Chapter 1: Basics of Insurance
Insurance is the most effective risk management tool which can protect individuals and businesses from financial risks arising out of various contingencies. The emotional and psychological loss can never be compensated, but at least the financial loss can be compensated with insurance. Though there are uncertainties in life that you cannot mitigate, insurance will surely help you transfer the financial risk associated with the same.
What is Insurance?
Insurance is the most effective risk management tool which can protect individuals and businesses Insurance is a legal contract between two parties- the insurance company (insurer) and the individual (insured), wherein the insurance company promises to compensate for financial losses due to the insured contingencies in return for the premiums paid by the insured individual. In simple words, insurance is a risk transfer mechanism, where you transfer your risk to the insurance company and get the cover for financial loss that you may face due to unforeseen events. And the amount that you pay for this arrangement is called the premium. There is insurance available for various risks, starting from your life to the mobile phones that you use. In the end, it’s essential to protect what is ‘important’ to you.
How does insurance work?
The concept of insurance works on the basis of ‘risk pooling‘. When you buy any type of insurance policy from the insurance company for a specified period with specific cover, you will make regular payments (referred to as premiums) towards the policy. Similarly, an Insurance Company collects premiums from all of its clients (referred to as insured) and pools the money collected to pay for losses arising out of an insured event. In case the insured event takes place, and you make a claim, losses will be compensated by the insurance company from the pool of policyholder’s premiums. In case you don’t make a claim during the specified policy period, no benefits will be paid to you. However, there are various types of products offered by insurance companies today which also involve savings elements attached to them.
Need of Insurance
Insurance enables risk transfer from the beneficiary (Insured) to the insurance company (Insurer), which undertakes to indemnify the insured for the financial loss suffered. In return, the insured pays a periodic fee, called premium, to the Insurer to receive this protection. To be insurable, the event being insured against, such as death, accident or fire must result in a financial loss which can be quantified and insured against. The premium payable will depend upon this expected loss and the probability of the event occurring during the period of the contract. For example, the premium payable on a health policy for an individual whose parents have a history of ill-health that is considered genetic, such as ailment of the heart, cancer, or diabetes may be much higher than that for an individual coming from parents with no such history. This is because the probability that the insurance company will be required to pay medical expenses in the first case is much higher than what it is in the second case.
Requirement of an Insurable risk
- A large Number of Exposure Units- An insurance company is able to offer the protection it does because it operates a common pool in which only a few will suffer loss in any one year. The entire pool pays a premium but the liability for the insurance company will be only a few in a year. In the absence of a large number of people being exposed to the same risk, the premium payable would be much higher and it would be unviable for the insurer and the insured. Also even if the pool of people likely to suffer the loss is large but the number of them who are willing to pay a premium for covering that loss is a fraction then also the insurance premium would be larger for the people who are willing to pay the premium.
- Insurable Interest – Insurable interest implies that the individual seeking insurance will face financial loss in the event of loss or destruction of the subject matter of insurance. The loss should be monetary in nature and not merely emotional or related to feelings. The interest must be lawful.
- Accidental and unintentional – Loss must be accidental, unintentional, and uncertain. The only exception is life insurance where the event being insured against, namely death, is certain. However, the time of death is uncertain, which makes it insurable. Loss should be fortuitous and outside the insured’s control.
- Determinable and measurable – Loss should be definite as to cause and amount. The cause must be known such as a death in the case of Life Insurance or fire in the case of property Insurance. It means that loss must be calculatable based on some definite evidence.
- No prospect of gain or profit – A further characteristic of the insurable risk is that it does not involve any prospect of gain or profit. In other words, it must be a pure risk with only the possibility of full or partial loss. Speculative risk is not insurable.
- Chance of loss must be calculable – Insurers must be able to calculate with some accuracy, average frequency, and average the severity of future losses.
- The premium must be economically feasible– Premiums should not only be affordable but also far less than the value of the risk covered. Else the option to retain risk will be more feasible than transfer risk through insurance.
Insurable Interest
Insurable interest is defined as the reasonable concern of a person to obtain insurance for any individual or property against unforeseen events such as death, losses, etc. A person is expected to have a reasonable interest in a longer life for himself, his family, and his business and hence is in need of acquiring insurance for these. Therefore, insurable interest is often related to ownership, relationship by law, or blood and possession. However, it is not an important element of life insurance contracts under modern law.
