Introduction to Insurance

Pooja Garg

Definition of Insurance From the viewpoint of an Individual: Insurance is an

economic device whereby an individual substitutes a certain cost (the premium) in consideration of the insurer incurring the risk of paying a large sum upon a given contingency

Features: Economic device Premium Large sum paid by Insurer (Sum Assured) Payment made only upon a contingency

Definition of Insurance From the viewpoint of Society: Insurance is an economic

device for reducing and eliminating risk through the process of spreading the loss among a group of people who are exposed to it and who agree to insure themselves against the risk.

Nature of Insurance Security: It does not decrease the uncertainty for the

individual as to whether the event will occur, nor does it alter the probability of occurrence but it does reduce the probability of financial loss connected with the event.

Sharing/Pooling of risk Co-operative device Evaluation of Risk Payment at Contingency Insurance is not Gambling Insurance is not charity

Purpose and Need of Insurance Uses to an Individual

Provide safety and security Affords peace of mind Eliminates dependency Life Insurance encourages saving Life Insurance provides profitable investment Life Insurance fulfills the needs of a person

Old-age needs Early Death Disability Sickness Readjustment needs Special Needs e.g Education, Marriage Tax Savings

Purpose and Need of Insurance Uses to Business

Uncertainty of Business Losses reduced Business efficiency increased Welfare of employees Enhancement of Credit Covers consequential losses Key man identification Group insurance

Uses to Society Economic Growth Protection of Wealth Increases the savings to GDP ratio Deep Insurance penetration makes an economy

stable.

How Insurance Works ?

Sharing and Pooling of risk by combining a sufficient

number of homogenous exposures into a group to

make the losses predictable for the group as a whole

and likely big impact on one is reduced to smaller

manageable impacts on all.

How Insurance Works ? Homogenous exposures compose a set of group of

people

Losses are predicted for the group as a whole

Sharing of proportional risk among each person in a group

Big impact on one reduced to smaller manageable impact on all

Examples1. 400 Houses

Value of each house=Rs. 20,000

Probability of risk=4 houses burn in a year (Degree of

Risk=1%)

Total Loss=Rs. 80,000/400

=Rs.200/person (1% of Value of House)

Examples (Contd.)Loss Shared in Proportion

A=(1,50,000*2)/400=Rs.750 (3.75% of value of House)

B=(1,50,000*4)/400=Rs.1500

C=(150,000*1)/400=Rs.375

D=(1,50,000*8)/400=Rs.3000

Probability of Risk does not always depend on the value of

house

Application of Probability Theory and Law of Large Numbers

Measures of Dispersion i.e. Variance and Standard

Deviation are used to calculate the average losses to

be born by the insurer.

The inertia of large numbers is applied while

calculating the probability. The larger the sample, the

smaller the margin of error.

Case Study: Probability Theory

Year Actual Losses (Houses that Burn)

Average Losses Difference Difference

Squared

1 7 10 3 92 11 10 1 13 10 10 0 04 9 10 1 15 13 10 3 9

20

Variance (Standard Deviation (

Estimation of Probability of Number of Houses Burning Next Year

10 12 14 16864

68.27%

95.45%

99.73%

No.of Houses Burning between Probability

8-12 68.27%6-14 95.45%4-16 99.73%

The Role of Insurance in Economic Development

Pooja Garg

Promote financial stability By indemnifying those who suffer or harm,

insurance helps stabilize the financial situation of

individuals, families and organizations.

It encourages individuals and firms to invest and

create wealth.

Peach of mind and financial carelessness

Substitutes for and complements government security programs

Private insurance can relieve pressure on social insurance system, preserving government resources for essential social security.

Pension fund and life insurance

Natural disaster indemnity plan

Facilitates trade and commerce

Many products and services are produced and

sold only if adequate liability insurance is

available to cover any claims for negligence.

Innovation

Credit enhancement

Helps mobilize savings Insurance and financial intermediation

Insurance enhance financial system efficiency in

three ways

Reduce transaction costs associated with bringing

together savers and borrowers

Create liquidity

Facilitate economies of scale in investment

Enables risk to be managed more efficiently

Risk pricing – greater the expected loss, higher the price

Risk transformation – risk exposures can be transferred to an insurer for a price

Risk pooling and reduction (1) insurers make reasonably accurate estimates as to

the pool’s overall losses. (2) insurers diversify their portfolios.

Fosters a more efficient capital allocation

Insurers will monitor the companies to reduce

risk-increasing behavior and act in the best

interests of their various stakeholders.

A watch-dog role.

Thank You