Risk Analysis and Insurance Planning

Q17. Insurance is a _____________ (a) Contract (b) Consideration (c) Protection Q18. In case of insurance who should normally make the offer? (a) agent (b) insurer (c) prospective buyer (d) anyone Q19. What is the binding force of any contract? (a) offer (b) acceptance (c) parties (d) consideration Q20. What is consideration that insurer makes under insurance contract? (a) promise to compensate of any loss (b) promise to compensate of any contingency which are insured (c) promise to pay on demand (d) promise to pay the premiums Q21. The parties to an insurance contact are: (a) Insurance company & minor (b) Insurance company and its agent (c) Insurance agent and the insured client (d) Registered insurer and the insured (individual or firm) who is competent to contract Q22. Which insurance contracts are not contracts of indemnity? (a) Fire (b) Marine (c) Life Insurance (d) Motor 89

Q23. In property insurance at what time insurable interest should exist? (a) At the time of entering contract (b) at the time of loss occurring (c) Not necessary at any time (d) both at the time of entering into the contract & at thetime of loss occurring Q24. Which of the following relationships does not satisfy insurable interest requirement under life insurancecontract? (a) Husband and wife (b) Parent - child (c) friends (d) employer and employee Q25. While exercising subrogation right how much amount can the insurer recover (a) Not more than 1 lakh (b) Equivalent to that amount he had paid as claim (c) Equivalent to sum insured (d) 20% of sum insured Q26. Material fact has been defined as (a) A fact that would influence the mind of insured (b) A fact that would influence the mind of underwriter in deciding the acceptance of the risk (c) A fact that would influence the mind of other policyholders (d) A fact that would not affect the insurance contract Q27. The proposer must disclose to the insurer (a) All material facts (b) Only those specifically asked by the insurer (c) Personal details (d) Office details 90

Q28. Under fire insurance following is an example of material fact (a) Previous medical history on the insured (b) Nature of treatment taken (c) Type of construction of the property and its use (d) All the above Q29. Under Life insurance following is an example of material fact (a) Occupation, health and habits of the person (b) Particular possessions of the person to be insured (c) Particulars about the vehicle owned (d) none of the above. Q30. Breach of utmost good faith gives the aggrieved party (a) the right to avoid the contract (b) the right to honour the contract (c) the right to nondisclosure of breach (d) None of the above Q31. Holder of a Life insurance policy has been allowed a cooling period of __________ under IRDA (Protection of Policyholders' Interests) Regulations (a) 7 days (b) 15 days (c) 30 days (d) 10 days Q32. Non-disclosure of material facts by a life assured has been dealt with in which of the following sections of the Insurance Act, 1938. (a) Section 64 (b) Section 44 (c) Section 45 (d) Section39 91

Answers 1 C 13 D 25 B 2 B 14 A 26 B 3 C 15 C 27 A 4 B 16 C 28 C 5 D 17 A 29 A 6 C 18 C 30 A 7 C 19 D 31 B 8 C 20 B 32 C 9 D 21 D 10 C 22 C 11 A 23 D 12 A 24 C 92

2.2 IMPORTANT TERMS IN INSURANCE CONTRACT 2.2.1 Endorsements/Riders Alterations Situations may arise where the policyholder may desire alterations in the terms of the contract to suit changed circumstances. The types of alterations for which requests are normally made are:  Alteration in plan or term  Reduction in SA  Change in mode of payment of premium  Alteration in name  Change of nominee  Removal of an extra premium  Splitting up of policy into two or more policies  Alteration from without profit to with profit or vice versa  Grant of accident benefit  Settlement option of payment of SA by installments Grant of premium waiver benefit  Correction in policy/change of address Some alterations are considered if the policy is in force for full sum assured. While considering the request for alteration, the insurer tries to ensure that there is no \"adverse selection\" against the insurer. That is, the risk should not increase after alteration. For this reason, the alterations are generally not allowed if they involve change (a) To a longer term (b) Extending the premium paying period (c) If premium becomes lower Some alterations are made by suitable endorsements on the policy itself. A fresh policy document may be issued if the alterations are of substantial nature. A fee is usually charged Different Insurers allow varying alterations in bearing with the underwriting standards. Rider Rider is a provision of an insurance policy that is purchased separately from the basic policy and that provides additional benefits at additional cost. 93

In other words, it is an endorsement to a life insurance policy that either adds additional coverage or limit's the life insurance company's liability for payment of benefits under certain conditions. Riders can provide more coverage to the insured in certain situations. For example, an accelerated death benefit rider on a life insurance policy would provide the insured with a payout while he or she was still alive, in the event of a terminal illness. The insured could use these funds to pay for medical expenses and to increase the quality of their remaining life. When the insured passes away, their beneficiaries will receive a reduced life insurance benefit, since the rider allowed a portion of the policy to be used early. 2.2.2 Deductibles Deductibles are provisions under the Insurance contracts that stipulate deduction of a pre- specified amount from the claims payable under the policy. Primarily there are 3 kinds of deductibles, which are briefly discussed below: Excess Excess is a compulsory deductible from each and every claim that the Insurer pays to the Insured. This is so even though the particular event giving rise to a claim in the terms of the policy. The purposes of excess are as follows: (a) To make the Insured his own Insurer for the specified amount of the excess, thus perhaps encouraging greater care or prudence on his part. (b) To relieve the Insurer from the necessity to deal with smaller losses, many of which will not even be notified to the Insurer, with the resultant reduction in the administrative cost. (c) To reduce by the amount of excess the cost of all claims to the Insurer thereby resulting in reduction of premium for all the Insured persons. (d) To avoid normal losses or trade losses which are inevitable for certain risks for example for liquid cargos in transit an excess of M>% of the value of cargo is customary because some liquid always remains stuck to the walls of the container of the tanker. The excess is generally compulsory and may not be deleted. Excess can also be of three types: (i) Fixed or Amount excess: In this kind of excess the amount of excess is fixed and expressed in rupees e.g. an excess of ₹1,000 for all private car insurance claims. 94

(ii) Percentage excess: In this kind of excess instead of fixed amount of rupees excess as shown as a percentage of loss e.g. Vi % of all claims for liquid cargo. (iii) Combined excess: This excess combines the features of fixed and percentage excess. For example an excess of 1% of sum insured subject to a minimum of ₹250 for machinery breakdown insurance. Franchise The difference between an excess and a franchise is that where excess is imposed the amount of excess is always deducted from the agreed amount of claim. Whereas with a franchise when the amount of franchise is exceeded, the agreed amount of claims is paid in full. An example below will make the position clearer: Type of Deductible Amount of Amount Deductible Amount Claim Payable Excess 250 300 50 Franchise 250 300 300 Franchise 250 230 0 The above example highlights the potential problems in the use of franchise as a deductible. Where a repair estimate is only slightly below the level of the franchise the Insured may wish to inflate the estimate in order to bring the claim above the franchise level and receive full payment. Similarly, in situations of high inflation it may be to the Insured's benefit to delay effecting repairs until costs have increased, thus bringing the claim above the franchise amount. 2.2.3 Co-insurance Co-insurance simply refers to the sharing of insurance by two or more Insurers in some agreed proportion. This may also refer to a situation where the Insured himself retains some portion of risk and insures only the residual value with an insurance company thus becoming a co-insurer with the insurance company for the share retained by him. However, the second type of coinsurance is more commonly known as under-insurance in India. In a co- insurance, claims under a policy are shared by all Insurers in the same proportion as their share bears to the total value Insured. Sharing of insurance by two or more Insurers will be observed mostly in large commercial insurances where one Insurer does not want to retain the whole risk or the Insured desires to involve two or more companies to share the risk. In such circumstances, generally, one Insurer acts as a leader, generally because his share may be the largest or by mutual consent among Insurers or by a choice of the Insured. 95

