Need Purpose & Working Mechanism of Insurance

1. Purpose, Need & Working Mechanism of
Insurance
Prof. Sidharth Raja Halder

2. Introduction to Principles & Practices of Life Insurance INS106
Introduction to Principles & Practices of Life Insurance
INS106
Concept Building
It is a benefit because it meets some
of his needs.
The business of insurance is related
to the protection of the economic
values of assets.
In the case of a factory or a cow, the
product generated is sold and an
income is generated.
Every asset has a monetary value.
In the case of a motor car, it
provides comfort and convenience
in transportation although, there is
no direct income.
The asset would have been created
through the efforts of the owner.
Every asset is expected to last for a
certain period during which it will
perform, after which, the benefit
may not be available.
The asset is valuable to the owner,
because he expects to get some
benefits from it.
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There is a life-time for a machine in
a factory or a cow or a motor car.
None of them will last for ever.
The benefit may be an income or
some thing else.

3. Introduction to Principles & Practices of Life Insurance INS106
Introduction to Principles & Practices of Life Insurance
INS106
 The owner is aware of the situation, and he can so manage his affairs that by the end of said
period or life-time, a substitute is made available.
 Thus, he makes sure that the value or income is not lost.
 However, the asset may get lost earlier.
 An accident or some other unfortunate event may destroy it or make it non-functional.
 In that case, the owner would be deprived of those benefits, and the planned substitute may
not have been arranged.
 There is an adverse or unpleasant situation.
 Insurance is a mechanism that helps to reduce the effect of such adverse situations.
Concept Building

4. Introduction to Principles & Practices of Life Insurance INS106
Introduction to Principles & Practices of Life Insurance
INS106
 Assets are insured, because they are likely to be destroyed, through accidental occurrences.
 Such possible occurrences are called Perils. Perils are the events.
 Fire, flood, breakdown, lightening, earthquake, war, nuclear explosion, dishonesty, negligence,
accidents etc. are Perils.
 If an asset may be damaged due a particular peril, we can say that the asset is exposed to risk
 Risk to an owner of a building due to earthquake may be a few lakhs or few crores depending upon
the cost of the asset.
 The risk only means that there is a possibility of loss or damage. The damage may or may not
happen.
 Insurance is done against the contingency that it may happen. There must be an uncertainty about
the adverse event.
 Insurance is relevant only if there are uncertainties. If there is no uncertainty about the occurrence
of an event, it cannot be insured against.
Purpose & Need of Insurance

5. Introduction to Principles & Practices of Life Insurance INS106
Introduction to Principles & Practices of Life Insurance
INS106
 In the case of a human being, death is certain, but the time of death is uncertain. In the case of
a person who is terminally ill, the death is not uncertain though not exactly known, hence
cannot be insured.
 Insurance does not protect the assets neither prevents its loss due to the peril.
 The peril cannot be avoided through insurance. The peril can sometimes be avoided, through
better safety and damage control management. Insurance only tries to reduce the impact of
the risk on the owner of the asset and those who depend on that asset.
 It only compensates the monetary losses- and that too, not fully.
 Only economic consequences can be insured. If the loss is not financial, insurance may not be
possible. (love and affection of parents, leadership of managers, sentimental attachment to
family, innovative and creative abilities)
Purpose & Need of Insurance

6. Introduction to Principles & Practices of Life Insurance INS106
Introduction to Principles & Practices of Life Insurance
INS106
Working Mechanism of Insurance
Pooling of large number of
common risks
Spreading of Losses
Sharing of Losses
Averaging of Losses
Measurability
Uncertainty
Accidental Nature
Radom Nature of Occurrence
Law of Large Numbers
Fair & Honest Management
Not a deliberate act or creation
Determinable before-hand
(total amount of loss,
contribution, extent of
compensation or benefits, and
the method of distribution
Law of Large
Numbers

7. Introduction to Principles & Practices of Life Insurance INS106
Introduction to Principles & Practices of Life Insurance
INS106
The Business of Insurance
Bring together
persons with
common
insurance
interest
(exposure to
same risk)
Assess the risk
and determine
the premium
Collect the share
or contribution
(called premium)
from all willing to
be insured
Pay out
compensation
(called claims) to
those who suffer

8. Introduction to Principles & Practices of Life Insurance INS106
Introduction to Principles & Practices of Life Insurance
INS106
The Business of Insurance
Suppose there are 100 people
in a group
With a 1% chance that any
one of them could get sick
and require Rs 10,000 in
medical care
But no one knows who will
get sick
If each person pays Rs 100
into a “pool” they will
collectively have Rs 10,000 to
cover the medical costs of the
person who gets sick
So, everyone gives up Rs 100,
but nobody loses more than
Rs 100
99 people do not collect
anything, but they gain peace
of mind and important
protection against large loss