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Chapter - 1 The Nature, elimination and spreading of risk

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. The insurance is A cooperative device to spread the risk The system to spread the risk over a number of persons who are insured against the risk The principle to share the loss of each member of the society on the basis of probability of loss to their risk The method to provide security against losses to the insured -- Functional

The insurance is a contract whereby A certain sum, called premium, is charged in consideration Against the said consideration , a large sum is guaranteed to be paid by the insurer who received the premium The payment will be made in a certain definite sum, the loss or the policy amount whichever may be and The payment is made only upon a contingency (incident ) Contractual

Importance of Insurance
The role and importance of insurance has been explained in three phases.

Uses to individual
Insurance provides security and safety: The insurance provides safety and security against the loss on a particular event. In case of life insurance payment is made when death occurs or the term of insurance is expired. The property of insured is secured against loss on a fire in fire insurance. The insurance provides safety and security against the loss of earning at death or in older age, against the loss at fire, against the loss at damage, destruction or disappearance of property, goods furniture and machines, etc.
Insurance affords Peace of Mind : The security banishes (drive out ) fear and uncertainty, fire, windstorm, auto mobile accident, damage and death are beyond the control of human agency and in occurrence of any of theses events may frustrate or weaken the human mind. By means of insurance much of the uncertainty that centres about the wish for security and its attainment may be eliminated.



3. Insurance protects mortgaged property : At the death of the owner of the mortgage property, the property is taken over by the lender of money and the family will be deprived of the uses of the property. The mortgagee wishes to get the property he will lose his right to get the loan re-paid. The insurance will provide adequate amount to the dependents at the early death of the property owner to pay off the unpaid loans. Similarly, the mortgagee gets adequate amount at the destruction of the property. 4. Insurance eliminates dependency : At the death of the husband or father, the destruction of family need no elaboration (explanation). Similarly, at destruction of property and goods, the family would suffer a lot. It brings reduced standards of living and the suffering may go to any extent of begging from the relatives, neighbors or friends. The insurance is here to assist them and provide adequate amount at the time of sufferings.

5. Life insurance encourages saving : The elements of protection and investment are present only in case of life insurance. Life policies elements of saving predominates. These policies combine the programs of insurance and savings. The saving with insurance has certain extra advantages i) systematic saving is possible because regular premiums are required to be compulsory paid. The saving with a bank is voluntary and one can easily omit a month or two and then abandon (dispose of ) the program entirely. ii) In insurance the deposited premium cannot be withdrawn easily before the expiry of the term of the policy. As contrast to this, the savings which can be withdrawn at any moment will finish within no time.

iii) The insurance will pay the policy money irrespective of the premium deposited while in case of bank deposit, only the deposited amount along with the interest is paid. The insurance provides the wished amount of insurance and the bank provides only the deposited amount. iv) The compulsion or force to premium in insurance is so high that if the policy holder fails to pay premiums within the days of grace, he subjects his policy to lapse and may get back only a very nominal portion of the total premiums paid on the policy. 6. Life Insurance provides profitable investment : Individuals unwilling or unable to handle their own funds have been pleased to find an outlet for their investment in life insurance policies. The elements of investment regular saving, capital formation and return of the capital along with certain additional return are perfectly observed in life insurance. An individual from his own capacity cannot invest

regularly with enough of security and profitability. The life insurance fulfils al these requirements with a lower cost. The beneficiary of the policy holder can get a regular in come from the life insurer, if the insured amount is left with him. 7. Life Insurance fulfils the needs of a person : The needs of a person are divided into a. Family needs : Death is certain, but the time is uncertain. So there is uncertainty of the time when the sufferings and financial stringencies (toughness ) may be fall on the family. It would be a more pathetic sight in the world to see the wife and children of a man looking for some one more considerate and benevolent than the husband or the father, who left them un-provided. The provision for children up to their reaching earning period and for widow up to long life should be made. Any other provision except life insurance will not adequately meet this financial requirement of the family. Whole life policies are the better means of meeting such requirements.

