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Study Material for Insurance

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INSURANCE

Risk in the context of insurance

There are uncertainties in an average life which is exposed to many types of dangers or risks which may
damage or destroy an asset, property or human life. The need for insurance arises out of the existence of
these risks. However, risk in this sense is not the investment risk discussed earlier, but encompasses other
types of financial risk, such as the loss of property, loss of income-earning capacity through illness or
disability, or liability for damages. We therefore need to distinguish between these two major categories of
risk. For the purposes of risk management, one of the important considerations in a financial plan, we will
use the following classification.
Meaning of risk
Risk in insurance only means that there is a possibility of loss or damage which may or may not happen. The
peril may sometimes be avoided through better safety and damage control management. Thus insurance is
relevant only if there are uncertainties about the happening of events which may bring about loss or damage.
The occurrence of the events insured against has to be random, accidental and not a deliberate act or
creation of the insured person.
Mechanism of insurance:
People facing common risks come together or they are brought together by insurers and make their small
contributions to the common fund. When risk occurs, the loss is made good out of this common fund. Thus
the risks are pooled and losses are shared.
Types of risks:
1. Pure risk refers to those situations where the consequences of the risk will be either a loss or no loss.
It involves situations such as a house burning down, a car being damaged in an accident or loss of a limb due
to an accident. These are instances where there is either a loss or no loss; a house may burn down or it may
not. Insurance relates to this form of risk.
2. Speculative risk refers to those situations where the consequences of the risk can result in either a
loss or a gain. Investing money as described earlier is a form of speculative risk.
Managing risk
Risk management is a new managerial discipline which has become a part of business management in many
corporate firms.
Risk management may be defined as a managerial function concerned with the protection of the firm's
assets, earning or profits, legal liabilities and personnel against financial loss that may result from fortuitous
events or accidental happenings. The process involves the following steps:
1. Risk identification
2. Risk evaluation
3. Selection of risk management techniques - these are risk avoidance and loss prevention and
reduction
4. Risk retention
5. Risk transfer
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Pure risk can be managed in a number of ways, and we can categorise these means in the following manner:
1 Risk control: here, steps are taken to minimise risk (for example, putting locks on the windows
partly controls burglary risk);
2 Risk avoidance: risk is eliminated by avoiding the risk altogether; for example, deciding not build a
house on a flood plain;
3 Risk retention: a person decides simply to accept and pay for any loss himself. Examples include
window replacement, where one agrees to pay an excess on a car insurance policy, or accept a certain
waiting period on an income protection policy -all for a reduced premium. Many people accept the risk
associated with medical and dental expenses. Effectively, risk retention is self insurance. Decisions to self
insure are based on a cost-benefit analysis - the cost of the premiums against the value of the possible loss. In
situations where the premium is disproportionately high relative to the risk for possible transfer,risk
retention is the more appropriate risk strategy.
4 Risk transfer: where through contract, the risk is transferred to another party. For example, if
property is leased, it may contractually transfer the risk of fire insurance to the lessee.

The most common form of risk transfer is through insurance, where through payment of a premium the risk
is effectively transferred to the insurance company.(Technically, some would argue that the risk is not
transferred per se, but rather shifted to, or shared among all the insures in the insurance pool. But the effect
is the same -the insured is protected from the loss.)
We are concerned primarily with risk transfer through insurance.
To be insurable, there is one very important attribute of pure risk that we need to keep in mind: the
occurrence of that risk needs to be mathematically predictable, using the law of probability. For example, we
can investigate the occurrence of a type of pure risk in the past and use that to predict the occurrence of this
type of risk in the future.

Pure risks that people face

Any analysis of insurance needs is predicted upon an understanding of the risks with which people may be
confronted. These risks include:
Personal risks
Risk of early death; (premature natural death or accidental death)
Risk of injury or debilitating illness (short-or long-term); and
Risk of loss of income through incapacity to work for some extended period.
Other risks related to insurance include the risk of leaving an inadequate estate for dependants or other
beneficiaries, or the risk of outliving retirement benefits.
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Property risks

Risk of loss or damage to one's own property (house, car).

Loss of use of property

Liability risks
 Risk of causing injury to other persons or the damage or loss of others ' property through one's
actions or inactions. For example, failure of any person in performing one's duty
 For professionals in the financial services field: risk of causing financial loss as a result of inadequate,
inappropriate, or otherwise negligent advice.

