Introduction to Insurance
Contents :
1. Meaning of Insurance
2. Characteristics of Insurance
3. Requirements of an insurable risk
4. Difference between insurance and assurance
5. Benefits of Insurance
6. Functions of insurance
7. Insurance company operations
8. Development of insurance in Nepal
9. Gambling
10. Insurance and Hedging
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Insurance
Insurance is a cooperative device to spread
the loss over a number of person who are
exposed to insurance contract.
Insurance is an agreement between parties namely insurer and insured in which insured agrees to pay the premium regularly to the insurer and insurer undertakes the responsibility to compensate the losses caused by specific risks or incidents.Insurance refers to a contractual arrangement in which one party, i.e. insurance company or the insurer, agrees to compensate the loss or damage sustained to another party, i.e. the insured, by paying a definite amount, in exchange for an adequate consideration called as premium. It is often represented by an insurance policy, wherein the insured gets financial protection from the insurer against losses due to the occurrence of any event which is not under the control of the insured. Insurance is the pooling of fortuitous losses by transfer of such risks to insurers, who agrees to indemnify insured for such losses, to provide other pecuniary benefits on the occurrences, or to render services connected with the risk.
Basic Characteristics of Insurance
Four characteristics of an insurance are as follows:
1. Pooling of losses
2. Payment of fortuitous losses
3. Risk transfer
4. Indemnification
1.Pooling of losses:
Pooling is the spreading of losses incurred by the few over the entire group, so that in the process, average loss is substituted for actual loss. It implies prediction of the future losses with some accuracy based on the 'law of large numbers'.
2. Payment of fortuitous losses:
A fortuitous loss is one that is unforeseen and unexpected events occurs as a result of chance. Law of large number is based on the
assumption that losses are accidental
and occur randomly.Insurance policies do not cover intentional losses.
3. Risk Transfer:
Risk transfer means that a pure risk is
transferred from the insured to the insurer,
who typically is in a stronger financial position to pay the loss than the insured. Pure risk includes the risk of premature death, poor health, disability, destruction and theft property etc.
4. Indemnification:
Indemnification means that the insured is restored to his or her approximate financial position prior to the occurrence of the loss.
Requirements of an Insurable Risk
Insurer normally insure only pure risk. Not all
pure risks are insurable.
Six requirements of an insurable risks:
1. There must be a large number of exposure
units.
2. The loss must be accidental and unintentional.
3. The loss must be determinable and
measurable.
4. The loss should not be catastrophic.
5. The chance of loss must be calculable.
6. The premium must be economically
Large Number of Exposure Units:
There should be a large group of similar,
not necessarily identical, exposure units
that are subject to the same peril or
groups of perils. Purpose of this requirement is to let the insurer to predict loss based on the law of large numbers.
Accidental and unintentional loss:
Loss should be fortuitous and outside the insured’s control. If an individual deliberately causes a loss, he or she should not be indemnified for the loss. Two purposes of this requirement are:
i) If intentional losses were paid, moral hazard would be substantially increased and and premiums would rise as a result.
ii) Law of large number requires random occurrence of events. As intentional loss is controlled by the insured, prediction of future experience may be highly inaccurate.
Determinable and measurable loss:
Loss should be definite as to cause, time, place, and amount. Life insurance in most cases meets this requirement easily. Some losses are difficult to determine and measure. For example, under a disability income policy, the insurer promises to pay a monthly benefit to the disabled person if the definition of disability stated in the
policy is satisfied. Some dishonest claimants may deliberately fake sickness or injury to collect from the insurer. Even if the claim is legitimate, the insurer must still determine whether the insured satisfies the definition
of disability. Purpose of this requirement is to enable an insurer to determine if the loss is covered under the policy.
No catastrophic loss:
This is to ensure that a large proportion of exposure units should not incur losses at the
same time.If not, the pooling of losses principle is violated and premium will increase prohibitively.Reinsurance is used by the insurer in order to avoid the concentration of loss exposures in a geographic area.
