Insurance 1

Monita JoshiKhamkar

Life Cycle Stages of an Individual

1. 2. 3. 4. 5. 6. 7. Childhood Stage - Learner Young Unmarried Stage - Earner Young Married Stage - Partner Married with Young Children Stage - Parent Married with Older Children Stage - Provider Post Family/Pre-Retirement Stage Empty Nester Retirement Stage - Retire (Dignified or Destitute)

Needs for Financial Products

Three types of savings needs in the life cycle: Enabling future transactions Specific & General Contingency Needs Unforeseen events Wealth Accumulation Savings & Investment to enhance net worth

Retail Finance - The Needs

Savings Protection & Investment Loans & Mortgages Pensions

The Players
Life Insurance Cos General Insurance Cos Life Insurance Cos Banks

Health care providers House Mortgage Cover Personal Loan Cover

Protection

Savings & Investment

Post office Mutual Funds Share Markets

Loans & Mortgages

Pensions Life Insurance Cos

Where Insurance Fits

Term Insurance Sickness & Accident Insurance Critical Illness Rider House Mortgage Cover Personal Loan Cover Savings & Protection Investment Endowment Policies Cash Back Schemes Unit Linked Policies Immediate Annuities Deferre d Annuitie s
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Loans & Mortgages

Pensions

Concept of Risk
Risk arises out of uncertainty Possibility of adverse results flowing from any occurrence. It is possibility of an outcome being different from the expected. For risk to exist there must be at least two possible outcomes. If loss is certain there is no risk. At least one possible out come must be undesirable. Loss in general accepted sense is something is lost, or a gain smaller than the gain that was possible.

3 Approaches of Risk
As a chance of Loss

As Measurable Uncertainty

As Statistical Dispersion

Risk as Chance of Loss

Exposure to a loss situation with a Probability of loss (from 0 to 1). Peril causes the loss situation.

Hazard increases chance and impact of loss.

Risk as Uncertainty
Both denote indeterminacy or randomness. Knowledge insufficient to predict . More the knowledge more accurate risk assessment. Lesser the Knowledge more the Subjectivity about risk.

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Risk as Statistical Dispersion

256, 258, 270, 274, 264, 260, 258, 262, 268, 272 - stock price H, H, T, H, T, H, H, H, T, H - toss of a coin

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Risk ,Peril and Hazard

Risk is uncertainty of loss. Peril is a source of loss (fire, windstorm, embezzlement, etc.) Hazard is a condition which increases the likelihood of loss (e.g., a known embezzler hired as an accountant).

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Peril and Hazard

Peril : is cause of loss. collision is a peril that causes the automobile accident and loss. Hazard: is condition for loss foggy weather is the hazard that creates the peril of collision.

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Types of Hazard
1. 2. 3. 4. Physical Hazard Moral Hazard Morale Hazard Legal Hazard

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Physical Hazard
Physical conditions which increase the likelihood of a peril occurring.

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Moral Hazard
Human behaviour that increase the exposure of individuals to potential perils is moral hazard depending on the intentions of the person. e.g. : Increase in the probability of loss that result from dishonesty in the character of the insured person.

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Morale Hazard
Attitude towards losses that it will be paid by insurance, than borne by the individual. e.g.: Morale hazard reflects the careless attitude towards the occurrence of loss.

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Legal Hazard
certain features of the legal system or regulatory environment can raise the chance or severity of losses.

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Type Of Risk
Static Risk Losses without change in the economy Affects small number of individuals Is predictable Dynamic Risk Losses due to change in economy Affects large number of individuals Less predictable than static risk

Occurs with a degree of regularityDo not occur with a precise degree of regularity eg: Perils of nature,Dishonesty eg: Change in price level,consumer taste
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Type Of Risk
Fundamental Risk Losses that are impersonal in origin and consequences Affect large segment or overall population Particular Risk Losses arising out of individual events Affects individuals rather than groups

Caused by conditions beyond the Caused directly by acts of control of individuals individuals Society has the responsibility to Private insurance is the deal with the losses by convenient mechanism to deal mechanism of social insurance with this risk Eg: Unemployment, War, Inflation, Earthquake Eg: Burning of Houses, bank robbery
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Type Of Risk
Pure and Speculative Risk Pure risk has the possibility of loss only thus, it is insurable. Speculative risk affords the opportunity for gain as well as the possibility of loss. e.g.: gambling and stock market investments this type of risk is not insurable.

