IC-38 Insurance Agents - Common Section - 2023 Edition PDF

IC - 38 INSURANCE AGENTS SECTION - COMMON ACKNOWLEDGEMENT This course is based on revised syllabus prescribed by Insurance Regulatory and Development Authority of India (IRDAI) and prepared by Insurance Institute of Ind...

IC - 38 INSURANCE AGENTS SECTION - COMMON ACKNOWLEDGEMENT This course is based on revised syllabus prescribed by Insurance Regulatory and Development Authority of India (IRDAI) and prepared by Insurance Institute of India, Mumbai. AUTHORS/ REVIEWERS (in Alphabetical order) Dr. R. K. Duggal Dr. Shashidharan K. Kutty CA P. Koteswara Rao Dr. Pradip Sarkar Prof. Madhuri Sharma Dr. George E. Thomas Prof. Archana Vaze G – Block, Plot No. C-46, Bandra Kurla Complex, Bandra (E), Mumbai – 400 051. i  INSURANCE AGENTS SECTION-COMMON IC - 38 Year of Edition: 2023 ALL RIGHTS RESERVED This course material is the copyright of Insurance Institute of India (III). This course is designed for providing academic inputs for students appearing for the examinations of Insurance Institute of India. This course material may not be reproduced for commercial purpose, in part or whole, without prior express written permission of the Institute. The contents are based on prevailing best practices and not intended to give interpretations or solutions in case of disputes, legal or otherwise. This is only an indicative study material. Please note that the questions in the examination shall not be confined to this study material only. Published by: Secretary General, Insurance Institute of India, G- Block, Plot C-46, Bandra Kurla Complex, Bandra (E) Mumbai – 400 051 and Printed at Any communication regarding this study material may be addressed to [email protected] mentioning the subject title and unique publication number mentioned on the cover page ii  PREFACE Insurance Institute of India, (the Institute) has developed this course material for Insurance Agents based on the syllabus prescribed by Insurance Regulatory and Development Authority of India (IRDAI). Industry experts were involved in preparing the course material. The course provides basic knowledge of Life, General and Health insurance to enable agents in the respective line of business to understand and appreciate their professional career in the right perspective. The course is structured as four sections. (1) Overview - a Common section that covers Insurance Principles, Legal Principles and Regulatory matters that Insurance agents need to know. Separate sections are provided for those aspiring to become (2) Life Insurance Agents, (3) General Insurance Agents and (4) Health Insurance Agents. A set of model questions are included in the course to give students an idea of the examination format and the types of objective questions that may be asked. The model questions will also help them in revising what they have learnt. Insurance operates in a dynamic environment. Agents need to be up to date about changes in the market. They should actively pursue knowledge through personal study and participation in the in-house training programmes arranged by the respective insurers. The Institute thanks IRDAI for entrusting this work to the Institute. The Institute wishes all interested in studying the material a successful career in insurance marketing. iii  CONTENTS Chapter no. Title Page no. SECTION COMMON CHAPTERS C-01 Introduction to Insurance 2 C-02 Core Elements of Insurance 18 C-03 Principles of Insurance 27 C-04 Features of Insurance Contracts 40 C-05 Underwriting and Rating 48 C-06 Claims Processing 56 C-07 Documentation 63 C-08 Customer Service 72 C-09 Grievance Redressal Mechanism 87 C-10 Regulatory Aspects for Insurance Agents 95 iv  SECTION AN OVERVIEW 1  CHAPTER C-01 INTRODUCTION TO INSURANCE Chapter Introduction This chapter aims to introduce the basics of insurance, trace its evolution and how it works. It intends to teach how insurance provides protection against economic losses arising as a result of unforeseen events and serves as an instrument of risk transfer. Learning Outcomes A. Insurance – History and evolution B. The Principle of Risk Pooling C. Risk management techniques D. Insurance as a tool for managing risk E. Considerations before opting for Insurance F. Insurance Market Players G. Role of Insurance in the Society 2 A. Insurance – History and Evolution We live in a world of uncertainty. We hear about:  Trains colliding  Floods destroying entire communities  Earthquakes destroying buildings  Young people dying unexpectedly Diagram 1: Events happening around us Why do these events make people anxious and afraid? The reason is simple. i. Firstly these events are unpredictable. If one can anticipate and predict an event, one can prepare for it. ii. Secondly, such unpredictable and untoward events are often a cause of economic loss and grief. The people around can come to the aid of individuals who are affected by such events, by having a system of sharing and mutual support. The idea of insurance is thousands of years old. Yet, the present form of insurance, is only two or three centuries old. 1. History of insurance Insurance has existed in some form or other since 3000 BC. Many civilisations, have practiced the concept of pooling and sharing among themselves, all the losses suffered by some members of the community. Let us take a look at some of the ways in which this concept was applied. 3 2. Insurance through the ages – Some instances Bottomry Loans Traders of Babylon paid extra money to their lenders to write off their loans if shipment was lost or stolen. Traders of Bharuch and Surat also had similar practices. Benevolent Greeks of 7th Cy. AD, used to pay in advance to take care of the Societies/ family of members who died and also the funeral expenses of the Friendly member. Societies Similar practices were followed in England as well. Rhodes Traders of Rhodes who were sending goods by sea, were sharing losses if any of them lost their goods due to jettison1. Chinese Traders Chinese traders in ancient days used to send their goods in different ships, so that even if some boats sank, their loss would be partial. 3. Modern concepts of insurance In India the principle of life insurance was reflected in the joint-family system. Losses arising from the demise of a member were shared by various family members so that each member of the family continued to feel secure. The break-up of the joint family system and emergence of the nuclear family in the modern era, coupled with the stress of daily life has made it necessary to evolve alternative systems for security. This highlights the importance of life insurance to an individual. i. Lloyds: The origins of modern commercial insurance started at Lloyd’s Coffee House in London, where traders agreed to share losses they suffered due to various perils at sea. ii. Amicable Society for a Perpetual Assurance founded in 1706 in London is considered to be the first life insurance company in the world. 4. History of insurance in India a) India: Modern insurance in India began in early 1800 or thereabouts, with agencies of foreign insurers starting marine insurance business. The Oriental Life The first life insurance company to be set up in India Insurance Co. Ltd was an English company Triton Insurance Co. Ltd. The first non-life insurer to be established in India Bombay Mutual The first Indian insurance company. It was formed Assurance Society Ltd. in 1870 in Mumbai 1 Jettison/ Jettisoning’ refers to throwing away some of the cargo to reduce the weight of the ship while at sea. 4  National Insurance The oldest insurance company in India. It was Company Ltd. founded in 1906 Many other Indian companies were set up subsequently as a result of the Swadeshi movement at the turn of the century. Important a) The Insurance Act 1938 was the first legislation to regulate the conduct of insurance companies in India. This Act, as amended from time to time continues to be in force. b) Life insurance business was nationalised on 1st September 1956 and the Life Insurance Corporation of India (LIC) was formed. From 1956 to 1999, the LIC held exclusive rights to do life insurance business in India. c) In 1972, the non-life insurance business was also nationalised and the General Insurance Corporation of India (GIC) and its four subsidiaries were set up. d) The Malhotra Committee, in its report submitted in 1994, recommended opening of the market for competition e) The Insurance market was liberalised in 2000, with the passing of the Insurance Regulatory & Development Act, 1999 (IRDAI), which also established the Insurance Regulatory and Development Authority of India (IRDAI) in April 2000 as a statutory regulatory body for the insurance industry. f) An amendment of the Insurance Act in 2021, has allowed Foreign investors, to hold up to 74% of the paid up equity capital in an Indian Insurance company. Foreign insurers can now establish branches in India to do reinsurance. a. Insurance industry today (As on 30th September 2021) a) There are 24 Life insurance companies operating in India. Of these, Life Insurance Corporation (LIC) of India is a public sector company (PSU) and the remaining 23 life insurance companies are in the private sector. b) There are 34 General Insurance companies of which 4 - National Insurance Co. Ltd, The New India Assurance Co. Ltd., The Oriental Insurance Co. Ltd and United India Insurance Co. Ltd. are PSU Companies dealing with all lines of general insurance. 26 Private Companies also deal with all lines of general insurance. 6General Insurers deal only in Health insurance. 2 are specialised insurers - Agricultural Insurance Company [AIC] and Export Credit and Guarantees Corporation [ECGC], both set up as Public sector entities. c) There is one Reinsurance Company – The General Insurance Corporation of India [GIC Re] and 11 foreign Reinsurers that operate through branch offices. 5  d) The Department of Posts (called as India Post) of the Government of India, also transacts life insurance known as Postal Life Insurance. India post is exempt from the purview of the Insurance Regulator. Test Yourself 1 Which among the following is the regulatory body for the insurance industry in India? I. Insurance Authority of India II. Insurance Regulatory and Development Authority of India III. Life Insurance Corporation of India IV. General Insurance Corporation of India How insurance works Modern commerce was founded on the principle of ownership of property. When an asset loses value (by loss or destruction), the owner of the asset suffers an economic loss. This loss can be compensated from a common fund made up of small contributions from many similar asset owners. This process of transferring the chance and consequence of a loss making event is insurance. This mechanism of pooling risks works differently in the case of death and disability as there is no loss/ destruction of a commercial asset. Definition Insurance may thus be considered as a process by which the losses of a few are shared amongst many of those exposed to similar uncertain events/ situations. Diagram 2: How insurance works There are however some questions that need to be answered. i. Would people agree to part with their hard earned money, to create such a common fund? ii. How could they trust that their contributions are actually being used for the desired purpose? 