Risk Analysis and Insurance Planning

Risk Analysis & Insurance Planning 'Approved courseware for the Certified Financial PlannerCM certification education programme in India' Published by 'International College of Financial Planning Ltd.

Risk Analysis and Insurance Planning After studying this module the learner would: • Have an understanding about the role of the financial planner in the personal risk assessment process. • Have a broad knowledge regarding insurance needs and risk assessment of clients. • Have a detailed understanding about the process of advising various types of insurance products for clients. • Have the analytical ability to assess individual risk areas and the extent and type of protection best suited for the client’s financial situation and financial goals. • Have a clear idea about how to integrate risk assessment and risk protection into a comprehensive financial plan. • Have the ability to provide solution for providing protection against exposures to risks of mortality, health, disability, property, liability, and long term care risk. • Have the ability to implement insurance plans for the insurance component and integrate tax efficiency. • Have a working knowledge regarding the various concepts and regulatory environment of insurance in India. ISBN 978-81-901956-0-3 (Set) ISBN 978-81-905887-2-0 (Volume 2) Revised and Reprinted in 2019 Price: Rs.16,500 (Inclusive of Workbook)

Risk Analysis and Insurance Planning Published by the © International College of Financial Planning Limited 2002 ISBN 978-81-905887-2-0 (Volume 2) No part of this publication may be reproduced, stored in a retrieval system or transmitted in any form by any means, electronic, mechanical, photocopying, recording, scanning or otherwise without the prior written permission of the publisher. This subject material is issued by the International College of Financial Planning Ltd. (the college) on the understanding that: 1. The College, its directors, author(s), or any other persons involved in the preparation of this publication expressly disclaim all and any contractual, tortious, or other form of liability to any person (purchaser of this publication or not) in respect of the publication and any consequences arising from its use, including any omission made, by any person in reliance upon the whole or any part of the contents of this publication. 2. The College expressly disclaims all and any liability to any person in respect of anything and of the consequences of anything done or omitted to be done by any such person in reliance, whether whole or partial, upon the whole or any part of the contents of this subject material. 3. No person should act on the basis of the material contained in the publication without considering and taking professional advice. 4. No correspondence will be entered into in relation to this publication by the distributors, publisher, editor(s) or author(s) or any other person on their behalf or otherwise.

Author Mr. Sanjiv Bajaj CFPCM, Joint Managing Director, Bajaj Capital Ltd. “Unless otherwise stated, copyright and all intellectual property rights in all course material(s) provided, is the property of the College. Any copying, duplication of the course material either directly, and or indirectly for use other than for the purpose provided shall tantamount to infringement and shall be strongly defended and pursued, to the fullest extent permitted by law.”

INTRODUCTION No Financial Planning is complete without the inclusion of Life Insurance, be it for an individual or a Firm or A Company. For example, let us consider a person who is the sole bread winner of the family and has saved over the last 15 to 20 years a certain amount of money in Bank Fixed Deposits for the higher education of his daughter. However he has not bought any life insurance on his own life. On an unfortunate day he suffers a stroke and passes away. The death of the breadwinner of the family completely changes the priority of the family. In this situation, the basic survival becomes its top priority. In such a situation the first causality is die savings done over the years because this is the money that will be used by the family for its basic livelihood need. The second causality is the dream of the daughter's higher education because money might not be available to fulfill that dream. Had there been life insurance on the life of the breadwinner, the death claim from the insurance company could have taken care of the livelihood of the family while the amount saved over the years could have been used for funding the higher education of the daughter; a win-win situation for all. Despite such high importance of life insurance in one's life, it is yet to receive its due recognition in the mind set of the mass. Payment of premiums for pure risk cover products, like term insurance, is considered a waste. Other insurance policies such as endowment plans or ULIPs are bought as short term investment products. Manufacturers/sellers of any products are generally responsible for creation of a proper image of their products in the minds of the consumer. And it is they only who can change this image as well. Therefore it is time for the Life Insurance Industry for self introspection and working towards a common goal of establishing life insurance as an item of necessity for all individuals in order to gain its due priority in the minds of consumers and in any formal or informal financial planning process. Here is a courseware titled “RISK ANALYSIS AND INSURANCE PLANNING” developed specially with the objective of creating such professionals. This courseware will cater to the needs of life insurance industry in converting their employees and their agents into financial planning professionals who will sell life insurance policies purely on the merit of the product and would thus become instrumental in changing the image of life insurance in the consumer's mind. For example, ULIP is a rich product capable of making its investor rich. But due to lack of proper knowledge about the utility of its features, it didn't find its due place in the consumer's mind. Features of a ULIP such as choice of funds, switch facility between the funds, flexibility of withdrawal, top ups, zero surrender charges after 5 years etc are such features which if used properly can truly make a client wealthy.

Besides other common aspects of life insurance industry, this courseware will specifically train an individual on the aspect of: • How to sell insurance as an item of necessity, • How to place an insurance policy against specific need of an individual, • How to make all the benefits of buying a life insurance policy visible to a prospect through sound logics in order to close sales on a win-win terms without resorting to any baseless and exaggerated projections of benefits and • How ULIP as an investment product scores high over mutual funds and how to utilize ULIP's features to the advantage of the investors.

CONTENTS Syllabus Page No. 1-74 Unit Outline 3 Topics and Sub Topics 3 SECTION - I: CONCEPTS OF INSURANCE AND RISK MANAGEMENT 9 10 1.1 INTRODUCTION TO INSURANCE 11 1.1.1 Overview of Insurance Sector in India 1.1.2 Purpose and Need of Insurance 15 1.1.3 Insurance as a Tool to Manage Risk 15 1.1.4 Cost and Benefits of Insurance to Individual and Society 15 16 1.2 BASIC CONCEPTS OF INSURANCE 16 1.2.1 Perils and Hazards 18 1.2.2 Law of Large Numbers 1.2.3 Adverse Selection 21 1.2.4 Insurable Risk 21 1.2.5 Self-insurance 21 23 1.3 INSURANCE AND RISK 24 1.3.1. Meaning of Risk 25 1.3.2 Types of Pure Risk 28 1.3.2. Other Types of Risk 29 1.3.3. The Principle of Pooling of Risk 31 1.3.4 Methods of Handling Risk 1.3.5 Difference Between Insurance and Hedging 1.3.6 Advantages and Disadvantages of Insurance in Handling Risk 1.3.7 Reinsurance

1.4 FUNDAMENTAL PRINCIPLES OF INSURANCE 37 1.4.1 Indemnity 37 1.4.2 Insurable Interest 40 1.4.3 Utmost Good Faith 42 1.4.4 Subrogation 46 1.4.5 Contribution 47 1.4.6 Proximate Cause 48 1.5 RISK MANAGEMENT 58 1.5.1 Meaning and Objective of Risk Management 58 1.5.2 Steps in Personal Risk Management 59 1.5.3 Risk Control and Risk Financing 61 1.5.4 Insurance Underwriting 63 SECTION - II: INSURANCE CONTRACT AND LEGAL LIABILITY 75-164 2.1. THE INSURANCE CONTRACT 77 2.1.1 Competent Parties 77 2.1.2 Offer and Acceptance 77 2.1.3 Consideration 77 2.1.4 Basic Parts of an Insurance Contract 78 2.1.5 Distinct Legal Characteristics of an Insurance Contract 79 2.1.6 Performance and Discharge of Insurance Contract 79 2.1.7 Insurance Policy Documents and their Legal Implications 80 2.2 IMPORTANT TERMS IN INSURANCE CONTRACT 93 2.2.1 Endorsements/Riders 93 2.2.2 Deductibles 94 2.2.3 Co-insurance 95 2.2.4 Assignment 97 2.2.5 Nomination and Beneficiary Status 98 2.2.6 Insurance Provisions - Depreciation/Market Value/Reinstatement Value 102 2.2.7 Miscellaneous 104

