Insurance: Definition, Types, Functions and Importance

Insurance: Definition, Types, Functions and Importance 1

Insurance: Definition, Types, Functions and Importance

WHAT IS INSURANCE ?

Insurance is a way or mechanism of transferring the insurable risk to an insurance company for a price called premium such that in the event of a loss, the insurance company will compensate the policyholder (individual or company) as per the terms set out in the insurance contract.

• Insurance works by creating a pool of homogenous risks from which the losses of the unlucky few are paid for by the premiums of the pool of risks from different policyholders.

• In the pool, each policyholder is charged a price that is equal to the level of risk that their property brings to that pool.

• Insurance as an industry is important to individuals, organizations and society as a whole.

Functions of Insurance

This refers to how insurance operates to manage the risks. The risks are transferred to the insurer by various individuals or organizations that are willing to pay up premium. The insurer has the responsibility of creating a financial pool out of which the few who suffer losses are compensated. There are three main functions of insurance and these are:

Risk transfer

It is a mechanism by which the financial consequences of an event are shifted from one party to another. Take an example of a property owner (landlord) asking a tenant to sign a tenancy agreement that holds the tenant responsible for any losses arising from the building catching fire.

Creation of a common pool
Insurance operates on the premise of large numbers where the insurer takes contributions in the form of premiums from individuals, corporate companies, government agencies/departments, non-government organizations, and business entities exposed to similar or homogeneous risks and creates a common pool/fund from which the insurer pays the few who suffer losses.

As in the example above, the insurance company would create a pool of residential house owners since they are exposed to similar or homogenous risks like theft, escape of water from its normal confines (tap and sink).

Equitable premium

It is a fair premium collected from members of a common pool that reflects the risk exposure that each of their risks brings to the pool. For example, a person proposing to insure a grass-thatched house would be charged a higher premium than that of a person proposing to insure an iron-roofed house.

Equitable premium should take into consideration the risk profile (frequency and severity of the risk) being passed onto the pool.

Each of the house owners in the example above would be charged premiums depending on a number of factors that include the location of the house, security systems installed, nature of the contents inside the house, etc. such that a house in upmarket Kololo and Naguru hills will be charged fairly lower on the factor of high security as compared to a house in the neighborhood of Bwaise where the chance of theft or burglary is close to 100% in a period of one year.

Importance of Insurance to an individual

• Insurance provides security and safety. For instance, where cover is taken for the assets of the business, the sole proprietor is guaranteed compensation in the event that they caught fire and that indemnification would safeguard the existence and continuity of the business.

• Insurance affords peace of mind. The major objective of any insurance cover is to provide peace of mind in the assurance that your losses have been taken care of by the insurance company and you will not need to deep into your pocket to cater for any expenses resulting thereof from the insured event

• Insurance protects mortgaged property. Where the individual uses the owned assets as collateral in a bank, the insurance company will have to state the interest of the specific bank/lender such that in the event of loss of the property through say accidental fire, then the insurance company will compensate the bank.

• Insurance eliminates dependency. This is better demonstrated for health funeral, and life insurance covers. For example in the event of a terminal illness, the insured will be compensated up to a limit that would help fend for his family without necessarily burdening the other family members

• Life assurance encourages savings profitable investment since premiums are usually paid on a monthly basis and that pool of money can then be used to invest in profitable ventures for higher returns.

Importance of Insurance to a Business/Company

• Uncertainty of business losses is reduced

• Business efficiency is increased since insurance compensation provides the necessary funds for business continuity

• Keyman indemnification In a company that has key employees with exceptional leadership, managerial and technical skills, the business will take up Keyman insurance such that in the event that it loses him/her to death, then the compensation shall be used to hire another of similar or related skills without having to incur extra costs say in recruitment.

• Enhancement of credit since the insurance policy can act as collateral for loans.

Importance of insurance to the economy

• The wealth of society is protected; e.g., the loss/damage of property by fire or accident can be well indemnified by property insurance.

• Insurance contributes to the economic growth of a country when, for instance, the pooled funds are deposited with commercial banks are accessed by borrowers to invest in the economy.

• The insurance industry creates jobs for insurance professionals.

The various types of risk

The various types of risk which we are exposed to are dynamic risk, static risk, fundamental risk, particular risk, pure risk, and speculative risk and there are life and general insurance available to cover us from such risks. Different types of insurance organizations have been formed to protect us from different kinds of risks. In this lecture, we will study the different types of Insurance organizations as well as the need and purpose of insurance.