b. Old age needs : The provision for old age is required where the person is surviving more than his earning period. The reduction of income in old age is serious to the person and his family. If no other family member starts earning, they will be left with nothing and if there is no property, it would be more piteous state. The life insurance provides old age funds along with the protection of the family by issuing various policies. c. Readjustment needs : At the time of reduction in income whether by loss of unemployment, disability or death, adjustment in the standard of living of family is required. The family members will have to be satisfied with meager (too little ) income and they have to settle down to the lower income and social obligations. Before coming down to the lower standard and to be satisfied with that, they require certain adjustment income so that the primary obstacles may be reduced to minimum. The life insurance helps to accumulate adequate funds.

d. Special needs : i) Need for education : There are certain insurance policies and annuities which are useful for education of the children irrespective of the death or survival of the father or guardian. ii) Marriage : The daughter may remain unmarried in case of father's death or in case of inadequate provision for meeting the expense of marriage. The insurance can provide funds for the marriage if policy is taken for the purpose. iii) insurance needs for settlement of children : After education , settlement of children takes time and in absence of adequate funds, the children cannot be well placed and all the education will go to waste. e. Clean up funds : After death, ritual ceremonies, payment of wealth taxes and income taxes are certain requirements which decrease the amount of funds of the family member. Insurance comes to help for meeting these requirements.

Uses to Business
1. Uncertainty of Business Losses is Reduced In world of business, commerce and industry a huge number of properties are employed. With a slight slackness or negligence, the property may be turned into ashes. The accident may be fatal not only to the individual or property but to the third party also. The owner of a business might foresee contingencies that would bring great loss. To meet such situations they might decide to set aside annually a reserve, but it could not be accumulated due to death. However, by making an annual payment, to secure immediately, insure policy can be taken. 2. Business-efficiency is Increased With Insurance The new as well as old businessmen are guaranteed payment of certain amount with the insurance policies at the death of the person; at the damage, destruction or disappearance of the property or goods. The uncertainty of loss may affect the mind of the businessmen adversely. The insurance, removing the uncertainty, stimulates the businessmen to work hard.

3. Key Man Indemnification Key man is that particular man whose capital, expertise, experience, energy, ability to control, goodwill and dutifulness make him the most valuable asset in the business and whose absence will reduce the income of the employer tremendously and up to that time when such employee is not substituted. The death or disability of such valuable lives will, in many instances, prove a more serious loss than that by fire or any hazard. The potential loss to be suffered and the compensation to the dependants of such employee require an adequate provision which is met by purchasing an adequate life policies. The amount of loss may be up to the amount of reduced profit, expenses involved in appointing and training, of such persons and payment to the dependants of the key man. The Term Insurance Policy or Convertible Term Insurance Policy is more suitable in this case.

4. Enhancement of Credit The business can obtain loan by pledging the policy as collateral for the loan. The insured persons are getting more loan due to certainty of payment at their deaths. The amount of loan that can be obtained with such pledging of policy, with interest thereon will not exceed the cash value of the policy. In case of death, this cash values can utilized for setting of the loan along with the interest. If the borrower is unwilling to repay the loan and interest, the lender can surrender the policy and get the amount of loan and interest thereon repaid. The insurance properties are the best collateral and adequate loans are granted by the lenders.

5. Business Continuation In any business particularly partnership business may discontinue at the death of any partner although the surviving partners can restart the business, but in both the cases the business and the partners will suffer economically. The insurance policies provide adequate funds at the time of death. Each partner may be insured for the amount of his interest in the partnership and his dependants may get that amount at the death of the partner. With the help of property insurance, the property of the business is protected against disasters and the chance of disclosure of the business due the tremendous waste or loss.

6. Welfare of Employees The welfare of employees is the responsibility of the employer. The former are working for the latter. Therefore, the latter has to look after the welfare of the former which can be provision for the early death, provision for disability and provision for old age. These requirements are easily met by the life insurance, accident and sickness benefit, and pensions which are generally provided by group insurance. The premium for group insurance is generally paid by the employer.