Loss/damage arising from negligence of third party

From recognition of these risks we can then establish the various needs that people have, needs that can be
met by insurance. However, it is important to recognise that personal insurance is not the only mechanism
available to handle aspects of risk. Depending on personal circumstances, there may be alternatives such as
employer-provided benefits (like accumulated sick leave, superannuation and others). Similarly, both central
and state governments make insurance compulsory in, transport (compulsory third party motor vehicle
insurance). It is the task of the financial planner to ascertain which risk-related needs are not at present
covered or not sufficiently covered, and to make recommendations to fill these gaps.

Risk-related needs
Having identified the risks to which people are exposed, we can now turn to a consideration of needs. Using
the categories of pure risk cited above, the more common needs include:
Personal protection

To provide a lump sum and/or income for any dependants in case of premature death;
 To provide for oneself and any dependants in the case of total and permanent disability (including the
cost of care);
 To provide for oneself and any dependants in the case of serious injury, accident or illness (i.e. trauma)
and a lump sum to cover major medical/hospital costs, or an income stream whilst unable to work; to provide
a lump sum upon death to meet all liabilities and debts (like mortgage, personal loans, etc.).
Property protection
To provide sufficient funds to replace that which has been lost or damaged through fire, flood, theft, accident
etc. including loss or damage to house, home contents, motor vehicles, boats, caravans and other vehicles.
Liability protection
To meet any liabilities associated with damage to another's property (like motor vehicle),or with injury to
another to somebody you employ as a part-time gardener),or with other 'damage ' like a financial loss.
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The client life cycle

While the needs listed in Figure 4.5 on the next page are common for most clients, client's specific needs will
vary according to individual personal circumstances. Of particular relevance in this regard is the client's stage
of life, as illustrated in the following Figure 4.5.
Of course, this is very much a traditional, stereotyped life cycle and you may find that many of your clients will
not conform to this pattern. However, Figure does illustrate the principle that clients ' needs change over
time, and that it is important to clearly identify all aspects of the clients ' circumstances in the analysis of
insurance needs.

Costing needs
The financial planner needs to ascertain the costs associated with any of the identified risks materializing as an
event. For example, in the case of early death, costs might include:
 The cost of meeting commitments: repayment of loans, mortgages and the provision for any
dependants lump sum (cash reserve) and/or ongoing income required to support the spouse/family in the
lifestyle desired; coverage of future expenses such as children 's education.
In the case of total and permanent disability or short-term critical illness, costs include immediate healthcare
costs, as well as the amount needed in ongoing income to support the client and his/her family.
In the case of property damage or loss, how much, in money terms, would this represent to the client? What
would be the replacement value?

Matching needs against insurance in place

A whole raft of insurance products have evolved to meet the many risk-related needs identified in the
previous section. As a planner, you need to identify the types of insurance policies that the client already has in
place, the premium costs, the rupee-value coverage, and any significant conditions attached to those policies
before you can develop a set of insurance recommendations that will meet the client 's overall insurance
needs.
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Insurance products can be simplistically classified into two main areas, life insurance and general insurance,
and it is these two areas of insurance that are normally differentiated on a data collection form.

Life insurance
This type of insurance relates to insurances that can be taken out over a human lifetime, whether it be
insurance for death, disability or serious illness. In addition to insurance against premature death, illness or
disability, life insurance may also have a savings or investment component. There are two key elements to a
life insurance policy:
 A life insurance policy requires an owner of the policy. This is the person, company or trustee who
receives the benefit if one of the specified events of the policy occurs.
 Secondly, a policy must have a life insured. This is the individual to which the life insurance policy
relates.