2. DIFFERENT TYPES OF INSURANCE ORGANIZATIONS

Let us continue this topic with the discussion on different types of insurance organizations. With the advancement in insurance practices, different forms of insurance organizations emerged and these different forms of insurance organizations are self-insurance, individual insurer, partnership, joint stock companies, mutual companies, cooperative insurance organizations, Lloyd’s associations and state insurance.

Let us proceed our discussion with self-insurance, In the words of M.N Mishra-

In case of self-insurance, the person saves some fund periodically to meet the risk.

Though it is termed as insurance but it is not insurance because the burden of payment at the time of loss is not distributed amongst number of individuals. In this case, the insured becomes his own insurer but self-insurance may be good in case of operating several properties like house, factories, machines, motor vehicle, etc. It is good where risks are greater at one place and lesser at the other place. Self-insurance is better for ship owners but it is not ideal where risk can be easily estimated. The next type of insurance organization is individual insurer; an individual like other business can perform the job of insurer if he has adequate resources and talent to conduct the insurance business, such insurers are rarely found. The next type of insurance organization is partnership, in order to earn profit; partnership firms can carry out the insurance business.

It is to be noted that partnership firm is not a distinct entity than its partners composing it so the liability of the partners may be unlimited. It was popular before the joint stock companies came into existence.

3. DIFFERENT TYPES OF INSURANCE ORGANIZATIONS

So students, let us continue our discussion on the different types of insurance organizations, the next type of insurance organization is joint stock companies
The shareholders are the real owners of the joint stock companies. Shareholders subscribe necessary capital to start the business and then they share the profit mutually. The management of the company is the responsibility of the board of directors elected by the shareholders amongst themselves; there is a memorandum of association and article of association framed by the members. The joint stock companies can operate insurance business but the policyholders have nothing to do with the management of the joint stock companies. But in case of life insurance policy, the policyholders may share some portion of the profit of the company in the form of bonus.

The next type of insurance organization is mutual companies. In the words of M.N. Mishra, “the mutual companies with cooperative associations formed for the purpose of effecting insurance on the property of its members.”

The policyholders were also the shareholders and each member was both insurers as well as insured, the expenses were less because they considered it as their own company, the members participated in the management and shared the profit. If the income was more than the expenses, then it was used as saving and the premium was reduced in that case. The other type of insurance organization is the cooperative insurance organization, these are the concerns which are incorporated or registered under the Indian cooperative society’s act 1938. This act provides special provisions to these concerns but after nationalization, the societies were seized.

These concerns are also known as cooperative insurance society. Unlike mutual companies, these concerns are also not for profit organizations, the main aim of mutual companies is to provide insurance and protect its members at the lowest cost. The next type of insurance organization is Lloyd’s association, it was named after coffee house of Edward Lloyd, where underwriters assembled to transact business and to pick up news. It is the oldest form of insurance organization, the individual insurers, in this case, are known as underwriters or syndicates, if an individual wants to be a member of Lloyd’s association, then he has to deposit a particular amount of fee as security for regular payment of his liabilities. The association is merely a guiding and controlling body.

The other types of insurance organization is state insurance. In this case, the government owns and runs the insurance business and it does so for the benefit and welfare of the society. Particularly the life insurance is in control of the government, in India the life insurance business was nationalized in the year 1956 and the general insurance was nationalized in the year 1971. The insurance business in India is under the control of the central government through different types of insurance organizations.

Insurance need and importance

4. THE VARIOUS TYPES OF INSURANCE ORGANIZATIONS IN INDIA

Now let us discuss the various insurance organizations in India. Departmental organizations, corporations, and government companies are mainly the three types of organizations that are active in the insurance business in India.

Let us discuss the departmental organizations, departmental insurances are prevalent in the different departments of the central and state governments, for example, the state government of different states in India may provide life insurance to their respective employees. It may also provide sickness, maternity, disability, medical and pension insurance to its respective employees.

The other type of organization is corporations, there are basically four different types of corporations which are dealing in insurance business in India and these are Life insurance Corporation of India or the LIC, the general insurance corporation of India, the employee’s state insurance corporation and the deposit insurance corporation. Life Insurance Corporation was established under the Life Insurance Corporation of India act of 1956; all the Life insurance businesses including the annuities in India are owned by LIC. The next category is the General Insurance Corporation of India, it was established under the general insurance corporation of India act 1972, it is composed of 4 companies and these 4 companies are National Insurance Companies limited, New India Insurance Companies Limited, Oriental Fire and General Insurance Companies Limited, United India Fire and General Insurance Companies limited. These companies work separately in their area of business but are owned and controlled by the general insurance corporation of India. The next category of insurance organization in India is employee’s state insurance corporation, it was established in the year 1948, it provides social insurance to the laborers of factories who get less than Rs. 400 per month as wages. They are provided assistance in sickness, disability, maternity, medical expenses and assistance to their dependents is also provided.