The lead Insurer on behalf of all the Insurers is responsible for risk survey, rating, collection of premium and completion of the insurance contract. The co-insurance may operate in three ways as follows:  Each Insurer will issue a separate policy for his share of insurance and will attach a co- insurance clause limiting his liability in accordance with the share of premium held by him.  The second method is to dispense with issuance of separate policies by each Insurer. Instead the leading Insurer prepares a specification showing the shares of all Insurers and attaches it to the policy. Each Insurer then puts his signatures on the specification for its share in the policy. This is called a collective policy.  The third and the most common method is for the leading office to issue the policy and sign on behalf of the participating Insurers. A clause called ‗collective insurance clause' is incorporated in the policy, which sets out the liability of each Insurer in case of a claim under the policy. In case of a claim under the policy, losses are shared by all the co-insurers in proportion of the value of risk shared by them. Reinsurance is also sharing of loss by two or more Insurers. But the difference between co- insurance and reinsurance are as under:  Co-insurance is the distribution of insurance business made by the Insured whereas reinsurance is an arrangement concluded by one Insurer with another.  Under co-insurance the Insured has a contractual relationship with all the co-Insurers whereas in reinsurance he has no such relationship with the reinsurer, who is answerable only to the original Insurer. Co-insurance is not very popular due to some inherent problems of its operation as discussed below:  Insurers, particularly the lead Insurers, do not prefer it because being the lead Insurer they have to provide all the policy related services to the Insured without enjoying the full premium. The other co-Insurers enjoy the premium without rendering services. Secondly, after settling the claim he has to follow up the other co- Insurers for recovery of their share of claim. Even if the risk is too large and the Insurer does not wish to retain the whole risk, he will prefer to have it reinsured rather than to co-insure except if the wish of the Insured is to the contrary.  The Insured usually does not prefer co-insurance, particularly the first type of co- insurance where each coinsurer issues a separate policy. In such an arrangement he has to liase with all coinsurers in case of a claim, which may be too tedious a job. 96

In spite of these problems co-insurance continues because the Insured want to keep it alive. By sharing their premium among different Insurers they get valuable insurance advice and guidance from all the co-Insurers, which they may use against other co-Insurers to extract maximum benefit. 2.2.4 Assignment A life insurance policy is a movable property. If represents rights. It is an actionable claim as defined in Transfer of Property Act, 1882. Like any other property, it can be sold, mortgaged, charged, gifted or bequeathed. Assignment transfers the right, title and interest of the assignor to the assignee. Section 38 of Insurance Act, 1938 which deals with the assignment of life insurance policies, states-  Assignment can be made by an endorsement on the policy or through a separate deed of assignment. If it is made by endorsement, no stamp duty is required. But, if assignment is made through a separate deed, it has to be stamped appropriately.  The transferor of his duly authorized agent must sing it.  A witness must attest the signature.  The assignment becomes effective as soon as it is executed.  It must be sent to the insurer along with the notice of assignment for registration. A person making assignment should have the right, title and interest in the policy in question Assignment should be major and competent to contract. Consideration is a must for assignment. It may be a valuable consideration or for natural love and affection. Assignment involving a part of the policy is considered bad in law. Once made, an assignment cannot be cancelled to altered by the assignor unless the assignee reassigns the policy to him. Assignments are of two kinds - Absolute and Conditional.  In both the cases, the assignor transfers all his rights, title and interest in the policy to the assignee reassigns the policy to him.  In Absolute Assignment Assignee can deal with the policy in any manner he likes. He is not required to obtain assignor's consent for this.  In conditional assignment, the rights in the policy revert to the assignor on happing of the specified condition can be that if the assignee predeceases the life assured or the life assured survives the date of maturity, the assignment will become ineffective and 97

all right, title and interest in the policy shall revert to the life assured. When a person takes policy on the life of another, all rights, the title and interests in the policy vest in him. The life assured has no right and cannot deal with the policy unless the proposer assigns the policy in his favour.  Life assured under a Children's Deferred Plan can assign the policy after the vesting date i.e. after the child attains the age of majority. 2.2.5 Nomination and Beneficiary Status Nomination provides a simple way for payments of policy moneys a named person without any hassle in case of death of the life assured. Section 39 of Insurance Act 1938 provides that the holder of the policy on his own life can nominate a person to whom the policy monies will be paid in the event of his death during the term of the policy. Nomination can be made at the proposal stage or at any time thereafter during the currency of the policy. A person having policy on the life of another person cannot effect a nomination. The policyholder can change the nomination by making an endorsement. If space is not available, nomination can be made on a separate piece of paper and pasted to the policy with signature of the life assured across the comers where the slip is pasted. How Assignment Affects Nomination? When the policy is assigned, it automatically cancels the nomination, if any. The assignee not being the life assured cannot make a nomination. But, if assignment is made in favour of the insurer in consideration of loan raised against surrender value of the policy, it does not cancel the nomination. Minor Nominees If he nominee is a minor, the life assured should appoint an Appointee. The Appointee has to affix his signature either on the proposal or on the text of the policy in token of his having given consent to act as Appointee. Life assured can revoke the appointment of appointee and appoint a fresh Appointee. The Appointee loses his status when the nominee becomes major. 98

If the nominee is a minor and no appointee has been appointed and the life assured dies during minority of the nominee- the claim amount will be paid to the heirs of the deceased and not to the natural or appointed guardian of the minor. If a nominee dies after the death of the life assured but before the claim is paid, then the policy will form part of the estate of the deceased life assured and would be paid to his heirs. The nomination does not became inoperative on the date of maturity but it holds good after maturity also where sum assured is payable in installments. If the assured dies before receiving all the installments, the remaining installments will be payable to the nominee. The nominee cannot commute future installments payable. If there are more than one nominee, the policy moneys will be payable to all of them jointly or to the survivor or survivors of them. Nomination with specific shares for each nominee cannot be made. Successive nominations like \"payable to ‘A' failing him to ‗B' failing him to ‘C' etc. are valid. Nominations made after the commencement of the policy will have to be intimated to the insurer to become effective. Normally in a joint life policy on the life of husband and wife, nomination may not be required because on the death of one, claim will be payable to the surviving life assured. However, there may be a situation where both the lives surviving life assured die simultaneously and it may not be possible to establish who died first. To provide for such an eventuality, after the policy is issued, both the lives assured can jointly effect the nomination, which will be by way of an endorsement on the policy. The new rules affected by the Insurance Laws (Amendment) Act, 2015, clearly make nominees, immediate family members such as spouse, parents and children, the beneficiary so that the insurance money can go to the intended recipient. In fact, the new rules have another nominee-friendly feature that you must know in detail, but first let‘s start with understanding what a beneficial nominee means. The amended Act has introduced the concept of a beneficial nominee. The nominee in this case is the person who ultimately benefits or owns the insurance money. According to the new rules, when a policyholder nominates parents, spouse or children, then the nominee or nominees will be beneficially entitled to the amount payable by the insurer. ―In the new insurance law, if an immediate family member such as spouse is made the nominee, then the death benefit will be paid to that person and other legal heirs will not have a claim on the money. This is good because it makes the nomination process more meaningful and clear. A policyholder knows that the immediate family member nominated by him will get the benefit. This will be applicable for all insurances that have a maturity date after March 2015 99

Distinction between Nomination & Assignment Description Nomination Assignment 1. How it is effect? At the proposal stage, in Only after issuance of the proposal form; policy by an Or endorsement on the policy or by a separate after issuance of the deed. policy by Endorsement on the policy 2. Can it be done by a No. Yes, separate deed has separate deed? to be on a stamped paper 3. Who can make it? Only the holder of the Owner of the policy or policy on his own life. absolute assignee 4. Where can it be Wherever Insurance Act Anywhere in the would effected/ executed? 1938 applies viz. according to the law of Pakistan & Sri Lanka that land relating to transfer of property. 5. Control over the Policy Assured retains full Assured loses control- control - can deal with absolute assignee can the policy without deal with the policy. nominee's consent 6. Consideration Need not be supported Consideration is a must by a consideration 7. Witness May be witnessed Must be witnessed 8. Notice Required to safeguard Required to enable the nominee's interest assignee to acquire priority over other assignees 9. Right to sue under the No Yes policy 10. Powers of the life Can alter, cancel or Cannot be cancelled by assured make new nomination the assignor. Assignee 100

during the term of the has to reassign the policy. policy 11. Minority If nominee is minor, life If assignee is a minor 12. Appointment assured has to appoint Guardian has to be ofAppointee and Guardian an Appointee. appointed. 13. Vested interest in the Can be appointed in the Cannot be appointed in policy wording of the the wording of the 14. Legal rights of the Nominee/ Assignee nomination assignment. 15. Death of Nominee or No immediate vested Acquires immediate Assignee interest; acquires vested vested interest and interest only after the ownership of the policy. 16. Death of Nominee/ death of the life assured. Assignee after the Life Assured Death but Nominee has only the Legally entitled to before settlement of right to collect policy receive all policy claim money in the event of moneys death of the life assured 17. Attachment of policy policy moneys. Nobody's rights are Rights pass on to the affected. heirs of the assignment No right passes on to the unless the assignment Nominees' legal heirs specifically provides for reversion of rights to the assignor The amount will be The amount will be payable to the heirs of payable to the heirs of nominee the Assignee Creditors of life assured Creditors cannot get the can get the policy policy attached unless attached. the assignment was done to defraud the creditors. 101

