B.com-I,II-banking and insurance
B.Com SEM-I
Subject:- Fundamentals of Banking / INSURANCE
Defines Banking? What are the types of Banking?
What is banking and what is the role of banking in an economy?
In simple words, Banking can be defined as the business activity of accepting and safeguarding money owned by other individuals and entities, and then lending out this money in order to earn a profit. However, with the passage of time, the activities covered by banking business have widened and now various other services are also offered by banks. The banking services these days include issuance of debit and credit cards, providing safe custody of valuable items, lockers, ATM services and online transfer of funds across the country / world.
It is well said that banking plays a silent, yet crucial part in our day-to-day lives. The banks perform financial intermediation by pooling savings and channelizing them into investments through maturity and risk transformations, thereby keeping the economy’s growth engine revving.
Banking business has done wonders for the world economy. The simple looking method of accepting money deposits from savers and then lending the same money to borrowers, banking activity encourages the flow of money to productive use and investments. This in turn allows the economy to grow. In the absence of banking business, savings would sit idle in our homes, the entrepreneurs would not be in a position to raise the money, ordinary people dreaming for a new car or house would not be able to purchase cars or houses.
What is a bank? Define a Bank ?
In simple words, we can say that Bank is a financial institution that undertakes the banking activity ie.it accepts deposits and then lends the same to earn certain profit.
What is a Banking Company?
Any company, which transacts the business of banking defined above is termed as Banking company
What is Banking System ?
Banking systems can be defined as a mechanism through which the money supply of the country is created and controlled.
Which are the oldest banks in India :
In 1839, some Indian merchants in Calcutta established India's first bank known as "Union Bank", but it could not survive for long and failed in 1848 due to economic crisis of 1848-49. Similarly, in 1863, "Bank of Upper India" was formed but it failed in 1913.
In 1865, "Allahabad Bank" was established as a joint stock bank. This bank has survived till date and is now considered as the oldest surviving bank in India.
Type of Banks:
Different Types of Banks & their Functions-
a) Public sector b) Private sector
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The focus of banking is varied, the needs diverse and methods different. Thus, we need distinctive kinds of banks to cater to the above-mentioned complexities. Deposit-taking institutions take the form of commercial banks, which accept deposits and make commercial, real estate, and other loans. There are also mutual savings banks, which accept deposits and make mortgage and other types of loans. Another type is credit unions, which are cooperative organizations that issue share certificates and make member (consumer) and other loans.
1. Retail Banks:
Retail banks provide basic banking services to individual consumers. Examples include savings banks, savings and loan associations, and recurring and fixed deposits. Products and services include safe deposit boxes, checking and savings accounting, certificates of deposit (CDs), mortgages, personal, consumer and car loans.
2. Commercial Banks:
Banking means accepting deposits of money from the public for the purpose of lending or investment. Commercial Banks provide financial services to businesses, including credit and debit cards, bank accounts, deposits and loans, and secured and unsecured loans.
Due to deregulation, commercial banks are also competing more with investment banks in money market operations, bond underwriting, and financial advisory work.
Commercial banks in modern capitalist societies act as financial intermediaries, raising funds from depositors and lending the same funds to borrowers. The depositors’ claims against the bank, their deposits, are liquid, meaning banks are expected to redeem deposits on demand, instantly.
Banks’ claims against their borrowers are much less liquid, giving borrowers a much longer span of time to repay money owed banks. Because a bank cannot immediately reclaim money lent to borrowers, it may face bankruptcy if all its depositors show up on a given day to withdraw all their money.
There are two types of commercial banks, public sector and private sector banks.
a) Public Sector Banks:
Public sectors banks are those in which the government has a major stake and they usually need to emphasize on social objectives than on profitability.
b) Private sector banks:
Private sector banks are owned, managed and controlled by private promoters and they are free to operate as per market forces.
3. Cooperative Banks:
Cooperative Banks are governed by the provisions of State Cooperative Societies Act and meant essentially for providing cheap credit to their members. It is an important source of rural credit i.e., agricultural financing in India.