The next category of insurance organizations in India is Deposit Insurance Corporation; it was established in the year 1962 and it provides protection to the depositors of the banks, in case if the bank fails, then the depositors can get their deposits back up to Rs. 10,000. The last category of insurance organizations in India is government companies, such companies were established by the government as per the provision of the company’s act, Export Risk Insurance Corporation was established to ensure against the export risk in the year 1957, later in the year 1964, its name was converted into export credit and guarantee corporation, so these were the various insurance organizations available in India.

Insurance types, benefits, purpose,

5. WHY INSURANCE

We need insurance because we are exposed to various kinds of risks and the purpose of insurance is to protect us from the loss caused due to those risks. Insurance plays a significant role in the development of the nation’s economy by providing the capital and it converts the uncertainty into certainty and thus brings mental peace to the individuals. Insurance companies evaluate the amount of loss and provide the amount to the insured to recover from the loss, the need and purpose of insurance can be understood through the different viewpoints, these different viewpoints are individual’s viewpoint, viewpoint of business and industry and the viewpoint of the society.

Let us begin with the need and purpose of insurance from the individual’s point of view, the various points included in this category are insurance provides safety and security to the individuals, insurance provide peace of mind, insurance protects the mortgaged property, insurance eliminates dependency, saving is encouraged through life insurance, profitable investment is encouraged by life insurance and the needs of the individual are fulfilled by life insurance. Let us discuss these points in detail, the first point is insurance provides safety and security, insurance provides safety and security to the individual against the loss caused due to the happening of a certain event for which he was insured.

In the case of life insurance, individual as well as his family are protected by the insurance company. The insured gets the amount of insurance at the time of expiry of the policy or due to premature death of the earning member of the family, the insured get the amount of insurance at the time of expiry of the policy or due to his premature death, his family members get insurance amount and this provides safety and security to the insured as well as his family members at the time of loss. Similarly, if the property is insured, then the insured gets the amount of insurance if the property catches fire or is damaged due to any loss or risk, again in this case, the insurance provides safety and security to the insured as well as its dependents.

The next point is insurance provides peace of mind, an individual purchases insurance policy with the primary aim of security, if the individual keep worrying about his life, his dependence, and his property, then he will not be able to concentrate on his mind in the constructive activities and will not be able to work properly. Insurance provides a great deal of security to the insured and leaves him tension free about his life, his dependents, and his property because, in case of loss, insurance company promises the insured to cover all the losses. The risks are uncertain and the insurance policy converts the uncertainty into certainty and thus brings peace of mind to the individual.

The next point is insurance protects the mortgaged property, if the owner of the mortgaged property expires, then at the time of his death, his property is taken over by the lender and the dependents of the deceased person are deprived of the uses of the property, but if the mortgagee gets the mortgaged property insured, then in case of loss or damage to the property, he will get the amount from the insurance company to recover from the losses. Similarly, if the mortgagee dies, then the insurance company provides the insurance amount to his dependents so that they may pay off the loan taken on the mortgaged property.

6. NEED AND PURPOSE OF INSURANCE

Let us continue this topic with the need and purpose of insurance from the viewpoint of the individual, the next point here is insurance eliminates dependency, at the time of death of the income earning member of the family, his family members or his dependents lose their economic freedom and they suffer the agony of losing the income earning person as well as losing their financial freedom. So they are forced to ask for monitory help from the friends and relatives and their situation becomes pitiable, but if the income earning member is insured, then at the time of his death, the insurance company will take care of his dependents and will financially assist them and make them financially independent.

The next point is saving is encourage through life insurance, life insurance provides both protection and investment to the insured but in case of property insurance, only the element of protection is present, in some of the life insurance policies, the element of saving and investment is dominating, such policies encourage systematic saving against the timely and regular payment of premium by the insured. In insurance premium, amount cannot be withdrawn so the savings remain with the insured to be enjoyed over a longer period of time, the insurance company provide full insurance amount irrespective of the premium deposited like in case of premature death of the insured, full amount is provided to his dependents, in insurance insured is bound to pay the premium so he makes an investment and this will help him in the long run.

The next point is profitable investment is encouraged through life insurance, individuals through life insurance policies unwillingly or unable to handle their funds get a good option to invest. These different forms of investment are endowment policy, multipurpose policies and deferred annuities. Such investment has an element of regular saving, capital formation and return on capital, in India insured is exempt from income tax, wealth tax, and gift tax.

