The business of insurance is related to the protection of the economic values of assets. Every asset has a value. The asset would have been created through the efforts of the owner. The asset is valuable to the owner, because he expected to get some benefits from it. It is a benefit because it meets some of his needs. The benefit may be an income or in some other form. In the case of a factory or a cow, the product generated by it is sold and income is generated. In the case of a motor car, it provides comfort and convenience in transportation. There is no direct income. Both are assets and provide benefits.
Every asset is expected to last for a certain period of time during which it will provide the benefits. After that, the benefit may not be available. There is a life-time for a machine in a factory or a cow or a motor car. Nome of them will last for ever. The owner is aware of this and he can so manage his affairs that by the end of that period or life-time, a substitute is made available. Thus, he makes sure that the benefit is not lost. However, the asset may get lost earlier. An accident or some other unfortunate event may destroy it or make it incapable of giving the benefits. An epidemic may kill the cow suddenly. In that case, the owner and those enjoying the benefits therefrom, would be deprived of the benefits. The planned substitute would not have been ready. There is an adverse or unpleasant situation. Insurance is a mechanism that helps to reduce the effects of such adverse situations, It promises to pay to the owner or beneficiary of the asset, a certain sum if the loss occurs.
Monday, August 30, 2010
Purpose and Need of Insurance
Assets are insured, because they are likely to be destroyed or made non-functional before the expected life time, through accidental occurrences. Such possible occurrences are called perils. Fir, floods, breakdowns, lightning, earthquakes, etc, are perils. If such perils can cause damage to the asset, we say that the asset is exposed to that risk. Perils are the events. Risks are the consequential losses or damages. The risk to a owner of a building, because of the perils of an earthquake, may be a few lakhs or a few crores of rupees, depending on the cost of the building, the contents in it and the extent of damage.
The risk only means that there is a possibility of loss or damage. The damage may or may not happen. The earthquake may occur, but the building may not have been affected at all. Insurance is done against the possibility that the damage may happen. There has to be an uncertainty about the risk. The word ‘possibility’ implies uncertainty. Insurance is relevant only if there are uncertainties. If there is no uncertainty about the occurrence of an event, it cannot be insured against. In the case of a human being, death is certain, but the time of death is uncertain. The person is insured, because of the uncertainty about the time of his death… In the case of a person who is terminally ill, the time of death is not uncertain, though not exactly known. It would be ‘soon’. He cannot be insured.
Insurance does not protect the asset. It does not prevent its loss due to the peril. The peril cannot be avoided through insurance. The risk can sometimes be avoided, through better safety and damage control measures. Insurance only tries to reduce the impact of the risk on the owner of the asset and those who depend on that asset. They are the ones who benefit from the asset and therefore, would lose, when the asset is damaged. Insurance only compensates for the losses – and that too, not fully.
Only economic consequences can be insured. If the loss is not financial, insurance may not be possible. Examples of non-economic losses are love and affection of parents, leadership of managers, sentimental attachments to family heirlooms, innovative and creative abilities, etc.
The risk only means that there is a possibility of loss or damage. The damage may or may not happen. The earthquake may occur, but the building may not have been affected at all. Insurance is done against the possibility that the damage may happen. There has to be an uncertainty about the risk. The word ‘possibility’ implies uncertainty. Insurance is relevant only if there are uncertainties. If there is no uncertainty about the occurrence of an event, it cannot be insured against. In the case of a human being, death is certain, but the time of death is uncertain. The person is insured, because of the uncertainty about the time of his death… In the case of a person who is terminally ill, the time of death is not uncertain, though not exactly known. It would be ‘soon’. He cannot be insured.
Insurance does not protect the asset. It does not prevent its loss due to the peril. The peril cannot be avoided through insurance. The risk can sometimes be avoided, through better safety and damage control measures. Insurance only tries to reduce the impact of the risk on the owner of the asset and those who depend on that asset. They are the ones who benefit from the asset and therefore, would lose, when the asset is damaged. Insurance only compensates for the losses – and that too, not fully.
Only economic consequences can be insured. If the loss is not financial, insurance may not be possible. Examples of non-economic losses are love and affection of parents, leadership of managers, sentimental attachments to family heirlooms, innovative and creative abilities, etc.
Insurance as a Social Security Tool
The United Nations Declaration of Human Rights 1948 provides that “Everyone has a right to a standard of living adequate for the health and wellbeing of himself and his family, including food, clothing, housing and medical care and necessary social services and the right to security in the event of unemployment, sickness, disability, widowhood or other lack of livelihood in circumstances beyond his control”.
When the bread winner dies, to that extent, the family’s income dies. The economic condition of the family is affected, unless other arrangements come into being to restore the situation. Life insurance provides such an alternate arrangement. If this did not happen, another family would be pushed into the lower strata of society. The lower strata creates a cost on society. Poor people cost the nation by way of subsidies and doles and so on. Poor people also cost by way of larger growth in population, poor education and vagaries in behaviour of children. Life insurance helps to reduce such costs. In this sense, the life insurance business is complimentary to the state’s efforts in social management.
Under a socialistic system the responsibility of full security would be placed upon the State to find resources for providing social security. In the capitalistic society, provisions of security is largely left to the individuals. The society provides instruments, which can be used in securing this aim. Insurance is one of them. In a capitalistic society too there is a tendency to provide some social security by the State under some schemes, where members are required to contribute e.g. the social security scheme in UK.
When the bread winner dies, to that extent, the family’s income dies. The economic condition of the family is affected, unless other arrangements come into being to restore the situation. Life insurance provides such an alternate arrangement. If this did not happen, another family would be pushed into the lower strata of society. The lower strata creates a cost on society. Poor people cost the nation by way of subsidies and doles and so on. Poor people also cost by way of larger growth in population, poor education and vagaries in behaviour of children. Life insurance helps to reduce such costs. In this sense, the life insurance business is complimentary to the state’s efforts in social management.