2.3 INSURANCE PRICING AND PREMIUM CALCULATION 113 2.3.1 Objective of Rate Making/Insurance Pricing 113 2.3.2 Important Factors in Rate Making 115 2.3.3 Risk Assessment and Rate Making 115 2.3.4 Rate Making for Life Insurance 119 2.3.5 Rate Making Property and Liability Insurance 126 2.3.6 Premium Calculation 127 2.4 ANALYSIS AND SELECTION OF INSURANCE PRODUCTS AND ITS 145 PROVIDER 145 2.4.1 Purpose of Coverage 146 2.4.2 Duration of Coverage 146 2.4.3 Participating or Non-participating 146 2.4.4 Cost-benefit Analysis Determining the Cost of Life Insurance 148 2.4.5 Claim Settlement 2.5 LEGAL LIABILITY 154 2.5.0 Introduction 154 2.5.1 Intentional Torts 155 2.5.2 Absolute Liability 155 2.5.3 Law of Negligence 157 2.5.4 Special Tort Liability Problems 158 2.5.5 Civil Justice System-IRDA, Insurance Ombudsman, Consumer Protection 158 SECTION - III: LIFE INSURANCE- ANALYSIS OF LIFE COVER, STRATEGIES AND PRODUCTS 165-296 3.1. ASSESSMENT AND IDENTIFICATION OF RISK EXPOSURE 167 3.1.1 Gathering Data on Current Life Insurance Coverage 167 3.1.2 Identifying Client's Life Insurance Needs 177 3.1.3 Situational Analysis for Perils and Hazards 177

3.2 ANALYSIS OF LIFE INSURANCE NEEDS 187 3.2.1 Economic Value of Human Life 187 3.2.2 Replacement of Future Income of the Insured 190 3.2.3 Replacement of Expenses and Financial Liabilities of the Family 192 3.2.4 Provision in the Life Cover of Certain Financial Goals and Financial Liabilities 195 3.2.5 Review of Coverage for Changes in Income, Assets and Financial Liabilities 198 3.3 TYPES OF LIFE INSURANCE POLICIES 208 3.3.1 Term Insurance 208 3.3.2 Whole Life Policy 212 3.3.3 Endowment Policy 215 3.3.4 Investment Linked Insurance 217 3.3.5 Insurance Linked Annuities 227 3.3.6 Life Insurance Policy Riders 240 3.4 CALCULATIONS OF CLAIM AMOUNT AND OTHER BENEFITS 256 3.4.1 Bonus- Revisionary, Performance, Maturity, etc. 256 3.4.2 Maturity of Policy 258 3.4.3 Death Claim 261 3.4.4 Surrender Value 264 3.4.5 Return on Savings Component 264 3.4.6 Taxation Aspects of Various Life Insurance Policy 267 3.5 OTHER PROVISIONS OF LIFE INSURANCE CONTRACT 278 3.5.1 \"Free Look\" Period and Grace Period 278 3.5.2 Claim Concession 279 3.5.3 Lapse, Non-forfeiture Provision, Surrender and Revival 280 3.5.4 Loans against Life Insurance Policies 287 3.5.5 Exclusions and Restrictions 288 3.5.6 Suicide Clause 289

SECTION - IV: GENERAL INSURANCE- PROPERTY, HEALTH AND LIABILITY INSURANCE 297-358 4.1. HEALTH INSURANCE AND ACCIDENT INSURANCE 299 4.1.1 Individual Health Insurance 299 4.1.2 Family Floater Policy 301 4.1.3 Critical Illness Policy 302 4.1.4 Group Health Insurance Policies 302 4.1.5 Pre-existing Disease Clause and Other Provisions 303 4.1.6 Personal and Group Accident Insurance 304 4.1.7 Long-term Care Insurance 307 4.1.8 Income Assurance - Hospitalization and Temporary Disability 308 4.2 PERSONAL DISABILITY INSURANCE 310 4.2.1 Disability - Permanent and Temporary 310 4.2.2 Disability - Partial and Total 310 4.2.3 Scope of Benefits - Short - Term and Long - Term Disability 311 4.3 PROPERTY AND LIABILITY INSURANCE 314 4.3.1 Basis of Property Cover - Reinstatement, Book or Market Value 314 4.3.2 Insuring House, Household Items, Business Unit, Plant and Machinery 317 4.3.3 Personal Umbrella Policy- Mortgage Cover 321 4.3.4 Miscellaneous Overseas Travel Insurance 322 4.3.5 Use of Excess/Deductible and Franchisee 323 4.3.6 Motor Insurance - Comprehensive and Mandatory Third Party Cover 325 4.3.7 Motor Insurance - No Claim bonus and Claims 327 4.4. OTHER BUSINESS SPECIFIC INSURANCE 330 4.4.1 Keyman Insurance 330 4.4.2 Professional Indemnity Insurance 331 4.4.3 Employee State Insurance Liability 332 4.4.4 Workers\" Compensation Insurance 334 4.4.5 Directors\" and Officers\" Liability Policy 335 4.4.6 Clinical Trials Liability Insurance 337

4.4.7 Employees\" Health Insurance 338 4.4.8 Commercial Auto Polices 338 4.4.9 Marine Insurance 338 4.4.10 Cargo and Hull Insurance 339 4.4.11 Inland Transit Insurance 342 4.4.12 Crop Insurance 343 4.4.13 Poultry Insurance 345 4.4.14 Terrorism and Riot Covers 345 SECTION - V: REGULATORY FRAMEWORK OF INSURANCE 359-407 5.1. REGULATIONS RELATING INSURANCE 361 5.1.1 Insurance Regulatory and Development Authority (IRDA) Act-1999 361 5.1.2 The Insurance Act-1938 362 5.1.3 Indian Contract Act-1872 363 5.1.4 Public Liability Insurance Act-1991 366 5.1.5 Motor Vehicle Act-1988 367 5.1.6 Consumer Protection Act-1986 369 5.1.7 Workmen’s Compensation Act-1923 372 5.1.8 Employee State Insurance Act-1948 373 5.2. OTHER REGULATORY ASPECTS OF INSURANCE AND AGENCY LAW 377 5.2.1 Laws Regarding Insurance Companies in India 377 5.2.2 Various Intermediaries - Agents, Brokers, Surveyors, Consultants, etc. 385 5.2.3 Difference Between Insurance Agents and Breakers 394 5.2.4 Agency Law and Functions of an Agent 394 5.2.5 Doctrines of Waiver and Estoppels 398

SECTION - I Concepts of Insurance and Risk Management 1

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1.1 INTRODUCTION TO INSURANCE 1.1.1 Overview of Insurance Sector in India The history of insurance in India is deep-rooted. Since the earliest times insurance has been carried out in some form or other. Insurance in India has developed over time and has taken ideas from other countries – England in particular. The history of insurance in India can be divided into three phases as follows: Phase I – Pre-liberalisation 1818– First insurance company: in 1818 the Oriental Life Insurance Company 1829 in Kolkata (then Calcutta) wasthe first company to start a life insurance business in India. However, the company failed in 1834. Inthe Madras Equitable had begun transacting life insurance business in the Madras Presidency. 1870 Following the enactment of the British Insurance Act 1870, the last three decades of the nineteenthcentury saw the creation of the Bombay Mutual (1871), Oriental (1874) and Empire of India (1897) inthe Bombay Residency. 1912 The Indian Life Assurance Companies Act 1912 was the first statutory measure to regulate lifebusiness. 1928 The Indian Insurance Companies Act 1928 gave the Government the power to collect statisticalinformation about both life and non-life business transacted in India by Indian and foreign insurers,including provident insurance societies. 1938 To protect the interest of the insuring public, the earlier legislation was consolidated and amended by theInsurance Act 1938 which gave the Government effective control over the activities of insurers. 3

