Insurance is basic form of risk management that provides against the loss of the economic benefits. You can enjoy that from assets. Assets may be physical assets such as building, machinery, or they may be human assets such as employees. There is financial or economic consequences to the risk. Insurance protects against these risks. You can minimize the events but you cannot prevent it totally with no such history. In absence of insurance, person has to bear the loss.
Requirements
Certain requirements are necessary for a risk to be insurable: an insurance company is able to offer the protection against perils, because it operates a common pool where only a few can suffer loss in any one year.
Entire pool pays premium but liability for insurance company will be only to few in a year.
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 insured event, 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. You must know the cost, such as 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.
For example, in case of health insurance, it is determinable with the help of medical bills.
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 pure risk with only the possibility of full or partial loss.
Speculative risk is not insurable. For example, investing in the stock market may result in loss, but it may also result in gain and as such this is a speculative risk and therefore not insurable.
The ‘Principle of Indemnity’ implies that insurance will restore the financial situation of the insured to where it was before the event that caused the loss or damage. The intent of insurance should not be to make a profit or gain. If it were possible to insure against not making a profit from selling goods in a shop, there would be very little incentive to try to sell the goods if the owner knew the insurance company would step in and pay up anyway.
Chance of loss must be calculateable. Insurer must be able to calculate with some accuracy, average frequency and average severity of future losses.
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.
Fundamental Principles of Insurance
Insurance is a unique form of a contract that enables the transfer of risk from one party (the insured) to another party (the insurer). There are two fundamental principles under given circumstances: Utmost good faith (Uberrimae Fidei) Since the insured get better information about himself or herself than the insurer, there is an information asymmetry between the two parties.
The party that has less information i.e. insurer, therefore impose certain screening processes before entering into the contract. Medical test is a typical screening process. However, medical test has its limitations. It does not reveal all ailments or the family history. Therefore, the insurer agrees to enter into the insurance contract based on utmost good faith in the insured.
The obligation is on the insured to disclose all relevant information truthfully. Family history of medical conditions, medical history of the insured, habits regarding smoking and drinking, nature of the profession etc. have implications on risk perception. The Insured should disclose information before getting Insurance. If this is not done, the Insured is said to have acted in breach of good faith. At times, the insured does not reveal the relevant information. On that basis, the insurance policy may be issued.
However, when a claim comes up, investigation by the insurer may throw up the facts about the information that were suppressed. Based on that, the insurer has the right to reject the claim entirely. It is therefore in the interest of the insured to share all material information.
What material can be subjective.
Anything that can influence the insurer’s risk perception on the insured is material. When in doubt, it is safer for the insured to reveal the information, rather than suppress it. An Insurance policy is a promise from the Insurance Company to pay on the happening of certain risk that causes loss. It is better to fully disclose everything and pay a higher premium to cover the additional risk factor and be sure that the policy will pay up when the risk occurs.
In the absence of full disclosure, the Insurance Company may reject the claim. The lower premium paid would be a complete waste and more importantly the loss will not be reimbursed. Insurable interest The insurer will cover the risk only if the insured has an insurable interest in the subject matter of insurance. The test of insurable interest is that the insured should be better off if the risk does not materialise but will be adversely affected if the risk materialises.
For example, a business owner has an insurable interest on his inventory, but not in the inventory of a competitor. Family members i.e. direct dependents and relationships of blood and marriage have insurable interest in each other. In other blood relationships, such as aunts and uncles, cousins, nieces, and nephews, the insurable interest would not exist unless there is a proof of financial dependence. Lender has insurable interest in the borrower to the extent of the amount outstanding. Employers have insurable interest in their key employees.
Concepts in Insurance
a) Indemnity Insurance
Indemnity is “a duty to make good any loss, damage, or liability incurred by another”. An insurance contract is thus a classical contract for Indemnity. A good example would be health insurance that normally promises to make good the losses incurred due to hospitalisation expenses. Thus, any indemnity policy will require a determination of actual loss suffered by the insured person before a pay-out of a claim is made under the indemnity policy.
b) Benefit Insurance
A defined benefit insurance plan is different from an Indemnity Insurance. In a defined benefit insurance plan a fixed sum of money, based on pre-estimated amount of loss, is 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.
A defined benefit plan is used in situations where it is certain that a loss has been incurred due to the happening of the covered event but: it is difficult to ascertain the exact actual loss caused – such as the example of life insurance where the exact loss of future income caused due to the untimely death of the insured person is difficult to ascertain.
Another example could be a critical illness policy where again there is a loss of future income due to a critical illness but it is difficult to ascertain the exact loss caused due to this. The amount of loss is small and the cost of determining the “actual loss” might not be worth the actual amount of loss caused.
An example is a fixed amount paid as daily hospital allowance in some health insurance policies. This amount is to reimburse the losses caused due to personal expenses of the attendant or travelling expenses from residence to hospital, or lost wages of the insured and/or attendant etc. which might be difficult to ascertain on an exact basis.
Thus, if there is a fixed daily hospital allowance as a part of a health insurance policy then this portion is a defined in benefit plan in contrast to the main policy, which is an indemnity policy that reimburses the actual loss caused due to the expenses paid to the hospital directly.
Thanks for reading.