Calculable chance of loss:
Both average frequency and the average severity of future losses with some accuracy.
Purpose of this requirement is to assess the
appropriate premium. Certain losses are difficult to insure because the chance of loss cannot be accurately estimated, and the potential for a catastrophic loss is present, i.e., floods, wars, cyclical unemployment due to an irregular basis, etc.
Economically feasible premium:
For the insurance to be attractive purchase, the premiums paid must be substantially less than the face value, or amount, of the policy.
To have an economically feasible premium, the chance of loss must be relatively low.
Difference Between Insurance and Assurance
Insurance is defined as an arrangement, in
which the insurer commits to indemnify the loss or damage caused to the insured due to natural calamity or any other event whose happening is not certain, for special consideration.
Assurance refers to the agreement in which the insurer provides cover of an event, which will happen sooner or later, such as death.
Benefits of Insurance
Insurance is important because both human
life and business environment are characterized by risk and uncertainty. Insurance plays a key role in minimisation of
risks.
Benefits of Insurance to individual:
1. Insurance provides security against risk and uncertainty.
2. It enables the insured to concentrate on his work without fear of loss due to risk and uncertainty.
3. It inculcates regular savings habit, as in the case of life insurance.
4. The insurance policy can be mortgaged and funds raised in case of financial requirements.
5. Insurance policies, especially pension plans provide for income security during old age.
6. The insured gets tax benefits for the amount of premium paid.
7. Insurance of goods may be a mandatory
requirement in certain contracts.
Benefits of Insurance to society:
1. Insurance is an important risk mitigation
device.
2. Insurance companies provide the required
funds for infrastructure development.
3. It provides a sense of security.
4. Insurance provides security to the insured during his life and to his dependents.
5. It provides employment opportunities. With the entry of private insurers employment opportunities have increased greatly.
Functions of Insurance
A. Primary Functions of Insurance:
1. provides certainty:
Insurance provides certainty of payment at the uncertainty of loss.The uncertainty of loss can be reduced by better planning and administration.There is the uncertainty of happening of time and amount of loss. Insurance removes all these uncertainties and the assured is given certainty of payment of loss.The insurer charges the premium for providing the said certainty.
2. provides protection:
The main function of insurance is to protect the probable chances of loss. The time and amount of loss are uncertain and at the
happening of risk, the person will suffer the loss in the absence of insurance. The insurance guarantees the payment of loss and thus protects the assured from sufferings. The insurance cannot check the
happening of risk but can provide for losses at the happening of the risk.
3. Risk-Sharing:
All business concerns face the problem of risk. Risk and insurance are interlinked with each other. Insurance, as a device is the outcome of the existence of various risks in our day to day life. It does not eliminate risks but it reduces the financial loss caused by risks. Insurance spreads the whole loss over the large number of persons who are exposed by a particular risk.
B. Secondary Functions of Insurance:
1. Prevention of loss:
The insurance joins hands with those institutions which are engaged in preventing the losses of the society because the reduction in loss causes the lesser payment to the assured arid so more saving is possible which will assist in reducing the premium. Therefore, the insurance assists financially to the health organizations, fire brigade, educational institutions and other
organizations which are engaged in preventing the losses of the masses from death or damage.
2. It Provides Capital:
The insurance provides capital to society. The accumulated funds are invested in the productive channel. The death of the capital of the society is minimized to a greater extent with the help of investment in insurance. The industry, the business, and the individual are benefited by the investment and loans of the insurers.
3. It Improves Efficiency:
Insurance eliminates worries and miseries of losses at death and destruction of property.
The carefree person can devote his body and soul together for better achievement, it improves not only his efficiency but the efficiencies of the masses are also advanced.
4. It helps Economic Progress:
The insurance by protecting the society from huge losses of damage, destruction, and death, provides an initiative to work hard for the betterment of the masses. The next factor of economic progress, the capital, is also immensely provided by the masses. The property, the valuable assets, the man, the machine and the society cannot lose much at the disaster.