6  iii. How would they know if they are paying too much or too little? iv. Who would take the responsibility of managing these funds and paying those who suffer the loss? The need for an Insurer comes as an answer to all these questions. The Insurer assesses the risk, decides and collects the individual contributions (called premium), pools the risks and premiums, and arranges to pay to those who suffer the loss. The insurer must also win the trust of the individuals and the community. 1. Insurance is about value a) Firstly, there must be an asset which has an economic value. The Asset may be: i. Physical (like a car or a building) or ii. Non-physical (like reputation, goodwill, liability to pay to someone) or iii. Personal (like one’s eyes, limbs, body and physical capabilities). b) The asset may lose its value if a certain event happens. This chance of loss is called as risk. The cause of the risk event is known as peril. c) There is a principle known as pooling. This consists of collecting numerous individual contributions (known as premiums) from various persons. These persons have similar assets which are exposed to similar risks. Their assets are also referred to as ‘risks’ in many contexts. d) This pool of funds is used to compensate the few who might suffer the losses caused by a peril. e) This process of pooling funds and compensating the unfortunate few is carried out through an institution known as the insurer (Insurance Company). f) The insurer enters into an insurance contract with each person who seeks to participate in this mechanism of pooling. The persons who participate are known as insured. 2. Insurance reduces Risk Burden The burden of risk refers to the costs, losses and disabilities one has to bear as a result of being exposed to a given loss situation/ event. Diagram 3: Risk burdens that one carries There are two types of risk burdens that one carries – primary and secondary. 7  a) Primary burden of risk The primary burden of risk consists of losses that are actually suffered by households (and business units), as a result of pure risk events. These losses are often direct and measurable; and can be easily compensated for by insurance. Example When a factory gets destroyed by fire, the actual value of goods damaged or destroyed can be estimated and the compensation can be paid to the owner of the factory who has suffered the loss. Similarly, if an individual undergoes a heart surgery, the medical cost of the same is known and compensated. In addition there may be some indirect losses. Example A fire may interrupt business operations and lead to loss of profits which also can be estimated and the compensation can be paid to the one who suffers such a loss. Someone whose scooter hits a pedestrian is liable to pay the victim the compensation that the Court decides. b) Secondary burden of risk Even when no such event occurs and there is no loss, the people who are exposed to the peril carry some burden. That is, apart from the primary burden, one also carries a secondary burden of risk. The secondary burden of risk consists of costs and strains that one has to bear, even if the said event does not occur, from the mere fact that one is exposed to a loss situation. Let us understand some of these burdens: i. Firstly there is physical and mental strain caused by fear and anxiety. This can cause stress and affect a person’s wellbeing. ii. Secondly when one is uncertain about whether a loss would occur or not, it would be prudent to keep a reserve fund to meet such an eventuality. Such funds may be held in liquid form and yield low returns. By transferring the risk to an insurer, it becomes possible to enjoy peace of mind and also invest one’s funds more effectively. It is precisely for these reasons that insurance is needed. In India, one must purchase third party insurance if he/ she owns a vehicle because it is mandatory if one wants to drive on a public road. At the same time it would be prudent to cover the possibility of loss of own damage to the car though it is not 8 mandatory. It is also compulsory to have a Personal Accident cover for the Owner- Driver. Test Yourself 2 Which among the following is a secondary burden of risk? I. Business interruption cost II. Goods damaged cost III. Setting aside reserves as a provision for meeting potential losses in the future IV. Hospitalisation costs as a result of heart attack B. The Principle of Risk Pooling Insurance companies enter into contracts with different entities – policyholders, who can be individuals or corporates. The benefits they pay to policyholders are contractual obligations. Insurance contracts are meaningful only if the Insurers are financially capable of taking over the risks and compensating for the losses, if and when they occur. The structure arises from application of the mutuality or the pooling principle. Mutuality and Diversification are two important ways to reduce risk in financial markets. They are fundamentally different. Diversification Mutuality Here the funds are spread out among Under mutuality or pooling, the funds of various assets (eggs are placed in different various individuals are combined (all eggs baskets). are placed in one basket). Funds flow from one source to many Funds flow from many sources to one. destinations. Diagram 4: Mutuality - Mutuality (Funds flow from many sources to one) The Principle of Mutuality is what gives insurance contracts their power and uniqueness. By paying a small contribution (the premium), an insured immediately creates a large quantity of funds ( corpus)that is available to him/ her in the event of a loss arising due to the insured risk. This potential corpus of money is what makes insurance unique and without any substitutes among all financial products. 9 C. Risk Management Techniques One may also ask whether insurance is the right solution to all kinds of risk situations. The answer is ‘No’. Insurance is only one of the methods by which individuals may seek to manage their risks. Here they transfer the risks they face to an insurance company. However there are other methods of dealing with risks, which are explained below: 1. Risk avoidance Reducing risk by avoiding a loss situation is known as risk avoidance. Thus one may try to avoid activities or situations, or avoid dealing with property or persons due to which there can be an exposure. Example i. One may avoid certain manufacturing risks by contracting out the manufacturing to someone else. ii. One may not venture outside the house for fear of meeting with an accident or may not travel at all for fear of falling ill when abroad. Risk avoidance is considered a negative way to handle risk. Individuals and societies need to take some risks for doing activities for their progress. Avoiding such risk taking activities would lead to losing the benefits from such activity. 2. Risk retention One tries to manage the impact of risk and decides to bear the risk and its effects by oneself. This is known as self-insurance. Example A business house may decide, based on experience about its capacity to bear small losses upto a certain limit, to retain the risk with itself. 3. Risk reduction and control This is a more practical and relevant approach than risk avoidance. It means taking steps to lower the chance of occurrence of a loss and/ or to reduce severity of its impact if such loss should occur. Important Measures to reduce the chance of occurrence of loss causing events are known as ‘Loss Prevention’. The measures to reduce the degree of loss, in case a loss happens, are called ‘Loss Reduction’/ Loss Minimisation. Risk reduction involves reducing the frequency and/ or sizes of losses through: 10  a) Education and training of various types of employees in proper risk practices – e.g. (i) participating in ‘fire drills’; (ii)wearing of seatbelts helmets on cars. b) Making Environmental changes – like improving physical conditions - e.g. (i) installing fire alarms; (ii) spraying chemicals to kill mosquitoes to reduce spread of Malaria. c) Changes made in dangerous or hazardous operations, while using machinery and equipment or in the performance of other task - e.g. (i) wearing helmets inside construction sites; (ii) wearing gloves and face shields while handling chemicals. d) Leading a healthy lifestyle- helps in reduce the incidence of falling ill - e.g. (i) undergoing regular medical check-ups; (ii) practicing yoga regularly. e) Separation, or spreading out various items of property into varied locations rather than concentrating them, to reduce impact of mishap in any one location - e.g. (i) storing large quantities of flammable substances at separate locations; (ii) fixing fire proof doors in hazardous areas of factories. 4. Risk financing This refers to the provision of funds to meet losses that may occur. a) Risk retention through self-financing involves bearing losses oneself as they occur. The firm assumes and finances its own risk, either through its own or borrowed funds, this is known as self-insurance. b) Risk retention within a bigger group: If the risk is part of a bigger group, like a parent company, the risk can be retained within the larger group which would finance the losses. This can be a group formed by mutual consent as well. c) Risk transfer is an alternative to risk retention. It involves transferring the responsibility for losses to another party. Insurance is one of the major forms of risk transfer. Instead of facing the uncertainty of many of the other forms, people prefer Insurance as it provides certainty and peace of mind. 5. Insurance vs Assurance Insurance is used for most General insurance contracts which provide protection against an event that may or may not happen, and where the loss amount can be assessed only after the event. Assurance refers to financial coverage for extended periods or until death. In the case of life, the happening of death (the loss making event), is certain. Only the timing is uncertain. Further, it is not possible to estimate the amount of economic loss suffered when a person dies. The loss amount that is to be paid, 11  must be fixed in advance. This is why people use the term ‘Assurance’ in case of Life insurance. Though there are such subtle technical differences, the terms ‘Insurance’ and ‘Assurance’ are used interchangeably in most markets, including India. [One of the biggest general insurers in India carries the name – New India Assurance Company Ltd. and no life company in India is using the word ‘Assurance’ in its name!] Diagram 5: How insurance indemnifies the insured Test Yourself 3 Which among the following is a method of risk transfer? I. Bank Fixed Deposit II. Insurance III. Equity shares IV. Real Estate D. Insurance as a tool for managing risk The term ‘Risk’ refers not to a loss that has actually been suffered but a loss that is likely to occur. It is thus an expected loss. The cost of this expected loss is the product of two factors: i. The probability that the peril being insured against may happen, leading to the loss ii. The severity (impact) or the amount of loss that may be suffered as a result. 