Under a socialistic system the responsibility of full security would be placed upon the State to find resources for providing social security. In the capitalistic society, provisions of security is largely left to the individuals. The society provides instruments, which can be used in securing this aim. Insurance is one of them. In a capitalistic society too there is a tendency to provide some social security by the State under some schemes, where members are required to contribute e.g. the social security scheme in UK.
Advantages of Life Insurance
Life insurance has no competition from any other business. Many people think that life insurance is an investment or a means of saving. This is not a correct view. When a person saves, the amount of funds available at any time is equal to the amount of money set aside in the past, plus interest. This is so in a fixed deposit in the bank. If the money is invested in buying shares and stocks, there is the risk of the money being lost in the fluctuations of the stock market. Even if there is no loss, the available money at any time is the amount invested plus appreciation. In life insurance, however, the fund available is not the total of the savings already made (premiums paid), but the amount one wished to have at the end of the savings period (which is the next 20 or 30 years). The final fund is secured from the very beginning. One is paying for it over the years, out of the savings. One has to pay for it only as long as one lives or for a lesser period, if so chosen. The assured fund is not affected. There is no other scheme which provides this kind of benefit. Therefore life insurance has no substitute.
This is not similar to a hire purchase scheme. In a hire purchase scheme, the intended purchase is effected immediately, but the price is paid in instalments later. However, in the event of death, the balance instalments are not excused. They have to be paid by the surviving family. In the case of life insurance, the premiums cease on death. There are no outstanding instalments. There is no financial arrangement that can equal the benefits of life Insurance.
A comparison with other forms of savings will show that life insurance has the following advantages.
• In the event of death, the settlement is easy. The heirs can collect the moneys quicker, because of the facility of nomination and assignment. The facility of nomination is now available for some bank accounts, provident fund, etc...
• There is a certain amount of compulsion to go though the plan of savings. In other forms, if one changes the original plan of savings, there is no loss. In insurance, there is a loss.
• Creditors can not claim the life insurance moneys. They can be protected against attachments by courts.
• There are tax benefits, both in income tax and in capital gains.
• Marketability and liquidity are better. A life insurance policy is property and can be transferred or mortgaged. Loans can be raised against the policy.
• It is possible to protect a life insurance policy from being attached by debtors. The beneficiaries interests will remain secure.
This is not similar to a hire purchase scheme. In a hire purchase scheme, the intended purchase is effected immediately, but the price is paid in instalments later. However, in the event of death, the balance instalments are not excused. They have to be paid by the surviving family. In the case of life insurance, the premiums cease on death. There are no outstanding instalments. There is no financial arrangement that can equal the benefits of life Insurance.
A comparison with other forms of savings will show that life insurance has the following advantages.
• In the event of death, the settlement is easy. The heirs can collect the moneys quicker, because of the facility of nomination and assignment. The facility of nomination is now available for some bank accounts, provident fund, etc...
• There is a certain amount of compulsion to go though the plan of savings. In other forms, if one changes the original plan of savings, there is no loss. In insurance, there is a loss.
• Creditors can not claim the life insurance moneys. They can be protected against attachments by courts.
• There are tax benefits, both in income tax and in capital gains.
• Marketability and liquidity are better. A life insurance policy is property and can be transferred or mortgaged. Loans can be raised against the policy.
• It is possible to protect a life insurance policy from being attached by debtors. The beneficiaries interests will remain secure.
Classification of Risks
Risks are classified in various ways. One classification is based on the extent of the damage likely to be caused. Critical or Catastrophic risks are those which may lead to the bankruptcy of the owner. It would happen if the loss is total, like in a tsunami, wiping out everything. It can also happen if the deceased person was heavily in debt. Important risks may not spell doom, but may upset family or business finances badly, requiring a lot of time to recover. The adverse effects of an economic recession is one such. Less damaging are Unimportant risks, like temporary illness or accidents.
Another classification is between Dynamic and Static risks. Dynamic risks are caused by perils which have national consequences, like inflation, calamities, technology, political upheavals, etc. Static risks are caused by perils which have no consequence on the national economy, like a fire or theft or misappropriation. Dynamic risks are less likely to occur than static risks, but are also less predictable… Static risks are more suited to management through insurance.
Fundamental risks are those that affect large populations while Particular risks affect only specific persons. A train crash is a fundamental risk while a theft is a particular risk. Life Insurance business deals with particular risks, but fundamental risks affect the life insurance company’s experience, as many persons will be affected at the same time, when there is an earthquake, flood or riot.
Another classification is between Pure risks and Speculative risks. The latter are in the nature of betting or gambling where the risk is, to some extent, under the control of the person concerned, while a pure risk is not so. It is more in the nature of an Act of God. Insurance deals with only pure risks and not speculative risks.
Another classification is between Dynamic and Static risks. Dynamic risks are caused by perils which have national consequences, like inflation, calamities, technology, political upheavals, etc. Static risks are caused by perils which have no consequence on the national economy, like a fire or theft or misappropriation. Dynamic risks are less likely to occur than static risks, but are also less predictable… Static risks are more suited to management through insurance.
Fundamental risks are those that affect large populations while Particular risks affect only specific persons. A train crash is a fundamental risk while a theft is a particular risk. Life Insurance business deals with particular risks, but fundamental risks affect the life insurance company’s experience, as many persons will be affected at the same time, when there is an earthquake, flood or riot.
Another classification is between Pure risks and Speculative risks. The latter are in the nature of betting or gambling where the risk is, to some extent, under the control of the person concerned, while a pure risk is not so. It is more in the nature of an Act of God. Insurance deals with only pure risks and not speculative risks.
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