4. Investment Banks:
An investment bank is a financial institution that assists individuals, corporations and governments in raising capital by underwriting and/or acting as the client's agent in the issuance of securities. An investment bank may also assist companies involved in mergers and acquisitions, and provide ancillary services such as market making, trading of derivatives, fixed income instruments, foreign exchange, commodities, and equity securities.
Investment banks aid companies in acquiring funds and they provide advice for a wide range of transactions. These banks also offer financial consulting services to companies and give advice on mergers and acquisitions and management of public assets.
5. Specialized Banks:
Specialized banks are foreign exchange banks, industrial banks, development banks, export-import banks catering to specific needs of these unique activities. These banks provide financial aid to industries, heavy turnkey projects and foreign trade.
6. Central Banks:
Central banks are bankers’ banks, and these banks trace their history from the Bank of England. They guarantee stable monetary and financial policy from country to country and play an important role in the economy of the country. Typical functions include implementing monetary policy, managing foreign exchange and gold reserves, making decisions regarding official interest rates, acting as banker to the government and other banks, and regulating and supervising the banking industry.
These banks buy government debt, have a monopoly on the issuance of paper money, and often act as a lender of last resort to commercial banks. The term bank nowadays refers to these commercial banks. The Central bank of any country supervises controls and regulates the activities of all the commercial banks of that country. It also acts as a government banker. It controls and coordinates currency and credit policies of any country. The Reserve Bank of India is the central bank of India.
Q.2 What are the Functions of Banks?
The functions of banks are briefly highlighted in following Diagram or Chart.
These functions of banks are explained in following paragraphs of this article.
A. Primary Functions of Banks ↓
These primary functions of banks are explained below.
a. Saving Deposits
b. Fixed Deposits
c. Current Deposits
d. Recurring Deposits
a. Saving Deposits
c. Current Deposits
The types of bank loans and advances are :-
a. Overdraft
b. Cash Credits
c. Loans
d. Discounting of Bill of Exchange
a. Overdraft
The client is allowed cash credit upto a specific limit fixed in advance. It can be given to current account holders as well as to others who do not have an account with bank. Separate cash credit account is maintained. Interest is charged on the amount withdrawn in excess of limit. The cash credit is given against the security of tangible assets and / or guarantees. The advance is given for a longer period and a larger amount of loan is sanctioned than that of overdraft.
c. Loans
It is normally for short term say a period of one year or medium term say a period of five years. Now-a-days, banks do lend money for long term. Repayment of money can be in the form of installments spread over a period of time or in a lumpsum amount. Interest is charged on the actual amount sanctioned, whether withdrawn or not. The rate of interest may be slightly lower than what is charged on overdrafts and cash credits. Loans are normally secured against tangible assets of the company.
d. Discounting of Bill of Exchange
The bank can advance money by discounting or by purchasing bills of exchange both domestic and foreign bills. The bank pays the bill amount to the drawer or the beneficiary of the bill by deducting usual discount charges. On maturity, the bill is presented to the drawee or acceptor of the bill and the amount is collected.
B. Secondary Functions of Banks
The bank performs a number of secondary functions, also called as non-banking functions.
These important secondary functions of banks are explained below.
1. Agency Functions
a. Transfer of Funds
b. Collection of Cheques
c. Periodic Payments
d. Portfolio Management
e. Periodic Collections
f. Other Agency Functions
a. Transfer of Funds
b. Collection of Cheques
The bank collects the money of the cheques through clearing section of its customers. The bank also collects money of the bills of exchange.
c. Periodic Payments
On standing instructions of the client, the bank makes periodic payments in respect of electricity bills, rent, etc.
d. Portfolio Management
The banks also undertakes to purchase and sell the shares and debentures on behalf of the clients and accordingly debits or credits the account. This facility is called portfolio management.
e. Periodic Collections
The bank collects salary, pension, dividend and such other periodic collections on behalf of the client.
They act as trustees, executors, advisers and administrators on behalf of its clients. They act as representatives of clients to deal with other banks and institutions.
2. General Utility Functions
a. Issue of Drafts, Letter of Credits, etc.
b. Locker Facility
c. Underwriting of Shares
d. Dealing in Foreign Exchange
e. Project Reports
f. Social Welfare Programmes
g. Other Utility Functions
a. Issue of Drafts and Letter of Credits
B.COM-II
Q.1 Meaning of insurance. explain it function and principle of insurance/ Also Explain nature and kind/ types of insurance.