1950s In the 1950s, competition in the insurance business was very high and there were allegations of unfairtrade practices. The Government of India therefore decided to nationalize insurance business. 1957 Formation of the General Insurance Council (GI Council): the GI Council represents the collective interests of the non-life insurance companies in India. The Council speaks out on issues of common interest, participates in discussions related to policy formation, and acts as an advocate for high standards of customer service in the insurance industry. 1972 The General Insurance Business (Nationalisation) Act 1972 (GIBNA) was passed. The General Insurance Corporation of India (GIC) was formed in pursuance of Section 9(1) of GIBNA. It wasincorporated on 22 November 1972 under the Companies Act 1956 as a private company limited byshares. Phase – II:Liberalisation The Start of Reform The international payment crisis of the 1990s forced the Government to re-think its industrial policies andregulations. The Government only had enough foreign currency reserves to finance a few days of imports. 1993 Malhotra Committee: in 1993 the Government set up a committee under 1999 the chairmanship of R N Malhotra, the former Governor of RBI, to make recommendations for the reform of the insurance sector. In its report in 1994, the committee recommended, among other things, that the private sector andforeign companies (but only through a joint venture with an Indian partner) be permitted to enter theinsurance industry. Formation of the IRDA: following the recommendations of the Malhotra Committee report, theInsurance Regulatory and Development Authority (IRDA) was constituted as an autonomous bodyin 1999 to regulate and develop the insurance industry. The IRDA wasincorporated as a statutorybody in April 2000. 4

Phase – III: Post-liberalisation As we have seen, following the recommendations of the Malhotra Committee, the insurance sector was opened to private companies. Foreign companies were also allowed to participate in the Indian insurance market through joint ventures (JVs) with Indian companies. Under current regulations the foreign partner cannot hold more than a 49% stake in the joint venture. The key objectives of the IRDA include the promotion of competition with a view to increasing customer satisfaction through more consumer choice and lower premiums, while ensuring the financial security of the insurance market. The IRDA has the power to make regulations under section 114A of the Insurance Act 1938. Since 2000 it has introduced various regulations ranging from the registration of companies for carrying on insurance business to the protection of policyholders‘ interests. The Insurance Act 1938 and GIBNA were amended which removed the exclusive privilege of GIC and its four subsidiaries to write general insurance in India. As a result, general insurance business was opened up to the private sector. With the General Insurance Business (Nationalisation) Amendment Act 2002, effective from 21 March 2003, GIC ceased to be a holding company of its four subsidiaries. Their ownership was vested with the Government of India. GIC was notified as a reinsurance company. Recent Developments in the Insurance Industry By 2010 India was the fifth largest insurance market in the world and it is still growing rapidly. There has been a lot of change in the decade since the market was opened up to the private sector. In this section we will look at some of the important developments of the last few years. Growing All insurance companies now use information technology (IT) to importance of IT benefit their business and toimprove convenience for their customers. Today, customers can pay their premiums and checkthe status and other details of their policy using the company‘s website. Updates relating to thereceipt of premiums or changes to their policy are sent to the customer through mobile SMS. Banc assurance Banc assurance Many banks have joined with insurance companies to cross-sell insurance products to their customers. 5

Online sales Insurance companies benefit from the wide network and loyal Micro-insurance customer baseof banks, and the contribution that banc assurance makes to insurance sales has steadilygrown over the last few Grievance years. The banks benefit through being able to provide value- redressal addedproducts to their customers and from the fee income they receive in return from the insurancecompanies. Many banks have Insurance started their own life insurance subsidiaries. Most of the insurance companies have now started selling insurance products online. Thiseliminates the need for an intermediary and reduces costs. This saving can be passed tocustomers in the form of reduced premiums. Micro-insurance guidelines were issued by the IRDA in 2005. Micro-insurance productsprovide insurance protection to people in lower income groups, such as self-help group (SHG)members, farmers, rickshaw pullers and others against the risks that they and their assets areexposed to. The premiums for these products may be as low as ₹15 and are collected ona weekly basis. The minimum life insurance cover specified by the Regulator for this categoryis ₹5,000 and the maximum cover that can be provided is ₹50,000. People who work inagriculture and allied activities are exposed to the hazards of nature so they need protectionagainst risks like monsoon failure, floods etc. This is where micro- insurance can come to theirrescue. Whenever any industry is experiencing fast growth there are bound to be concerns, and theinsurance industry is no different. There has been an increase in complaints from customersabout the settlement of their claims and customer service in general. As we saw earlier, theIRDA has taken steps to protect the interest of the policyholders. It has asked insurancecompanies to set up internal customer grievance redressal cells/departments, and anInsurance Ombudsman has been established. The latest initiative from the IRDA is the setting up of a call centre which an insured can contactto seek the resolution of a grievance they have against their insurer. The unhappy customercan either call a toll-free number (155255) or email [email protected] to register theircomplaint. On 16 September 2013, IRDA launched₹Insurance Repository' 6

Repository services in India. It is a unique concept and first to be introduced in India. This system enables policy holders to buy and keep insurance policies in dematerialized or electronic form. Policy holders can hold all their insurance policies in an electronic format in a single account called electronic insurance account (eIA). The objective of creating an insurance repository is to provide policyholders a facility to keep insurance policies in electronic form and to undertake changes, modifications and revisions in the insurance policy with speed and accuracy. The Insurance Sector is a Colossal One and is growing at a speedy rate of 15-20%. Together with banking services, insurance services add about 7% to the country‘s GDP. A well- developed and evolved insurance sector is a boon for economic development as it provides long- term funds for infrastructure development at the same time strengthening the risk taking ability of the country. Insurance Business Practices Understand relevant insurance business practices. To advise clients properly on insurance products, the financial planner must be familiar with relevant business practices in the insurance industry. In particular, as the insurance sales has a wide exposure to and impact on the clients, their sales practices and regulations have to be properly appreciated. In particular, the following merit attention:  Available distribution channels  The structure of the agencies  Remuneration to the sales force Available Distribution Channels In the liberalized insurance market, insurers are likely to have the following types of distribution channels viz  Insurance Agents  Corporate Agents a) Firms b) Banking Companies c) Companies under the Companies Act 7

 Brokers a) Individual Brokers b) Firms c) Companies under the companies Act  Insurance Consultants Structure of the Agencies The agency structure in India is a three tier structure namely, the agents (as the basic tier), the Development Officers/Sales Managers of the insurance company (as the intermediate tier) and the Branch Managers (as the highest tier). Remuneration Insurance companies pay remuneration to their agents in the form of commission as specified under section 40 A of the Insurance Act, 1938. The types of commission that are usually paid to agents are:  First Year Sales Commission - As the name suggests, the commission paid on the sale of Whole Life or Endowment plan, paid in the first year premium.  Renewal Commission - As per the Section 44 of the Insurance Act, agents who have put in at least 5 years and have done business of at least ₹50,000 or have put in at least 10 years, will be entitled to receive the renewal commissions, even after the agency has terminated. Such commission will continue to be paid to the heirs of the agent after his death subject to following conditions. a) The termination should be for reasons other than fraud. b) Agent does not procure business, directly or indirectly, for another person.  Hereditary Commission - In the event of death of the agent renewal commission is continued to be paid to the nominee or heirs of the agent. 8

1.1.2 Purpose and Need of Insurance Insurance is a form of risk management in which the insured transfers the cost of potential loss to another entity in exchange for monetary compensation known as the premium. Insurance allows individuals, businesses and other entities to protect themselves against significant potential losses and financial hardship at a reasonably affordable rate. We say \"significant\" because if the potential loss is small, then it doesn't make sense to pay a premium to protect against the loss. After all, you would not pay a monthly premium to protect against a ₹2000 loss because this would not be considered a financial hardship for most. Insurance is appropriate when you want to protect against a significant monetary loss. Take life insurance as an example. If you are the primary breadwinner in your home, the loss of income that your family would experience as a result of our premature death is considered a significant loss and hardship that you should protect them against. It would be very difficult for your family to replace your income, so the monthly premiums ensure that if you die, your income will be replaced by the insured amount. The same principle applies to many other forms of insurance. If the potential loss will have a detrimental effect on the person or entity, insurance makes sense. Everyone that wants to protect themselves or someone else against financial hardship should consider insurance. This may include:  Protecting family after one's death from loss of income  Ensuring debt repayment after death  Covering contingent liabilities  Protecting against the death of a key employee or person in your business  Buying out a partner or co-shareholder after his or her death  Protecting your business from business interruption and loss of income 9