12 The cost of risk would increase in direct proportion with both the probability and the severity (amount of loss). This works in different ways – (a) If the amount of loss is very high, and the probability of its occurrence is small, the cost of the risk would be low as such instances may be very few. (b) Even if the amount of loss is small, if the probability of its occurrence is very high, the cost of the risk would be high, as there would be many such occurrences. Insurance can be seen as a powerful tool for managing one’s risk. It protects one from the financial impact of losing one’s assets/ wealth due to an insured loss. Diagram 6: Considerations before opting for insurance E. Considerations before opting for Insurance When deciding whether to insure or not, one needs to evaluate the cost of transferring the risk [the insurance premium] against the cost of bearing it oneself. Insurance would be most required where the loss impact could be very high, but the probability (and hence the premium), is very low. E.g. (i) the chance of an earthquake; (ii) the chance of a ship sinking. a) Do not risk a lot for a little: A reasonable relationship must be there between the cost of transferring the risk and the value derived. Would it make sense to insure an ordinary ball pen? b) Do not risk more than one can afford to lose: If the loss that can arise as a result of an event is large enough to cause bankruptcy, retention of the risk would not be appropriate. If a large oil refinery gets destroyed, the owners cannot afford to bear the loss. c) Consider the likely outcomes of the risk carefully: It is best to insure those assets for which the probability of occurrence (frequency) of a loss is low but the possible impact (severity), is high. The loss of a space satellite can be so costly that it has to be insured. 13 Test Yourself 4 Which among the following scenarios needs insurance? I. The sole bread winner of a family might die untimely II. A person may lose his wallet III. Stock prices may fall drastically IV. A house may lose value due to natural wear and tear F. Insurance Market Players The Insurance Companies (Insurers) are the major players in the insurance industry. In addition to insurers, there are multiple parties who are part of the Insurance value chain. There is the Insurance Regulator, which regulates the entire market. Intermediaries like Agents, Brokers, Banks (through Bancassurance) Insurance Marketing Firms and Point of Sales Persons are in the field of interacting with the prospects/ insured finding out their needs, giving them information about the policies available for covering their needs. Surveyors and Loss Assessors/ Adjusters go into assessing claims and ancillary work. Third Party Administrators deal with Health and Travel Insurance Claims. Regulations provides that all intermediaries have a responsibility towards the customer. Agents, being intermediaries between the insurance company and the insured have the responsibility to ensure all material information about the risk is provided by the insured to insurer. Important Duty of an Insurance Agent/ Intermediary towards the Prospect (Customer) IRDAI regulations provides that intermediaries have certain responsibilities towards the prospect. The intermediary has a responsibility towards the insurer as well. The regulation states that where the prospect depends upon the advice of the insurer or his agent or an insurance intermediary, such a person must advise the prospect in a fair manner. It also says that “An insurer or its agent or other intermediary shall provide all material information in respect of a proposed cover to the prospect to enable the prospect to decide on the best cover that would be in his or her interest”. If the proposal and other connected papers are not filled by the customer, a certificate may be incorporated at the end of proposal form from the customer that the contents of the form and documents have been fully explained to him and that he has fully understood the importance of the proposed contract. When the customer pays the insurer towards premium, the insurer is bound to issue a receipt. That is, even if the premium is paid in advance. 14 G. Role of Insurance in the Society Insurance companies play an important role in a country’s economic development. They ensure that the wealth of the country is protected and preserved. Some of their contributions are given below. a) Insurance is founded on the principle of Mutuality, in which the collective power of the community is brought together to support its unfortunate few members who suffer an economic loss. There are no substitutes for insurance. b) Insurance companies collect small amounts of premium and pool them together as huge funds. These funds are held and invested for the interests of policyholders and the benefit of the community. They are not unduly invested in speculative ventures. c) Insurance provides the benefit of protection to numerous insured - both individuals and enterprises –against losses caused by accidents or fortuitous events. It preserves capital and releases it for development of business and industry, which helps the country’s growth. d) Insurance enables investment of capital leading to commercial and industrial development. It also helps in removing the fear, worry and anxiety associated with entrepreneurship. e) Many Banks and Financial institutions do not advance loans on property unless it is insured against loss or damage. Many of them insist on assigning the policy as collateral security. f) Before accepting large complicated risks, general insurers arrange for inspection of the property by qualified engineers/ other experts. They assess the risk and suggest risk management measures to reduce the risk and help in rating. g) Insurance earns foreign exchange for the country like trade, shipping and banking services. h) Insurers are associated with institutions engaged in fire loss prevention, cargo loss prevention, industrial safety and road safety. i) Entrepreneurs get the confidence to invest in new or relatively unknown fields with the protection offered by Insurance. Information Insurance and Social Security a) Social security is an obligation of the State. Social security schemes of the State involve the use of compulsory or voluntary insurance, as a tool of social security. The Employees State Insurance Act, 1948 provides for Employees State Insurance Corporation to pay for the expenses of sickness, 15  disablement, maternity and death for industrial employees and their families, who are covered. b) Insurers play an important role in social security schemes sponsored by the Government such as 1. PMJJBY –Pradhan Mantri Jeevan Jyoti Bima Yojana 2. PMSBY – Pradhan Mantri Suraksha Bima Yojana 3. PMFBY- Pradhan Mantri Fasal Bima Yojana 4. PMJAY – Pradhan Mantri Jan Arogya Yojana (Ayushmaan Bharat) 5. PMVVY - Pradhan Mantri Vaya Vandana Yojana – a Pension plan 6. APY - Atal Pension Yojana These, and other Government schemes have been benefiting the Indian society/ community. c) In addition to supporting Government schemes, the insurance industry offers insurance covers on a commercial basis which have the ultimate objective of providing social security. The rural insurance schemes, operated on a commercial basis, are designed to provide social security to the rural families. Test Yourself 5 Which of the following insurance schemes are sponsored by the Government of India? I. PM Jan Arogya Yojana - Ayushmaan Bharat II. PM Fasal Bima Yojana III. PM Suraksha Bima Yojana IV. All of the above Summary  Insurance is risk transfer through risk pooling.  Commercial insurance business as practiced today started at the Lloyd’s Coffee House in London.  An insurance arrangement involves the following:  Asset,  Risk,  Peril,  Contract,  Insurer and  Insured  When persons having similar assets, exposed to similar risks, contribute into a common pool of funds it is known as pooling.  Apart from insurance, other risk management techniques include:  Risk avoidance, 16   Risk control,  Risk retention,  Risk financing and  Risk transfer  The thumb rules of insurance are:  Do not risk more than one can afford to lose,  Consider the likely outcomes of the risk carefully and  Do not risk a lot for a little Key Terms 1. Risk 2. Pooling 3. Asset 4. Burden of risk 5. Risk avoidance 6. Risk control 7. Risk retention 8. Risk financing 9. Risk transfer Answers to Test Yourself Answer 1 - The correct option is II. Answer 2 - The correct option is III. Answer 3 - The correct option is II. Answer 4 - The correct option is I. Answer 5 - The correct option is IV. 17  CHAPTER C-02 CORE ELEMENTS OF INSURANCE Chapter Introduction In this chapter, we shall learn about the various key elements and principles of insurance that govern the working of insurance. Learning Outcomes A. Elements of Insurance Assets and Risk Hazard and Peril Risk Pooling After studying this chapter, one should be able to: 1. Understand Assets are 2. Understand Risk, Hazards and Perils 3. Appreciate Risk Management 4. Understand Risk Pooling in insurance 18 A. Elements of insurance We have seen that the process of insurance has four elements  Asset  Risk  Risk pooling Let us now look at the various elements of the insurance process in some detail. 1. Asset Definition An asset may be defined as ‘anything that confers some benefits and has an economic value to its owner’. An asset must have the following features:  Economic value: An asset must have economic value. Value can arise in two ways. a) Income generation: Asset may be productive and generate income. Example A machine used to manufacture biscuits, or a cow that yields milk, both generate income for their owner. A healthy worker is an asset to an organization. b) Serving needs: An asset could also add value by satisfying one or a group of needs. Example A refrigerator cools and preserves food while a car provides comfort and convenience in transportation, similarly a body free of illness adds value to oneself and family also.  Scarcity and Ownership What about air and sunlight? Are they not assets? - The answer is ‘No’. Few things are as valuable as air and sunlight. We cannot live without them. Yet they are not considered as assets in the economic sense of the term. There are two reasons for this:  Their supply is abundant and not scarce.  They are not owned by any one individual but are freely available to all. This implies that an asset must satisfy two more conditions to qualify as such - its scarcity and its ownership or possession by someone. 19  Insurance of assets Insurance provides protection only against financial losses arising from unexpected events and not natural wear and tear, of assets due to usage over time. We must note that insurance cannot protect an asset from loss or damage. An earthquake will destroy a house whether it is insured or not. The insurer can only pay a sum of money, which would reduce the economic impact of the loss. Losses can arise in the event of breach of an agreement. Example An exporter would lose a great deal if the importer on the other side refused to accept the goods or defaulted on payments.  Life insurance What about our lives? There is indeed nothing as valuable to us as our own lives and those of our loved ones. Our lives can be seriously affected when subjected to an accident or an illness. This can impact in two ways:  Firstly there are costs of treatment of a particular disease.  Secondly there may be loss of economic earnings, both due to death or disability. These kinds of losses are covered by insurances of the person or personal lines of insurance. Insurance is possible for anyone who has assets that have value [i.e. which generate income or meet some needs]; the loss of which [due to fortuitous or accidental events] cause financial loss that can be [measured in terms of money]. Thus these assets are commonly referred to as subject matter of insurance in insurance parlance. 