Uses to Society
1. Wealth of the Society is Protected With the advancement of the society, the wealth or the property of the society attracts more hazardous and, so new types of insurance are also invented to protect them against the possible losses. Each and every member will have financial security against old age, death, damage, destruction and disappearance of his wealth including the life wealth. Through prevention of economic losses, insurance protects the society against degradation. Through stabilization and expansion of business and industry, the economic security is maximized. The present, future and potential human man property resources are well-protected. The children are getting expertised education, working classes are free from botherations and older people are guiding at ease. The happiness and prosperity and observed everywhere with the help of insurance.

2. Economic Growth of the Country For the economic growth of the country, insurance provides strong hand and mind, protection against loss of property and adequate capital to produce more wealth. The agriculture will experience protection against losses of cattle, machines, tools and crop. This sort of protection stimulates more production in agriculture, in industry, the factory premises, machines, boilers and profit insurances provide more confidence to start and operate the industry. 3. Reduction in 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 sufficient funds for production narrow down the inflationary gap. The tow main causes of inflation, namely, increased money in supply and decreased production are properly controlled by insurance business.

Risk, Uncertainty, Chance and Probability Chance Reference to the probability of the outcome of a fortuitous (accidental) event. Often is used qualitatively, e.g.., one speaks of the chance of passing an examination as being high or low Probability A neutral mathematical term, used quantitatively and usually expressed by the symbol p and measure in a range from 0 to 1. 0 represents absolute impossibility , and 1 absolute certainty. Thus, the probability of a coin when tossed coming down head is 1 in 2, so p= .5; the probability of throwing a 4 on a dice in 1 in 6the dice having six slides- so p= .166

Uncertainty Refers to the subjective doubt as to the outcome of a future event. Risk This term is used for uncertainties where the doubt as to outcome can be measured either mathematically or statistically. It may be defined as objective doubt as to the outcome of a future event, being measured by the degree of variation in actual from expected results.

Classification of Risk

The word risk is used to mean financial risk or the uncertainty of financial loss. Financial risks can be classified in may way, but two divisions are particularly useful: The distinction between pure and speculative risks, The separation of fundamental risks and particular risks

Pure and speculative risks Speculative risks are taken with the promise of gain or the possibility of loss or of breaking even. Pure risks are taken with only the prospect of loss or no loss. Example : if a trader buys a stock of goods at 10 per ton hoping to re-sell them at 15 per ton he is taking a speculative risk: he may win or be may lose. If he resells at a price greater than 10 he gains, but if he can only get a lower price than 10 he loses. If he gets 10 he breaks even. The risk of fire totally destroying ones home is , however, a pure risk. The only possibilities are that the house will burn down, in which case one has suffered a loss. Speculative risks are normally dealt with by commercial techniques such as hedging and buying of futures. Pure risks can be dealt with by insurance techniques.

Fundamental and particular risks Fundamental risks arise from losses that are impersonal in origin and in consequence. The losses are not caused by individuals and do not fall upon individuals: war, inflation, fashion and prejudice are risks which arise form the problems of living together in a community, problems of social interdependency. Earthquakes, floods and hurricanes are fundamental risks arising from physical phenomena. Particular risk arise from losses that have their origin in individual events, like the stranding of a ship or the bursting of a boiler.

The distinction between fundamental and particular risks is not a fixed one. At one time unemployment was regarded as the result of the idleness, insobriety or incapacity of the individual workman- a particular risk which could be pinpointed. Now we tend to regard unemployment as a general phenomenon arising from the malfunctioning of the economic systema fundamental risk for which society not the individual is responsible. If it is speculative, commercial methods should be use, if it is fundamental, then government rather than commercial insurers should deal with it. Only the pure and particular risks properly from the area in which insurance operate.

Response to Risk
Risk Management Speculative risks are handled by the business entrepreneur and lay beyond the scope of this study. The control and management of pure risk is known as risk management, and basically there are three steps Discovering the sources from which risks may arise; Evaluating the impact on the individual or organization if a loss should occur Selecting the most effective technique or techniques to deal with the risk. No one is aware that a risk exists until a particular case brings it to light. For example, the case of in re Owers demonstrated certain liabilities resting on the legal personal representatives of deceased persons. As soon as the risk was brought to light a form of insurance was devised.