 Protecting yourself against unforeseeable health expenses  Protecting your home against theft, fire, flood and other hazards  Protecting yourself against lawsuits  Protecting yourself in the event of disability  Protecting your car against theft or losses incurred because of accidents  And many more 1.1.3. Insurance as a Tool to Manage Risk Life is a constant process of taking risks. If a person commutes to work by bus, he runs the risk of being involved in a traffic accident. If he chooses to walk to work, he risks being knocked down by a car during the journey. If he chooses to dine outside, he runs the risk of food poisoning. Although some of the risks mentioned may be farfetched, they can never be totally eliminated. Most activities undertaken by people normally entail risks of some sort. Risk mainly refers to a condition where there is a chance that the risk - taker may suffer or enjoy a gain or maintain status quo. Insurance is an only instrument to help a sufferer to do so. If Jayeshkumar purchases a lottery ticket, he runs the risk of either losing the money used to buy the ticket or striking the top prize of ₹lCrore. This is Gambling. When a share broker put sum of money into certain shares, he can make profit, suffer a loss or meet the break even. He undertakes the result of gambling. Though it is a risk no insurance tax available to compensate the loss out of gambling. A condition where the risk taker either suffers a loss or avoids losses without enjoying any gain. For example, if Jayeshkumar owns a property, there is a risk that it may be decimated by an accidental fire. The loss out of damage due to fire can be compensated through insurance. Thus insurance is a protection against financial loss due to pure risk but the loss out of speculation is gambling for which is tools to compensate the losses. Definition of Risk Analysis It is an estimation of the possibility of suffering loss. In other words, it is the process of assessing identified risks to estimate their impact and probability of occurrence (likelihood)Perils named in the policy as Insured e.g. Fire, Theft, Accident, Lighting etc. 10

1.1.4 Cost and Benefits of Insurance to Individual and Society The society and the national economy draw substantial benefits from the operation of the insurance mechanism. On one hand, life insurance and pension provide relief to the members of the society from financial difficulties arising from premature death of a bread earner or surviving to old age. Burden of the state to provide relief to destitute and aged citizens is reduced through the insurance mechanism. Besides large sums sum of monies become available for the period between the payment of premium and payment of claims. These sums can be invested in such a manner that the economy develops for the benefit of the society. Business/ industry and trade would be seriously handicapped if insurance protection is not available to cover the business risks, for example, fire or engineering insurance. Insurance from the point of view of the society is a mechanism, which relieves the individual citizens, and the industry from the burden of carrying on themselves the various risks they are likely to face from day to day. Costs of Insurance to Society Though insurance provides vast benefits to individuals and society, it carries some social costs that must be realized. Heavy expenditure is incurred in running of insurance companies, which are increasing over time. This results in scarce economic resources being diverted for the development of insurance industry. Besides, insurance sometimes has the effect of encouraging unscrupulous individuals to resort to fraud, which is a heavy cost to the companies and the nation. Also, it has now become increasingly common to make highly inflated claims particularly in motor insurance and health insurance to cover₹deductibles‘. This results in heavy underwriting losses to insurance companies who are forced to raise premiums. In our own country, most of the nationalized insurance companies all along have been incurring heavy underwriting losses. The huge increase in motor insurance and health insurance premiums is a direct result of this factor. The costs of insurance thus also include: Fraudulent claims Inflated claims Benefits Derived by Society through Insurance Some of the benefits derived by society through insurance are given below:  Reduces worry and fear  Makes available large funds for investment at low cost  Provides employment to a large number of people  Insurance enhances credit worthiness and reduces credit risk  Invisible earnings  Social benefits 11

Reduces Worry and Fear Insurance helps in reducing the anxiety and fear before and after the loss occurs, as it is known that the insurance company will compensate the loss. Even large insurance companies gain peace of mind by reinsuring their extra risk. This way they can perform better in their operations. Makes available Funds for Investment Insurance industry is a major provider of capital for business and industry. The funds of insurance companies are also available for national development activities. Provides Employment to a Large Number of People Insurance industry offers regular full-time employment to a large number of people in the country. Besides, a number of agents, professionals like actuaries, accountants, brokers, medical examiners, legal advisors etc., are also engaged by the industry to render professional services. Insurance Enhances Credit Worthiness Life insurance policies are often offered as collateral security for credit. Property insurance affords protection to the lenders‘ financial interest. It is not unusual for lenders to insist on insurance for business assets such as plant, machinery, vehicles, inventory etc. Thus, insurance enhances the amount of credit that can be secured against assets. Invisible Earnings In the way risk is spread within the country, it can also spread among the countries. The benefits derived by a country through such spread of risk widely are termed as invisible earnings. England acting as a centre of international widely insurance is a good example of this. U.K. insures overseas risk and the earnings from these transactions, after meeting the costs, represent invisible earnings for the country. Social Benefits From all the above benefits we derive social benefits. People with secured jobs and peaceful mind tend to carry on their operations properly and in a better way. This contribution to the economy as a whole is valuable. It ensures that unnecessary economic hardships are avoided. 12

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QUESTIONS Q1. The concept of Fire Insurance was born the Great fire of ___________ in 1666. (a) America (b) London (c) Germany Q2. A fund that is used for expenses immediately incurred upon a person's death. By having sufficient funds, existing assets belonging to the estate need not be liquidated on unfavourable terms to pay for such expenses is a _______________. (a) emergency fund (b) education fund (c) final expenses Q3. The very nature of insurance is to provide ____________________________. (a) protection for events that don't happen frequently (b) service at a right time (c) none of the above Answers 1 B2 B3A 14

1.2 BASIC CONCEPTS OF INSURANCE 1.2.1 Perils and Hazards A peril is an immediate, specific event causing a loss. In other words, a peril is something that can cause a loss. Examples include falling, crashing ones car, fire, wind, hail, lightning, water, volcanic eruptions, choking, falling objects etc. On the other hand a hazard is the condition which increases the risk or seriousness of a loss. In other words, a hazard is any condition or situation that makes it more likely that a peril will occur. There are four types of hazards known to the insurance profession. They are as follows:  Physical hazards: These include hazards which arise from structural or operational features of the situation. For example a slippery floor or a huge tree branch in the middle of the road would be classified as a physical hazard.  Moral hazards: These include hazards which arise from a person's habits and values. The attempt to create a loss for the purpose of collecting from an insurance company is a moral hazard. Another moral hazard is the filing of a false claim. Also, every day someone sets themselves up to be the victim of an auto theft. In many cases this is done just to avoid having to pay anymore on the loan. This is a very common moral hazard which could easily result in prison time for the one who attempts this type of fraud.  Morale hazards: These include hazards which arise from carelessness or irresponsibility. An example of a morale hazard is when some driver flies into oncoming traffic while trying to reach their dropped cell phone.  Legal hazards: These include hazards which arise from court actions that increase the likelihood or amount of loss. Legal hazards will continue to increase as more people file lawsuits for large rewards. 1.2.2 Law of Large Numbers No one can predict the losses that a specific person will experience. We do not know when a specific person will die, become disabled, or need hospitalization. It is possible, however, to predict with a fairly high degree of accuracy the number of people in a given large group who will die or become disabled or need hospitalization during a given period of time. These predictions of future losses are based on the concept that, even though individual events - such as the death of a particular person - occur randomly, we can use observations of past events to determine the likelihood that a given event will occur in the future. This likelihood is called probability of event. An important concept that is used to determine the probability of an event occurring is the law of large numbers. 15