Next point is needs of individual are fulfilled by life insurance policy, the need of individual like family needs, old age needs, readjustment needs, special needs and clean up needs get fulfill through life insurance, let us understand how. It is certain that every individual who is born in this world will die someday or the other but the time of death is uncertain, so the time of sufferings and financial problems is also uncertain, in case of insurance policy purchased by the deceased person, assistance is provided to his dependents so that they become financially independent.

Similarly, the provision of old age need is required when the person is surviving more than his earning period, different types of insurance policies are available which provide the amount to the insured to fulfill his old age needs so that he does not have to become a burden on his family members. Reduction in income of an individual may be due to unemployment, disability or death and this requires adjustment in the standard of life of the individual, life insurance policy provides the platform for the insured as well as his dependents to adjust to this change and it does so through endowment policy, anticipated endowment policy and guaranteed triple benefit policies. There are certain special needs like need for education, marriage, and need for settlement of the children for which the earning member of the family is responsible and if these needs are not fulfilled, then the family suffers a lot.

There are certain insurance policies and annuities available which are useful for the education of the children irrespective of the death or survival of the income earning person or the insured. The insurance policy provides funds for the marriage of the daughter of the insured irrespective of his survival, similarly insurance provides for the settlement of the children of the insured when they are done with their education. After the death of the insured, the ritual ceremonies, payment of income and wealth tax is taken care of by the insurance company, so these were the special needs and for the fulfillment of these special needs, multipurpose policies, education, and marriage policy and capital redemption policies are available.

7. THE NEED AND PURPOSE OF INSURANCE FROM THE VIEWPOINT OF BUSINESS AND INDUSTRY

Now let us talk about the need and purpose of insurance from the viewpoint of business and industry, the various points included in this category are insurance reduces the uncertainty of business losses, insurance increases the efficiency of the business, insurance provides key man indemnification, insurance enhances credit, insurance helps in continuation of business, insurance encourages welfare of the employees. Let us continue this lecture with the first point that is insurance reduces the uncertainty of business losses, in business property is employed and if there is negligence towards the property, then it may turn into ashes. Accident may cause loss to the individual, property as well as the third party, reconstruction cost may be higher, in such case if the property is insured then the insured can claim the amount of loss from the insurance company and in this way, he feels secure about the business as well as his dependents.

The next point is insurance increases the efficiency of the business, insurance provides mental peace to the individual and in this case, the insured is relieved from the worry and he can devote more time to the business and can find out more ethical ways to maximize his profit. Insurance converts uncertainty into certainty by providing the insurance amount at the time of loss. The next point of need and purpose of insurance from the viewpoint of business and industry is insurance provides key man indemnification, key man is the particular man who has the expertise, experience as well as the management skills that makes him the asset for the business, in case if the life of such a person is lost, then the business will lose an asset and at the same time, training and employing a new person in his place will be expensive for the business. The dependents of the key man also require special provisions and financial assistance if his life is lost on duty. In such situation, term insurance policy or convertible term insurance policy fulfill such purpose for the business.

The next point is insurance enhances credit, business can obtain loan by pledging the insurance policy as the collateral for the loan. Insured get more amount of loan due to certainty of payment at the time of his death. In case of death of the insured, the cash value obtained from the insurance company can be utilized in repayment of loan along with the interest. If the insured is unable to repay the amount, then the lender can surrender the insurance policy and get the loan repaid along with the interest. The next point is insurance helps in continuation of the business, in the partnership business, the business may discontinue due to the death of one partner and there may be financial problems to the firm as well. If each partner in the insurance firm is insured, then the insurance company will pay the amount at the time of his death.

In this way, business, as well as the dependents of the deceased person, will not suffer financially and the same is the case with the property insurance. The next point is insurance encourages the welfare of the employees; the welfare of employees is the responsibility of the employer because the employees work for the employer. The employer must provide the provision for the death, disability or old age of the employees, life insurance, accidental insurance, sickness benefits, and pension are provided by general insurance, premium for group insurance is paid by the employer, this plan is cheap, reliable and secured, such policies help in maintaining good relationship between the employer and the employees.

8. THE NEED AND PURPOSE OF INSURANCE FROM THE VIEWPOINT OF SOCIETY

So dear readers, let us continue this topic with the need and purpose of insurance from the viewpoint of the society, the various points included in this category are insurance protects the wealth of the society, insurance encourages economic growth, insurance reduces inflation.

