An Introduction to Insurance

So, with all the talks about Uttarakhand disaster and LIC paying a record amount of money to the policy holders, insurance business has come into limelight like never before. And combine that with the talks of LIC holding stakes in some of the largest oil companies and others such companies, the whole business of insurance does become interesting!

So, what is Insurance?  Insurance is a form of risk management in which the insured transfers the cost of potential loss to another entity in exchange for monetary compensation known as the premium.  Now, what does that mean? Simply speaking,  insurance is risk management.

How?

Let me explain this through a very basic example. Say, you live in a village of 100 houses and it’s winter time. All of the families depend heavily on burning firewood to counter that. Now, as you might guess, fires will be a big concern  and somehow, you do calculate that there is one in a hundred chance of a house being burnt. Now, let’s say the price of reconstructing a house is Rs 10,000. So, a smart guy comes along and says that if everyone pays Rs. 110 rupees, he will pay the amount if any house burns! So, in effect, he gets RS 110*100=Rs 11000. Now, a house does get burnt and he does pay Rs. 10,000 to the family. So, in effect, the family whose house got burnt  got the amount he needed by just spending Rs 100 and the smart guy pockets Rs. 1000 as his profits. And all others who paid Rs 100 are actually happy seeing that an amount of Rs 100 secures his house, which would otherwise have cost them Rs 10,000!

       

The above story actually encompasses almost everything about insurance! Let’s see how!

The families were under pressure and if faced with the problem, here, their houses being burnt, would have suffered huge financial setbacks! So, they were under a risk! And what is a risk? Simply speaking, it is the probability of a loss occurring. And a smart guy saw that some people are under risk and sensed a business opportunity, wherein he could transfer their risks to himself and earn some money in the process! But then again, what if two houses caught fire. What if that number, in the highly unlikely case, goes to five? He will be broke! So, even he is under a risk that his calculations of the risk he is taking goes off chart (And this is where those FRM’s and Actuaries come into picture!)! Now, in pure business, even he can pass on those risks at some cost to some even smarter guy (In Technical terms, Insurers of the insurers).

And talking of technical terms, the families in the example are the insured and the smart guy is the insurer! And the amount of Rs 100 paid by every family is what we call a premium. An dthe amount of Rs.10,000 which will be given to the family whose house got burnt is what we call pledged amount or, sum assured! Simple enough, I believe!

Now, of course, there are various kinds of risks. Like a motor accident or a flood or your life or your shop getting looted or your house getting burnt! Fairly enough, there are various kinds of insurance. Broadly, it is divided into two parts: Life Insurance which insures life or in simple terms, promises a definite amount of money if someone (The insured dies) and Non-Life Insurance, such as theft insurance which promises to pay back the value of the goods stolen!

Insurance is appropriate when you want to protect against a significant monetary loss. Say, life insurance . If you are the primary breadwinner in your home, the loss of income that your family would experience as a result of our premature death is considered a significant loss and hardship that you should protect them against. It would be very difficult for your family to replace your income, so life insurance ensures that if you die, your income will be replaced by the insured amount. The same principle applies to many other forms of insurance. If the potential loss will have a detrimental effect on the person or entity, insurance makes sense. Now, you would not want to insure if you get a cold! That would not be worth the effort and the money involved!

Insurance works by pooling risk. What does this mean? It simply means that a large group of people who want to insure against a particular loss pay their premiums into what we will call the insurance bucket, or pool. Because the number of insured individuals is so large, insurance companies can use statistical analysis to project what their actual losses will be within the given class. They know that not all insured individuals will suffer losses at the same time or at all. This allows the insurance companies to operate profitably and at the same time pay for claims that may arise. For instance, most people have bike insurance but only a few actually get into an accident.

                      

                        Pooling Risks so that no one person has to pay the whole!

You pay for the probability of the loss and for the protection that you will be paid for losses in the event they occur!

So this was a general introduction to the business of Insurance. In the most basic sense, it is Risk Management! Though it is not easy and in fact, professionals are ther to manage risks for both the insured and the insurer! Let’s talk about Risk Management in the next article on the Insurance series!