Probability: The likelihood that agiven event will occur in the future Law of Large numbers states that, typically, more times we observe a particular event, the more likely it is that our observed results will approximate the \"true\" probability that an event will Occur. For example, if you toss an ordinary coin, there is a 50-50 probability that it will land with the heads side up; this is a calculable probability. Four, or even a dozen, tosses might not give the result of an equal or approximately equal number of heads and tails. If you tossed the coin 1,000 times, though, you could expect a result of approximately 50 percent heads and 50 percent tails to occur. The more often you toss the coin, the more likely it is that you will observe an approximately equal proportion of heads and tails, and thus, the more likely it is that your findings will approximate the \"true\" probability. 1.2.3 Adverse Selection Some insureds do not reveal knowledge that would effect their underwriting classification. This failure to reveal relevant information may be because the insurer did not ask the right questions or because of applicant forgetfulness or misreprentation. This leads to adverse selection. An important purpose of underwriting is to deter adverse selection. 1.2.4 Insurable Risk Insurance products are designed in accordance with some basic principles that define which risks are insurable. In order for a risk - a potential loss - to be considered insurable, it must have certain characteristics. 1. The loss must occur by chance. 2. The loss must be definite. 3. The loss must be significant. 4. The loss rate must be predictable. 5. The loss must not be catastrophic to the insurer. These five basic characteristics used to define an insurable risk form the foundation of the business of insurance. A potential loss that does not have these characteristics generally is not considered to be an insurable risk. The Loss Must Occur by Chance In order for a potential loss to be insurable, the element of chance must be present. The loss should be caused either by an unexpected event or by an event that is not intentionally caused by the person covered by the insurance. For example, people cannot generally control whether they will become seriously ill; as a result, insurance companies can offer 16

health insurance policies to provide economic protection against financial losses caused by the chance event that the person who is insured will become ill and incur medical expenses. When this principle of loss is applied in its strictest sense to life insurance, an apparent problem arises: death is certain to occur. The timing of an individual's death, however, is usually out of the individual's control. Therefore, although the event being insured against - death - is a certain event rather than a chance event, the timing of that event usually occurs by chance. The Loss Must be Definite For most types of insurance, an insurable loss must be definite in terms of time and amount. In other words, the insurer must be able to determine when to pay policy benefits and how much those benefits should be. Death, illness, disability, and old age are generally identifiable conditions. The amount of economic loss resulting from these conditions can, however, be subject to interpretation. The Loss Must be Significant As described earlier, insignificant losses, like the loss of an umbrella, are not normally insured. The administrative expense of paying benefits when a very small loss occurs would drive the cost for such insurance protection so high in relation to the amount of the potential loss that most people would find the protection unaffordable. On the other hand, some losses would cause financial hardship to most people and are considered to be insurable. For example, if a person were to be injured in an accident that resulted in a long period of disability, he/she would lose a significant amount of income. Insurance coverage is available to protect against such a potential loss. The Loss Rate Must be Predictable In order to provide a specific type of insurance coverage, an insurer must be able to predict the probable rate of loss that the people insured by the coverage will experience. To predict the loss rate for a given group of insured's, the insurer must predict the number and timing of covered losses that will occur in that group of insured's. An insurer predicts the loss rate for a group of insured's so that it can determine the proper premium amount to charge each policy owner. Loss Rate: The rate at which covered losses are expected to occur in a specified group of insureds. The loss should not be catastrophic 17

It means that a large proportion of exposure units should not incur losses at the same time. Otherwise, the insurance pooling would break down and become unworkable. 1.2.5 Self-insurance Self-insurance is a risk management method in which a calculated amount of money is set aside to compensate for the potential future loss. Self-insurance is possible for any insurable risk, meaning a risk that is predictable and measurable enough in the aggregate to be able to estimate the amount that needs to be set aside to pay for future uncertain losses. For a risk to be insurable, it must represent a future, uncertain event over which the insured has no control. Other characteristics which assist in making a risk self-insurable include the ability to price or rate the risk. Normally, catastrophic risks are not self-insured as they are highly unpredictable and high in loss- value. 18

QUESTIONS Q1. The ______________ states that, typically, the more times we observe a particular event, the more likelyit is that our observed results will approximate the \"true\" probability that the event will occur. (a) The Law of an Individual (b) The Law of Large Numbers (c) The Law of Insurance Q2. There must be a sufficiently large number of __________ exposure units to make the losses reasonablypredictable. (a) Heterogeneous (b) mixed (c) homogeneous (d) All the above Q3. To be insurable the loss produced by the risk must be __________ and __________. (a) Indefinite, measurable (b) definite, measurable (c) vague, calculable (d) none of the above Q4. An insurable loss must be ____________. (a) certain to happen (b) fortuitous or accidental (c) indefinite (d) impossible to happen Q5. A loss to be insurable, must not be _____________. (a) Catastrophic (b) fortuitous or accidental (c) definite (d) none of the above 19

Q6. The insurance principle is based on ______________. (a) sharing of resources (b) sharing of losses (c) sharing of capital (d) none of the above Q7. Damage that results from enemy attack would be _____________ in nature. (a) catastrophic (b) calamity (c) provisional (d) negligible Q8. Who will share the premium (level), given the number of persons to be insured and the number of persons expected to die in the given period for the sum assured? (a) No. of persons to be insured (b) No. of persons expected to die (c) Survivors (d) None of the above Answers 1 B4 B7A 2 C5 A8 A 3 B6 B 20

1.3 INSURANCE AND RISK 1.3.1 Meaning of Risk Risk is a condition where there is a possibility of an adverse deviation from a desired outcome that is expected or hoped for; when an event is stated to be possible, it has a probability between zero and one; it is neither impossible nor definite. The degree of risk may or may not be measurable. Since our purpose is to relate risk to insurance, focus will be on risk, which entails the possibility of financial loss. Financial loss may be defined as a decline in or disappearance of value due to a contingency. This means that if the loss of value is intended or if it is certain, it is not a loss within the context of the above definition. For those who define risk as uncertainty, the greater the uncertainty, the greater is the risk. For an individual, higher the probability of loss, greater is the probability of an adverse deviation from what is hoped for and therefore, greater is the risk. The expected value of loss in a given situation, or the mathematical value of risk at any point of time, is the probability of the loss materializing multiplied by the amount of the potential or anticipated loss. Risk may be defined as \"condition in which there is a possibility of an adverse deviation from a desired outcome that is expected or hoped for.\" Risks can be divided into two basic types, namely, speculative risk and pure risk. Speculative risk refers to a condition where there is a chance that the risk-taker may suffer a loss or enjoy a gain or maintain status quo. For example, if Jayesh purchases a lottery ticket, he runs the risk of either losing the monies used to buy the ticket or striking the top prize of ₹lcrore. This would be an example of taking speculative risk. When an investor invests a sum of money into certain shares, he could end up making a profit, suffering a loss or breaking even. He has also undertaken a speculative risk. Pure risk refers to a condition where the risk taker either suffers a loss or avoids losses without enjoying any gain. For example, if Jayesh owns a property, there is a risk that an accidental fire may decimate it. This is an example of a pure risk as the best that Jayesh can hope for is to maintain status quo and ensure that the property is safe. 1.3.2 Types of Pure Risk In risk management a financial planner has to advise and help the client minimize or eliminate the adverse consequences of pure risks. Pure risks can be classified into four categories: 21