Concepts in Insurance:-
Indemnity Insurance- Indemnity Insurance means that the insurance policy will pay the amount necessary to put you back in the same financial position as you were before the claim was made. This is a technical term insurance companies like to use which basically means that they will recover your damage.
Benefits Insurance– A defined benefit Insurance plan is different from an Indemnity Insurance in that a fixed sum of money based on a pre-estimated amount of loss will be paid on the happening of a covered event. A life Insurance policy is a good example of a defined benefit Insurance as it pays a pre-fixed sum of money on the death of the insured person without really trying to ascertain the exact actual loss caused due to the death of the insured person.
-
- it is difficult to ascertain the exact actual loss caused
- The amount of loss is small and the cost of determining the “actual loss” might not be worth the actual amount of loss caused.
- Subrogation- Subrogation means the insurance company steps into the shoes of the insured person after paying the claim and taking all actions that the insured person could have taken. An example could be a loss incurred by the insured person due to the accident caused by another car that was at fault. In such cases, the insurance company pays the claim to the insured person and then steps into the shoes of the insured person and pursues the claim with the “at fault” driver or her insurance company and recovers the loss from them.
Contribution- The principle of contribution is implemented when multiple insurance policies are covering the same property or loss, the total payment for actual loss is proportionally divided among all insurance companies.
Co-Pay- is the proportion of the claim amount which will be met by the Insured person. It is most popularly used in the context of car Insurance and health Insurance. For example, if the insured person has agreed on a co-pay of 15% and the ascertained claim amount is Rs. 2,00,000 then the insured person will pay Rs. 30,000 (15% of Rs. 2,00,000) and the Insurer will pay only the balance amount of Rs. 1,70,000/- .
Deductible- Deductible is the amount that a policyholder has to pay before the insurance company starts paying up. In other words, the insurance company is liable to pay the claim amount only when it exceeds the deductible. If the deductible of your policy is Rs 30,000 and the claim by the insured is Rs 40,000, then the insurance company is liable to pay only Rs 10,000. However, if the claim amount is less than the deductible, the insurer is not liable to pay any amount. For high deductible policies, the premium is lower while the low deductible policies have a higher premium.
Cashless claim payment– This is relevant for indemnity insurance and mostly used in the context of health insurance and car insurance. Under normal circumstances, the insured person first incurs the expenditure at the hospital/garage and then files a claim for reimbursement with the insurer. This blocks the cashflow of the insured person. In many cases, the insured person may not have that amount of cash available to first make payment to the hospital/garage.
Role of Insurance in Personal Finance-
Insurance is a very crucial part of everyone’s financial plan. Staying prepared for the unforeseen would ensure that you could still accomplish your goals even after encountering a financial crisis. An insurance policy would help to preserve your emergency fund in case of emergencies. Insurance could also protect your family if you’re part of an accident and have sustained injuries, become disabled, ill, or die. Some situations could be very expensive for the ones with no insurance coverage, so it is vital to have any policy you require depending on your financial situation.
The insurance decisions that you take must be dependent on your age, family, and financial situation. There are several forms of insurance that one can choose from. For instance, life insurance could be a necessity, particularly in case you’re married and have children.
Role of Insurance Adviser-
- Steps in Insurance Planning- Just like financial planning, insurance planning is also specific to the individual and their situation.
-
- Identify insurance need– Insurance is primarily a tool for protection from financial loss. Identifying insurance needs, therefore, requires identifying all those situations that can result in a loss of income or an unexpected charge on income. Insurance needs can be broadly categorized as:
- Income replacement needs in the event of a risk to the earning ability of an asset, which includes the life of an individual as well as his earning ability as an asset generating income. Eg. such- Life Insurance, Critical Illness, and Accidental Disability insurance.
- Income protection needs to protect the available income from an unexpected charge. Eg. Health Insurance and Motor Insurance.
- Asset protection needs include the need to protect assets created from theft or destruction. Eg.-Household insurance.