A firm may decide to assume a risk but to set aside a fund from which losses may be paid. Often such a procedure is called self insurance. The status of the person or organization exposed to the risk will influence the decision. The possibility of insuring against a loss of 5,000 would be attractive to most private individuals but to a company with assets of 250 million the chance would be less compelling. Risk retention therefore is influenced by ones capacity to retain; with the growth of larger business units one must expect an increase of retained risks.

Risk Prevention
The term risk prevention covers both risk elimination and risk reduction. Prevention therefore deals with a)Eliminating or reducing the factors that may cause a loss to a person or organization; b)Minimizing the loss when it occurs when prevention methods are not fully effective. Minimization may again be subdivided into: Detecting the adverse occurrence when it occurs and then attempting to eliminate it; Minimizing the loss after the adverse occurrence has happened. The main approaches to prevention are sometimes described as

1. The engineering approach

Controlling the physical aspects of the risk situation so that a loss-producing event can not occur; if it does it is minimized. Building construction, alarms, sprinklers, plant lay-out, machine guarding and so on are examples of this approach.

2. The human approach

As well as physical cause losses are also caused by actions that are due to the faults and habits of people. Accidents can be caused by people being maladjusted to their environment and this approach tries to remedy this inculcating (instill) a proper respect for cars, machinery and the like.

3.The statistical approach

By analyzing data of losses preventive measures can be taken at the points which past experience shows to have been vital in causing losses. All road accident to happen at certain times of day and to certain types of people the preventive measures can be concentrated on those factors.

4. The enforcement approach


Some authorities feel that the identification of loss prevention measure and the training of people to employ them is not sufficient. Human nature is such that without enforcement by an employer or by the State through police and various inspectorates action will often not be

Insurance Transfer and Pooling of Risk Having considered and rejected the possibility of retaining the risk, and having endeavored without complete success to eliminate the risk, the individual or firm is left with the possibility of transferring the risk to another, and of pooling his risk with others in like situation. The primary economic function of an insurer is the assumption of the pure risks of many insured. These risk reducing techniques are basically a. Increase knowledge By being a specialist in risk bearing the insurer has a greater knowledge of risk than individual insured

b. Pooling Permits the operation of the law of large numbers and makes risk more predictable. If the pool of risks is still not large enough to increase predictability insurers will arrange inter company pools so that the spread is wide enough to reduce the deviation of the actual losses for the expected.

c. Loss Prevention The insurer may enforce or provide risk reducing facilities which individual insured would not or could not do for themselves. d. Financial Capacity Most insures are larger financial units and as pointed out earlier the larger can assume risks which would daunt (deter) the small e. Further transfer of risk Insurers have open to them the reinsurance mechanism whereby they can transfer all or some of the risks they have assumed.

Spreading Risks by Insurance

The means of risk spreading so far considered involve a sharing not only of the risk by also of the management and profits of the business, i.e. in order to share the risk everything has to be shared. Insurance differs form this sort of risk sharing in that it isolates risk. It may be pictured as a fund into which each member puts a contribution commensurate with the risk he introduces. The insurer settles the amount of contributions and manages the fund, making , if possible, a reasonable profit in return for his expertise. The members of the fund (policyholders) are thus only bound together in their desire jointly to provide against a possible risk to which all are exposed, e.g.., fire, theft, shipwreck. In no way have they joined together their separate business operations.

In ancient times, if the master of vessel was unable to meet expenses at a foreign port and could not raise money on his own or on the ship owner's credit, he was empowered to raise money for the completion of the voyage by pledging his ship for repayment. The loan was made on bottomry bond, and repayment was due within a fixed number of days after arrivals at destination. The loan was not repayable if the ship was lost before completion of the voyage. The rate of interest was sufficiently high to include a premium for the risk of total loss. Similar loans could be made on the security of the carried cargo by means of resondentia bonds.

Another marine practice which is still in use is general average, which has a similar objective in that the loss is divided among several parties. General average affords indemnity only for losses voluntarily incurred, such as throwing cargo overboard in order to save the common venture. The loss is made good by contributions from all the interests- ship, freight, and cargo- which have been saved by the general average sacrifice. The system is closely identified with marine insurance, for marine insurers are normally liable for general average contributions.