2. Risk The second element in the process of insurance is the concept of risk. Risk can be defined as the chance of a loss. Risk thus refers to the likely loss or damage that can arise on account of happening of an event. [Risk is sometimes used to refer the subject matter of insurance, as well.] One do not usually expect one’s house to burn or one’s car to have an accident. Yet it can happen. Examples of risks are the possibility of economic loss arising from the burning of a house or a burglary or an accident which results in the loss of a limb. This has two implications. i. Firstly, it means that that the loss may or may not happen. ii. Secondly, the event, the occurrence of which actually leads to the loss, is known as a peril. It is the cause of the loss. 20 Example Examples of perils are fire, earthquakes, floods, lightning, burglary, heart attack etc. Natural wear and tear It is true that nothing lasts forever. Every asset has a finite lifetime during which it is functional and yields benefits. This is a natural process and one discards or changes one’s mobiles, washing machines and clothes when they are worn out. Therefore losses arising out of normal wear and tear are not covered in insurance. Exposure to risk: Occurrence of a peril need not necessarily lead to a loss. A person staying in Mumbai does not suffer any loss due to a flood in coastal Andhra. For loss to happen the asset must be exposed to the peril. Exposure to risk alone is not enough ground for insurance compensation. Example A fire may break out in factory premises without causing actual damage. Insurance comes into play only if there is an actual economic (financial) loss as a result of a peril. Degree of Risk Exposure: Two assets may be exposed to the same peril but the likelihood of loss or the amount of loss may vary greatly. A vehicle carrying explosives can yield far greater loss from fire than tanker carrying water. 3. Risk Management  Extent of damage likely to be suffered This is given by the degree of loss and its impact on an individual or business. On this basis one may identify three types of risk events or situations:  Critical Where losses are of such a magnitude; that may result in total loss or bankruptcy. Losses can be critical when the accident results in significant and severe impact, disability, damage to equipment and the environment, which may be reversible to some extent. Critical losses would include those resulting in serious financial losses, compelling a firm to borrow to continue operations. Example: Critical  A fire in the plant of a large multinational company at Gurgaon destroys inventory worth Rs 1 crore. The loss is heavy but not so high as to lead to bankruptcy. 21  A torpedo from a pirate ship sinks an entire passenger ship but most passengers are saved.  A major accident resulting in a kidney damage necessitating a kidney transplant operation entailing prohibitive costs.  Catastrophic Catastrophic losses signify death or total disability for a large number of people, widespread loss of assets, having significant environmental impact which are practically irreversible. Catastrophic losses usually signify disasters that are sudden, widespread and unstoppable. Example: Catastrophic  An earthquake or flood that completely destroys a few villages  A major fire that completely destroys a multi crore installation over a large territory  The terrorist attack of 9/ 11 on World Trade Centre which caused injuries to a large number of people  A pandemic like Covid – 19 causing disease to people across the globe.  Marginal/ Insignificant Where the possible losses are insignificant and can be easily met from an individual or a firm’s existing assets or current income without imposing any undue financial strain. Example  A minor car accident results in the side being slightly grazed due to which some of the paint is damaged and a fender is slightly bent.  An individual suffering from common cold and cough.. 4. Hazards and Perils The condition or conditions which increase the probability of a loss or its severity, and thus impact(s) the risk is known as hazard. When insurers make an assessment of the risk, it is generally with reference to the hazards to which the asset is subject. The term hazard in insurance language refers to those conditions or features or characteristics which create or increase the chance of loss arising from a given peril. A thorough knowledge of various hazards to which a risk is exposed to is most essential for underwriting. Examples of the link between assets, peril and hazards are given below. 22  Asset Peril Hazard Life Cancer Excessive Smoking Factory Fire Explosive material left Unattended Car Car Accident Careless driving by driver Water seeping in cargo and spoiling; Cargo not packaged in Cargo Storm waterproof containers Important  Types of hazards a) Physical hazard is a physical condition that increases the chance of loss. Example i. Defective wiring in a building ii. Indulging in water sports iii. Leading a sedentary lifestyle b) Moral hazard refers to dishonesty or character defects in an individual that influence the frequency or severity of the loss. A dishonest individual may attempt to commit fraud and make money by misusing the facility of insurance. Example If one deliberately sets a fire to one’s property and collects claims against losses under the policy, such claims are clearly fraudulent and could be justifiably rejected A classic instance of moral hazard is purchasing insurance for a factory and then burning it down to collect the insurance amount or buying health insurance after onset of a major ailment. c) Legal hazard is more prevalent in cases involving a liability to pay for damages. It arises when certain features of the legal system or regulatory environment can increase the incidence or severity of losses. Example The enactment of law governing workmen’s compensation in the case of accidents can raise the amount of liability payable considerably. A major concern in insurance is the relationship between risks and associated hazards. Assets are classified into various risk categories on this basis and the price [premiums] charged for insurance coverage would increase if the susceptibility to loss, arising as a result of the presence of associated hazards, is high. 23 5. Mathematical Principle of Insurance (Risk pooling) The third element in insurance is a mathematical principle that makes insurance possible. It is known as the principle of risk pooling. Example Suppose there are 100000 RCC houses exposed to the risk of fire that can cause an average loss of Rs. 50000. If the chance of a house catching fire is 2 in 1000 [or 2/ 1000 = 0.002] it would mean that the total amount of loss suffered would be Rs 10000000 [= 50000x 0.002 x 100000]. If an insurer were to get the owners of each of the 100000 houses to contribute Rs 100 and if these contributions (100000 x 100 = Rs.10000000) were to be pooled into a single fund, it would be enough to pay for the loss of the unfortunate few who suffered from the fire. To ensure that there is equity [fairness] among all those being insured, it is necessary that the houses should all be similarly exposed to the risk. In the above example risk exposure to mud houses will be different. a) How exactly does the principle work in insurance? It is by pooling number of risks of all the insured similarly placed and exposed to possibility of loss due to a peril that the insurer is able to assume that risk and its financial impact. Large Paying Premium Paying Claims to a number Premium few who suffered of people loss Many Small These small amounts are pooled Big amounts are people amounts of together as a Common Pool, big paid to those who pay money as enough to pay a statistically suffer a loss Premiums estimated number of claims b) Risk pooling and the law of large numbers The probability of damage [derived as 2 out of 1000 or 0.002 in the example above] forms the basis on which the premium is determined. The insurer would face no risk of loss if the actual experience was as expected. In such a situation the premiums of the numerous insured would be sufficient to completely compensate for the losses of those who have been affected by the peril. The insurer would however face a risk if the actual experience was more adverse than expected and the premiums collected were not sufficient to pay the claims. How can the insurer be sure about its predictions? This becomes possible because of a principle known as the “Law of large numbers”. It states that the larger the size of the pool of risks, the actual average of losses would be closer to the estimated or expected average loss. 24  c) Insurance Companies to remain Solvent: If the pools of risks and the premium pools created are not sufficient to meet the liabilities towards paying claims (in case they occur), the system of risk pooling and insurance may fail. Insurers need to have sufficient money with them to honour their promises to all the members of the pool. If they have the sufficient money, they are considered solvent and if they do not have money to meet their obligations, they become insolvent. In other words, Insurers need to keep with them some surplus money (or solvency margin) to meet unforeseen deviations between expected and actual claims situations. Solvency Ratio assesses the extent to which assets are available to cover the insurers’ commitments towards future payments. Different countries use different measures to assess Solvency Ratio. In India, IRDAI has mandated that insurers are required to maintain a minimum solvency ratio of 1.5. Example To give a simple illustration, the probability of getting heads on a toss of the coin is 1 out of 2. But one cannot be sure to actually get 2 heads if a coin is tossed four times. Only when the number of tosses gets very large and closer to infinity, the chance of getting heads once for every two tosses will become closer to one. It follows that insurers can be sure of their ground only when they have been able to insure a large number of insured. An insurer who has insured only a few hundred houses, likely would be worse affected than one who has insured several thousand houses. Important Conditions for insuring a risk When does it make sense to insure a risk from the insurer’s point of view? Six broad requirements for a risk to be considered insurable are given below. i. A sufficiently large number of homogenously [similar] exposed units to make the losses reasonably predictable. This follows from the law of large numbers. Without this it would be difficult to make predictions. ii. Loss produced by the risk must be definite and measurable. It is difficult to decide the compensation if one cannot say for sure that a loss has occurred and how much it is. iii. Loss must be fortuitous or accidental. It must be the result of an event that may or may not happen. The event must be beyond the control of insured. No insurer would cover a loss that is intentionally caused by the insured. 