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Type Of Pure Risk

Pure risks is classified into three types of risks Property risks - These arise from various risk events that result in loss or damage to property .They include fire, earthquake, floods, theft and damage to goods while in transit, and a host of others which are covered under general insurance Liability Risks - Arise when one is held liable to pay damages for omission or commission of an act that results in injury to person or name or damage to property of another.

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Type Of Pure Risk

Pure risks is classified into three types of risks Personal risks - events that directly affect the individual person. It may either result in loss of earned income or cause extra expenditure or a depletion of financial assets. These risks are generally covered by personal insurance covers

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Type Of Personal Risk

Premature death - when one has unfulfilled financial obligations. Insufficient income during retirement - to be replaced through a pension or by drawing on financial assets or other sources of retirement income Poor Health - leads to high costs of medical expenses. It can also lead to loss of income earnings on account of disability

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Insurance
The contract of insurance is generally applicable only to risks that are static, particular and pure.

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Insurable Risk
A risk that meets the following criteria is insurable: 1. The insured loss must have a definite time and place; 2. The insured event must be accidental; 3. The insured must have an insurable interest in the subject of coverage; 4. The insured risks must belong to a sufficiently large group of homogeneous exposure units to make losses predictable; 5. The risk must not be subject to a catastrophic loss where a large number of exposure units can be damaged or destroyed in a single event.
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Insurable Risk
A risk that meets the following criteria is insurable: 6. The coverage must be provided at a reasonable cost; 7. The chance of loss must be calculable.

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Uninsurable Risk
A risk where there is no insurable interest; A risk where the potential for loss is so great it does not meet the definition of insurance; A risk where insurance is prohibited by public policy or is illegal.

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Method of treating Risk

There are established and tested techniques by which risks may be controlled. 1) AVOIDING RISK - A risk may be avoided by not accepting or entering into the event which has hazards. Such a choice is not always possible, or if possible, it may require giving up some important advantages. Nevertheless, in some situations risk avoidance is both possible and desirable.

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Method of treating Risk

2) SPREADING RISK - It is possible to spread the risk of loss to property and persons. Duplication of records and documents and then storing the duplicate copies elsewhere is an example of spreading the risk. A small fire in a single room can destroy the entire records of a department.

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Method of treating Risk

3) LOSS PREVENTION OR REDUCTION OF RISK - "An ounce of prevention is worth a pound of cure," according to an old saying. Risk may be reduced, eliminated, or certainly controlled by using a well-planned loss prevention program.

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Method of treating Risk

4) RETENTION, ASSUMPTION OR ACCEPTANCE OF RISK - Some risks have to be retained because insurance cannot be purchased or the cost of insurance is not economically sound. Therefore, some risks should be retained, assumed, or accepted. E.g.: earthquake, war, flood, accidental breakage, wear and tear etc.

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Method of treating Risk

5) TRANSFER OF RISK TO INSURANCE CARRIERS OR OTHERS - Risk may be transferred contractually to others. For example, when leasing facilities from others, the lease could require the lessor to assume all property and liability losses.

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Spreading of Risk

An insurer would achieve spread of risk by: 1. 2. 3. 4. 5. 6. Writing different classes of insurance business. Writing business in different geographical locations. Have larger capital resources and write larger volumes of business to have larger spread. By Reinsurance By entering into risk pools for certain risks. By spreading risk over a longer period of time.

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Theory Of Insurance
Insurance works on two mechanisms Probability theory Law of large numbers

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Spreading of Risk
Probability theory That body of knowledge that measures the likelihood that something will happen. Makes estimates on the basis of likelihood. Is based on the premise that some events appear to be a matter of chance. but, They actually occur with regularity over a large number of trials revealing a measurable pattern. The likelihood are assigned values between 0 and 1,impossible 0,inevitable 1.