Insurance Company Operations / Functions of Insurer
The most important insurance company
operations consist of the following:
● Ratemaking
● Underwriting
● Production
● Claim settlement
● Reinsurance
● Investments
● Insurers also engage in other operations,
such as accounting, legal services, loss
control, and information systems.
Rating and Ratemaking:
Ratemaking refers to the pricing of insurance and the calculation of insurance premiums. A rate is the price per unit of insurance. An exposure unit is the unit of measurement used in insurance pricing, which varies by line of insurance.The person who determines rates and premiums is known as an actuary . An actuary is a highly skilled mathematician
who is involved in all phases of insurance company operations, including planning, pricing, and research.
Underwriting:
Underwriting refers to the process of selecting, classifying, and pricing applicants for insurance.The underwriter is the person who decides to accept or reject an application. Underwriting starts with a clear statement of underwriting policy. An insurer must establish an underwriting policy
that is consistent with company objectives.The insurer’s underwriting policy is determined by top-level management in charge of underwriting.
Production:
The term production refers to the sales and
marketing activities of insurers. Agents who
sell insurance are frequently referred to as
producers .Life insurers have an agency or sales department. This department is responsible for recruiting and training new agents and for the supervision of general agents, branch office managers, and local agents. Property and casualty insurers have
marketing departments. To assist agents in
the field, special agents may also be appointed.
Claims Settlement:
Every insurance company has a claims division or department for adjusting claims. This section of the chapter examines the basic objectives in adjusting claims, the different types of claim adjustors, and the various steps in the claim-settlement process.Basic Objectives in Claims Settlement includes: Verification of a covered loss, Fair and prompt payment of claims,Personal assistance to the insured etc.
Reinsurance:
Reinsurance is an arrangement by which the primary insurer that initially writes the insurance transfers to another insurer (called the reinsurer) part or all of the potential losses associated with such insurance . The primary insurer that initially writes the insurance is called the ceding company .The insurer that accepts part or all of the insurance from the ceding company is called the reinsurer. The amount of insurance retained by the ceding company for its own account is called the retention limit or net retention .
Investments:
The investment function is extremely important in the overall operations or insurance companies.Because premiums are paid in advance, they can be invested until
needed to pay claims and expenses.The funds available for investment are derived primarily from premium income, investment earnings, and maturing investments that must be reinvested.
Other Insurance Company Functions:
-The electronic data processing area maintains information on premiums, claims, loss ratios, investments, and underwriting
results.
- Computers are widely used in many areas, Including policy processing, simulation studies market analysis, and policyholder
services.
- The accounting department prepares financial statements and develops budgets
- In the legal department, attorneys are used in advanced underwriting and estate planning.
Development of insurance in Nepal
Three Phases:
1. Pre-committee period (till 1967)
2. Pre-board period (1968-1991)
3. Board Period (1992 onwards)
Pre-committee period (till 1967):
*The history of financial system began in 1937 AD with NBL's establishment.
*First insurance company 'Nepal Mal Chalani Tatha Beema Company (Nepal Transport and Insurance Company Limited) as a subsidiary of established in 1947 (2004 BS) as per the company act 1936.
*The Mal Chalani Company was established to provide insurance facilities against fire and theft while carrying cash and goods from one place to another place.
*The company also helped export and import through insurance services.
*Till 1968, there was no insurance regulatory authority or committee had formed.
*Insurance companies were registered under government authority and did the business without any regulation and special supervision.
*At that period, only two non-life (general) insurance companies: Nepal insurance and oriental insurance companies were established.
Pre-board period (1968-1991):
Government planned two things:
a) Establishment of state-Owned insurance companies and
b) Forming a regulatory authority
* A Committee was formed and it suggested government to form state owned insurance company.
*At the beginning, Rastriya Beema Sansthan was formed as a private company under company Act, but after the enactment of Rastriya Beema Sasthan Act 2005, t was converted into government owned enterprise
*In 2025, government enacted company act.