25 iv. Sharing of losses of the few by many can work only if a small percentage of the insured group suffers loss at any given period of time. v. Economic feasibility: The cost of insurance must not be high in relation to the possible loss; otherwise the insurance would be economically unviable. vi. Public policy: Finally the contract should not be contrary to public policy and morality. Test Yourself 1 Which one of the following does not represent an insurable risk? I. Fire II. Stolen goods III. Burglary IV. Loss of goods due to ship capsizing Summary a) The process of insurance has four elements (asset, risk, risk pooling and an insurance contract). b) An asset may be anything that confers some benefit and is of economic value to its owner. c) A chance of loss represents risk. d) Condition or conditions that increase the probability or severity of the loss are referred to as hazards. e) The mathematical principle, that makes insurance possible is known as principle of risk pooling. Key terms a) Asset b) Risk c) Hazard d) Risk pooling e) Offer and acceptance f) Lawful consideration Answers to Test Yourself Answer 1 - The correct option is II. 26  CHAPTER C-03 PRINCIPLES OF INSURANCE Chapter Introduction In this chapter, we discuss the principles, based on which the mechanism of insurance works. a) Utmost Good Faith or "Uberrima fides" is defined as involving “a positive duty to voluntarily disclose, accurately and fully, all facts material to the risk being proposed, whether requested or not". All insurance contracts are based on the principle of Uberrima Fides b) The existence of ‘Insurable Interest’ is an essential ingredient of every insurance contract and is considered as the legal pre-requisite for insurance. c) Indemnity ensures that the insured is compensated to the extent of his loss on the occurrence of the contingent event. d) Subrogation means the transfer of all rights and remedies, with respect to the subject matter of insurance, from the insured to the insurer. e) The principle of contribution implies that if the same property is insured with more than one insurance company, the compensation paid by all the insurers together cannot exceed the actual loss suffered. f) Proximate cause is a key principle of insurance and is concerned with how the loss or damage actually occurred and whether it is indeed as a result of an insured peril. Learning Outcomes A. Uberrima fides B. Insurable Interest C. Proximate Cause D. Indemnity E. Subrogation F. Contribution 27 A. Uberrima Fides Insurance contracts have various special features that are discussed below: 1. Utmost Good Faith or ‘Uberrima Fides’ Utmost Good Faith or "Uberrima fides", one of the fundamental principles of an insurance contract, is defined as “a positive duty to voluntarily disclose, accurately and fully, all facts material to the risk being proposed, whether requested or not". All commercial contracts are based on Good Faith in so much as there shall be no fraud or deceit when giving information or doing the transaction. The rule observed here is that of “Caveat Emptor” which means Buyer Beware. The parties to the contract are expected to examine the subject matter of the contract and so long as one party does not mislead the other and the answers are given truthfully, there is no question of the other party avoiding the contract. Insurance contracts stand on a different footing as the subject matter of the contract is intangible and cannot be easily known to the insurer. Again, there are many facts, which may be known only to the proposer. The insurer has to rely entirely on the proposer for information. Hence the proposer has a legal duty to disclose all material information about the subject matter of insurance to the insurers. That is, the insured should not make any misrepresentation regarding any fact that is material for the insurance contract. This higher obligation of full representation and full disclosure in respect of Insurance contracts makes them contracts of Utmost Good Faith. If Utmost Good Faith is not observed by either party, the contract may be avoided by the other. This follows from the logic that no one should be allowed to take advantage of his own wrong especially while entering into a contract of insurance. a) Material fact has been defined as a fact that would affect the judgment of an insurance underwriter in deciding whether to accept the risk and if so, the rate of premium and the terms and conditions. The insured has an obligation to fully and accurately disclose all facts that are material to an insurance contract. Whether an undisclosed fact was material or not would depend on the circumstances of the individual case and could be decided ultimately only in a court of law. The insured has to disclose facts that affect the risk. Material facts denote the information which enables the insurers to decide:  Whether they will accept the risk?  If so, at what rate of premium and subject to what terms and conditions? This legal duty of utmost good faith arises under common law. The duty applies not only to material facts which the proposer knows, but also extends to material 28  facts which he ought to know. There is a corresponding duty of the insurer not to withhold any information about the policy to the insured. Example The following are some examples of material information that the proposer should disclose while making a proposal: i. Life Insurance: One’s own medical history, family history of hereditary illnesses, habits like smoking and drinking, absence from work, age, hobbies, financial information like income details of proposer, pre-existing life insurance policies, occupation etc. ii. Fire Insurance: Construction, location/ situation of risk and usage of building, age of the building, nature of goods in premises etc. iii. Marine Insurance: Description of goods, method of packing and mode of transit etc. iv. Motor Insurance: Description of vehicle, date of purchase and Regional Registration authority etc. v. Health Insurance: Pre-existing disease, age etc. b) When a Fact becomes ‘Material’: Some types of material facts that one needs to disclose are those indicating that the particular risk represents a greater exposure than can be normally expected. Example Hazardous nature of cargo being sent by a ship, past history of illness, past history burglary of a house. i. Existence of policies taken from all insurers and their present status ii. All questions in the proposal form or application for insurance are considered to be material, as these relate to various aspects of the subject matter of insurance and its exposure to risk. They need to be answered truthfully and be full in all respects. The following are some scenarios wherein material facts need not be disclosed. Information a. Material Facts that need not be disclosed: Unless there is a specific enquiry by underwriters, the proposer has no obligation to disclose facts like: i. Measures implemented to reduce the risk. E.g.: The presence of a fire extinguisher ii. Facts which the insured does not know or is unaware of. E.g.: An individual, who had high blood pressure but was not aware about the same 29  at the time of taking the policy, cannot be charged with non-disclosure of this fact. iii. Which could be discovered, by reasonable diligence. It is not necessary to disclose every minute material fact. The underwriters must be conscious enough to ask for the same if they require further information. E.g.: When insuring a textile shop one does not need to specifically say that some of the synthetic clothes in the shop are highly combustible. iv. Matters of law: Everybody is supposed to know the law of the land. E.g.: Municipal laws about storing of explosives v. About which insurer appears to be indifferent (or has waived the need for further information) In such cases, the insurer cannot later disclaim responsibility on grounds that the answers were incomplete. b. Duty to Disclose: In the case of insurance contracts, the duty to disclose is present throughout the entire period of negotiation until the proposal is accepted and a Life Insurance policy is issued. Once the Life Insurance policy is accepted, there is no further need to disclose any material facts that may come up during the term of the policy. Example Mr. Rajan has taken a Life insurance policy for a term of fifteen years. Six years after taking the policy, Mr. Rajan has some heart problems and has to undergo some surgery. Mr. Rajan does not need to disclose this fact to the insurer. [However, if the policy is in a lapsed condition because of failure to pay the premiums when due and the policy holder seeks to revive the policy contract and bring it back in force, he may, at the time of such revival, have the duty to disclose all facts that are material and relevant, as though it is a new policy.] In the case he has Health Insurance, at the time of renewing the policy, Mr. Rajan has to inform the insurer about this health issue. Similarly, in the case of General Insurance, at the time of renewing the Fire policy for an enterprise/ factory, the insured has to inform the insurer if a change was made in the occupancy of the building. At the time of renewing the Hull policy for a ship, the insured has to inform the insurer if the ship was modified to carry a different type cargo; say, hazardous chemicals instead of pulses. c. Situations of Non-Disclosure may arise when the insured is silent about material facts because the insurer has not raised any specific enquiry. Such situations may also arise through evasive answers to queries raised by the insurer. 30  Often non-disclosure may be inadvertent (meaning that it may be made without one’s knowledge or intention) or because the proposer thought that a fact was not material. In such a case it is innocent. When a fact is intentionally suppressed it is treated as concealment. Here, there is the intent to deceive. d. Misrepresentation: Any statement made during negotiation of a contract of insurance is called representation. A representation may be a definite statement of fact or a statement of belief, intention or expectation. It is expected that the statement must be substantially correct. Representations that concern matters of belief or expectation must be made in good faith. Misrepresentation is of two kinds:- i. Innocent Misrepresentation relates to inaccurate statements, which are made without any fraudulent intention. ii. Fraudulent Misrepresentation on the other hand refers to false statements that are made with deliberate intent to deceive the insurer or are made recklessly without due regard for truth. An insurance contract generally becomes void when there is a clear case of concealment with intent to deceive, or when there is fraudulent misrepresentation. Amendments (March, 2015) to Insurance Act, 1938 have provided certain guidelines about the conditions under which a policy can be called into question for fraud. The new provisions are as follows e. Fraud: The term “Fraud” has been specified under Section 45 (2) of the Insurance Act (amended in 2015). Accordingly, a Life Insurance policy can be called in question on the ground of Fraud by the insurer only within a time period and not later. However, Insurers can do so only within three years from (a) the date of issuance of the policy (b) the date of commencement of risk, (c) the date of revival of the policy or (d) the date of the rider to the policy, whichever is later. The insurer needs to communicate the reasons on which the policy is questioned in writing to the insured or his/ her legal representatives, nominees or assignees. The expression "fraud" means any act committed by the insured, with the intent to deceive the insurer or to induce the insurer to issue an insurance policy. It is also provided that in case the policyholder is not alive, the onus of disproving fraud, lies upon the beneficiaries. B. Insurable interest The existence of ‘insurable interest’ is an essential ingredient of every insurance contract and is considered as the legal pre-requisite for insurance. 