Types of life insurance

There are various types of life insurance, but they generally fall under the following categories:
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Figure 4.6: Forms of life insurance

Description Owner Comments

Term life insurance component. Individual, company or trustee 4Life insurance with no
(superannuation fund) investment component
4Contract cover the event of
death within a specified period
(hence, often referred
to as temporary insurance)

4Pays on agreed lumpsum on

death.
No Surrender Valu
Total and permanent As for term insurance above Usually attached to life
disabil(TPD)*ty insurance cover and pays a
lumpsum on specified total and
permanent disability
conditions.
There is some variation in
definition between companies
and policy owners need to read
contracts carefully
Trauma insurance* (with life cover) Individual Pays out a lump sum on
satisfying a covered life
Stand-alone trauma insurance threatening medical condition
Terminal illness* As for term insurance Pays out a percentage of death
benefit when terminal illness
diagnosed.
Accidental death benefits As for term insurance Pays out on death accident only.
Income Protection* Life Insured Individual Pays out a percentage of life
insured's regular income for
illness or injury for a specified
period after a set waiting period
Whole of life and endowment As for term insurance Collectively called permanent
life insurance policies: pays out
when the insured dies (see
further below)
Has surrender value
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*Usually extensions or 'riders' to life insurance contracts, but may be 'stand alone'; hence, not strictly life
insurance (death protection) policies as such. However all of the above could be considered 'personal
protection' policies.
A life insurance policy may specify certain events where cover is not provided. For example, cover may not
be provided when a person injures him-or herself intentionally or commits suicide. These events are known
as exclusions and the nature and type of exclusions will vary from company to company.
The amount paid by the policy owner to provide the cover is referred to as the insurance premium .The
level of premium for a given risk is determined by a number of factors including:
4 Age of the life insured;
4 Health;
4 Habits
4 Family medical history;
4 Exclusions (HIV being a major exclusion);
4 The sum or amount being insured;
4 Any existing insurance in place or being applied for;and
4 Profitability and marketing objectives of the insurer.
Whole of life and endowment policies
Many life insurance policies may deal not only with the pure risks described, but may also provide some form
of investment or savings component. These types of policies are sometimes referred to as life assurance
policies.
Historically, these types of life insurance policies fall into two main types:
4 Endowment policies generally have a specified maturity date where the cover ceases and the accrued
investment is repaid.(The sum insured is also usually paid out on the earlier death of the insured.)These
policies can thus be used as a means of saving for retirement while protecting dependants from the financial
effects of the insured person 's premature death; and
4 Whole life policies generally mature when the life insured is very old (100 years),and thus the maturity
date of a whole of life policy is the same for each person insured. In practice, most policies therefore never
mature before the death of the insured life. These types of policies generally have a low level of investment
component and, as such, the investment value, relative to an endowment policy is less. Conversely, the sum
insured or life insurance value is greater.
Convertible whole life policies:
Some companies permit the whole life policy to be converted to an endowment policy by the policy owner
and specify an earlier maturity date. This ability to convert is a feature exploited by players in the secondary
insurance policy market. As the premiums are paid, funds are gradually built up to pay the claim when it
inevitably occurs. This accumulation in funds generates an equity in the policy - otherwise known as the
surrender (or cash) value. This equity or surrender value is not the value of the premiums paid, but the
residue, after taking expenses and other costs into account.
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Policy loans:
Lastly, these 'traditional ' types of life insurance policies generally allow the policy owner to borrow against
the policy, at interest rates generally lower than prevailing market rates. This can be one source of cash in the
event that a client needs to access funds in an emergency situation but does not wish to cash out his or her life
insurance policy.

General insurance
General insurance is insurance that relates to risk financing of property. Property can take many forms and it
need not specifically relate to tangible goods or items; it may relate to loss suffered by another party because
of a person 's action or inaction. Loss can thus be tangible (as in damage to property)or intangible (such as the
loss of future earnings due to receiving negligent advice).Note the distinction between this form of insurance
and the 'personal protection ' insurance discussed previously, which relates purely to coverage of risk to the
individual person who is the subject of the policy.
Once again, the policy owner enters into a contract of insurance with a product provider that provides
coverage for specific events in exchange for a premium.