Meaning
Meaning of Insurance:
If one goes by the word meaning insurance is a contract between two parties whereby the insurer agrees to indemnify the insured upon the happening of a stipulated contingency, in consideration of the payment of an agreed sum, whether periodical or fixed (the premium). Insurance falls into the main groups of life, property, marine, aviation, health, transport, motor vehicle – third party liability, and personal accident and sickness.
The term “assurance” is generally limited to the first of these, because the event in respect of which the policy is taken out – namely the death of the person – is assured, or certain. Only the time of the death is uncertain.
Definition of Insurance:
Insurance is contract between two parties (one the insurer and second the insured) whereby the insurer agrees to undertake the risk of the insured in consideration of some amount known as premium and in return promises to compensate a fixed sum of money to the insured party on happening of an uncertain event like DEATH.
Nature of Insurance:
1. By nature insurance is a devise of sharing risk by large number of people among the few who are exposed to risk by one or the other reason.
2. If a large number of subscribers to insurance serve the purpose of compensation to few among them exposed to uncertain risks appears as a co-operative look.
3. Valuation of risk is determined as per predefined terms and conditions of the insurance policies.
4. Insurance provides facility of financial help in case of contingency.
5. However it depends on the value of insurance for which payment is made in case of contingency. This provides basis of the amount to be paid.
6. Insurance is a policy regulated under laws and therefore the amount of insurance can neither be paid as gambling nor as charity.
Basic Types/ kinds of Insurance:
1. Credit Insurance:
Credit insurance means of insuring the payment of commercial debts against the risk of non-payment by the borrower because of his insolvency or for some other reason.
2. Group Insurance:
Group Insurance is insurance or life insurance obtained by a person as a member of a group, such as a professional organization, rather than as an individual, because in this way better terms can often be obtained. This is because there is an administrative saving for the company, and sometimes also because a particular group has a better life expectancy than people in general.
3. Life Insurance:
As the name suggests, life insurance is insurance on your life. You buy life insurance to make sure your dependents are financially secured in the event of your untimely demise. Life insurance is particularly important if you are the sole breadwinner for your family or if your family is heavily reliant on your income. Under life insurance, the policyholder’s family is financially compensated in case the policyholder expires during the term of the policy.
Life Insurance/Assurance is a contract by which the insurer/assuror undertakes to pay the person for whose benefit the cover is effected, or to his personal representative, a certain sum of money on the happening of a given event, or on the death of the person whose life is assured.
4. Marine Insurance:
It is contract by which underwriters engage to indemnify the owner of a ship, cargo or fright against losses from certain perils or sea risks to which their ship or cargo may be exposed. In case of marine insurance another type of insurance is prevalent known as Mutual Insurance.
This type of insurance is provided by ship-owners throughout the world who have clubbed together in various mutual protection and indemnity associations to cover hazards which are not covered by marine policies, which have standard clauses leaving a number of contingencies un-provided for, or only partially provided for. The liabilities of mutual insurance company are periodically divided amongst the subscribers in proportion to the tonnage they have entered with the company.
5. Fire Insurance:
Is a contract of indemnity by which an insurance company undertakes to make good any damage or loss by fire to buildings or property during a specific time.
6.Health insurance
Health insurance is bought to cover medical costs for expensive treatments. Different types of health insurance policies cover an array of diseases and ailments. You can buy a generic health insurance policy as well as policies for specific diseases. The premium paid towards a health insurance policy usually covers treatment, hospitalization and medication costs.
7.Car insurance
In today’s world, a car insurance is an important policy for every car owner. This insurance protects you against any untoward incident like accidents. Some policies also compensate for damages to your car during natural calamities like floods or earthquakes. It also covers third-party liability where you have to pay damages to other vehicle owners.
8.Education Insurance
The child education insurance is akin to a life insurance policy which has been specially designed as a saving tool. An education insurance can be a great way to provide a lump sum amount of money when your child reaches the age for higher education and gains entry into college (18 years and above). This fund can then be used to pay for your child’s higher education expenses. Under this insurance, the child is the life assured or the recipient of the funds, while the parent/legal guardian is the owner of the policy. You can estimate the amount of money that will go into funding your children’s higher education using Education Planning Calculator.