(a) Personal Risks These are risks that affect the income-producing ability of the client arising from events such as employment, death, disability, illness or accident. They can also cause the client to incur additional expenses relating to his maintenance and sustenance. For example, if a client is struct by disability, then he will not only be economically unproductive, but additional expenses, e.g. medical expenses, will be incurred to look after his needs arising from the disability. (b) Property Risks The ownership of property carries with it risk, since property maybe damaged, destroyed or stolen. There are two distinct types of losses that can occur in relation to property risks. These are referred to as₹direct' or₹indirect₹ losses. A direct loss is one in which the property in question is damaged or stolen; for example, a car crashes, a building bums down or goods are stolen. Indirect or consequential losses are those that follow on from that initial loss. If the building bums down, a manufacturer is unable to produce his product or a shop owner is unable to sell his goods. As a consequence they suffer a loss of income. In addition, in trying to get back into a position where they are earning an income, they may be involved in additional expenses. For example, the shop owner may rent temporary premises to conduct the business. The rental of these premises may be at a greater rental than was paid previously. Another example of indirect losses arises where, following a fire in the premises, the refrigeration equipment is damaged, but not the coolstore that the refrigeration equipment serves. As a result, the goods in the coolstore become unusable as the refrigeration equipment is not operating. To summarise, property risks can involve loss from three different areas: 1. Damage to the property itself; 2. Loss of use of the property or loss of income derived from it; and 3. Indirect losses as a result of damage to property. (c) Liability Risks These are risks that expose the client to liability to third parties. They arise as a restilt of the client's words, conduct, property or legal relationships. For example, if client is a lawyer, he owes a duty of care to his client to give proper advice. If this duty is breached and client suffers losses, he could be liable for damages. Another example is where a person negligently steers his car and causes an accident resulting in injuries inflicted on a pedestrian. The driver will be liable to the pedestrian for damages to compensate him for any pain and loss suffered. 22

Liabilities can arise when our actions or inactions result in loss, damage or injury to other people or their property. There are three broad areas of law under which a liability risk arises:  Under statute;  At common law; and  Under contract. (d) Failure of Others These are risks that expose the client to loss due to the acts or omission by others. For example, if a person engages a contractor to renovate his home but the contractor botches up (spoil) the job, resulting in extensive damage to the home to the person will have to suffer losses due to the contractor's negligence. The situation will be exacerbated (worsened) if the contractor is impecunious (poor), as any legal action instituted against him will probably not result in any compensation for the client. 1.3.2.1Other Types of Risk Financial and Non-Financial Risk The first distinction is between financial and non-financial risk. In its widest sense the termrisk embraces all situations in which there is exposure to adverse circumstances. In some cases, these adverse circumstances will involve financial loss. In other cases, there may be a risk of pain or inconvenience. We are concerned with only those risks with which financial loss is associated. 23

Static and Dynamic Risks Dynamic risks are those resulting from changes in the economy. Changes in the price level, consumer tastes, income and output, and technology may cause financial loss to the members of the economy. These dynamic risks normally benefit society over the long run since they are the result of adjustments to misallocation of resources. Since these dynamic risks may affect a large number of individuals, they are generally considered less predictable than static risks, as they do not occur with any precise degree of regularity. Static risks involve those losses that occur even if there were no changes in the economy. If we could hold consumer tastes, output and income, and the level of technology constant, some individuals would still suffer financial loss. These losses arise from causes other than the changes in economy, such as perils of nature and dishonesty of other individuals. Unlike dynamic risks, static risks are not a source of gain to society. Static losses tend to occur with a degree of regularity over time and, as a result, are generally predictable. Because they are predictable, static risks are more suited to treatment by insurance than are dynamic risks. Fundamental and Particular Risks Fundamental risks involve losses that are impersonal in origin and consequences. They are group risks, caused for the most part in economic, social and political phenomena, although they may also result from physical occurrences. They affect large segments or even all of the population. Unemployment, war, inflation, earthquakes and floods are all fundamental risks. Particular risks involve losses that arise out of individual events and are felt by individuals rather than by the entire group. They may be static or dynamic. The burning of a house and the robbery of a bank are particular risks. Since fundamental risks are caused by conditions more or less beyond the control of individuals who suffer the losses and since they are not due to the fault of any one in particular, it is held that society rather than the individual has responsibility to deal with them - social insurance should be for fundamental risks - private insurance for particular risks though some fundamental risks like earthquake are covered by private insurance. 1.3.3 The Principle of Pooling of Risk The biggest problem in insurance is the unpredictability of the event capable of producing a loss and the probable amount of loss. To be able to predict this for an individual is impossible. We shall try to understand this from the classic coin-tossing example. If you toss an unbiased coin either a head will come or a tail, i.e., out of the two possible outcome of head or tail has a chance of one out of two. Alternatively, we can say that each 24

outcome has a probability of ½. A probability is a way of describing how likely (or not) \"something\" is to happen. The maximum value of any probability is 1 and an event with a probability of 1 is called acertainty. The minimum value of a probability isO and an event with a probability ofO is impossibility. When talking about a risk we are concerned with probabilities, which are greater, than zero but less than one i.e. there is an element of uncertainty. Going further in the coin tossing experiment we know the probability of getting a head or not getting a head is ½. Suppose the first toss, gave a head, can we say with some degree of certainty that the second toss will give a tail? Or if the coin is tossed 10 times, can we say that there will be exactly 5 heads and 5 tails? But if we toss the coin 1,000 times, we can say with a reasonable degree of certainty that there will be 500+50 heads or tails. If the number of tosses is increased to 100,000 or more we can fairly accurately predict the number of heads and tails with very little percentage error. Similarly, as discussed in chapter one, predicting the loss for one house may be near impossible, but predicting loss for 1,000 houses is fairly practicable. If this number is further increased, losses can be predicted fairly accurately, in terms of number of losses and also the average amount of each loss. This is law of large numbers. Probability theory can be applied to a large number of loss exposures to predict future losses and this is the basic principle on which insurance companies operate. In real life situations, probability of loss occurrence is not as simple as in the coin tossing experiment. Firstly, there can be a large number of outcomes. Secondly, the outcomes may be dependent on some other outcome and may complicate the probability calculations. For a given event, different outcomes will have different probabilities ranging between 0 and 1. Insurers are interested in knowing the probability of each outcome or a set of outcomes. This can be made available to insurers either through a table or a graph. This table or graph can be called probability distribution. It will be observed here there are large number of claims of small amounts but as the amount of loss increases the number of claims decreases fast and then tapers very slowly. Insurers frequently use these probability distributions to estimate the future losses on the risks they have accepted and to fix future price of insurance on the basis of past experience as evidenced by these distributions. 1.3.4 Methods of Handling Risk We are surrounded by risks. We take risks when we travel, when we engage in recreational activities, even when we breathe. Some risks are significant; others are not. When we decide to leave an umbrella at home, we take the risk that we might get caught in a rain shower. Such a risk is insignificant. But what about the risks in the following situations?  Ricky Agarwal is a 23-year-old single man who is working his way through college 25

with part-time jobs. What if he becomes ill and requires a long hospital stay and expensive medical treatment?  Dinesh and Jaya patel are working parents of two school-aged children. What if either Dinesh or Jaya becomes disabled and cannot work to support the family?  Jagdish and JayendraGoswami own and manage a convenience store. What if a fire damages their building?  The Wilson Software Development Company's product development process depends on the genius of two employees who are computer \"whizzes\". What happens to the company if one or both of them dies?  KavitaWaghmare is an artist who supports herself by selling her artwork. What happens when she retires and her income is no longer sufficient to meet her economic needs? Risk management: The practice of Identifying risk, Assessing risk and Dealing with risk. In each situation, the individual, family, or business can use risk management to deal with the financial risk it faces. The practice of risk management involves identifying risk, assessing risk, and dealing with risk. In order to eliminate or reduce our exposure to financial risk, we can do at least four things: (1) avoid risk, (2) control risk, (3) accept risk, and (4) transfer risk. Avoiding Risk The first, and perhaps most obvious, method of managing risk is simply to avoid risk altogether. We can avoid the risk of personal injury that may result from an airplane crash by not riding in an airplane, and we can avoid the risk of financial loss in the stock market by not investing in it. Sometimes, however, avoiding risk is not effective or practical. Controlling Risk We can try to control risk by taking steps to prevent or reduce losses. For instance, Jagdish and JayendraGoswami in one of our earlier examples could reduce the likelihood of a fire in their convenience store by banning smoking in their building. In addition, the Goswamis could install smoke detectors and a sprinkling system in their building to lessen the extent of damage likely to happan if there is a fire. In these ways, the Goswamis are attempting to control risk by reducing the likelihood of a loss and lessening the severity of a potential loss. 26