2.2.6 Insurance Provisions - Depreciation Basis/ Market Value Basis/ Reinstatement Value Basis Now we shall discuss some other insurance provisions briefly which have not been taken up till now. (a) Condition of Average The condition of average is inserted in most of the policies except non-indemnify policies like personal accident, to maintain an equity between the Insurer and the Insured. This condition provides that in case the sum Insured on a property is less than the value at risk at the time of loss then the Insured shall be deemed to be his own Insurer for the value not Insured and will share the loss in the same proportion as the value not Insured bears to the total value at risk. The provision will be clearer from a simple example. Suppose a house has been Insured for ₹600,000 under fire insurance. Some portion of the house is damaged by a small fire and the Insurer's surveyor has assessed the loss at ₹1,00,000. At the time of assessment the surveyor also found that the insurable value of the house just prior to the loss was ₹1,000,000. Notice that the house is under Insured. Although, the loss amount is well within the value Insured, still the Insurers will not pay the full amount of loss because of the condition of average. You will appreciate here that Insured has retained a risk of ₹400,000 out of the total insurable value of ₹1,000,000. Hence he is his own Insurer to the extent of 40% and Insurer has insured only 60% of the risk. Therefore, the Insurer will pay only 60% of the loss i.e. ₹60,000, whilst the remaining ₹40,000 will have to be borne by the Insured himself. Motor policies are generally not subject to the condition of average. Similarly, some policies waive a certain amount of under insurance. For example the fire section of Householders Insurance, which will be discussed in the next topic. (b) Reinstatement The word reinstatement is used in two different contexts in insurance, reinstatement of loss and reinstatement of sum Insured. (i) Reinstatement as a basis of indemnity: This basis of indemnity is generally applied to buildings and machinery if the Insured requests that the policy be issued subject to ‗reinstatement value clause'. The Insured then selects the sum Insured of the Insured property so as to reflect the new replacement value ofthe property. In such a policy Insurers agree to pay the claims on the basis of full cost of replacement of the property at the time of reinstatement, without deduction for wear and tear. 102

Reinstatement of sum Insured following a loss under the policy: In most of the policies except the policies like motor, the sum Insured of the property Insured gets reduced by the amount of loss as from the date of loss and needs to be reinstated by payment of additional premium to avoid the operation of average clause for further claims. However, some policies provide for an auto reinstatement of sum Insured following a loss like fire policy. The premium for this is adjusted from the claim amount at the time of claim payment. (c) Market value basis This represents the amount at which property of the same age and condition can be bought or sold. This value takes into account both depreciation to the physical asset and appreciation due to inflation. The current cost of construction of similar building is taken and to this is applied depreciation for age, usage, maintenance, wear & tear, etc. For determining the sum insured for buildings, apart from excluding the value of land and plinth, the present cost of construction of similar building should be taken and then the depreciation for age and usage deducted. The generally accepted method currently in use for building is to apply unit cost rate to the gross external areas of the building or cubic measurement of building and adjust subsequently to suit particular circumstances (built up area and construction specification). (d) Valued Policy A valued policy means where the value of a property has been agreed in advance and will be the amount payable at the time of a claim without any reference to the real or intrinsic value of the property. Most of the general insurance policies are on indemnity basis. But there are some exceptions to this e.g.:  Marine Insurance policies of cargo are valued policies  Insurers do agree to issue valued policies to curios, works of art which have a special value and vintage cars Even though valued policies are issued, there may be problems at the time of claims settlements like;  The value may increase between the time of its being agreed and the time of its loss;  It can only apply to Total Loss. Partial losses will still be dealt with on an \"Indemnity\" basis.  Certain items may have rarity value, which in the event of discovery of similar items elsewhere may make the agreed value very high and unrealistic. 103

(e) Salvage Most often in property insurance claims, the Insured property is not completely damaged and may still command some realisable value. Insurers are entitled to collect the wreck generally at the time of settlement of claim in terms of principle of indemnity studied earlier in this section 2.2.7 Miscellaneous Section 45 of the Insurance Act 1938, provides some safeguard to the insured. No policy of life insurance shall be called in question on any ground whatsoever after the expiry of three years from the date of the policy, i.e., from the date of issuance of the policy or the date of commencement of risk or the date of revival of the policy or the date of the rider to the policy, whichever is later. A policy of life insurance may be called in question at any time within three years from the date of issuance of the policy or the date of commencement of risk or the date of revival of the policy or the date of the rider to the policy, whichever is later, on the ground of fraud: Provided that the insurer shall have to communicate in writing to the insured or the legal representatives or nominees or assignees of the insured the grounds and materials on which such decision is based. Notwithstanding anything contained in sub-section (2), no insurer shall repudiate a life insurance policy on the ground of fraud if the insured can prove that the misstatement of or suppression of a material fact was true to the best of his knowledge and belief or that there was no deliberate intention to suppress the fact or that such misstatement of or suppression of a material fact are within the knowledge of the insurer: Provided that in case of fraud, the onus of disproving lies upon the beneficiaries, in case the policyholder is not alive. Provided further that in case of repudiation of the policy on the ground of misstatement or suppression of a material fact, and not on the ground of fraud, the premiums collected on the policy till the date of repudiation shall be paid to the insured or the legal representatives or nominees or assignees of the insured within a period of ninety days from the date of such repudiation. Nothing in this section shall prevent the insurer from calling for proof of age at any time if he is entitled to do so, and no policy shall be deemed to be called in question merely because the terms of the policy are adjusted on subsequent proof that the age of the life insured was incorrectly stated in the proposal 104

Age Age of life assured is to be admitted before entertaining and claim. Policy conditions provide that, if age proof is submitted after the policy has been issued and if age of the life assured is found to be higher than the age stated in the proposal form, then (a) the difference of premium with interest on it is collected or else it will remain a debt on the policy, (b) an endorsement to the effect that age has been admitted, will be made to the policy contract and (c) revised premium at a higher rate will be charged thereafter. If age is found to be lower, (a) premium received in excess will be refunded without interest, (b) endorsement to the effect that age has been admitted, will be made to the policy contract, and, (c) lower premium will be charged thereafter. If age is found to be same as stated in the proposal form, an endorsement to this effect is made to the policy contract. All these provisions have now become less significant as proof of age is invariable insisted upon at the proposal stage. Nevertheless, there may be odd cases where age proof submitted turns out to be false. In such cases, the insurer can declare the contract null and void on ground of suppression of material facts. Age is important as premium calculation and underwriting of risk are based on age. Standard Proofs of age usually acceptable to Insurers are - 1. Matriculation/SSC or any other such certificate containing date of birth 2. Certified extract from the municipal record 3. Certificate extracts from family Bible if it contains date of birth 4. Certified extracts from school or collage records 5. Certified extracts from service register of employer 6. Passport 7. Identity Card issued by defence department in the case of defence personnel 8. Marriage certificate issued by a Roman Catholic Church 9. PAN Card 105

If none of the above age proofs is available then the following non-standard age proofs may be accepted as proof of age, in which case some extra premium may be charged and some other restrictions can be imposed on the policy. 1. Horoscope 2. Self-declaration by way of an Affidavit 3. Elder's by village panchayat 4. Voter's List 5. Driving Licence Foreclosure Foreclosure action is initiated in respect of policies whereunder Loan has been granted and amount interest on loan is not being received regularly. This means closure or writing off the policy before the Date of Maturity. 1. When a policyholder avails loan, he has the option to pay the interest regularly or allow it to accumulate to be recovered out of claim. 2. In case the policyholder regularly pays premiums, the surrender value will be increasing and at any point of time it will be more than the outstanding loan with interest. 3. If the policyholder stops paying premiums, the surrender value will not increase so fast (because paid-up value will remain constant) and after sometime when it may not cover outstanding loan and interest, Foreclosure action may become necessary. A possible office procedure for Foreclosure action:  Before taking foreclosure action, a registered notice is sent to the policyholder to clear arrears of loan interest.  If there is no response, the Foreclosure action a taken by adjusting outstanding loan and interest out of the surrender value and the balance of surrender value, if any, is paid to the policyholder after obtaining discharge voucher.  A foreclosed policy can be Reinstated. Procedure is the same as in case of revival except that instead of premium arrears, interest arrears will have to be paid.  Onforeclosure, nomination ceases to operate. If life assured dies before receiving balance of surrender value, this amount will not be payable to the nominee. It will go to the legal heirs of the deceased life assured. This provision is to protect the policyholder's and claimant's interests. 106

