Insurance (Currently a part from the Finance Ministry) should be made
independent.

4) Investments

• Mandatory Investments of LIC Life Fund in government securities to be reduced from

75% to 50%.
• GIC and its subsidiaries are not to hold more than 5% in any company (There
current holdings to be brought down to this level over a period of time).

5) Customer Service

• LIC should pay interest on delays in payments beyond 30 days.

• Insurance companies must be encouraged to set up unit linked pension plans.
• Computerisation of operations and updating of technology to be carried out in the
insurance industry The committee emphasized that in order to improve the customer
services and increase the coverage of the insurance industry should be opened up to
competition.

But at the same time, the committee felt the need to exercise caution as any failure on the
part of new players could ruin the public confidence in the industry. Hence, it was decided to
allow competition in a limited way by stipulating the minimum capital requirement of Rs.100
crores. The committee felt the need to provide greater autonomy to insurance companies in
order to improve their performance and enable them to act as independent companies with
economic motives. For this purpose, it had proposed setting up an independent regulatory
body.

Purpose and Need of Insurance

The business of insurance is related to the protection of the economic value of assets. Every asset
has value. The asset would have been created through the efforts of the owner, in the expectation
that, either through the income generated there from or some other output, some of his needs
would be met. In the case of a factory or a cow, the production is sold and income generated. In
the case of a motorcar, it provides comfort and convenience in transportation. There is no direct
income. There is normally expected life time for the asset during which time it is expected to
perform. The owner, aware of this, can so manage his affairs that by the end of that life time, a
substitute is made available to ensure that the value or income is not lost. However, if the assert
gets lost earlier, being destroyed or made non functional, through an accident or other
unfortunate event, the owner and those deriving benefits there from suffer. Insurance is
mechanism that helps to reduce such adverse consequences.

Assets are insured, because they are likely to be destroyed or made non-functional through an
accidental occurrence. Such possible occurrences are called perils. Fire, floods, breakdowns,
lightning, earthquakes, etc, are perils. The damage that these perils may cause the asset, is the
 risk.

The risk only means that there is possibility of loss or damage. It may or may not happen. There
has to be uncertainity about the risk. Insurance is done against the contingency that it may
happen. Insurance is relevant only if there are uncertainties. If there is no uncertainty about the
occurrence of an event, it cannot be insured against.

There are other meanings of the term ‘risk’. To the ordinary man in the street risk means
exposure to danger. In insurance practice risk is also used to refer to the peril or loss producing
event. For example, it is said that fire insurance covers the risks of fire, explosion, cyclone, flood
etc. again, it is used to refer to the property covered by insurance. For example, a timber
construction is considered to be a bad risk for fire insurance purpose. Here the term risk refers
to the subject matter of insurance.

Conceptually the mechanism of insurance is very simple. People who are exposed to the same
risks come together and agree that, if any one of the members suffers a loss, the others will share
the loss and make good to the person who lost. All people who send goods by ship are exposed
to the same risk related to water damage, ship sinking, piracy, etc. those owning factories are not
exposed to these risks, but they are exposed to different kinds of risks like, fire, hailstorms,
earthquakes, lightening, burglary, etc. like this, different kinds of risks can be identified and
separate groups, made including those exposed to such risks. By this method, the risk is spread
among the community and the likely big impact on one is reduced to smaller manageable
impacts on all.

The manner in which the loss is to be shared can be determined before hand. It may be
proportional to the likely loss that each person is likely to suffer, which is indicative of the
benefit he would receive if the peril befell him. The share could be collected from the members
after the loss has occurred or the likely shares may be collected in advance, at the time of
admission to the group. Insurance companies collect in advance and create a fund from which
the losses are paid.

A human life is also an income generating asset. This asset also can be lost through unexpectedly
early death or made non-functional through sickness and disabilities caused by accidents.
Accidents may or may not happen. Death will happen, but the timing is uncertain. If it happens
around the time of one’s retirement, when it could be expected that the income will normally
cease, the person concerned could have made some other arrangements to meet the continuing
needs. But if it happens much earlier when the alternate arrangements are not in place, insurance
is necessary to help those dependent on the income.

In the case of a human being, he may have made arrangements for his needs after his retirement.
 Those would have been made on the basis of some expectations like he may live for another 15
years, or that his children will look after him. If any, of these expectations do not become true,
the original arrangement would become inadequate and there could be difficulties. Living too
long can be as much a problem as dying too young. These are risks which need to be safeguarded
against. Insurance takes care.

Insurance does not protect the asset. It does not prevent it loss due to the peril. The peril cannot
be avoided through insurance. The peril can sometimes be avoided through better safety and
damage control management. Insurance only tries to reduce the impact of the risk on the owner
of the asset and those who depend on that asset. It compensates, may not be fully, the losses.
Only economic or financial losses can be compensated.

The concept of insurance has been extended beyond the coverage of tangible assets. Exporters
run the risk of the importers in the other country defaulting as well as losses due to sudden
changes in currency exchange rates, economic policies or political disturbances. These risks
are now insured. Doctors run the risk of being charged with negligence and subsequent liability
for damages. The amounts in question can be fairly large, beyond the capacity of individuals to
bear. These are insured. Thus, insurance is extended to intangibles. In some countries, the voice
of a singer or the legs of a dancer may be insured; even through the advantages of spread may
not be available in these cases.

Satisfaction of economic needs requires generation of income from some source. If the property,
which is the source of such income, is lost fully or partially, permanently or temporarily, the
income too would stop. The purpose of insurance is to safeguard against such misfortunes by
making good the losses of the unfortunate few, through the help of the fortunate many, who were
exposed to the same risk but saved from the misfortune. Thus the essence of insurance is to share
losses and substitute certainty by uncertainty

.
There are certain basic principles which make it possible for insurance to remain popular and a
fair arrangement. The first is the fact that people are exposed to risks and that the consequences
of such risks are difficult for anyone individuals to bear. It becomes bearable when the
community shares the burden. The second is that no one person should be in a position to make
the risk happen. In other words, none in the group should set fire to his assets and ask others to
share the costs of damage. This would be taking unfair advantage of as arrangement put into
place to protect people from the risks they are exposed to. The occurrence has to be random,
accidental and not the deliberate creation of the insured person.