Underlying principles and features

As with life insurance, the purpose of general insurance is to indemnify the insured against loss, or to ensure
they are no worse off after the specified event(s)occurs. This is an important concept, as an insurer will not
better the insured 's position after the event. This reduces the 'moral risk ' on the part of the insurer and
prevents the insured causing the event to effectively enhance their position.
This underlying principle of indemnification lies at the heart of all general insurance contracts. Generally
speaking, an insurer will not reimburse for a value greater than that, which was lost. Whilst you may insure
your home for Rs 1,000,000, if is subsequently destroyed and was valued at Rs. 80,000,this is the amount
which will be paid out (if covered under a normal indemnity value policy -see below).
However, insurance companies have recognized that the indemnity value of, for example a home or its
contents may not be sufficient to cover the replacement of those items should they be lost/stolen or
destroyed. Hence two types of policies have evolved:
4 An indemnity value policy, where the insurer simply pays the value of the property or contents at the
time of the loss;
4 A replacement value policy, where the sum provided is more in keeping with what is needed in the
event of a loss. While the insured has only lost an amount equal to the indemnity value, it may well cost more
to replace the property/contents with something equivalent i.e there is often a gap between the indemnity
and replacement values. A replacement value policy leaves the insured in the same financial position after the
loss as before. Of course, as the replacement value is normally higher than the indemnity value, the insurance
premium is correspondingly higher. In your general insurance needs analysis, you should consider the type of
policy that is in place, or to be recommended.
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The insured is required, to fully disclose all matters which might materially affect the risk on the part of the
insurer. This is normally dealt with in the application for insurance, which provides a number of questions
relating to the items to be insured and the individual or company applying for insurance.
In your data collection process, you need to discuss the real value of particular assets and their insured values.
One common error is to include the land value in determining house insurance cover levels, rather than the
building itself and valuable items of furniture or equipment. Another error is to use the current value of the
property instead of the replacement value of the home and contents.

Terms of the contract

In some cases, an insurer may be prepared to specify the value of cover if sufficient in-depth information is
provided at the time the contract is prepared.
Similarly, the term of the general contract specifies dates and times at which cover will cease. Prior to the
expiry of the contract, the insurer may decide to offer a new contract to renew the policy. There is no
compulsion on the part of a general insurer to renew the policy and the insurer may decide to alter the terms
offered to the insured. This is quite different from life insurance, where the insurer is required to provide
ongoing cover, provided the premiums are paid. This allows companies to increase premiums and alter the
terms of the contract based on general or specific claims experience of the insured.
Insurers may also offer payment terms for annual premiums. Usually, the price includes a financing
component and with a higher number of installments, the finance component can be relatively high. For
example, Company XYZ charges Rs. 550 per annum for a contract paid annually, but charges Rs. 49.28 if paid
monthly.

12 x 49.28 =Rs.591.36
This shows the annual finance cost is Rs.41.36 per annum or 7.52%p.a.
General insurance contracts usually provide for a degree of self insurance by including a deductible amount or
excess on any claim. Whilst in the fiercely competitive domestic insurance market these can be reduced or
waived, they are a means to prevent petty claims clogging up a claims department. Similarly, excesses are
sometimes used to limit 'risky ' activities on the part of the insured. For example, your client 's motor vehicle
excess may be Rs.100 on a claim. Yet, if their 18-year-old son is driving, the excess increases to Rs.1,000.This
'penalty ' acts as a deterrent to having the 18-year-old use the car.
Insurance contracts usually specify those events, or perils, which are covered in what is known as the
'operative clause ' of the contract. In addition, the contract will specify perils that are not covered as
exclusions to the policy. Exclusions are often the source of dispute between insurers and the insured. One of
your responsibilities as a financial planner is to identify these problems before they occur and highlight these
to you client so that action may be taken.

Categories of general insurance

General insurance is usually separated into commercial and personal type contracts. Whilst there are many
similarities, there are differences in the types of cover offered.
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One other difference is the nature of obtaining cover. Whilst in the personal market there are a number of
players all vying for similar types of business, commercial insurance can sometimes present specific insurance
needs which are difficult to 'place ' or find takers for. This need is often served by a general insurance broker
who specialises in obtaining cover for these specific needs and, indeed, is able to obtain the 'best deal ' for
their clients.
The following list identifies some of the more common forms of insurance contract. The list is by no means
exhaustive and many insurers may provide features and options not listed.
Many insurance policies are 'bundled ' into packages. In some cases, insurers may be reluctant to offer one
type of policy if others are not included. For example, public liability may only be offered if other policies are
included.
Similarly, many insurers provide for minimum sums insured or minimum premiums. This ensures that
insurance contracts accepted are commercially viable.
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Forms of general insurance

