What is insurance?

What is insurance?

We can define insurance as follows: 

Insurance is a contract between the insurance company (insurer) and the policyholder (insured). In return for a consideration (the premium), the insurance company promises to pay a specified amount to the insured on the happening of a specific event.

That is all very well. But what does it mean? The first step in being able to answer this question is to understand why insurance is needed.

The need for insurance 

Consider the following case study to understand the need for insurance.

Case study

Ajay is 35 years old and works for a multinational corporation (MNC). He has a ten-year-old son, Vijay, whom he dreams will one day become a doctor. Ajay’s spouse is a housewife, and his parents are retired and dependent on him. Ajay has a home loan and is making monthly investments for Vijay’s higher studies and marriage and his own retirement. Ajay wants to ensure that Vijay gets the best of everything and that he himself is not dependent on Vijay during his retirement in the way that Ajay’s parents are on him. So far everything is going well with Ajay’s plans. But imagine what will happen in the following scenario.

One day while returning home from the office Ajay has an accident and dies. What will happen? Who will take care of the family, Vijay’s education and marriage, the home loan etc.? What are the options available to Ajay so that his family can be taken care of in his absence?

Now put yourself in Ajay’s shoes and imagine you are the family income provider and have to face the above scenario. What will you do? Relax! Our intention is not to panic or scare you. We are using this case study to try to help you realise the importance of insurance which is the solution to all the problems Ajay faces should the above scenario happen. So, let’s look at the scenario again and see how insurance can provide a solution.

Life insurance provides protection to a family on the untimely death of the income provider. If Ajay has adequate life insurance cover, then should he die, the money received from the life insurance company can help to support his family. The insurance money will help to take care of the family’s living expenses, Vijay’s education and marriage, and the cost of the home loan etc.

Now that we have looked at the above scenario, we can see how insurance, in this case life insurance, can safeguard a person against unexpected events.

Consider this…

As the income provider for your family, what risks are you exposed to? Do you have any financial goals that you would like to protect?

How does insurance work?

Now that you understand the need for insurance, we can move on to understanding how insurance works exactly.

Let us continue with our case study of Ajay. The risk of premature death described above is only one of the risks that Ajay faces. He faces many other risks – that he will need medical care at some point, that his home may burn down, for instance. Ajay can handle these risks in different ways.

Risk retention: One, not very wise way, of handling these risks is to retain them, i.e. for Ajay to bear the risk that he will have to provide for these situations himself, and so do nothing about them. While times are good and none of these events happen, Ajay need not be worried. But the moment any one of them does happen, Ajay will be in trouble. So it is definitely not wise for Ajay to retain, or handle, these risks himself. 

Risk transfer: The other way of handling these risks is to transfer them to someone who can handle them properly. In simple words, the process of transferring risks from one person who does not have the capacity to bear them to someone who does have the capacity for them, is known as insurance.

At this point, it may be useful to return to our definition of insurance:

Insurance is a contract between the insurance company (insurer) and the policyholder (insured). In return for a consideration (the premium), the insurance company promises to pay a specified amount to the insured on the happening of a specific event.

Insurance, then, is nothing but a risk transfer mechanism wherein the person taking out insurance transfers their risk to the insurance company in return for a payment (known as the premium). So in Ajay’s case he can take out insurance, pay the premium and transfer his risks to the insurance company.

Insurance companies collect premiums from people like Ajay – from all those who are exposed to the same risks – and put the money into a risk pool. Not everyone will experience the happening of an insured event at the same time, but those who do are compensated from this risk pool.

So, from the above explanation we can see that insurance is:

• the process of transferring the risk from the owner (insured person);

• to another party (insurer) who can bear that risk;

• in return for a consideration (premium).

The business of insurance relates to the protection of the economic value of assets. An asset is valuable to its owner because they expect some benefits from it. The benefit can be in the form of income generated from the asset (giving a car on rent) or convenience (using the car for their own travel).

Human beings are also assets in the sense that they have the capacity to generate income themselves. Every human being has a finite life span, and death is certain. But the timing of death is uncertain. If a person dies unexpectedly early in their working life, then their family will lose the income that person would have generated in future, had they survived for their entire working life. This is where life insurance acts to fill the financial gap left behind by the early death of a person. The timing of death is uncertain for everyone, so potentially every human being needs life insurance from an early age, to protect future income.

Life insurance can protect the family from financial hardship in the event that the untimely death of an individual leads to a loss of income.

So now we know, in the simplest of terms, how insurance works. We have seen how it can benefit the individual by providing protection against the losses that arise from life’s most unhappy events. However, insurance and the insurance industry also have benefits beyond the individual, and we will look at these in the following sections.


Anand Khemka
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