2. Estimate the insurance coverage-
-
- Estimate the amount of insurance required- The purpose of insurance is to compensate for the financial loss suffered from a specified event. It is not to profit or gain from it. The amount of insurance required must be calculated by giving due consideration to factors such as the future value of the costs being sought to be replaced, the period for which protection is required, and the ability to bear the cost of insurance.
- Estimate the tenure for which the insurance is required– Longer the coverage tenure higher is the yearly premium from the first year itself. Thus, taking a life insurance policy that has a higher premium because it covers death after retirement can also be considered wasteful.
- Identify the most suitable insurance product- Having decided on the insurance coverage, the next decision is the choice of product. Various types of insurance products are discussed in the next section.
- Optimize the insurance premium- Within the same insurance product and coverage, there are choices that help the insured reduce the insurance premium.
- Monitor the insurance coverage- Insurance is not a one-time activity. The exposure and coverage need to be monitored continuously. Where necessary, the policy coverage would need to be modified to mitigate additional risks.
Unit linked insurance products (ULIPs)-
(1) Lock-in period increased to five years: IRDA has increased the lock-in period for all Unit Linked Products from three years to five years, including top-up premiums, thereby making them long-term financial instruments which basically provide risk protection.
(2) Level Paying Premiums: Further, all regular premium /limited premium ULIPs shall have uniform/level paying premiums. Any additional payments shall be treated as a single premium for the purpose of insurance cover.
(3). Even Distribution of Charges: Charges on ULIPs are mandated to be evenly distributed during the lock-in period, to ensure that high front-ending of expenses is eliminated.
(4). Minimum Premium Paying Term Of Five Years: All limited premium unit-linked insurance products, other than single premium products shall have a premium paying term of at least five years.
(5). Increase In Risk Component: Further, all unit linked products, other than pension and annuity products shall provide a mortality cover or a health cover thereby increasing the risk cover component in such products.
(i) The minimum mortality cover should be as follows:
|
Minimum Sum assured for age at entry of below 45 years |
Minimum Sum assured for age at entry of 45 years and above |
|
Single Premium (SP) contracts: 125 percent of single premium. Regular Premium (RP) including limited premium paying (LPP) contracts: 10 times the annualized premiums or (0.5 X T X annualized premium) whichever is higher. At no time the death benefit shall be less than 105 percent of the total premiums (including top-ups) paid. |
Single Premium (SP) contracts: 110 percent of single premium Regular Premium (RP) including limited premium paying (LPP) contracts: 7 times the annualized premiums or (0.25 X T X annualized premium) whichever is higher. At no time the death benefit shall be less than 105 percent of the total premiums (including top-ups) paid. |
(In case of whole life contracts, term (T) shall be taken as 70 minus age at entry)
(ii)The minimum health cover per annum should be as follows:
|
Minimum annual health cover for age at entry of below 45 years |
Minimum annual health cover for age at entry of 45 years and above |
|
Regular Premium (RP) contracts: 5 times the annualized premiums or Rs. 100,000 per annum whichever is higher, At no time the annual health cover shall be less than 105 percent of the total premiums paid. |
Regular Premium (RP) contracts: 5times the annualized premiums or Rs. 75,000 per annum whichever is higher. At no time the annual health cover shall be less than 105 percent of the total premiums paid |
(6). MINIMUM GUARANTEED RETURN FOR PENSION PRODUCTS: As regards pension products, all ULIP pension/annuity products shall offer a minimum guaranteed return of 4.5% per annum or as specified by IRDA from time to time. This will protect the life time savings for the pensioners, from any adverse fluctuations at the time of maturity.
(7). RATIONALISATION OF CAP ON CHARGES: With a view to smoothening the cap on charges, the capping has been rationalized to ensure that the difference in yield is capped from the 5th year onwards. This will not only reduce the overall charges on these products but also smoothen the charge structure for the policyholder.
Do’s and Don’ts under SEBI (IA) Regulations
SEBI Investment Adviser (IA) Regulations provide an exemption to an insurance agent or insurance broker registered with IRDAI who offers investment advice solely on insurance products. However, if the insurance agent or insurance broker also offers investment advice on non-insurance securities or investment products then such advice would be covered by IA regulations. In that case, while advising on insurance-based security or Investment products also the IA cum insurance intermediary would need to keep the principle of risk profiling, suitability, and fiduciary responsibility to the client in mind.