Married Women's Property (MWP) Act Policies Section 6 of MWP Act 1874 provides that:  A policy of insurance effected by a married man on his own life and expressed on the face of it to be for the benefit of his wife, or his life and children, or any of them.  Shall ensure and be deemed to be a trust for the benefit of wife, or his wife and children, or any of them, according to the interests so expressed, and  Shall not, so far any object of the trust remains, be subject to the control of the husband, or of his creditors or form part of his estate. Policy must be on his own life. The beneficiaries can be -  Wife alone  Any one or more children.  Wife or any one or more children. 'Married man' includes a widower, a divorcee. He may be a Hindu, Mohammedan, Sikh, Jain or a Budhist. In case of Mohammedan proposers, - wife and children as a class cannot become beneficiaries. They must be named and existing on the date of policy. If two or more beneficiaries are named, their respective shares should be stated. Non-Mohammedan proposers can specify beneficiaries as a class.  In that event the benefit will go to surviving beneficiaries only.  If the proposer specifies equal or unequal shares for them, on death of a beneficiary, his share will go to his legal heirs. Adoptive father may take out a policy for the benefit of his adopted child. The word ‗effected' in sec. 6 means that the provisions of this Act will be attracted only where the intention to take a policy under MWP Act is so expressed at the inception of the policy. There is nothing to prevent a new policy being issued under section 6 of MWP Act in cancellation of an earlier policy not under the MWP Act. The life Assured does not have any right to deal with the policy. He cannot make any alterations or surrender the policy. No loan will be granted. Claim will be paid to the trustees. 107

QUESTIONS Q1. The practice of passing on the excess risk taken by the insurance company to another form of insurer is called (a) Group insurance (b) Deductible (c) Reinsurance (d) None of the above Q2. An express warranty in insurance means (a) It runs concurrently with the policy (b) It is expressly mentioned in the policy (c) It overrides all other conditions and warranties (d) All the above Q3. Franchise in insurance parlance refers to (a) An outlet of an insurance company having franchise agreement to sell insurance (b) A kind of deductible from the insurance claims (c) An insurance company having its base in France (d) None of the above Q4. Replacement cost in insurance parlance refers to (a) Market value (b) Market value less depreciation (c) Cost of new product less depreciation (d) Cost of new product Q5. An endorsement is (a) a warranty (b) an implied warranty (c) an alteration in the policy conditions (d) a compulsory deductible 108

Q6. Average or co-insurance clause is introduced in property insurance (a) to reduce the number of claims (b) to reduce the premium paid (c) to reduce both claims and premium (d) to make the insured more responsible towards the protection of his property. Q7. A Warranty is an undertaking by the Insured that (i) Something shall be done (ii) something shall not be done. (a) only (i) is correct (b) only (ii) is correct (c) both (i) an (ii) are correct (d) both (i) and (ii) are incorrect. Q8. Which of the following is not a Deductible: (a) Compulsory Excess (b) Voluntary Excess (c) Re Insurance (d) Franchise. Q9. Identify the \"odd man out\" in the following list of elements required for a valid insurance transaction: (a) Premium payment (b) Reinsurance arrangement stipulation (c) Contractual agreement (d) Benefit payment stipulated on contingency. Q10. Can the terms of an insurance contract be changed by (a) Issue of a letter (b) Any other means of communication (c) Placing an endorsement on policy bond (d) Cannot be changed Q11. Two companies insuring a single subject matter is a form of (a) Re-insurance (b) Co-insurance 109

(c) Both (d) None Q12. A policy with a sum insured of ₹1 lakh is subject to a ‗franchise' or ₹10,000. What is the amount of claim payable, if the loss is ₹8,000? (a) ₹2,000 (b) ₹10,000 (c) ₹ 18,000 (d) Nil Q13. What is the amount of claim payable if loss is ₹l5,000 in case of a policy with sum assured ₹1 lakh and excess clause ₹10,000? (a) ₹2,000 (b) ₹5,000 (c) ₹3,000 (d) ₹4,000 Q14. A _____________ which is also called an endorsement, is an amendment to an insurance policythat becomes a part of the insurance contract and that either expands or limits the benefits payable under the contract. (a) Policy term (b) Policy anniversary (c) Policy rider Q15. A warranty in insurance contracts are (a) Guarantee (b) Stipulations imposed by insurer because he wants to ensure that the risk remains same throughout the contract and does not increase (c) Guarantees to increase the risk in case of default on part of insurer (d) Guarantee to pay the loss to the insurer in case of the loss being higher than the sum insured. Q16. What are used when the terms of insurance contracts are to be altered? (a) deductibles (b) endorsements 110

(c) olicies (d) all the above Q17. __________ are the provisions under insurance contracts that stipulate deduction of a pre- specified amountfrom the claims payable under the policy. (a) Endorsement (b) rules (c) deductibles (d) none of the above Q18. ______________ is a compulsory deductible from each and every claim that the insurer pays to the insured (a) premiums (b) excess (c) premiums and excess Q19. Primarily how many kinds of deductibles exist? (a) 8 (b) 3 (c) 4 (d) 15 Q20. Deductible that is voluntary on the part of insured for a possible discount in the premium is called as (a) compulsory excess (b) excess (c) voluntary excess (d) none of the above Q21. The sharing of insurance by two or more insurers in some agreed proportion is called as (a) mixed insurance (b) bancassurance (c) coinsurance (d) reinsurance 111

Q22. In coinsurance the claims under policy are shared by (a) all insurers in the same proportion as their share bears to the total value insured (b) Insured and insurers (c) Total value insured will be paid by main insurer (d) Main insurer and the insured Q23. Reinsurance is (a) Distribution of insurance business made by the insured (b) An agreement concluded by one insurer with another (c) The other name given to coinsurance (d) The action of the insured in getting the same risk insured by another insurer Answers 1 C 9 B 17 C 2 B 10 C 18 B 3 B 11 B 19 B 4 D 12 D 20 C 5 C 13 B 21 C 6 D 14 C 22 A 7 C 15 B 23 A 8 C 16 B 24 B 112

2.3 INSURANCE PRICING AND PREMIUM CALCULATION 2.3.1 Objective of Rate Making/ Insurance Pricing Objectives of Rate Making Ratemaking has a number of basic objectives. It can be classified into two basic categories: (1) Regulatory objectives and (2) Business objectives. Regulatory Objectives The purpose of insurance regulations is to protect the insured persons. In India under section 64 U of the Insurance Act 1938 there shall be a established committee to be called the Tariff Advisory Committee (TAC) to control and regulate the rates to meet certain standards, advantages, terms and conditions that may be offered by insurers in respect of general insurance business. Provision is made for extra premium or discount in premium according to size and severity of risk. Every decision of TAC is valid only after it has been ratified by the IRDA. In general the rates charged by the insurers must be adequate but not excessive and not unfairly discriminatory. Adequacy of the Rate If the rate is to be adequate but not excessive; how wide a margin should these limits imposed? Firstly, to have an adequate premium rate, it is necessary to collect the amount sufficient for all possible contingencies and accurately estimate of the size of possible contingencies. This means that the rates charged by the insurer should be high enough to pay all losses and expenses and still earn profit for the business. The insurer has given assurance that losses will be paid if and when they may occur and if the rates are inadequate an insurer may become insolvent and the policyholders may face financial hardships if their claims are not settled. However, rate adequacy is a complicated issue because insurance rates are fixed before all actual costs (i.e. size of contingencies, expenses, interest rates, inflation rates, etc.) are not known. The premium, which is paid in advance, may not be sufficient to meet all the claim costs and expenses during the policy period. The insurer can ascertain his actual costs only after the term of protection is over. Frequently, the estimate is incorrect because the insurer uses his past experience to estimate the future while the insurance contract involves substantial future period during which conditions may change drastically. On the other hand, the rates should not be so high that the policyholders are paying more than the actual value of their protection. Due to excessive rates the insurer may face competitive disadvantage. Also excessive rates are not in public interest. 113