9.Home insurance
We all dreaming of owning our own homes. Home insurance can help with covering loss or damage caused to your home due to accidents like fire and other natural calamities or perils. Home insurance covers other instances like lightning, earthquakes etc.
Need of Insurance:
Life of everyone is full uncertainties. Nobody knows what is going to happen in next moment. This element of unknown situation always hounds around the mind of a person and keeps him worried to think as to what will happen in future in case of any mishappening. This worry is to think about the future of the person and his family. Among a number of worries the main and very important is economic uncertainty of himself or his family.
If anyone is satisfied with his present earnings, he also thinks whether or not his present day capacity of earning will last for long. Perhaps there remains an iota of fear that it may not last for the long. On this very point everyone thinks about to secure his future.
Under the impression of securing future one thinks about the adoption of saving and investment plans. . He not only thinks about himself but also about his family. In case of any miss happening everyone is worried as to what shall happen to his family.
Everyone knows that there is no substitute in case of death of an earning member of the family and no compensation is able to fulfil the gap in case of death of the earning member. But for supporting economically upto some extant the method adopted is known as insurance.
The life insurance is such a cover that provides security to the family of insured in case of his death. Life Insurance in such cases provides some solutions to the worries of family members.
Once upon a time it was very difficult to convince people for getting an insurance cover but today it has become a need of the day. Today the life insurance does not cover the risk of life only but also provides many added benefits also in the field of saving and investments.
People need insurance because the unexpected does happen. Whether it is a fire, a car wreck, illness or a death, the financial consequences can be devastating if you are uninsured. Insurance helps people have peace of mind when life’s unexpected events happen.
Functions of an Insurance Company
1) Primary Functions:
(i) Protection:
The Primary function of Insurance is as we think about any insurance. One feels insured and contended about future risks only because one is sure to be compensated for any loss of future. It is therefore Primary function of Insurance to provide protection against future risks, accidents and uncertainty.
No insurance can arrest the risk from taking place, no insurance can prevent future miss happenings, but can certainly provide some cover for the losses of risk. In real terms Insurance is a protective cover against economic loss by sharing the risk with others, (the pooling members).
(ii) Collective Risk:
The Insurance policies whether life insurance or general insurance are purchased by lacs of people. But all of them are not subjected to losses every year. It is only a few or negligible who become victim of some miss happenings. In other word lacs of people contribute towards insurance and only a few people need its cover.
It is therefore clear that insurance is a method by means of which a few losses are shared by a large number of people. All the people insured contribute by paying annual premium towards a fund out of which the persons exposed to risks are paid as per the terms and conditions of the insurance policy purchased by them.
(iii) Assessment of Risk:
What is volume of risk is determined by the Insurance companies by assessing diverse factors that give rise to risk. The rate of premium is also decided on the basis of risk involved.
(iv) Certainty:
Unless we are insured we remain uncertain about our capability to meet the future risks. But once we are insured it converts our uncertainty into certainty of bearing future risks.
2) Secondary Functions:
(i) Prevention of losses:
In simple words we can say precautions are better than the treatment. It is better instead of seeking the help of insurance if one adopts such measure which prevent the losses. Every Insurance prescribes to take preventive measures against losses. Such as installation of safety devices like automatic sparkler or alarm system, CCTV system etc.
If such type of preventive measure exist there shall be lower rate of premium for getting insurance cover against risks. Prevention of losses is to adopt preventive measures against unexpected losses. For example while driving a two wheeler we use helmets only because we take preventive measures to avoid any accidental loss. It is not certain that an accident is going to happen even than a preventive measure is adopted.
If an insured take such steps he saves a lot in form of the amount of premium required to be paid. If prevention techniques have been adopted and applied the Insurance company may rate the risk at lower level and shall prescribe a lower rate of premium otherwise a higher rate of premium shall be charged.
(ii) Covering Larger Risks with small capital:
Every businessman is always worried about the security of his business. After making large investments in the business it is natural to take care of the business investments. There are two alternatives first one is that the concerned businessman should invest out of his own pocket to create a proper security. The second method is to get his business activities insured.