Accepting Risk A third method of managing risk is to accept, or retain risk. Simply stated, to accept a risk is to assume all financial responsibility for that risk. Sometimes, as in the case of an insignificant risk - losing an umbrella - the financial loss is not great enough to warrant much concern. We assume the cost of replacing the umbrella ourselves. Some people consciously choose to accept more significant risks. For instance, a couple like Dinesh and Jaya Patel from one of the previous examples may decide not to purchase disability income insurance because they believe they can just reduce their standard of living if one of them becomes disabled. Self-Insurance: Risk-management technique by which a person or business accepts financial responsibility for losses associated with specific risks. Individuals and business sometimes decide to accept total responsibility for a given risk rather than purchasing insurance to cover the risk. In this situation, the person or business is said to self-insure against the risk. Self- insurance is a risk-management technique by which a person or business accepts financial responsibility for losses associated with specific risks. For example, many employers provide medical expense benefits to their employees'. An employer can self-insure the benefit plan by setting aside money to pay employees' medical expenses or can pay those expenses out of its current income. Individuals and business can also decide to accept only part of a risk. For instance, an employer can partially self-insure a medical expense benefit plan by paying its employees medical expenses up to a state amount and buying insurance to cover all expenses in excess of that stated amount. Many employers now use self-insurance to fund their employees1 health insurance plans. We describe self-insurance more fully in section 3. Transferring Risk Transferring risk is a fourth method of risk management. When you transfer risk to another party, you are shifting the financial responsibility for that risk to the other party, generally in exchange for a fee. The most common way for individuals, families, and business to transfer risk is to purchase insurance coverage. When an insurance company agrees to provide a person or a business with insurance coverage, the insurer issues an insurance policy. The policy is a written document that contains the terms of the agreement between the insurance company and the owner of the policy. The agreement is a legally enforceable contract under which the insurance company agrees to pay a certain amount of money - known as the policy benefit, or the policy proceedswhen a specific loss occurs, provided that the insurer has received a specified amount of money, called the premium. 27

In general, individuals and business can purchase insurance policies, which covers three types of risks: property damage risk, liability risk, and personal risk. 1.3.5 Difference between Insurance and Hedging The word hedging means planting or trimming of bushes and shrubs to form a hedge. The word hedge means a way of protecting oneself against any kind of loss or other adverse circumstances. Typically the term hedging, in finance parlance, means using futures and options contract(s) for the purpose of minimizing the impact of adverse price movements of one's investments in stocks and other tradable securities. Let‘s take an example. Say Ramanathan owns a stock. But he is very worried about adverse future price movements. So he enters into a futures contract whereby he becomes eligible to sell his stock on a predetermined future date at a set price, therefore avoiding future market fluctuations. Now refer to the under mentioned discussion for the differences between the concepts of insurance and hedging. 28

Parameter of Insurance H edging Comp arisen Target category of Pure Risks are insured Speculative Risks are hedged Risk Impact on risk Once insured, the risk still Once hedged, die risk is exists eliminated Impact on Insurance is done of pure Hedging eliminate the risk of loss profitability risk which cannot be a of speculative risk by giving up source of profit anyways the potential forgain Methodology Insurance involves paying Hedging involves making an someone else to bear risk investment that offsets risk by thereby shifting potential reducing uncertainty financial losses from the insured to the insurer Costs Invoked Premiums Charges of derivative contracts Consequence Insurance reduces the Hedging typically involves only objective risk of the risk transfer, not risk reduction insurer by application of The risk of adverse price the law of large numbers; fluctuation is transferred from the as the number of expo hedger to the speculator sure units increases, the insurer's prediction of future losses improves 1.3.6 Advantages and Disadvantages of Insurance in Handling Risk Although insurance is only one of the techniques available for dealing with the pure risks that the individual of the firm faces, many of the risk management decisions boil down to a choice between insurance and non- insurance. The following benefits flow out of the mechanism of insurance: Indemnification: The direct advantage of insurance is indemnification for unexpected losses. Organizations/ Individuals having the insurance protection, as well as the benefits to the society by this are obvious. Reduction of Uncertainty: Before purchasing insurance, the potential insured bears the risk 29

associated with possible losses. As a result, the person is uncertain about the outcome. The insurance transfers financial consequences of loss to the insurer, who then becomes responsible for compensating the insured for the loss and providing other loss related services according to the insurance contract. This is expected to reduce the insured's anxiety and uncertainty. Funds for Investment: Insurance Premiums are normally payable in advance and held by the insurer till the time of payment of claims. This enables the insurers to invest these funds, which is always sizable, and earns attractive returns on the investments made. The returns on the investments go on to reduce the premium required to be paid for the contract. Though the individual insured persons can also earn returns on their premium amounts, had they not purchased insurance, the investment expertise available with the insurers, the opportunities for investing available to the insurers and the size of the investible funds that the insurer have will make the returns earnedby the insurer much more attractive than what individuals can think of. Also, since the Government governs the way the insurers invest the funds, most of the accumulated funds are invested in the development of infrastructure of the nation and also the development of capital markets, which is beneficial to the society as a whole. Loss Control: After insuring the various risks of the organizations, insurance companies take interest in controlling the losses by providing loss reduction education and advices by trained experts, which result in lesser losses even in cases where losses have occurred. The organizations would have had to spend heavily for getting such loss control and loss minimization expertise if they were not to go in for insurance. Although the advantages of purchasing insurance as a tool in management of risks are numerous, insurance has a few disadvantages also: Operating Expenses: Insurers incur expenses in loss control measures, in acquisition of insurance business, claim settlement activities, in risk inspections and rating activities, and other general administrative works. These expenses and a reasonable amount of profit for the insurer must be charged to the premium payable by the Insured. Thus the premium paid by the insured is more than expected value of losses. The Insured pays more than what is his share in the losses that the group is likely to experience because of the expenses listed above. Moral Hazard: The other disadvantage of insurance mechanism is the moral hazards. Insurance coverage reduces the insured's incentives to prevent loss or to contain the amount of damage due to the loss when it occurs. In certain cases, there can be intentional damages created by the insured themselves, such as arson or staging accidents or hospitalization when not required etc. In some other cases, there can be attempts to overstate the damage due to the loss in order to get higher compensations than what would have been allowed. 30

Thus moral hazard increases the amount of losses experienced by the group in relation to what would have been in the absence of insurance arrangement. This also gets provided for in the insurance premium calculations, which the insured persons will have to pay. Overall, the advantages that the insurance mechanism provides are much more than the effects of the disadvantages discussed above, in most of the cases. 1.3.7. Reinsurance Reinsurance is a contract made between an insurance company and a third party (Reinsurance Company) to protect the insurance company from losses. The reinsurance contract provides for the reinsurer to pay for the loss sustained by the insurer when the latter makes a payment on the original contract. A reinsurance contract is a contract of indemnity, meaning that it becomes effective only when the insurance company has made a payment to the original policyholder. Reinsurance provides a way for the insurance company to protect itself from financial disaster and ruin by passing on the risk to other companies. The reinsurance industry became more popular during the late 1990s and early 2000s because natural disasters and mass tort litigation resulted in large payouts by insurance companies. Because of the large size of the payments, some insurance companies became insolvent. 31