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Spreading of Risk

Law of large numbers To estimate the probability accurately large data is required, larger the sample more accurate will be the estimate of the probability. Once probability is worked large number of contracts must be entered to avoid losses. The insurance company believes, things continue to happen in future as they happen in the past and if the estimates of past are accurate ,this is what is expected. The insurance company bases its rates on its expectation of future losses.
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Insurance and Society

What happens if there is no Insurance Primary burden Actual losses that are not covered Secondary burden Due to uncertainty arising from exposure to a loss situation

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Secondary burden

Physical and mental strain Caused by fear and anxiety Larger Emergency Fund Its opportunity cost

Sub-optimal allocation of resources since individuals worry and commit resources only to safe & low risk avenues

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Conditions for Insurance

Sufficiently large number of homogenous exposure units to make the losses reasonably predictable Loss produced by the risk must be definite and measurable Loss must be fortuitous or accidental The loss must not be catastrophic Economic Feasibility and Public Policy
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Insurance Mechanism
Insurance as the predominant device for handling many pure risks that are faced by individuals and firms. It is defined as Risk Transfer through Risk Pooling. This implies Shifting of burden of loss from individual to group All members of the group share the losses that arise on some equitable basis From the individuals viewpoint it involves a small certain cost (the insurance premium) is borne in exchange for a large uncertain financial loss

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Insurance Mechanism
Creation of a common (pooled) fund into which the contributions of premium received from numerous individuals are poured. Drawings from the fund are used to pay for individual claims An Insurer who processes information to predict the amount and probability of losses; size of the fund (liability) for financing the losses and amount of contribution (premium) needed from each of the participants Risk transfer and its pooling achieved through a contractual arrangement
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Insurance Mechanism
The success of an insurance company depends on its accuracy in predicting future losses. If predictions fall short of actual, the premiums that the insurer charges may be inadequate This accuracy of prediction is based on the law of large numbers. By combining a large number of homogenous exposure units the insurer is able to make predictions for the group as a whole.
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Insurance Mechanism
This is accomplished through the theory of probability. Probability Theory is the body of knowledge concerned with measuring the likelihood that something will happen and making predictions on the basis of this likelihood. It deals with random events and is based on the premise that, while some events appear to be a matter of chance, they actually occur with regularity over a large number of trials .

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Insurance Mechanism
The probability is assigned a numerical value between 0 & 1 0 represents impossibility and 1, certainty It deals with random events and is based on the premise that, while some events appear to be a matter of chance, they actually occur with regularity over a large number of trials

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Insurance Mechanism
There are two interpretations of probability: Relative Frequency : The probability assigned to an event signifies the relative frequency of its occurrence that would be expected, given a large number of separate independent trials. The Subjective Interpretation: The probability of an event is measured by degree of belief in the likelihood of occurrence of the given incident.

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Insurance Mechanism
Relative frequency estimates of probability are obtained via two methods 1. By examining the underlying conditions that cause the event and making deductions which are obvious from the nature of the event. E.g. Toss of a coin yields 50% chance of getting heads. These are known as a priori probabilities as they are determined, before an experiment is conducted (experienced), on the basis of causality,
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Insurance Mechanism
Relative frequency estimates of probability are obtained via two methods 1. Conducting a long series of trials or observations and making estimates after observation of the past, rather than from the nature of the event. It is then called aposteriori or empirical probability

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Insurance Mechanism
The basis for both a priori and aposteriori estimates is the law of large numbers. In estimating the probability of an event, the parameter we are interested in is the mean or average frequency of occurrence. This value is estimated based on the sample mean. The law of large numbers tells us that the greater the number of trials examined, the better will be our estimate of the probability.
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Insurance and Gambling

Insurance sometimes considered a form of gambling. In both instances, a payment is made only on the happening of an event. There are two differences between insurance and gambling: In a wager or gamble, there is no chance of loss, and hence no risk before the wager. In case of insurance, the chance of loss exists whether an insurance contract is in effect or not. Gambling thus actually creates a risk while insurance 50 provides for the transfer of an existing risk.

Insurance and Gambling

In case of a wager, the participants have no further interest in the happening of the event, other than its (monetary) gain or loss implications. In an insurance contract on the other hand, the occurrence of the event causes the insured to suffer a loss which one might otherwise wish to avoid. The purpose of insurance is to reduce this financial loss through risk transfer. e.g. An individual is expected to have an interest in his own life which he insures. A game of cards is of interest to the extent it leads to a cash win. 51

Thank You!

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