Name Type Description
Home building the only Personal Provides cover for a number of Listed
ones. perils. Fire, storm, water, burglary,
impact are the principal ones but not
the only ones
Home contents Personal Provides cover for a number of listed
perils, plus theft and, sometimes,
accidental damage.
Public liability (home) Personal Covers the owner's legal liability to
those who may sustain bodily injury or
damage to property whilst on the
insured's property.
Domestic workers' Personal Covers the legal liability in relation
tcompensation those employed at the house for injury
they sustain
Building Commercial As for home building
Contents Commercial Provides cover similar to home
contents against a similar range of
perils
Public liability Commercial Provides cover for the legal liability of
the insured in relation to bodily injury
or property damage to others arising
out of the business.
Product liability Commercial Similar to public liability except it
applies in relation to liability arising out
of products
Professional indemnity Commercial Covers legal liability for wrongful
advice on the part of a professional to a
client
Crop insurance Commercial Provide cover for damage to crops as a
result of fire or hail.
Comprehensive motor vehicle Commercial/ Private Provides cover for collision, fire, theft
and third party accident (see below).
Third party Accident Commercial/ Private Covers legal liability for damages to
third party property arising from the
use of the motor vehicle.
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Health insurance
In India, most people who have healthy insurance are covered under the mediclaim policy for individuals.
There are certain other health insurance policies also.

Mediclaim policy (individual)

This policy provides for reimbursement of hospitalisation/domiciliary hospitalisation expenses for
illness/disease or acccidental injury sustained during the policy period.
The liability in respect of all claims for expenses incurred in hospital/nursing home - boarding, nursing,
doctors fees, operation charges, diagnostics and anaesthesia, blood, oxygen, medicines and so on shall not
exceed the sum assured for the person during the period of insurance.
Domiciliary treatment means medical treatment for a pperiod exceeding three days for such illness/injury
which in the normal course woiuld require treatment at the hospital at actually taken whilst confined at home
in India under any of the following circumstances namely:
1) Condition of the patient is such that he/she cannot be removed to the hospital
2) The patient cannot be moved to the hospital for lack of accommodation therein.
But expenses incurred for pre and post hospital treatment are not covered and certain ailments are also
excluded.
The insured is entitled to cost of health check-up not exceeding 1% of sum assured once in every four years
subject to no-claim preferred during this period.

Group mediclaim policy:

It is available to any group/association/institution/corporate body subject to a minimum number of persons to
be covered. The coverage under this policy is same as under individual mediclaim policy but health check-up
expenses are not payable and there are some other minor differences.

Jan Arogya Bima policy

This is also similar to individual mediclaim policy and is available to individuals and family members with age
limit (5 to 70 years). However, children between age of three months and five years can be covered provided
one or both parents are covered concurrently. The sum assured per person is restricted to RS. 5,000/- only.

Cancer policy for members of

1. Indian cancer society - The insured member and his/her spouse are covered and if any of them
contracts cancer, the cost of diagnosis , biopsy, surgery, chempotherapy, radiotherapy, hospitalisation and
rehabilitation to the extent of Rs. 50,000/- only for each claim. Two dependent children can also be covered
for nominal premium of Rs. 50 per child.
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1. Cancer Patients Aid Association (CPAA) - In 1994, CPAA introduced the Cancer Insurance Policy in
colaboration with New India Assurance Company. The polici is available to healthy individuals who have not
suffered from cancer in the past. There is a 20-year comprehensive scheme and a full life scheme for various
sums assured. Under these schemes, the policyholder has the benefit of a fresh limit every year to take care
of his treatment expenses. The policy also covers free annual check-up at CPAA facilities. There is also a
corporate policy in which 6,500 individual members are participating.

Bhavishya Arogya policy

This is adeferred mediclaim policy for persons aged between 25 to 55 years. The retirement age to be
selected may be between 55 to 60 years.

Overseas medical policy

Overseas medical schemes are available under different plans (A to H)

Videsh Yatra Mitra policy

This policy is another overseas mediclaim scheme with benefits comparable with those offered by foreign
insurance companies like personal accident, illness, accident, loss of checked baggage or delay in its arrival,
loss of passport and so on.
Managed health care
This is a new and innovative concept in health insurance. The services made available include wide network
of hospitals/nursing homes where a policy holder can avail of cashless services i.e. admission to these
hospitals without payment of admission fees or deposits and other expenses which are reimbursed to the
hospital concerned by the insurer.