Almost all insurance companies have a reinsurance program. The ultimate goal of that program is to reduce their exposure to loss by passing part of the risk of loss to a reinsurer or a group of reinsurers. Reinsurance can help a company by providing: 1. Risk Transfer - Companies can share or transfer of specific risks with other companies 2. Arbitrage - Additional profits can be garnered by purchasing insurance elsewhere for less than the premium the company collects from policyholders. 3. Capital Management - Companies can avoid having to absorb large losses by passing risk; this frees up additional capital. 4. Solvency Margins - The purchase of surplus relief insurance allows companies to accept new clients and avoid the need to raise additional capital. 5. Expertise - The expertise of another insurer can help a company obtain a proper rating and premium. There are two basic methods of reinsurance: 1. Facultative Reinsurance which is negotiated separately for each insurance contract that is reinsured. 2. Treaty Reinsurance under which all insurance contracts are reinsured at a standard rate pre-negotiated by the reinsurer and the insurer. 32

QUESTIONS Q1. Industrial Risks includes ______________. (a) Residential Premises (b) Permanent amusement parks (c) Manufacturing premises Q2. Dynamic risks are those resulting from the changes in ______________. (a) The economy (b) The status (c) The sources Q3. Indemnification, Reduction of Uncertainty, funds for Investment & Loss control are the ______________ of insurance in handling risks. (a) Advantages (b) Disadvantages (c) Both Q4. Reserve management has the effect of ______________ by causing profits to be reportedwhen the business is no longer profitable (a) Intending the cycle (b) Extending the cycle (c) Both of it Q5. Risks which involve financially quantifiable loss are termed as ______________. (a) Monetary risk (b) Speculative risk (c) Financial risk (d) Personal risk Q6. Pure risk involves ______________. (a) Gain (b) loss or no loss (c) loss and gain (d) all the above Q7. What types of risks are insurable? (a) Speculative risk (b) pure risk (c) Gambling risk 33

(d) All the above Q8. Speculative risk involves the possibility of ______________. (a) Loss only (b) gain only (c) loss or gain (d) none of the above Q9. What are the components of personal risks that are faced by individuals? (a) death (b) disability (c) medical (d) all the above Q10. Generally in insurance the risks are separated in following categories ______________. (a) Personal and property and liability risks (b) Private and official risks (c) all the above Q11. What is the direct advantage of insurance? (a) Indemnification for unexpected losses (b) Indemnification for expected profits (c) safety of funds (d) elimination of chance of occurrence of insured risk Q12. What are the disadvantages of insurance mechanism? (a) reduction of uncertainty (b) operating expenses & moral hazard (c) capital gain & financial risk (d) none of the above Q13. An event with Probability 1 is called a ______________. (a) Impossibility (b) Certainty (c) Uncertainty (d) Neither of above. 34

Q14. Which of the following is not an ideal element of an insurable risk ______________. Q15. (a) The Risk must be definite. (b) The Risk must be catastrophic (c) The risk must be fortuitous (d) The risk must be measurable. (e) Gambling is primarily an instance of ______________. (a) Pure Risk (b) Financial Risk (c) Investment Risk (d) Speculative Risk Q16. Pure Risks that have a financial cost to them may arise in which of the following categories. (a) Personal (b) Property (c) Liability (d) All of the above Q17. Which \"characteristic\" of risks among the following is not an \"absolute must\" for a risk to be insured: (a) The loss produced by the risk must be definite and measurable. (b) The loss must be fortuitous and accidental (c) The loss must be \"reinsurable\" (d) The loss must not be catastrophic Q18. Reinsurance is ______________. (a) an insurance company insuring other insurance companies business (b) a treaty for future insurance (c) Co-insurance (d) facultative insurance Q19. Indian insurance company reinsures with an reinsurer whose head office is in Germany. In case of a dispute what laws will apply? (a) Indian law (b) German law (c) Both the country's law (d) International law 35

Q20. Risk of not realizing the desired return from an investment constitutes (a) Pure risk (b) Speculative risk (c) Financial risk (d) Non - financial risk Q21. Death disability liability are ______________. (a) Pure risks (b) Financial risks (c) Both (d) None Q22. As per IRDA Regulations, a reinsurance broker must have a minimum paid-up capital of ₹ ____________ lakhs. (a) ₹250 (b) ₹200 (c) ₹50 Answers 1 C 9 D 17 C 2 A 10 A 18 A 3 A 11 A 19 D 4 B 12 B 20 C 5 C 13 B 21 C 6 B 14 B 22 B 7 B 15 D 8 C 16 D 36

1.4 FUNDAMENTAL PRINCIPLES OF INSURANCE 1.4.1 Indemnity One of the important terms of the contractual agreement between the insurance company and the owner of an insurance policy is the amount of policy benefit that will be payable if a covered loss occurs. Depending on the way in which a policy states the amount of the policy benefit, every insurance policy can be classified as either a contract of indemnity or a valued contract. A contract of indemnity is an insurance policy under which the amount of the policy benefit payable for a covered loss is based on the actual amount of financial loss that results from the loss, as determined at the time of loss. The policy states that the amount of the benefit is equal to the amount of financial loss or the maximum amount stated in the contract, whichever is less. When the owner of such a contract submits a claim - a request for payment under the terms of the policy - the benefit paid by the insurance company will not be greater than the actual amount of the financial loss. Many types of health insurance policies pay a benefit based on the actual cost of a person's medical expenses and, as such, are contracts of indemnity. For example, assume that Bala Swami is insured by a health insurance policy that will pay any covered hospital expenses Bala incurs. The policy states the maximum amount payable to cover Bala's expenses while he is hospitalized. If he is hospitalized and his actual hospital expenses are less than that maximum amount, the insurance company will not pay the stated maximum; instead, the insurance company will pay the stated maximum; instead, the insurance company will pay a sum that is based on the actual amount of Bala's hospital bill. Property and liability insurance policies are also contracts of indemnity. 37

Principle of Indemnity Insurance cannot be used as a means to make profit out of it. The mechanism of insurance is meant to compensate losses. Simply put, insurance should not place the Insured in a better financial position after loss as he enjoyed before the loss. This broadly is the principle of indemnity. Indemnity and insurable interest are linked together. It is the insured's financial interest in the subject matter of insurance that is insured. Therefore, amount of compensation on claim cannot be more than the extent of insurable interest. In the case of life insurance, insurable interest in one's own life is unlimited. Therefore, the principle of indemnity is not applicable to life insurance contracts. In these contracts the sum assured is decided at the time of entering into contract. Therefore, life insurance contracts are called valued contracts. Fire insurance policy may be issued on Reinstatement Value basis. Under these policies, generally issued for covering building or machinery, the basis of indemnity is the cost of reinstatement or replacement of damaged or destroyed property by new property of the same type. In as much as the Insured gets new property in the place of old, the principle of indemnity is thus modified. However, the basic idea of indemnity is still preserved because the reinstatement of damaged property is by property in a condition equal to, but not better than, its condition when new. In other words the Insured will get new property of the same kind but not a superior property. The subject matter of motor insurance could be physical property (the vehicle), and /or legal liability for third party injury or property damage. The principle of indemnity is strictly applicable to both the subject matters. The indemnity shall not exceed. (a) For total/constructive total loss of the vehicle the Insured's Declared Value of the vehicle (including accessories thereon) as per Schedule of the policy less the value of the wreck. (b) For partial losses, costs of repair/ replacement as per depreciation limits specified in the policy. Claims for liability are indemnified as per law, subject to limits, if any, under the policy. The values of cargo are subject to constant fluctuations during transit from one country to another. Besides, the market values of ships fluctuate widely, but the market value may not reflect the true value of the ship to its owner. Therefore, almost all the marine insurance policies are issued as valued policies or agreed value policies, where under the sum Insured is agreed between the Insurers and the Insured as the value of the Insured property. The agreed amount is payable in the event of total loss, irrespective of considerations of 38