In such a case the insurance relives a businessman from security investments by paying small amount in the shape of premium against larger risks and uncertainties. This assuages the businessman from security investments for a small amount of premium against larger losses.
(iii) Helps in development of larger Industries:
Larger Industries are prone to more risks in their setting up. The large industries have diversified fields of functioning where one field sometimes has no relation with the other field of the same industry. The activities of large industries are diversified that it goes above any planning to cover every type of risk.
It is only insurance that comes not only to help these large industries against possible risk but also help them to grow. It becomes possible only because insurance provides an opportunity to develop to those larger industries which have more risks in their setting ups.
3) Other Functions:
(i) Insurance is a tool used for saving and investments:
By purchasing any Insurance Policy it becomes completion by the purchaser to make payment of the insurance policy. This completion is blessing in disguise. Most of the policy buyers particularly individuals do not know the purpose of payment of premium. They know only one thing that paying premium is compulsory for them. The fact is otherwise true.
Once an insurance policy is purchased it assume the compulsory way of savings. Not only savings but such funds collected by insurance companies are further invested to the benefit of insured.
Because it is compulsory it restricts the unnecessary expenses by the insured’s on one hand and on the other hand insurance provides them the opportunity to avail Income tax exemption for the amount paid as insurance premium. Some prudent people take up insurance as good investment option also.
Such savings help growth in national economy.
(ii) It is one of sources to earn Foreign Exchange:
The business of insurance has crossed the national borders of any country. While traveling by Air one needs aviation insurance. While on board at sea whether humans or cargo it needs marine insurance which is also spread over across the boarders of any country. In simple words the insurance has become an international business and is necessary also.
It being an international business any country is free to earn foreign exchange as much as per the polices of insurance devised in a way to attract more and more foreign business. It is a good source of earning foreign exchange for any country.
(iii) Risk Free Trade:
Insurance promotes export insurance, which makes the foreign trade risk free with the help of different types of polices under marine insurance cover.
(iv) Subrogation:
In its most common usage refers to circumstances in which an insurance company tries to recoup expenses for a claim it paid out when another party should have been responsible for paying at least a portion of that claim.
Ongoing through the functions of insurance there appear that the business of insurance has inherited certain character sticks as well.
Principles of Insurance
As we discussed before, insurance is actually a form of contract. Hence there are certain principles that are important to ensure the validity of the contract. Both parties must abide by these principles.
1] Utmost Good Faith
A contract of insurance must be made based on utmost good faith ( a contract of uberrimate fidei). It is important that the insured disclose all relevant facts to the insurance company. Any facts that would increase his premium amount, or would cause any prudent insurer to reconsider the policy must be disclosed.
If it is later discovered that some such fact was hidden by the insured, the insurer will be within his rights to void the insurance policy.
2] Insurable Interest
This means that the insurer must have some pecuniary interest in the subject matter of the insurance. This means that the insurer need not necessarily be the owner of the insured property but he must have some vested interest in it. If the property is damaged the insurer must suffer from some financial losses.
3] Indemnity
Insurances like fire and marine insurance are contracts of indemnity. Here the insurer undertakes the responsibility of compensating the insured against any possible damage or loss that he may or may not suffer. Life insurance is not a contract of indemnity.
4] Subrogation
This principle says that once the compensation has been paid, the right of ownership of the property will shift from the insured to the insurer. So the insured will not be able to make a profit from the damaged property or sell it.
5] Contribution
This principle applies if there are more than one insurers. In such a case, the insurer can ask the other insurers to contribute their share of the compensation. If the insured claims full insurance from one insurer he losses his right to claim any amount from the other insurers.
6] Proximate Cause
This principle states that the property is insured only against the incidents that are mentioned in the policy. In case the loss is due to more than one such peril, the one that is most effective in causing the damage is the cause to be considered.
Q.2 Role of insurance in economic development
The Role of Insurance to Economic Development
The following point shows the role and importance of insurance:
Insurance has evolved as a process of safeguarding the interest of people from loss and uncertainty. It may be described as a social device to reduce or eliminate risk of loss to life and property.
