Insurance in simple terms is a contract between two parties to cover the risks which may incur in the due course of life. There are basically two types of risk: one is speculative risk and the other is pure risk. Speculative risk is a risk which yields either a profit or a loss or a no change, and pure risk is a risk which yields either a loss or effects to a no change situation. Insurance can cover only pure risk because insurance works under the principle of putting back the party in same position as they were before the loss occurred.
There are broadly two categories of insurance. One is general insurance and the other is life insurance. Insurance in the life category can be further divided into whole life policies, term insurances, endowment assurance and pure endowment. General insurances are available for a wide range of risks such as health insurance, motor insurance, fire insurance, marine insurance, etc.
Insurance players also work on reinsurance. Reinsurance means when an insurance company transfers risk or a part of the risk to another insurance company. There are two types of reinsurances; one is facultative reinsurance which means analysing policies on an individual basis and then deciding which risk is to be transferred and how much. The second type of reinsurance is reinsurance by treaty. In this type of reinsurance there is an agreement between ceding company and accepting company. Reinsurance companies in case of later kind of reinsurance state what amount of or kind of risks they are ready to accept. Facultative reinsurance is not that popular because of the administrative hassles involved in analysing the risks in each policy and then transferring the risk.
All contracts of life insurance are valued contracts while general insurance are contract of indemnity. Valued contracts are those contracts in which the sum assured depends on what the policy holder feels like placing on insured’s life. Contract of indemnity is when a property has a value and is insured for only that much. Therefore a person can have as many life insurance policies as he feels like and can assure his life for the sum that he feels like, provided he is in a position to pay the premiums. In case of a general insurance contract one cannot receive benefits from more than one policy on a property. Say for example a building has a value of 10 lacs and has been insured for 10 lacs from two insurance companies then in case of claims he can claim only from one insurance company and hence the premium paid towards the other policy becomes null and void.
Insurance companies now a day’s undertake a process to classify risks into different categories depending on the intensity or probability of the occurrence of the risk covered. Insurance as we all know is a subject matter of solicitation .i.e. one should seek for it and it should not be sold. So the person who wishes to insure his life or his property must submit a proposal in the form of application form to the insurance company from which he wants insurance. The insurance companies then scrutinize these proposals and decide what premium needs to be charged based on the category of risk it falls into. This process of classification is called as underwriting process. This is based on the underwriting standards of an insurance company.
There are basically four categories in which the risk to be covered in the proposal are classified into :
This is a perfect situation as in the premium charged is very nominal. An example would be a life aged 35yrs of age with no ailments seeking for a whole life policy. Any insurance company will accept this policy proposal.
This is slightly riskier than preferred risk category; insurance companies will accept these kinds of proposals for a higher premium.
This is in the high risk zone category only as per the insurance companies standards however; they accept the proposal for very high premium amounts. Say for example a person aged 45yrs of age who is a diabetic for the past 5 years and a BP patient for last 10 years and also has heart problem.
This is the category of risk which the insurance companies will not accept at all.
Based on the category the proposal falls into decision as to the acceptance and premium is taken by insurance companies. All insurance companies have their own hired expertise to do the underwriting work. Underwriting plays a crucial role in insurance business because any error in the classification of these risks might lead to losses to the company. Now a day’s re-insurance companies have started involving themselves in the underwriting process of other insurance companies to be assured of the kind of risks they are accepting from these companies.
The purpose of an insurance policy is to protect the family members of a person from any financial complexities in case of his/her premature death. Such unfortunate eventuality to a breadwinner in the family can put the other family members in serious financial problems. Insurance seeks to offer financial help in such times.
This, therefore, must be the main objective for buying an insurance policy. Any other benefit such as tax advantage etc. must be of secondary consideration.
The primary aim of the insurance policy is to provide a risk cover. Therefore a part of the premium paid is first appropriated towards this purpose. The balance amount is invested in financial instruments, which are generally very safe ones. Also, the commissions and charges are substantially higher than other investment options.
Consequently the returns from an insurance policy are nothing much to talk about therefore it cannot be considered as a feasible investment option in comparison with other competing financial products.
Term policies are pure insurance products with no investment option. They are the cheapest and the simplest among the available plans. But cheapest does not mean they are inferior to other costlier insurance policies. As far as the basic purpose of risk cover is concerned, there is no difference. And usually for most of us this term policy must be more than sufficient.
In such policies the premium paid is foregone at the expiry of the policy and one does not get anything if one survives the policy term. This fact that one does not get anything back is possibly the most important psychological factor for the low popularity of a term policy.
In contrast to the term policies, savings-linked insurance policies are such as money-back, endowment and whole-life provide the risk cover and also give back some returns to the insured at the end of the policy term, in case nothing happens to him/her in the interim. The premiums of such policies are much higher than the term policies. This assurance of getting some returns at the end of the policy term is why most people choose for such savings-linked policies in comparison with term policies.
They however fail to understand the fact that a part of the premium is anyway earmarked to provide for risk cover. Then a part of the premium goes towards paying commissions, administrative and other charges. And it is only the balance amount, which gets invested to provide some returns to the insured at the end of the day. These returns are normally very low as the investment is made in risk-free low-return options.
Therefore, a person may be wealthier if he were to buy the cheaper term policy and invest the balance amount, which would have otherwise gone towards high premiums of saving-linked policies, like MFs. In this way he would be risk-covered and also generate higher returns.
From their business viewpoint the insurance companies and the agents may be keener to sell saving-linked policies in comparison with the term policies, as the premiums and commissions are much higher. And hence the advertisements and promotions may speak more about such policies. Therefore, it is for the insured to keep his interests & needs in mind and not be carried away by influential agents and publicity.
Unit Linked Insurance Policies (ULIPs) offer an alternative to traditional policies where the returns will be market-linked. Further, one can also choose one’s own investment objective amongst equity, debt and balanced funds.
However, the charges in the first years are quite high. Thus the actual benefit of ULIP starts accruing only if one has a long-term investment horizon. The minimum lock-in period of 3-5 years may look attractive, but is too short a period to fully reimburse for the high charges in the first 2-3 years. ULIP can prove to be a good investment option (together with insurance) if one keeps paying premium for at least for 10 years.
Insurance is for the benefit of the dependents. Thus, if you are single with no one being financially dependent on you, it is not necessary for you to buy an insurance policy.
If you are a person of plentiful means, you have lots of wealth – properties, bank balances, investments, etc. in your absence; this may be more than enough for your family and dependents to continue living comfortably. A few lakhs of rupees from an insurance company may not make any material difference to their future financial security.
Any unfortunate eventuality involving a child is no doubt emotionally very shocking. But it usually does not hurt the family financially. Whereas, insurance cover is for justifying the financial difficulty, that may arise with the death of the insured. Therefore, taking a policy for a child is meaningless. It is a needless expense.
As they say ‘the devil is in the details’. Therefore, understand the characteristics of the policy, the charges etc., before you buy an insurance policy. Further, most insurance companies offer a 15-day look-in period after you have taken the policy. Go through the terms and conditions in the policy very carefully. And if you feel that it does not meet your necessity, you can cancel the policy. You may have to pay some administrative charges, but this would be much better than investing on to a bad policy for years to come.
Insurance is a long-term contract generally spanning over decades. Also, these contracts have very little flexibility. A wrong insurance product can financially injure for a very long time, unlike many other financial products. Therefore, one should be extra careful and cautious when deciding on how much to insure, how long to insure, which policy to buy, etc.