Fair Allocation of Cost Burden Secondly, the rates of premium have to be based on evaluation of hazards and on past loss experience and also adjusted wherever necessary for future expected loss experience. For this purpose, risks are classified into groups according to a few important and easily identifiable characteristics. These groups should be homogeneous and are exposed to more or less same degree of hazard. When the exposures are similar with respect to the losses and expenses the rate should be the same. E.g. if there are two males aged 35, both having good health and have purchased life covers from the same insurer; they should not be charged different rates. On the other hand suppose there are two lives to be insured one life aged 35 years and the other aged 55 years. While both are healthy and free from slightest impairment, it is unfair to charge the same rate for both the lives because with age, the probability of death increases. Therefore, a life aged 55 will be charged more. Business Objectives The insurance pricing should also meet the following business objectives: (1) Simplicity: The rates should be easy to understand so as to avoid time lag and expenses. In case of life insurance cover, the premiums are relatively small and do not call for large amount of time for premium quotes. In case of non life insurance e.g. engineering insurance or business interruption insurance, the purchaser should know how the premiums are determined so that they can take active steps to reduce their costs. (2) Stability: Rates should be stable over a short time span. Frequent fluctuations in the premium rates may causes dissatisfaction among the customers. (3) Periodical revision to reflect loss exposures: Insurance rates are generally revised periodically. Often it is more than 10 to 12 years before the rates can be modified to reflect higher or lower cost. In case of life insurance new mortality tables are adopted only after 10 to 15 years and any errors in rate making will be corrected, if at all, through changes in bonus schedules. Because of these time lags, the rate maker for observable trends makes certain allowances. Errors in these allowances automatically affect the criteria of adequacy and reasonableness. But, one cannot change the rate structure immediately according to loss experience. Recently, in the Indian scenario, some life insurance products have been withdrawn due to decrease in market rates of interest. In case of non-life products, the premium rates have been increased taking into consideration claims experience and investment experience. (4) Encouragement of loss prevention efforts: Ideally the insurer should encourage loss prevention activities through the pricing system. The insured will realize the effect that their own loss prevention will have on the general rate level and on their own 114

premium rates relative to those paid by the other insured persons. It is difficult to achieve this objective as losses from most insurable perils occur outside the control of the insured persons e.g. fire insurance; rate credits are given for measures that tend to reduce severity of the perils. These loss control and loss prevention efforts helps to keep insurance affordable. 2.3.2 Important Factors in Rate Making There are some terms that are often used while discussing ratemaking. The insurance rate is the amount charged per unit of exposure. A rate is the price per unit of insurance. Exposure unit is the measurement used in insurance pricing, for E.g. In life insurance the exposure unit is ₹1,000 (sum assured) of coverage and in non life insurance the exposure unit is ₹100 (sum insured) of coverage. Net premium refers to that portion of the rate needed to pay losses and loss adjustment expenses. Loading is the amount that will be added to the net premium for other expenses, allowance for profits, margin for contingencies, agent's commission, taxes and fees. Usually, loading expressed as a percentage of expected office premium is called expense ratio. Office premium consists of net premium and loadings. In simple words net premium is the cost of expected loss and loading is cost of doing business. 2.3.3 Risk Assessment and Rate Making Generally there are three major rating methods used in life insurance and property and liability Insurance. They are as follows: (1) Judgemental Rating: In this method each exposure is individually evaluated and the rate is determined by the underwriter's judgment. This method is used when loss exposures are so varied that the underwriter is unable to group the data for rating or when plausible loss data is not available. (2) Class Rating: This is the most commonly used method in insurance business. In Class rating, exposures with similar characteristics are placed in the same underwriting class and each is charged the same rate. The rate is charged on the basis of average loss experience of the class. In this method the forecasting of probable losses to the insured during the term of the policy is done for the whole class by using the same factors. In some countries, this system of rating is used in life insurance business where the rating depends upon age, sex, health, occupation, habits i.e. smokers/non-smokers; alcoholic etc., Accordingly, healthy lives of same age, sex, non smokers, having safe occupation are grouped together and placed in the same underwriting class. Various 115

underwriting classes are made on the basis of unhealthy lives, lives with physical impairments, lives with hazardous occupations and extra premium is charged accordingly. It is the practice of insurance companies to publish rating manuals for standard risk. Class rating is an easy method to give premium quotes to the customers. In case of substandard lives in addition to the table premium, some extra premium will be charged according to the size of risk. Class rating method is widely used in automobile insurance, householder's insurance, life and health insurance. There are two methods to determine premium for class rating. The first is the pure premium method and the second is loss ratio method. Pure premium method: The pure premium is that proportion of the gross rate required to pay the incurred losses and loss adjusted expenses. Incurred losses include all losses that occur during the accounting period whether or not they have been paid by the end of period. Loss adjustment expenses are the expenses incurred by the company in adjusting losses during the same accounting period. Pure premium = (amount of incurred loss & loss adjusted expenses) No. of exposure units Finally, loading for marginal contingencies, expenses and profit will be added. Expense loading is normally expressed as a percentage of gross rate and is called expense ratio. Gross premium is calculated by dividing the pure premium by (1- expense ratio) ILLUSTRATION OF WORKING METHODOLOGY OF SUMS ON RATE MAKING Let us assume that Pure Premium is 80. Also assume that Expense Loading is 20. Thus, Office Premium = Pure Premium + Expense Loading = 80 + 20 = 100. Now, Expense Loading is ((20/100)* 100) = 20% of Office Loading. Hence, the formulae works out as follows: Pure Premium = 80 Office Premium = (80/(l-0.2)) = 80/0.8 = 100. Loss ratio method: In this method the actual loss ratio is compared with the expected loss ratio and the rate is adjusted accordingly. The actual loss ratio is the ratio of incurred losses and loss adjustment expenses to earned premiums. Expected loss ratio 116

is the percentage of premiums that is expected to be used to pay losses. Rate Change = (Actual loss ratio - Expected loss ratio) Expected loss Ratio e.g. A comprehensive motor insurance policy is purchased by ₹1,50,000 insured persons in a given underwriting class. They generate incurred losses and loss adjustment expenses of ₹90,00,000 within a year. If expenses are 45% of the gross rate, calculate the final gross premium by pure premium method. The pure premium can be calculated as follows: Pure premium = 90,00,000/1,50,000 = ₹60. Gross rate = 60/(1-0.45) = 60/0.55 = ₹109.09 Suppose for one line of business has incurred losses and loss adjustment expenses amounting to ₹6,00,000 and earned premium is ₹8,00,000. Expected loss ratio is 0.6 i.e. 60%. Calculate the rate of change in the existing premium. Actual loss ratio is ₹6,00,000 / ₹8,00,000 = 0.75 or 75 % Expected loss ratio is 60% or 0.6 Then Rate of change = (0.75 - 0.6)/0.6 - 0 .25 or 25% (3) Merit Rating: Merit rating is a rating plan in which class rates are adjusted upward or downward based on individual loss experience. Merit rating is based on assumption that the loss experience of a particular insured will differ substantially from the loss experience of other insured persons. Thus, the class rates are modified according to the individual's loss experience. There are three different types of merit rating viz. schedule rating, experience rating and retrospective rating: Schedule rating: It is used in property insurance for large set of buildings e.g. industrial complexes, hotels, shopping mall, multiplex etc. Each building is separately rated on the basis of (a) construction i.e. the material used for construction, height and large open areas are taken into account. (b) Occupancy refers to the use of building and material storage in the building. (c) Protection refers to the protective devices like fire extinguishers, fire alarm system, automatic sprinkler system, etc. It also refers to the security system and quality of water supply and fire department (d) Exposure refers to the possibility of the damage to the building if fire catches the neighbouring buildings and spreads to the insured building (e) Maintenance refers to the housekeeping of the building. 117

Experience Rating: Experience rating is another form of merit rating. In this rating the past experience is utilized to determine the premium for the next policy year. The dass or manual rate is adjusted downward or upward according to the past loss experience. If the insured's loss experience is worse than the average for the class, the class rate is increased and vice versa. Experience rating is generally limited only to larger firms that generate a sufficiently high volume of premiums and more credible experience. Smaller firms are normally not eligible for experience rating. This system is used in general liability insurance, automobile insurance and group health insurance. In its application in automobile insurance this system is called bonus-malus. Retrospective Rating: Under this rating plan/ the insured's loss experience during the current policy period determines the actual premium paid for that period. If actual losses during the currentpolicy period are small than minimum premium will be charged and if they are large/ the premium is high. The actual premium paid will lie somewhere between minimum and maximum. This rating is widely used by general liability insurance, automobile liability or burglary insurance. 118