Insurance contributes a lot to the general economic growth of the society by provides stability to the functioning of process. The insurance industries develop financial institutions and reduce uncertainties by improving financial resources.
1. Provide safety and security:
Insurance provide financial support and reduce uncertainties in business and human life. It provides safety and security against particular event. There is always a fear of sudden loss. Insurance provides a cover against any sudden loss. For example, in case of life insurance financial assistance is provided to the family of the insured on his death. In case of other insurance security is provided against the loss due to fire, marine, accidents etc.
2. Generates financial resources:
Insurance generate funds by collecting premium. These funds are invested in government securities and stock. These funds are gainfully employed in industrial development of a country for generating more funds and utilised for the economic development of the country. Employment opportunities are increased by big investments leading to capital formation.
3. Life insurance encourages savings:
Insurance does not only protect against risks and uncertainties, but also provides an investment channel too. Life insurance enables systematic savings due to payment of regular premium. Life insurance provides a mode of investment. It develops a habit of saving money by paying premium. The insured get the lump sum amount at the maturity of the contract. Thus life insurance encourages savings.
4. Promotes economic growth:
Insurance generates significant impact on the economy by mobilizing domestic savings. Insurance turn accumulated capital into productive investments. Insurance enables to mitigate loss, financial stability and promotes trade and commerce activities those results into economic growth and development. Thus, insurance plays a crucial role in sustainable growth of an economy.
5. Medical support:
A medical insurance considered essential in managing risk in health. Anyone can be a victim of critical illness unexpectedly. And rising medical expense is of great concern. Medical Insurance is one of the insurance policies that cater for different type of health risks. The insured gets a medical support in case of medical insurance policy.
6. Spreading of risk:
Insurance facilitates spreading of risk from the insured to the insurer. The basic principle of insurance is to spread risk among a large number of people. A large number of persons get insurance policies and pay premium to the insurer. Whenever a loss occurs, it is compensated out of funds of the insurer.
7. Source of collecting funds:
Large funds are collected by the way of premium. These funds are utilised in the industrial development of a country, which accelerates the economic growth. Employment opportunities are increased by such big investments. Thus, insurance has become an important source of capital formation
Q.3 Evolution of insurance
A Brief Timeline of Insurance in India
1818
In 1818, the first insurance company in India was established in Calcutta (modern day Kolkata), The Oriental Life Insurance Company. Similarly, Bombay (Mumbai) had the Bombay Life Assurance Company and Madras (Chennai) had the Madras Equitable Assurance Company, which were started in 1823 and 1829 respectively. In the initial days, Indians had to pay an extremely high premium than compared to the British residents. It was the Bombay Life Assurance Company, which became the first insurance company established by an Indian that started insuring Indians without charging extra premiums.
1912
During the initial year of this century, the industry was highly unregulated. It was only in 1912 that the Indian Life Insurance Companies Act, 1912 was passed. This Act structured insurance and made it mandatory for premiums and company valuations to be certified by an actuary.
1938
By 1938, there were around 176 insurance companies in India with the total business valuing around Rs. 300 crores. It was around the same time that the Insurance Act of 1938 was passed. This was the first piece of legislation covering both life insurance and general insurance.
1950
While the demand for nationalisation of insurance companies had been going on for a while, it was only with the passing of the Life Insurance Corporation Act of 1956 that nationalisation of insurance as finally achieved. On September 1, 1956, the Life Insurance Corporation of India (LIC of India) was established with the intent of covering all Indians across the length and breadth of the nation.
1972
In 1972, the General Insurance Business (Nationalisation) Act was passed which nationalised all general insurance companies in India. The 107 odd companies existing around the time were all merged into four companies:
· New India Assurance Company Ltd.
· National Insurance Company Ltd.
· Oriental Insurance Company Ltd.
· United India Insurance Company Ltd.
1999
As per the recommendations made by the Malhotra Committee, two things happened in the year 1999: one, the private sector was permitted to enter the insurance business and, two, the Insurance Regulatory and Development Authority of India (IRDAI) was constituted. IRDAI was incorporated in April 2000 and is now an autonomous body that works towards growing the insurance industry.
Till date, IRDAI frames regulations under Section 114A of the Insurance Act, 1938.
