What is Insurance?

When this question is asked, the answers come as follows:

It is risk cover, safety, protection against loss etc. While many have a vague idea of insurance, most of them do not know how the mechanism of insurance works and how the insurance companies are able to pay large sums of money much more than what they have received as premium.

Now let us define some of the basic words so that any layman can understand some of the concepts related to insurance.

Peril is an uncertain event, which may result in a bad or adverse consequence and a consequent loss.

What is risk? It is the probability or chance of a loss arising out of peril. Loss is not risk. It is the uncertainty relating to the peril that is risk.

Then, insurance is the sharing of the loss arising out of peril. While the risk may be there for a large number of persons, the actual loss happens only to a few.

Let us take an example. In all cities, a large number of persons travel on the roads every day. Daily we hear or read from the newspapers about accidents. Normally one to 5 persons either die or get injured etc., more frequently, 5 to 10 persons die or get injured less frequently, 0 accidents or more than 10 deaths occur very rarely.

Here all the persons who travel on the road have a risk of getting involved in an accident. It may result in either death or injury or loss of limbs. Daily the event happens, but to whom it will happen is not known.

The regularity of some natural events is observed and probabilities of the happening of an event are calculated out of that. From these probabilities, the premiums are calculated and collected from a large number of people, who are exposed to similar risks. The amount of premiums is collected by the Insurance Companies, and given to those who actually suffer from losses.

Life Insurance covers the risks related to life – early death or long life.
Non-Life or General Insurance covers the risks relating to accident, fire, marine, motor etc., or all insurance other than those related to life.
While Life Insurance is a long-term contract, Non-Life Insurance or General Insurance is a one-year contract.

While the assets have a value for which the insurance is done, the human life is invaluable. Then how much insurance a person can take? This is called Human Life Value (HLV). It is considered as the economic value of the person, which the family suffers due to the death of the person. For this, the person is considered to be an income-generating Asset.

Now how do the insurance companies calculate premiums?

Actuaries based on the past experience of deaths prepare mortality tables. The table gives the probability of death of a person age wise. Suppose the probability of death at age 30 is 0.00130, what does it mean? It means that out of 100000 persons all aged 30 who are insuring their lives, 130 out of them are likely to die within one year. If all of them have insured for a sum of Rs. 100000, then the company may have to pay 130 lakhs in case 130 deaths occur. Thus the amount payable i.e. 130 lakhs divided by the number of persons i.e. 100000, or Rs. 130 is collected from each person as premium and kept with the company. The company goes on paying claims as and when deaths occur. At the end of the year, if there are 130 deaths, the company pays the amount with no profit or loss. If there are more deaths, the company incurs a loss and if there are fewer deaths, the company makes a profit.

Further the companies do not keep the premiums with them. They invest the premiums received by them and earn interest on them. They have also to incur expenses in the administration of their business. So the three factors on which the premiums are calculated are mortality, interest and expenses.

Insurance does not protect the asset; does not prevent its loss. Insurance cannot replace the asset. Insurance only compensates for the economic or monetary or financial or pecuniary value of the asset.

Insurance covers only risks, the happening of which is uncertain or random.
Insurance does not cover speculative risks or wagers (gambling).
Insurance does not cover sentimental, emotional or status losses.
Insurance Companies are the Trustees of people’s money coming to the rescue of the people who suffer losses arising out of risks.

The premiums received by the Insurance Companies are to be invested in mostly Government and approved securities. The Government for infrastructure development, electricity, water supply etc. uses these funds. These investments help in the economic development of the people. The economic development results in reduced mortality and increased life expectancy. The average age of an Indian in 1947 was about 35, whereas now it is about 60 years. Thus with economic development, the longevity of people increases, which means the deaths are less and the profits of insurance companies are more.