*A committee formed under the ministry of finance worked as regulator and supervisor of insurance companies.
*During the period, three insurance companies were established :
i) Rastriya Beema Sansthan, (life and non-life),
ii) National insurance Co. Ltd.[Life)
iii) National life insurance co. Lidt(Life)
Board Period (1992 onwards):
*Insurance act 1992, was enacted after the change in political System.
*Insurance regulation 1995 came into force.
*After the formation of insurance board in 1992, Insurance committee dissolved and all the responsibilities or the then committee is transferred to the board.
*Financial liberalization policy of government encouraged many domestic and foreign investors to invest in insurance business
*During the period, 20 additional companies (15 general insurance companies) were established.
*Insurance act was amended two times in 1996 and 2003.
*There are 16 insurance companies till 2016 A.D
*Currently there are altogether 20 non life insurance , 19 life insurance and 2 Reinsurance companies doing their business in Nepal.
Gambling
Gambling (also known as betting) is the wagering of money or something of value on an event with an uncertain outcome, with the primary intent of winning money or material goods. Gambling thus requires three elements to be present: consideration (an amount wagered), risk(chance), and a prize. The outcome of the wager is often immediate, such as a single roll of dice, a spin of a roulette wheel, or a horse crossing the finish line, but longer time frames are also common, allowing wagers on the outcome of a future sports contest or even an entire sports season. Insurance and gambling seem to be same in some extent. Insurance is often erroneously confused with gambling. But actually there is great difference in nature and function between them. The basic difference among them can be summarized as given below:
1. Exacting risk and creation of risk:
Insurance is a technique for handling an already existing pure risk. For example, we pay $ 20 an insurer for auto insurance; the risk of vehicle accident is already present and is transferred to the insurer by a contract. No new risk is made by the transaction. But gambling creates a new speculative risk. For example, we bet $100 on football game, anew speculative risk is created.
2. Interest in the prevention of a loss: Insurance and the insured both have a common neither the insurance not the insurer is place in apposition where the gain of the winner comes at the expense of the loser. But gambling is socially unproductive, because the winner’s gain comes at the budgets of the loser.
3. Minimizing uncertainty and increasing uncertainty:
Insurance helps to minimize the uncertainty and risks in the society, hence it promotes industrialization and economic development. In contrast, gambling increases uncertainty,
risks and conflict in the society. It does not promote industrialization. Rather than it increases people’s will to earn money by speculation or luck, not by honest activities of labor. Hence gambling increases bad people and social crime.
4. Restore:
Generally, insurance contract restore the insured financially in completely of partially if a loss occurs. In contrast, consistent gambling transactions generally never restore the losers to their former financial position.
5. Prevention of loss:
Insurer and the insured both have a common interest in the prevention of a loss. Both parties win if the loss doses not occur. But in case of gambling one can win only if the second party loses financially.
Insurance and Hedging
The concept of hedging is to transferring the risk to the speculator through purchase of future contracts .An insurance contract, however, is not the same thing as hedging. Although both technique are similar in that risk is transferred by a contract, and no new risk is created, there are some important
difference between them.
- First, an insurance transaction involves the transfer of insurable risks, because the requirement of an insurable risk generally can be met .However, hedging is a technique for
handling risks that are typically uninsurable ,such as protection against a decline in the price agriculture products and raw materials.
- A second difference between insurance and hedging is that insurance and hedging is that insurance can reduce the objective risk of an insurer by application of the law of large numbers. As the number of exposure units increases, the insurer’s prediction of future losses improves, because the relative variation of actual loss from expected loss
will decline Thus, many insurance transactions reduce objective risk.
- In contract, hedging typically involves only risk transfer , not risk reduction. The risk of adverse price fluctuation is transferred because of superior knowledge of market
conditions. The risk is transferred, not reduced, and prediction of loss generally is not based on the law of large numbers.
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