2.3.4 Rate Making for Life Insurance Premium is the price charged by the insurer for a promise to pay the sum assured in the event of death. Objective of rate making is to assure that the company collects enough premium from each group or individual insured to pay benefits promised under the contract. Premium is usually expressed as rate per thousand sum assured. Life insurance premiums can be paid by various modes. When the premium is paid in lumpsum at the time of purchase of policy it is called single premium. Premium may be paid yearly, half yearly, quarterly and monthly. Net single premium is defined as the present value of benefits promised under the policy. Net single premium of the policy is calculated on the basis of mortality and interest rate. While calculating the premium the following assumptions are made (1) Premiums are paid at the beginning of the policy year and (2) Claims are paid at the end of the year. Therefore, the amount required to pay death benefits is discounted for compound interest rate. Though these are the assumptions made for premium calculations, in practice insurance companies pay death claims immediately after death occurs. Value of office premiums = value of benefits + value of expenses Mortality Loading Life Insurance is based on the notion of rate of mortality. Rate of Mortality at a given age is the probable proportion of persons of given age who would die during a year before attaining another age. In simple words, it is the probability of death of an individual within a given period of time. The probability of death varies between individuals. Healthy individuals have low probability of death. Substandard lives i.e. the lives having some physical deformity or impairment have a greater probability of death. The probability of death varies between smokers and non-smokers, alcoholics and non-alcoholics, individuals belonging to different occupations, different geographical areas and also between males and females. When insurers accept risks, they are required to make an assessment of the probability of death. But, this probability depends upon several factors. Insurance companies, therefore, follow a step-by-step approach to estimate the probability of death. To make a correct guess insurance companies produce mortality tables relating to their own experience of lives they have insured. E.g. Suppose 1,00,000 (10) people born in the year 1990, 98,020 (11) were alive at age 1, 97,903 (12) were alive at age 2 and 97,712 (15) were alive at age 5 and 97,445 (112) are alive at age 12 i.e. in the year 2002. The number of people died before reaching age 1 is = 1,00,000 - 98,020 = 1,980 and so on. 119

The Mortality table shows the following columns which might look very daunting but which in fact are very easy to understand when you understand the headings: lx no. of persons who attain exact age x; 10,11,12 ... where suffix 1,2, 3.... indicates the age dx no. of persons who die between the ages of x and x+1. qx probability that a person aged x will die before reaching age x+1. It is known as rate of mortality, qx = dx/lx E.g. A person aged 25 purchases a life insurance policy; what will be the chances that he will die before attaining age 35? No. of deaths at age 35 (d35) the group of people who have completed age 34 and died in 35th year. No. of Lives at age 25 (125) =989,691 Probability that a person dies at age 35 is = (d25 + d26 +....+d34)/125= 1,120 +1,134+1,144+1,150+1,153+1,151+1,151+1,179+1,222+1,281= 11,685/989,691= 0.0118068 Probabilities of Life and Probabilities of Death are measured with the help of Mortality Table Mortality Table Age (x) lx dx Age(x) lx dx 14 999999 713 57 893579 9198 15 999286 769 58 884380 9750 16 998517 822 59 874630 10453 17 997695 871 60 864177 11297 18 996824 916 61 852880 12274 19 995908 957 62 840606 13369 20 994951 994 63 827237 14569 21 993957 1027 64 812668 15860 22 992930 1055 65 796808 17223 23 991874 1081 66 779585 17715 120

24 990793 1103 67 761869 19517 25 989691 1120 68 742353 21397 26 988570 1134 69 720956 23339 27 987436 1144 70 697617 25319 28 986292 1150 71 672298 27311 29 985142 1153 72 644987 29277 30 983989 1151 73 615710 31179 31 982838 1151 74 584531 32970 32 981687 1179 75 551561 34598 33 980508 1222 76 516963 36009 34 979286 1281 77 480954 37145 35 978005 1356 78 443809 37947 36 976649 1447 79 405862 38362 37 975202 1553 80 367501 38342 38 973648 1676 81 329159 37851 39 971972 1813 82 291308 36866 40 970160 1992 83 254442 35385 41 968168 2175 84 219058 33095 42 965992 2336 85 185963 30181 43 963657 2507 86 155782 27129 44 961149 2722 87 128653 24011 45 958427 2981 88 104641 20905 46 955447 3285 89 83736 17883 47 952162 3633 90 65854 15014 121

48 948528 4025 91 50839 12358 49 944504 4457 92 38482 9958 50 940047 4930 93 28523 7847 51 935117 5441 94 20676 6038 52 929676 5990 95 14638 4531 53 923686 6573 96 10107 3311 54 917113 7189 97 6797 2352 55 909923 7835 98 4445 1622 56 902088 8509 99 2822 1085 Life insurers prepare the mortality tables on the basis of their records and these reflect the mortality of persons who are assured under life assurance policies. Insurers always consider their own experience as it differs from the experience of population as a whole. For their own use insurers prepare various tables viz. Mortality table of male life assured, female life assured, smokers mortality table, etc. These tables help them to know the number of people who will die. The company will have to pay death benefit to them before expiry of the policy and will not receive any further payment towards premium and any income by way of investment. Mortality tables may be classified as (1) Select mortality tables (2) Ultimate mortality table (3) Aggregate mortality table. These terms have reference to whether the tables reflect the effects of the underwriting process. Insured lives having fulfilled the necessary requirements before becoming insured, show a lower rate of mortality than the lives not subject to such scrutiny. Thus, the number of deaths occurring among 10,000 insured persons aged 35 who have just insured after medical examination can be expected to be lesser than that of 10,000 persons aged 35 who were insured earlier. This is because due to the lapse of time since taking out insurance, the lives in the latter case may become impaired due to several reasons. A Select mortality table reflects the mortality experience of newly insured healthy lives. It shows rates of mortality by age and duration of insurance. Since the effect of selection generally wears off in five to fifteen years, the mortality rates are relative to others of their same age and sex and insurable at standard rates. This select period is usually between 5 & 15 years. 122

An Ultimate mortality table excludes these early data, usually the first five to 15 years following entry and is based on the ultimate mortality among insured lives. The mortality tables used by insurers are ultimate tables. Thus, select table represents very favourable initial experience, whereas ultimate table excludes this experience and therefore exhibits higher mortality. Aggregate mortality table includes the data of select and ultimate experience. It includes all the data for early years following entry as well as the later years. It is necessary to take into consideration the type of lives to whom the assurance policies are to be issued while selecting a mortality table for the calculations of premiums. If life assureds are from higher income group enjoying better living conditions, they can naturally expect longer life and fewer deaths amongst them compared to poor and lives living under unhealthy conditions or people living in cold climate. They have a lower mortality and longer span of life than those living in tropical countries or persons working tinder unhealthy conditions such as mines, chemical factories etc. Such lives are exposed to heat, dust, fumes and usually experience heavy mortality. Naturally, there should be different mortality tables for different groups. Therefore, select the mortality table, which rationally reflects the mortality of lives insured by an insurer. In spite of all the care that has been taken it is likely that the actual experience may deviate from the selected table. Selection of table is an intelligent presumption and actual experience may show variations, which may not always be favourable. To protect the interest of insurer in case of such unfavourable experience, some safeguards have to be provided in the premium. Such a provision is made as a small addition to the net premium. This loading is called loading for adverse mortality experience. Interest loading: The effect of interest on insurance premiums is also significant. Insurance may be made attractive by assuming a higher rate of interest. But, if the insurer cannot earn the assumed interest, premium charge will prove to be insufficient and insurer will not be able to meet claims. To avoid such a contingency a slightly lower rate of interest than that which can be earned with certainty is usually assumed in the calculations. This method provides margin in the insurance premiums. Though insurer earns higher interest rate, the assumed interest rate must be slightly lesser than the actually realised rate. This factor is called interest loading. Net Premium: Interest and mortality are taken into consideration while calculating net premiums. The next important factor is expenses that are needed to manage the insurer's business. Expenses Initial Expenses 123

Commission to Intermediaries Commission on premiums collected. First year - higher rate of commission (35%). Second, third year (7.5%) fourth & subsequent premiums at lower rate 5%. Salaries for staff who act as connecting link between insurer and agents (development officers). Expenses to run branch offices. Though salaries of staff in new business department are fixed, they have some bearing on new business figures. Other expenses like:  Medical fees  Printing and stationery  Salaries of staff in New Business department who scrutinise all proposals for the insurer and issue the policy contracts  Cost of stamp duty to be affixed on the policies issued  Advertisement expenses These expenses arise only at the time of selling of policy but do not occur, again during the policy period. The expenses in the first year are very high and during subsequent years they will be much lower. If we go on adding expenses of every year to the premium of that year, then uniformity of premium will be lost. Therefore all major part of expenses of first year has to be distributed throughout the duration of the policy. Renewal Expenses Servicing policyholders  Issuing premium notices  Collecting premiums  Accounting premiums  Issue of receipts  Attending to correspondence  Settlement of claims etc. 124

