The concept of insurance originates from the principle of sharing the risks by a large group to reduce the burden on the few. Insurance also refers to ‘Risk Transfer’ in the language of risk management techniques.
Insurance is a legal contract involving two parties, where one party proposes to the other for indemnification against financial loss arising from an event which is not in control of either party. The party proposing the contract is called proposer and the party examining and reacting to the proposal is the insurer. If the insurer accepts the proposal, the proposer becomes the insured and pays the premium specified by the insurer for the cover.
Life insurance contracts are different in the manner that the insured himself does not benefit from the protection. Since it is difficult to assign an economic value to a person’s life, deciding the sum assured becomes hard.
A life insurance can also be seen as covering the financial interests of the dependents of the insured. Though, conceptually it remains the same as any other insurance contract.
Let us see an example to understand the same.
A town has about 5000 families and houses, and each year about 10 of these houses are either damaged or destroyed by the storm and temporary floods that hit the area in the rainy season. Repairing these houses costs on an average Rs. 150,000 each year.
The simple statistical analysis of historical data shows that while all the houses are at risk of damage or destruction only 10 (i.e. Rs. 150,000 in repair costs) will need all time preparation. Therefore, it is decided that funds to the tune of the town management should pool Rs. 1.5 Lakh with the contribution from each family.
Since there are 5000 houses individually owned by the families, each family must contribute only Rs. 30 every year to cover the cost of property damage. This is the simplest arrangement of the insurance contract, where Rs. 30 is the premium payable for the insurance cover.
Another example of the same can be, a merchant seeking insurance cover for his cargo going overseas. To insure the shipment cost he can approach a person with sound financial stature and repute (possibly a bank) and propose to pay a premium to the banker, if he/she agrees to cover the costs if the cargo is lost on the seas. The banker, on the other hand, will try to diversify his risk of covering entire loss by insuring multiple merchant shipments.
The premium in this case as well will be based on the experience of losses.
Case of Life Insurance
In a city of 4 lakh inhabitants, 1 lakh are employed and earning money. These one lakh income earners are responsible for the remaining three lakh residents. Assume that each working person has three dependents. Any mishap with this person can lead to loss of income for the remaining dependent members, and result in long enduring distress and poverty for them.
To safeguard the citizens from such future, the city has estimated the magnitude of funds they need to pool for supporting the dependents of those who meet a premature death. It is estimated that out of 1 lakh working population at least two are expected to die each year prematurely. It is also estimated that a family of three needs approximately Rs. 20 Lakh to survive and complete their education goals and thus, the city must maintain a pool of at least Rs. 40 lakh each year, to support such families.
The income earners must share the pool burden equally, and thus they all get to pay a premium of Rs. 40 each year to safeguard their dependents future.