31 Three essential elements of insurable interest: i. There must be property, right, interest, life or potential liability capable of being insured. ii. Such property, right, interest, life or potential liability must be the subject matter of insurance. iii. The insured must bear a legal relationship to the subject matter such that he stands to benefit by the safety of the property, right, interest, life or freedom of liability. By the same token, he must stand to lose financially by any loss, damage, injury or creation of liability. Let us see how insurance differs from a gambling or wager agreement. a) Gambling and insurance: Unlike a card game, where one could win or lose, a fire can have only one consequence – loss to the owner of the house. The owner takes insurance to ensure that the loss suffered is compensated for in some way. In other words, Insurable Interest is the interest the insured has in the subject matter of insurance. Insurable interest makes an insurance contract valid and enforceable under the law. Example If Mr. Patel has brought a house with a mortgage loan of Rs 15 lakhs from a bank and he has repaid 12 lakhs of this amount, the bank’s interest would be only to the tune of the balance three lakhs which is outstanding. Thus the bank also has an insurable interest financially in the house for the balance amount of loan that is unpaid and would ensure that it is made a co insured in the policy Mr. Patel owns a house for which he has taken a mortgage loan of Rs. 15 lakhs from a bank. Ponder over the questions below:  Does he have an insurable interest in the house?  Does the bank have an insurable interest in the house?  What about his neighbour? Mr. Dass has a family consisting of spouse, two kids and old parents. Ponder over the below questions:  Does he have an insurable interest in their well-being?  Does he stand to financially lose if any of them are hospitalised?  What about his neighbour’s kids? Would he have an insurable interest in them? 32 It would be relevant here to make a distinction between the subject matter of insurance and the subject matter of an insurance contract. The subject matter of insurance relates to property being insured against, which has an intrinsic value of its own. The subject matter of an insurance contract on the other hand is the insured’s financial interest in that property. It is only when the insured has such an interest in the property that he/ she has the legal right to insure. The insurance policy in the strictest sense covers not the property per se, but the insured’s financial interest in the property. Diagram 1: Insurable interest according to common law b) Time when insurable interest should be present: In life insurance, insurable interest should be present at the time of taking the policy. In general insurance, insurable interest should be present both at the time of taking the policy and at the time of claim with some exceptions like marine policies in which case it must exist at the time of claim. In case of fire and accident insurance, insurable interest should be present both at the time of taking the policy and at the time of loss. In case of health and personal accident insurance apart from self, family can also be insured by the proposer since he/ she stands to incur financial losses if the family meets with an accident or undergoes hospitalisation. However, in marine cargo insurance, insurable interest is required only at the time of loss as the ownership of the goods would change hands when the cost is paid, which can happen during the period of transit. C. Proximate Cause Proximate cause is a key principle of insurance and is concerned with how the loss or damage actually occurred and whether it is as a result of an insured peril. If the loss has been caused by the insured peril, the insurer is liable. If the immediate cause is an insured peril, the insurer is bound to make good the loss, otherwise he is not. This application of principle is practically more in respect of non-life insurance claims. 33 When a loss occurs, there can often be a series of events leading up to the incident and so it is sometimes difficult to determine the nearest or proximate cause. Under this rule, the insurer looks for the predominant cause which sets into motion the chain of events producing the loss. This may not necessarily be the last event that immediately preceded the loss i.e. it is not necessarily an event which is closest to, or immediately responsible for causing the loss. For example, a fire might cause a water pipe to burst. Despite the resultant loss being water damage, the fire would still be considered the proximate cause of the incident. Other causes may be classified as remote causes, which are separate from proximate causes. Remote causes may be present but are not effectual in causing an event. Definition Proximate cause is defined as the active and efficient cause that sets in motion a chain of events which brings about a result, without the intervention of any force started and working actively from a new and independent source. How does the principle of proximate cause apply to insurance contracts? Since insurance provides for payment of a death benefit, regardless of the cause of death, the principle of proximate cause would not usually apply. However many insurance contracts may also have an accident benefit add-on wherein an additional sum assured is payable in the event of accidental death. In such a situation, it becomes necessary to ascertain the cause - whether the death occurred as a result of an accident. The principle of proximate cause would become applicable in such instances. To understand the principle of proximate cause, consider the following situation: Example Scenario 1: Mr. Ajay had parked his car in the garage and gone on a long vacation. Six months later, when he came back and started the car, he noticed that the air- conditioning of the car was not working. Mr. Ajay filed a claim with the insurance company for the cost of repairing the air-conditioning and the insurance company rejected the claim. The reason given by the insurance company was that the damage was due to the ‘normal wear and tear’ of the car and the air-conditioning system, which was an excluded peril in the insurance policy. Mr Ajay approached the Court and after examining the survey report which said that the car was 12 years old and neither the car nor the air-conditioning had been serviced/ repaired during the previous 6 years, the damage was due to the ‘normal wear and tear’ and the insurance company was not liable to pay the claim. Scenario 2: Mr. Pinto, while riding a horse, fell on the ground and had his leg broken, he was lying on the wet ground for a long time before he was taken to hospital. Because of lying on the wet ground, he had fever that developed into pneumonia, finally dying of this cause. Though pneumonia might seem to be the 34 immediate cause, in fact it was the accidental fall that emerged as the proximate cause and the claim was paid under personal accident insurance. There are certain losses which are suffered by the insured as a result of fire but which cannot be said to be proximately caused by fire. In practice, some of these losses are customarily paid by business under fire insurance policies. Example of such losses can be –  Damage to property caused by water used to extinguish fire  Damage to property caused by fire brigade in execution of their duty  Damage to property during its removal from a burning building to a safe place Test Yourself 1 Mr. Pinto contracted pneumonia as a result of lying on wet ground after a horse riding accident. The pneumonia resulted in death of Mr. Pinto. What is the proximate cause of the death? I. Pneumonia II. Horse III. Horse riding accident IV. Bad luck D. Indemnity The Principle of Indemnity is applicable to Non-life insurance policies. It means that the policyholder, who suffers a loss, is compensated so as to put him or her in the same financial position as he or she was before the occurrence of the loss event. The insurance contract guarantees that the insured would be indemnified or compensated up to the amount of loss and no more. The philosophy is that one should not make a profit through insuring one’s assets and recovering more than the loss. The insurer would assess the economic value of the loss suffered and compensate accordingly. Example Ram has insured his house, worth Rs. 10 lakhs, for the full amount. He suffers loss on account of fire estimated at Rs. 70,000. The insurance company would pay him an amount of Rs. 70,000. The insured can claim no further amount. The indemnity to be paid would depend on the type of insurance one takes.Indemnity might take one or more of the following modes of settlement:  Cash payment  Repair of a damaged item  Replacement of the lost or damaged item  Reinstatement (Restoration). E.g. Rebuilding a house destroyed by fire 35  Diagram 2: Indemnity a) Agreed Value: However, there is some subject matter whose value cannot be easily estimated or ascertained at the time of loss. For instance, it may be difficult to put a price in the case of family heirlooms or rare artefacts. Similarly in marine insurance policies it may be difficult to estimate the extent of loss suffered in a ship accident half way around the world. In such instances, a principle known as the ‘Agreed Value’ is adopted. The insurer and insured agree on the value of the property to be insured, at the beginning of the insurance contract. In the event of total loss, the insurer agrees to pay the agreed amount of the policy. This type of policy is known as “Agreed Value Policy”. b) Underinsurance: Consider a situation now where the property has not been insured for its full value. One would then be entitled to indemnity for loss only in the same proportion as one’s insurance. Suppose the house, worth Rs. 10 lakhs has only been insured for a sum of Rs. 5 lakhs. If the loss on account of fire is Rs. 60,000, one cannot claim this entire amount. It is deemed that the house owner has insured only to the tune of half its value and he is thus entitled to claim just 50% [Rs. 30,000] of the amount of loss. This is known as underinsurance. In most types of non-life insurance policies, which deal with insurance of property and liability, the insured is compensated to the extent of actual amount of loss i.e. the amount of money needed to replace lost or damaged property at current market prices less depreciation. E. Subrogation Subrogation means the transfer of all rights and remedies with respect to the subject matter of insurance, from the insured to the insurer. Subrogation follows from the principle of Indemnity. Hence, it is often called a ‘corollary’ of Indemnity. In other words, if an insured suffers a loss and the loss has been indemnified by the insurer, the insured’s right to get compensated by any third party for that loss, 36 would get shifted to the insurer. Note that the amount of damage that can be collected by the insurance company is only to the extent of the amount paid by the insurance company. Important Subrogation: It is the process an insurance company uses to recover claim amounts paid to a policy holder from a negligent third party. Subrogation can also be defined as surrender of rights by the insured to an insurance company that has paid a claim against the third party. Example Mr. Kishore’s household goods were being carried in Sylvain Transport service. They got damaged due to driver’s negligence, to the extent of Rs. 45,000 and the insurer paid an amount of