These expenses are neither related to premiums nor to sum assured. They are more related to the number of policies and expressed as constant addition to the premium per unit sum assured. Bonus loading:With advancement in medical science, mortality rates have improved. With premiums calculated on the basis of past mortality experience, the insurer earns handsome profits as actual mortality improves. Insurer offers these profits to his policyholders to encourage them to go in for more insurance. To satisfy the wishes of investors regular provision in the premium is to be made for definite profits to be declared as bonus. Such policies with definite provision of profit are called with-profit policies. These profits can be distributed to policyholders after periodical intervals in the form of bonus. Bonuses are generally declared on per thousand sum assured. Cost of bonuses is much less at young age and short-term policies than at advanced ages with short duration policies. To maintain uniformity of premiums the total cost of bonuses for whole duration of policy has to be distributed uniformly over all the premiums by dividing it with present value of annuity due. With profit policyholders can participate in the profits of the insurer but if there are no profits in a particular period because of unfavourable experience, the life assured has no right to demand any bonus. In prosperity when good profits are made by the insurer, life assured may get bonuses far in excess of the provisions made in premium by way of bonus loading. Office Premium After taking into consideration interest, mortality and expenses the office premium is calculated. Office premium is the minimum that the insurer should charge in order to make business feasible. The amount of office premium charged also depends upon the contingencies covered and the future benefits promised under the policy and also the selected mode of premium payment. E.g. Term insurance single premium plan attracts very less premium than that of endowment or money back plan of same term with level annual premium. Eligibility of a person for insurance at the standard office premium rate published in the company's table of rates is calculated on the basis of certain factors like age, present health, physical build of life assured, personal history viz. record of illness suffered in the past and his habits. Family history is also taken into consideration to gather data on longevity and health of family members. Occupation and environment also play a very important role in assessment of risk. 125

2.3.5 Rate Making Property and Liability Insurance The rates of premium are influenced by following factors: (A) Risk classification: There are four categories depending upon the type of manufacturing activity. Risk Group I: Biscuit factories, Coir factories, Glass & Ceramic factories Risk Group II: Breweries, Cement factories, Motorcar manufacturing units Risk Group III: Distilleries, White cement factory, Soap & Detergent factory Risk Group IV: Celluloid goods manufacturers, Match factories The rates are in ascending order from group I to group IV (B) Secondly, the ratio of indemnity limit of any one accident to any one year selected by the insured. The rates are the lowest if the ratio is 1:1 and the highest if the ratios are 1:2 or 1:3 (C) Limit of Indemnity - any one accident A multiplier depending on this limit is applied on the rate arrived at on the (A) and (B) above. The gross rate, thus, calculated is applied on the limit of indemnity to produce what is known as indemnity premium. Turnover loading: In addition to the indemnity premium, premium is also charged on the year's gross annual turnover or current year's projected turnover whichever is higher. Turnover means annual gross sales including all taxes and levy. Premium Discounts: Discounts are available for various specified features and improvement subject to inspection of premises by the insurer. Discounts are also available when the insured opt for ₹ voluntary excess'. Non Industrial risks are classified into nine groups 1. Hotels, motels, club houses, restaurants, boarding and lodging houses 2. Cinema halls, auditoriums, theatres, public halls, etc. 3. Residential premises 4. Office administrative premises, medical establishment, airport premises, research Institutes and laboratories 5. Schools, educational institutions, public libraries 6. Exhibitions, fairs and fetes 7. Permanent amusement parks 8. Film studios, circus, zoo, etc. 126

9. Depots, warehouses, godowns, shops and similar other non-industrial risks. For all these risks groups the subject matter is potential legal liabilities towards third parties for personal injury/ property damage and financial consequences of such accidents. Therefore the rate of premium differs in every case. For Product liability risks are classified into 7 groups 1. Carpet, clocks and watches, batteries 2. Alcoholic beverages, fans(domestic), kitchenware, wooden goods 3. Bread, cakes and biscuits, for lift trucks, milk products, soft drinks, meat products 4. Agricultural implements and farm machinery, motor vehicles, toys, pressure cookers 5. Air conditioning units and ducts, chemical products, cosmetics, pharmaceutical products 6. Cast iron products, motor vehicle tyres and tubes, wire products (mesh and chain 7. Explosives and fireworks, ladders, scaffolding (metal), phenyle pesticides. The lowest rate applies to group 1 and the highest rate is to group 7. Intermediate rates are charged for groups to 6 on an ascending scale. The rates of premium for the basic cover depend upon the type of industrial/non industrial unit, the indemnity limit (i.e. the maximum amount payable) for any one accident and any one year of insurance and gross annual turnover. Motor vehicles are broadly classified into private and commercial vehicles. Private vehicles include Motor cycles, scooters, cars and commercial vehicles include taxis, passenger vehicles, goods vehicles. 2.3.6 Premium Calculation Premium is the price for insurance. It is the consideration amount payable by the insured for the selected suminsured, plan and term of the insurance. Under a life insurance contract, it is payable – 127

 at the commencement as a one-time payment; or  at the commencement and also at a regular periodical interval as specified in the contract. It is always payable in advance. Default in premium payment leads to the policy being lapsed and benefits there under not being available or only partially available. Risk Premium Amount required to cover the risk of death for a given age for a period of one year. Net Premium/Pure Premium When interest yield is taken into account in the risk premium, it becomes Net Premium or Pure Annual Premium. Office Premium When provision for administrative or operating expenses, unexpected contingencies and fluctuations is made, the calculated amount is called Office Premium. Office Premium = Risk Premium - Interest + Management Expenses Tabular Premium After making modifications in the office premium for certain other factors, (e.g. mortality rate is higher between the ages of 13-18 years & lower at age 20-21), the premium is sequentially graded and the final premium that is arrived at is called Tabular Premium. This is the premium that insurance companies publish as Table of Premium Rates. Generally, it is per thousand sum assured for a given age, term and type of policy. Insurance companies make available to their agents the tables of premiums for each plan of insurance. Illustration: Suppose one person is likely to die out of 1,00,000 at a particular age within one year, the mortality rate in that case will be 0.001% (ldivided by 1,00,000 multiplied by 100) or 0.00001. In the illustration the risk premium for that age for every ₹1000 sum assured would be ₹0.01paisa. 128

If the policy has a term of 10 years, the risk premium would be increasing every year due to increase in age.  But in actual practice, a uniform premium or level premium is charged for all the 10 years.  This implies charging premium higher than necessary for the risk in early years and lower than necessary for the risk in later years.  This involves complex arithmetic and is taken care of by the Actuaries. Why ‘Level Premium’? Premium amount at higher age of the insured, i.e. during the later part of the policy term, would have considerably increased and the insured may find this beyond his paying capacity. Discontinuance of premium payment would leave the insured without protection of insurance, particularly when he needs it most. For obvious reason, insured persons with good health during the later part of the policy term may discontinue paying increased premium, while insured persons with bad health will tend to continue paying increased premium. This would lead to adverse selection. For the insurer, it is difficult to administer varying premium. Extra Premiums Extra premium is one that becomes chargeable in addition to the normal premium rate ('tabular premium') for a plan of insurance at the given age of the life to be assured. This may arise due to- The insured seeding additional benefits over and above the normal life cover like accident benefit, premium waiver benefit, critical illness benefits etc. (known as’riders') Extra risk on life assured involved by way of hazardous occupation, adverse family history, personal habits and his physical condition. Extra premium is normally charged per thousand sum assured; for example, say, ₹2 per thousand sum assured. Calculation of Age of Life to be Assured Risk of death is closely related to the age of the life to be assured; hence the age at entry into the contract of insurance becomes the most significant factor to determine premium. 129

Months and days over the completed years of age are not taken as such, but the age to be taken is rounded off to the years in integer which may be- Age Nearer birthday, or Age Next birth day; or Age Last birth day. This depends upon the practice of the insurance company and the plan of insurance. Example of age calculation: On 19-03-2008, in case of a person having born on 01.04.1985, his age- nearer birthday will be 23 years; last birthday will be 22 years; and next birthday will be 23 years. Calculation of Actual Premium The ‗Tables of Premiums' prescribed by various life insurance companies in India, show their premium amount per thousand per year. However, some insures have adopted ‘quarterly' mode of payment as the basis, while others have adopted ‘yearly' mode as the basis. Simply put - The insurers adopting quarterly basis assumed that the premium for a full year prescribed by them will be received in four quarterly installments. Those adopting yearly basis expect the yearly premium to be received in one installment for the whole year. Premium Payment Mode The policyholder may select yearly, half - yearly, quarterly or monthly mode of premium payment. Insurance companies also allow premium payment through deductions from the policyholder's salary under their salary savings scheme. Insurance companies also have ‗Single Premium' payment plan for some of their products. Rebate or Loading for Premium Payment Mode In case, a policyholder selects a mode involving payment frequency higher that the basis adopted by the insurance company, the tabular premium is loaded with an additional charge. 130