Q.4 Element of insurance risk
- Large numbers of exposure units.
- Define and measurable loss.
- Determinable probability distribution.
- Calculable chance of loss.
- Fortuitous loss.
- Non-catastrophic loss.
- Premium should be economically feasible
These are explained below;
1. Large Numbers of Exposure Units
Therefore the prime necessity for a risk to be insurable is that there must be a sufficiently large number of homogeneous exposures to combine reasonably predictable losses.
Lost data can be compiled over time, and losses for the group as a whole can be predicted with some accuracy. The loss costs can then be spread over all insured’s in the underwriting class.
Also, the probabilistic estimates used by the insurance company, by logic, assume a large number of units in a distribution and insurance products are priced accordingly.
2. Define and Measurable Loss
A second requirement is that the loss should be both determinable and measurable. This means the loss should be definite as to cause, time, place, and amount. Life insurance is most cases meets this requirement easily.
3. Determinable Probability Distribution
The probability distribution of happening of an adverse event if determinable. This condition is necessary to establish a free premium according to the theory of equivalence.
If there is not determinable distribution, there is no question of issuing a cover by an insurance company.
4. Calculable Chance of Loss
A fourth requirement is that the chance of loss should be calculable. The insurer must be able to calculate both the average frequency and the average severity of future losses with some accuracy.
This requirement is necessary so that a proper premium can be charged that is sufficient to pay all claims and expenses and yield a profit during the policy period.
Certain losses, however, are difficult to insure because the chance of loss cannot be accurately estimated, and the potential for a catastrophic loss is present.
Example: floods, wars, and cyclical unemployment occur on an irregular basis, and prediction of the average frequency and the severity of losses are difficult.
Thus, without government assistance, these losses are difficult for private companies to insure.
5. Fortuitous Loss
The adverse event may or may not occur in the future and once the insurance company has no control. Naturally, if the event is non-random or the loss has occurred in the past, there is no question of insurance.
Also, it is important to note that randomness is ensured by underwriters who guard against adverse selection; the tendency of the poorer than average insured to seek or continue insurance coverage.
6. Non-catastrophic Loss
The losses should be non-catastrophic. Not all the units in a homogeneous group will be subject to an adverse event. This means that a large proportion of exposure units should not incur losses at the same time.
As we stated earlier, pooling is the essence of insurance. If most or all of the exposure units in a certain class simultaneously incur a loss, then the pooling technique breaks down and becomes unworkable.
Premiums must be increased to prohibitive levels, and the insurance technique is so long a viable arrangement by which losses of the few are spread over the entire group.
Example: insurers ideally wish to avoid all catastrophic losses.
In reality, however, this is impossible, because catastrophic losses periodically result from floods, hurricanes, tornadoes, earthquakes, forest fires, and other natural disasters. Catastrophic losses can also result from acts of terrorism.
7. Premium Should be Economically Feasible
It is the final requirement that the premium should be economically feasible. The insured must be able to pay the premium.
Also, for the insurance to be an attractive purchase, the premiums paid must be substantially less than the face value, or amount, of the policy.
Since the insurance pool is structured to be sufficiently large, the price charged by the insurer for buying the risk is generally low. It should be sufficient to cause the rich for the insurer as well as viable for the insured.
Q.5 Explain concept and types of Risk.
What is the Definition of Risk
This is a term which refers to the probable disadvantageous, undesirable or unprofitable outcome of a fortuitous event, an event which is not desired but taking place.
For example,
We usually say the risk of death and not the risk of survival as death is something which is never desired.
What is risk
Risk insurance refers to the risk or chance of occurrence of something harmful or unexpected that might include loss or damage of the valuable assets of the person or injury or death of the person where the insurers assess these risks and, based on which, work out the premium that the policyholder needs to pay.
The following are the different types of risk in insurance:
#1 – Pure Risk
· Pure risk refers to the situation where it is certain that the outcome will lead to loss of the person only or maximum it could lead to the condition of the break-even to the person, but it can never cause profit to the person. An example of pure risk includes the possibility of damage to the house due to natural calamity.