Rs. 30,000 to Mr. Kishore. The insurer stands subrogated to the extent of only Rs. 30,000 and collect that amount from Sylvain Transports. In case the matter went into litigation and the Court directed Sylvain Transports to pay Rs.35,000 as compensation to Mr. Kishore, he is liable to pay the insurer the claim amount of Rs 30,000 under the subrogation clause, and to keep the balance amount of Rs 5,000 with himself. The Subrogation Clause prevents the insured from collecting more than the loss - from the insurance company and from any third party. Subrogation arises only in case of contracts of indemnity and not against benefit policies like Life Insurance Policy or Personal Accident Policy. Example Mr. Suresh dies in an air crash. His family is entitled to collect the full Sum Assured of Rs 50 lakhs from the insurer who has issued a Personal Accident Policy plus the compensation paid by the airline, say, Rs 15 lakhs. F. Contribution: Like Subrogation, ‘Contribution’ also follows from the Principle of Indemnity. Hence, it is also called a ‘corollary’ of Indemnity. Contribution is a principle that arises in general insurance contracts. It tells us how the liability is to be met when the insured has taken insurance from more than one insurer. Contribution implies that if the same property is insured with more than one insurance company, the compensation paid by all the insurers together cannot exceed the actual loss suffered. The policy holder can claim from each of the insurers only a portion of the loss in proportion to the amount insured with each. Example: If Mr Srinivas has taken a fire policy on his house with two insurance companies, with both of whom, he insured for the full value of Rs.12 lakhs. Suppose 37 a fire breaks out and he suffers a loss of Rs 3 lakhs as a result, he can claim an amount of Rs 1.5 lakhs from each of the insurers. The Principle of Contribution applies only to indemnity policies. It does not arise in the case of Life Insurance, because there is no upper limit that can be placed on the losses suffered when there is a loss of life. Test Yourself 2 Which among the following is an example of coercion? I. Ramesh signs a contract without having knowledge of the fine print II. Ramesh threatens to kill Mahesh if he does not sign the contract III. Ramesh uses his professional standing to get Mahesh to sign a contract IV. Ramesh provides false information to get Mahesh to sign a contract Test Yourself 3 Which among the following options cannot be insured by Ramesh? I. Ramesh’s house II. Ramesh’s spouse III. Ramesh’s friend IV. Ramesh’s parents Test Yourself 4 What is the significance of the principle of contribution? I. It ensures that the insured also contributes a certain portion of the claim along with the insurer II. It ensures that all the insured who are a part of the pool, contribute to the claim made by a participant of the pool, in the proportion of the premium paid by them III. It ensures that multiple insurers covering the same subject matter; come together and contribute the claim amount in proportion to their exposure to the subject matter IV. It ensures that the premium is contributed by the insured in equal instalments over the year. Summary  The special features of insurance policies include: i. Uberrima fides, ii. Insurable interest, iii. Proximate cause, iv. Indemnity v. Subrogation 38  vi. Contribution Key Terms 1. Non-Disclosure 2. Misrepresentation 3. Material facts 4. Agreed Value 5. Under Insurance Answers to Test Yourself Answer 1 - The correct option is III Answer 2 - The correct option is II Answer 3 - The correct option is III Answer 4 - The correct option is III 39  CHAPTER C-04 FEATURES OF INSURANCE CONTRACTS Chapter Introduction In this chapter, we discuss the elements that govern the working and special features of an insurance contract. Learning Outcomes A. Legal Aspects of Insurance Contracts B. Elements of a valid contract C. Premium payment in advance D. Solicitation E. Enabling Provisions like Grace Period and Free-look 40 A. Insurance contracts – Legal aspects and special features. The chapter also deals with the legal aspects and special features of an insurance contract. 1. The Insurance Contract Insurance involves a contractual agreement in which the insurer agrees to provide financial protection against certain specified risks for a price or consideration known as the premium. The contractual agreement takes the form of an insurance policy. 2. Legal aspects of an insurance contract This section looks at some features of an insurance contract and considers the legal principles that govern insurance contracts in general. Important A contract is an agreement between parties, enforceable at law. The provisions of the Indian Contract Act, 1872 govern all contracts in India, including insurance contracts. An insurance policy is a contract entered into between two parties, viz., the company, called the insurer, and the policy holder, called the insured and fulfils the requirements enshrined in the Indian Contract Act, 1872. Diagram 1: Insurance contract 41 B. Elements of a valid contract Diagram 2: Elements of a valid contract The elements of a valid contract are: 1. Offer and acceptance When one person signifies to another his willingness to do or to abstain from doing anything with a view to obtaining the assent of the other to such act, he is said to make an offer or proposal. Usually, the offer is made by the proposer, and acceptance made by the insurer. When a person to whom the offer is made signifies his assent thereto, this is deemed to be an acceptance. Hence, when a proposal is accepted, it becomes a promise. The acceptance needs to be communicated to the proposer which results in the formation of a contract. When a proposer accepts the terms of the insurance plan and signifies his/ her assent by paying the deposit amount, which, on acceptance of the proposal, gets converted to the first premium, the proposal becomes a policy. If any condition is put, it becomes a counter offer. The policy bond becomes the evidence of the contract. 2. Consideration This means that the contract must contain some mutual benefit for the parties. The premium is the consideration from the insured, and the promise to indemnify, is the consideration from the insurers. 3. Agreement between the parties (Consensus Ad-Idem) Both the parties, the insurer and the policyholder, should agree to the same thing in the same sense. In other words, there should be “consensus ad-idem” between both parties. 42 4. Free consent There should be free consent while entering into a contract. Consent is said to be free when it is not caused by  Coercion/ By Force  Undue influence  Fraud  Misrepresentation  Mistake When consent to an agreement is caused by coercion, fraud or misrepresentation, the agreement is voidable. 5. Capacity of the parties Both the parties to the contract must be legally competent to enter into the contract. The policyholder must be legally an adult at the time of signing the proposal and should be of sound mind and not disqualified under law. For example, minors cannot enter into insurance contracts. 6. Legality The object of the contract must be legal, for example, no insurance can be had for illegal acts. Every agreement of which the object or consideration is unlawful is void. The object of an insurance contract is a lawful object. Also one’s entering into an insurance contract should be done out of one’s free will, without any kind of force, fear or mistake. C. Paying Premium in Advance As per Indian laws, Insurers are not allowed to assume risk unless they receive the premium in advance. In other words, insurance protection cannot be sold on credit basis in India. Section 64 VB of the Insurance Act 1938 states, “No risk to be assumed unless premium is received in advance”. No insurer shall assume any risk unless and until the premium is received in advance or is guaranteed to be paid or a deposit is made in advance in the prescribed manner. This is an important feature of the insurance industry in India. The Insurance Rules, 1939, provide certain exceptions to this condition of advance payment of premium, in respect of particular categories of insurances. Section 59 of the Insurance Rules allows accepting premiums in instalments in respect of Sickness Insurance, Group Personal Accident Insurance Medical Benefits Insurance and Hospitalisation Insurance Schemes, subject to certain conditions. Section 59 of the Insurance Rules allows relaxations for policies issued to Government and semi- Government bodies, Fidelity Guarantee Insurance policies covering Government and 43 semi-Government employees, Workmen's Compensation policies, Cash in Transit policies, and some other categories of insurances subject to certain conditions. Solicitation Insurance has always been regarded as something to be purchased after a proper understanding the product and not just bought/ sold. Hence, insurance is to be ‘solicited’ or asked for by the customer. Traditionally, insurers declare that “Insurance is the subject matter of solicitation”. To elucidate, insurance is not a ready-made product like a packet of biscuits or a bar of chocolate to be bought/ sold outright. Customers have to discuss their insurance needs with a person qualified for the same and based on professional advice, the right insurance product is to be purchased. The Insurance product has to be understood and the offering most suited to the specific needs and requirements of the customer in terms of the policy coverage, exclusions, terms and conditions, is to be considered. ‘Solicitation’ is usually initiated when an insurer or an authorised intermediary approaches a prospect with a view to understand his/ her insurance needs and provides professional advice in selecting appropriate insurance products. The prospect solicits the proper solution and provides all requisite details to the advisor. As per regulations of IRDAI, Insurance Agents are appointed by an insurer for the purpose of engaging in the solicitation process and procuring insurance business, including business relating to the continuance, renewal or revival of policies of insurance. Only authorised employees of insurance companies, and specified persons of licensed intermediaries, who are trained and authorised for the purpose can be part of the process of solicitation and sales of insurance. D. Enabling Provisions 1. Grace Period Grace period is the specified period of time immediately following the premium due date during which a payment can be made to renew or continue a policy in force without loss of continuity benefits such as waiting periods and coverage of pre-existing diseases. Coverage is not available for the period for which no premium is received. The days of grace are computed from the next day after the due date fixed for payment of the premium. For Life insurance, if there is no grace period, a single delay in payment can lead to a policy lapse. This would be detrimental for the policyholder, the insurer and the insurance industry in general. IRDAI Regulations allow a grace period of 15 days is applicable in case of Monthly mode of Premium collection and 30 days in other modes. 