In case, a policyholder selects a mode involving payment frequency lower than the basis adopted by the insurance company, a rebate is allowed on the tabular premium. While ‗rebate' referred to above leads to reduction in the tabular premium, ‗loading' leads to enhancement of the tabular premium. The rates of rebate and loading mentioned above are mere assumptions. For actual application of such rebate or loading, rules of the company concerned will have to be followed. Rebate for Large Sum Assured For every new policy there are certain - 'Fixed costs' which are uniform for all policies irrespective of sum assured, for example, cost of policy preparation or postal expenses for mailing the policy document. Variable costs' depending on the sum assured; for example stamp duty on the policy document or medical examiner's fee. When the sum assured is large, fixed costs get reduced per thousand sum assured resulting into savings to the insurer. Insurer shares these savings with the policy holders by offering rebate in tabular premium for large sum assured ranges from ₹l to ₹ per thousand varying from company to company and the type of product. Types of Premium Single Premium  Payable at the commencement of the policy as a one- time payment. Regular  Payable at the commencement & also at a regular Premium periodical intervals throughout the policy tenure. Limited  Payable at the commencement & also at a regular Premium periodical intervals as specified in the contract. Illustration of Working Mythology of Sums on Life Insurance Premium Calculation Adjustment Particulars Amount Note (7000) Tabular Premium XXX Less: Large Sum XX If it is expressed as a % then calculate Assured Rebate the same as a % of Tabular Premium XXX 131

Add/ Less: Adjustment for XX If it is expressed as a % then calculate Mode of the same as a % of Tabular Premium Premium XXX Payment XX Upto this all values are considered as XX 7000 Add: Extra Premium XXX Add: Rider Premium Applicable Premium Sl.No. Particulars Amount Formulae 1 2 (₹) Premium Payable XXX (AP/1000)*SA per Policy Year XXX PPPY/Number of Installments in a year Installment Premium ILLUSTRATION OF SUMS ON RATE MAKING: 1. A comprehensive motor insurance policy has been purchased by ₹1,500 people belonging to the same class. The average sum assured is ₹1,00,000. The insurer usually incurs loss and loss adjusted expenses of ₹1,05,000 per claim logged. The average number of claims lodged in a year is 90. The expense ratio is 10%. Calculate the office premium per thousand. Solution: Pure Premium = (Incurred Loss and Loss Adjustment Expenses/ Number of Exposure Units) = ((90*105,000)/1,500) = ₹6,300 (per unit) Pure Premium = (Pure Premium per exposure unit / Value of one exposure unit) * ₹1,000 = ((6,300/1,00,000)*1,000) = ₹63 (per thousand) Office Premium = Pure Premium/ (1 - Expense Ratio) = 63/ (1-0.10) = ₹70 (per thousand) 132

2. If for the previous sum, the expense ratio is 55%, calculate the office premium. Solution: Pure Premium = (Incurred Loss and Loss Adjustment Expenses/ Number of Exposure Units) = ((90*1,05,000)/ (1,500*1,00,000))*1,000 = ₹63 (per thousand) Office Premium = Pure Premium/ (1 - Expense Ratio) = 63/ (1-0.55) = ₹140 (per thousand) ILLUSTRATION OF SUMS ON AGE CALCULATION: 3. Date of birth of Ravi is January 7, 1990. He is applying for a life insurance policy today i.e. March 13, 2018. What is his age? Solution: 13. 03. 2018 DOC (Date of Commencement) 07. 01. 1990 06D 02M 28Y Less: DOB (Date of Birth) 28 years AGE 29 years 28 years Age last birthday: Age next birthday: (28 + 1) Age nearer birthday: (since 2M) 4. Calculate age of Hari who is applying for a policy today i.e. 13th March 2018 and was born on 25th February 1985. Solution: 13. 03. 2018 DOC (Date of Commencement) 25. 02. 1985 18D00M 33Y Less: DOB (Date of Birth) 33 years AGE 34 years 33 years Age last birthday: Age next birthday: (28 + 1) Age nearer birthday: (since 0M) 133

ILLUSTRATION OF SUMS ON PREMIUM CALCULATION: 5. Calculate installment premium with the help of the following information: Sum Assured -₹25000 Term - 35 years Tabular Premium - ₹36.55/ thousand of Sum Assured Large Sum Assured Rebate - ₹1/ thousand of Sum Assured Rebate for Half Yearly Mode - 1.5% of Tabular Premium Premium for Accidental Death Benefit Rider - ₹1/ thousand of Sum Assured Solution: ADJUSTMENT PARTICULARS AMOUNT (HYL) Less: Tabular Premium (₹/000) Large Sum Assured Rebate 36.55 (1.00) Add/ Less: Adjustment for Mode of Premium Payment 35.55 (0.55) Add: Rider Premium 35.00 Applicable Premium 1.00 SL NO 36.00 1 PARTICULARS 2 AMOUNT Premium Payable per Policy Year (₹) Installment Premium 900 450 6. Calculate installment premium with the help of the following information: Sum Assured - ₹50000 134

Tabular Premium - ₹28.40/ thousand of Sum Assured Large Sum Assured Rebate - ₹1.50/ thousand of Sum Assured Rebate for Yearly Mode - 3% of Tabular Premium Extra Premium - ₹5/ thousand of Sum Assured Premium Payment Modes - Annually/ Quarterly Solution: AMOUNT AMOUNT ADJUSTMENT PARTICULARS (YL) (QTR) (₹/000) (₹/000) Tabular Premium 28.40 28.40 Less: Large Sum Assured Rebate (1.50) (1.50) 26.90 26.90 Add/ Less: Adjustment for Mode ofPremium (0.85) - Payment 26.05 26.90 Add: Extra Premium 5.00 5.00 Applicable Premium 31.05 31.90 SL NO PARTICULARS AMOUNT AMOUNT (₹) (₹) 1 Premium Payable per Policy Year 1552.50 1595 2 Installment Premium 1552.50 398.75 7. Calculate Half yearly premium based on the following information: Sum Assured - ₹100000 Date of Birth - 28/06/1974 Date of Commencement - 20/12/2002 Rebate for Half Yearly Mode - ₹1/ thousand of Sum Assured Rebate for Sum Assured of ₹50000 and above - ₹1.50/ thousand of Sum Assured Tabular Premium for Age: 27 nearer birthday: ₹27.46, 28 nearer birthday: ₹27.83& 29 nearer birthday: ₹28.37 135

Solution: 20. 12. 2002 DOC (Date of Commencement) 28. 06. 1974 22D 05M 28Y Less: DOB (Date of Birth) AGE Age nearer birthday: {since 5M) ADJUSTMENT PARTICULARS AMOUNT (YL) Less: Tabular Premium Large Sum Assured Rebate (₹/000) 27.83 Add/ Less: Adjustment for Mode of Premium Payment (1.50) Applicable Premium 26.33 SL NO. (1.00) 1 PARTICULARS 25.33 2 AMOUNT Premium Payable per Policy Year Installment Premium (₹) 2533 1266.50 8. Mr. Praveen is planning to buy a term insurance of ₹10 Lakh for which the tabular premium is ₹3.50 per thousand. He is also interested to take an accidental benefit rider along with the base policy of ₹10 Lakh for which the tabular premium is ₹0.50 per thousand. Calculate the total premium payable by Mr. Praveen. Solution: ADJUSTMENT PARTICULARS AMOUNT (₹/000) Tabular Premium 3.50 Add: Rider Premium 0.50 Applicable Premium 4.00 136

SL NO. PARTICULARS AMOUNT (₹) 1 Premium Payable per Policy Year 4000 2 Installment Premium 4000 9. What will be your answer if in the above sums Mr. Praveen takes term insurance of₹10 Lakh &accidental death benefit rider of ₹5 Lakh only and the premium is paid on a half yearly mode? Solution: ADJUSTMENT PARTICULARS AMOUNT (₹/000) Applicable Premium for Base Policy 3.50 Applicable Premium for Rider 0.50 SL NO. PARTICULARS AMOUNT (₹) 1 Premium Payable per Policy Year 3750 2 Installment Premium 1875 137

QUESTIONS Q1. ____________ = risk premium + savings premium + expenses. (a) Endowment (b) Policy (c) Premium Q2. Insurance companies employ specialists, known as _____________, who are responsible forcalculating the premium rates the company will charge for its products. (a) Organizer (b) Actuaries (c) Supervisor Q3. Premium rates are based on - Risk + ____________________ (a) saving element (b) coverage (c) savings and expenses Q4. _____________ refers to that portion of the rate needed to pay losses and loss adjustment expenses. (a) Office premium (b) Net premium (c) Loading Q5. Pure premium = _________________________________________ (a) Expected loss ratio (b) Actual loss ratio (c) No. of exposure unit Q6. _______________ is a rating plan in which class rates are adjusted upward or downward based onindividual loss experience. (a) Merit rating (b) Schedule rating (c) Experience rating 138