Let us discuss the first point that is insurance protects the wealth of the society, individuals make the society and insurance provides the life insurance policy to the individuals, this not only helps in compensating the loss of the skillful and talented human beings but provides financial assistance to the dependents of the deceased person. Various types of insurance like cattle insurance, crop insurance, and property insurance are available and such insurances promote security, this security is about the life and property, this makes the individual tension free and promotes mental peace in the society, insurance promotes education and advancement and helps the society grow by providing security to the people in the society against the various types of risk which they are exposed to.

The next point is insurance encourages economic growth, insurance provides security of life as well as property and provides capital to generate more money. Machine, cattle and crop insurance protects against the different types of losses, employee insurance and other types of insurance related to business provide confidence to the parties related to the business and the business itself. Thus insurance helps in economic growth of the country, the next point is insurance reduces inflation, insurances help in narrowing down the inflation gap by collecting the premium and investing the same. It helps in making the funds available when required, the main cause of inflation is increased money in supply and decreased production, this is controlled by insurance, so students, this was the need and purpose of insurance and we also discussed the various types of insurance organizations in this lecture, in the next lecture we will talk about the insurance contract, thank you students.

INSURANCE COMPANIES

Insurance companies are essential for the stability of financial systems mainly because they are huge investors in financial markets because there are growing links between insurers and banks and because insurers are safeguarding the financial stability of households and firms by insuring their risks.

This special feature discusses the main reasons why insurance companies can be important for the stability of the financial system. It also highlights the special role of reinsurers in the insurance sector and discusses some of the key differences between insurers and banks from a financial stability point of view.

Traditionally, the insurance sector has been seen as a comparatively stable segment of the financial system. This is mainly because most insurers’ balance sheets, unlike those of banks’, are composed of relatively illiquid liabilities that protect insurers against the risk of rapid liquidity shortages that can and do confront banks. In addition, insurers are not generally seen to be a significant potential source of systemic risk. One of the main reasons for this view is that insurers are not interlinked to the same extent as banks are, for instance, in interbank markets and payment systems.

The insurance sector can, however, be a source of vulnerability for the financial system, and the failure of an insurer – an event that has occurred from time to time – can create financial instability. In addition, the traditional view that insurers pose a limited systemic risk can be challenged, however, because it does not take account of the fact that interaction between insurers, financial markets, banks, and other financial intermediaries have been growing. It is

important, however, to recognize that insurance companies, given their role as mitigators of risk and their often long-term investment horizons, often also support financial stability.

INSURANCE COMPANIES AND FINANCIAL STABILITY

There are three main reasons why insurers are important for the stability of the financial system.
1. First, insurers are large investors in financial markets.
2. Second, insurers often have close links to banks and other financial institutions, and problems confronting an insurer can, therefore, spread to the banking sector.

3. Third, insurers contribute to the safeguarding of the stability of household and firm balance sheets by insuring their risks.

THE DIFFERENCE BETWEEN BANKS AND INSURANCE COMPANIES

Banks have a special role in the financial system on account of their central role in the transmission of monetary policy and their participation in payments systems.
The interconnections between banks in interbank markets and payment systems can also cause problems faced by one bank to spread to others. Banks are therefore of particular importance for financial system stability. This importance is exacerbated by the fact that banks’ assets (such as customer loans) are mostly long-term in character, whereas their liabilities (such as deposits) are of shorter-term duration. This leaves the banks vulnerable to depositor runs that can result in liquidity shortages.
Insurers on the other hand, unlike banks, generally, have liabilities with a longer maturity than their assets, which makes them less vulnerable to customer runs. In addition, insurers’ liabilities are usually less liquid than bank deposits, as the possibility of withdrawing savings is restricted in most insurance contracts and is also more costly for customers.

As discussed above, the insurance sector can be of considerable importance to financial system stability, but insurers do not pose the same systemic risk for the financial system as banks. This is because insurers are not as closely interconnected as banks are since they do not directly participate in payments systems. This does not necessarily, however, mean that simultaneous defaults are less likely to occur in the insurance sector than in the the banking sector, at least not during periods of financial turmoil.

The traditional view that insurers pose less systemic risk than banks did not take into account the growing interaction between insurers, financial markets, banks, and other financial intermediaries. As insurers are increasingly more involved in financial transactions with other financial intermediaries, such as banks, the potential for problems confronting an insurer to spread in the financial system has increased. In addition, insurance-linked securities market (with instruments such as catastrophe bonds) has created direct links between insurers as they sometimes buy such securities to diversify their own risk exposure, while benefiting from investment in instruments linked to their area of expertise.

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