44 In respect of Health insurance also, certain number of days as grace period is allowed for renewal of individual health policies. This period depends on the policy of the company and the product offered. All continuity benefits are maintained if the policy is renewed within the grace period. However Claims, if any, during the break period will not be considered. As per IRDAI Regulations, the grace period is 15 days in case of Monthly mode of Premium collection and 30 days in other modes. Motor Policies are usually valid for a period of one year and have to be renewed before the due date. Grace period for paying the premium do not apply. In case a comprehensive policy lapses for more than 90 days, the accrued No Claim Bonus (NCB) benefit would also be lost. In the interest of smooth operation of affairs during the Covid-19 pandemic, IRDAI permitted the following relaxations: i. In case of Life insurance policies, Insurers were asked to enhance the grace period by additional 30 days if desired by the policyholders. ii. In case of Health insurance policies, Insurers were told to condone delays in renewal up to 30 days without deeming such condonation as a break in policy. Insurers were requested to contact the policyholders well in advance to avoid discontinuance in coverage. iii. As regards Motor Vehicle Third Party Insurance policies that fell due for renewal and premiums could not be paid due to the Covid-19 situation, IRDAI allowed a grace period till 15th May, 2020. 2. Free-Look Period introduced by “IRDAI” Insurance contracts are drafted by the insurer, and the other party has to adhere to it if he/ she wants the insurance. Such contracts where someone has to accept the contract as it is and cannot make any change to it are legally called Contracts of Adhesion. Because of this one-sided situation, the Courts always make insurers liable for any ambiguity or confusion that may arise in interpreting these terms and conditions. To reduce this one-sidedness and make insurance transactions more customer friendly, IRDAI has built into its regulations a consumer-friendly provision called ‘Free-Look Period’ whereby, if the customer is not satisfied with any term and conditions of the policy, he/ she can return it and get a refund. This provision whereby policyholders are given the option of cancelling the policy within 15 days (30 days, in case of electronic policies and policies sourced through distance mode) after receiving the policy document, in case they are not satisfied with the policy, has been introduced for Life Insurance and Health Insurance policies (having a tenure of at least one year). The company has to be intimated in writing and the premium is refunded less, proportionate risk premium for the period of cover, expenses and charges. 45 Cancellation of Policies: When policies are cancelled by the insurer, the proportion of the premium corresponding to the expired period of insurance is charged/ retained by the insurer and the proportion corresponding to the unexpired period of insurance is returned to the insured, provided no claim has been paid under the policy. Such proportionate calculation of premium is called Pro-rata premium. When annual policies are cancelled by the insured, insurers usually charge/ retain premiums at a higher rate and refund premiums at higher rates, instead of calculating pro-rata premiums. This would prevent anti-selection against the insurers and take care of the initial expenses of the insurer. Such rates are disclosed as part of the terms and conditions of the insurance contract and referred to as Short period scales. Important i. Coercion - Involves pressure applied through criminal means. ii. Undue influence – using one’s position to dominate the will of another person, to obtain an undue advantage over that person. iii. Fraud – inducing another to act on a false belief that is caused by a representation one does not believe to be true. It can arise either from deliberate concealment of facts or through misrepresenting them. iv. Mistake - Error in one’s knowledge or belief or interpretation of a thing or event. This can lead to an error in understanding and agreement about the subject matter of the contract. Test Yourself 1 Which among the following cannot be an element in a valid insurance contract? I. Offer and Acceptance II. Coercion III. Consideration IV. Legality Summary i. Insurance involves a contractual agreement in which the insurer agrees to provide financial protection against specified risks for a price or consideration known as the premium. ii. A contract is an agreement between parties, enforceable at law. iii. The elements of a valid contract include:  Offer and acceptance  Consideration,  Consensus ad-idem,  Free consent  Capacity of the parties and 46   Legality of the object Key Terms 1. Offer and Acceptance 2. Lawful consideration 3. Consensus ad idem Test Yourself 2 During the Free-look period, if the policyholder, who has bought a policy through an Agent, disagrees to any of its terms and conditions, he/ she can return it and get a refund subject to the following conditions: I. He/ she can exercise this option within 15 days of receiving the policy document II. He/ she has to communicate to the company in writing III. The premium refund will be adjusted for proportionate risk premium for the period on cover, expenses incurred by the insurer on medical examination and stamp duty charges IV. All the above Test Yourself 3 If the policyholder has bought a policy and does not want it, he/ she can return it during the _________ period, and get a refund. I. Free evaluation II. Free-look III. Cancellation IV. Free trial Answers to Test Yourself Answer 1 - The correct option is II. Answer 2 - The correct option is IV. Answer 3 - The correct option is II. 47  CHAPTER C-05 UNDERWRITING AND RATING Chapter Introduction In this chapter you will learn the basics of underwriting and rating. You will learn about the different methods of dealing with hazards in the process of rating of risks. You will be able to appreciate the common aspects of underwriting, product approval and rating. Learning Outcomes A. Basics of Underwriting B. Product Filing with IRDAI C. Basics of Ratemaking D. Rating factors After studying this chapter, you should be able to: 1. Define the basics of underwriting 2. Understand the basics of product approvals in India 3. Appreciate rating factors and the importance of ratemaking 48 A. Basics of Underwriting In the previous chapters, we have seen that the concept of insurance involves managing risk through pooling. Insurers create a pool consisting of premiums that are made by several individuals/ commercial/ industrial firms/ organizations. This process of understanding risks, classifying risks, identifying which category they fall into, deciding whether to accept the risk or not and if so, how much premium the insurer would require to accept the risk and whether any extra conditions are to be imposed on the risk - all these are part of underwriting. It is also important to know what rate is to be charged and how the rates are made. Definition Underwriting is the process of determining whether a risk offered for insurance is acceptable, and if so, at what rates, terms and conditions. Underwriting comprises the following steps: i. Assessment and evaluation of hazard and risk in terms of frequency and severity of loss ii. Formulation of policy coverage and terms and conditions iii. Fixing of rates of premium The underwriter decides on whether or not to accept the risk The next step would be to decide the rates, terms and conditions under which the risk is to be accepted. Underwriting skills are acquired through a continuous learning process involving adequate training, field exposure and deep insights. To be a fire insurance underwriter one needs to have a good knowledge of the likely causes of fire, impact of fire on various physical goods and property, the process involved in an industry, geography, climatic conditions etc. Similarly a marine insurance underwriter must be aware about port/ road conditions, problems encountered by cargo/ goods in transit or storage, ships and their seaworthiness and so on. A health underwriter needs to understand the risk profile of the insured, age, medical aspects, fitness levels and family history and measure the effect of each factor affecting the risk. Sources of information for underwriting The first stage in any numerical (or statistical) analysis is the collection of data. When pricing a risk, an underwriter should gather as much information as possible to aid accurate assessment. 49 Sources of information are: i. Proposal form or underwriting presentation ii. Risk surveys iii. Historic claims experience data: For some classes of business, such as personal and motor lines, underwriters often utilise historic claims experience data to provide an indication of the likely future claims experience, and to arrive at a suitable premium. Underwriting, equity and business sustainability The need for careful underwriting and risk classification in insurance arises from the simple fact that all risks are not equal. Each risk thus needs to be appropriately assessed and priced in accordance with the likelihood of loss occurrence and severity. Since all risks are not equal, it would not be proper to ask all those who are to be insured, to pay equal premium. The purpose of underwriting is to classify risks so that, depending on their characteristics and degree of risk posed, an appropriate rate of premium may be charged. It is important for the underwriter to ensure that the risk evaluation is done properly and the premium charged is neither too low to cover the risk nor too high to make it non-competitive. The main features of underwriting are as follows i. To identify risk based upon the characteristics ii. To determine the level of risk presented by the proposer The objectives of underwriting are achieved, in short, by deciding the level of acceptability, adequacy of premium and other terms. B. Product Filing with IRDAI Every Insurance product needs to be filed with IRDAI for approval before it is offered for sale. IRDAI allots a Unique Identification number (UIN) for every insurance product. Once products are introduced in the market, there are guidelines to be followed for withdrawing the product as well. 1. The Regulator asks for a clear commitment by the Board of the insurer that it is willing to accept the risks in the policy and agrees to pay the claims. It also asks the insurer to commit that the policy wordings are fair to the customer and that the prices are decided on a scientific basis. 2. The insurer should plan for the possibility of withdrawal of the products in the future and the options that would be available to the policyholder on such withdrawal of the product. 3. The withdrawn product shall not be offered to the prospective customers. 50 C. Basics of Ratemaking Insurance is based on transfer of risk to the insurer. By purchasing an insurance policy, the insured is able to reduce the impact of financial losses arising from the peril against which the property is insured. The Insurer needs to adopt a process of calculating a price to cover the future cost of insurance claims and expenses, including a margin for profit. This is known as ratemaking. A rate is the price of a given unit of insurance. For example, a rate may be expressed as Rs.1.00 per mile (per thousand) sum assured for earthquake coverage. Each rate is established after looking at past trends and changes in the current environment that may affect potential losses in the future. Note that rates are not the same as premiums. Premium = (Sum Insured) x (rate) Example Taking an example of health insurance, numerical or percentage assessments are made on each component of the risk. Factors li