· In case any natural calamity occurs, it will damage the house of the person and its household items, or it will not affect the person’s home and household items. Still, this natural calamity will not give any profit or gain to the person. So, this will fall under the pure risk, and these risks are insurable.
#2 – Speculative Risk
· Speculative risk refers to the situation where the direction of the outcome is not specific, i.e., it could lead to a condition of loss, profit, or break-even. These risks are generally not insurable. An example of speculative risk includes the purchase of the shares of a company by a person.
· Now, the prices of the shares can go in any direction, and a person can make either loss, profit, or no loss, no profit at the time of the sale of those shares. So, this will fall under the Speculative risk.
#3 – Financial Risk
Financial risk refers to the danger in which the outcome of the event is measurable in terms of the money, i.e., any loss that could occur due to the risk can be measured by the concerned person in monetary value. An example of the financial risk includes a loss to the goods in the warehouse of the company due to the fire. These risks are insurable and are generally the main subjects of the insurance.
#4 – Non-Financial Risk
Non-Financial risk refers to the risk in which the outcome of the event is not measurable in terms of the money, i.e., any loss that could occur due to the risk cannot be measured by the concerned person in the monetary value. An example of the non-financial risk includes the risk of poor selection of the brand while purchasing mobile phones. These risks are uninsurable since they cannot be measured
#5 – Particular Risk
Particular risk refers to the risk which arises mainly because of the actions or the interventions of the individual or the group of some individuals. So, the origin of the particular risk by individual-level and impact of the same is felt at a localized level. An example of a specific chance includes an accident on the bus. These risks are insurable and are generally the main subjects of the insurance.
#6 – Fundamental Risk
Fundamental risk refers to the risk which arises due to the causes which are not under the control of any person. So, it can be said that the fundamental risk is impersonal in its origin and the consequences. The impact of these risks is essentially on the group, i.e., it affects the large population. The fundamental risk includes risks on the group by events such as natural calamity, economic slowdown, etc. These risks are insurable.
#7 – Static Risk
Static risk refers to the risk which remains constant over the period and is generally not affected by the business environment. These risks arise from human mistakes or actions of nature. An example of static risk includes the embezzlement of funds in a company by its employees. They are generally easily insurable as they are easy to measure.
#8 – Dynamic Risk
Dynamic risk refers to the risk which arises when there are any changes in the economy. These risks are generally not easy to predict. These changes might bring financial losses to the members of the economy. An example of the dynamic risk includes the changes in the income of the persons in an economy, their tastes, preferences, etc.
Q. 6 Risk Vs Uncertainty
Definition of Risk
In the ordinary sense, the risk is the outcome of an action taken or not taken, in a particular situation which may result in loss or gain. It is termed as a chance or loss or exposure to danger, arising out of internal or external factors, that can be minimised through preventive measures.
In the financial glossary, the meaning of risk is not much different. It implies the uncertainty regarding the expected returns on the investments made i.e. the probability of actual returns may not be equal to the expected returns. Such a risk may include the probability of losing the part or whole investment. Although the higher the risk, the higher is the expectation of returns, because investors are paid off for the additional risk they take on their investments. The major elements of risk are defined as below:
· Systematic Risk: Interest Risk, Inflation Risk, Market Risk, etc.
· Unsystematic Risk: Business Risk and Financial Risk.
Definition of Uncertainty
By the term uncertainty, we mean the absence of certainty or something which is not known. It refers to a situation where there are multiple alternatives resulting in a specific outcome, but the probability of the outcome is not certain. This is because of insufficient information or knowledge about the present condition. Hence, it is hard to define or predict the future outcome or events.
Uncertainty cannot be measured in quantitative terms through past models. Therefore, probabilities cannot be applied to the potential outcomes, because the probabilities are unknown.
Key Differences Between Risk and Uncertainty
The difference between risk and uncertainty can be drawn clearly on the following grounds:
1. The risk is defined as the situation of winning or losing something worthy. Uncertainty is a condition where there is no knowledge about the future events.
2. Risk can be measured and quantified, through theoretical models. Conversely, it is not possible to measure uncertainty in quantitative terms, as the future events are unpredictable.
3. The potential outcomes are known in risk, whereas in the case of uncertainty, the outcomes are unknown.
4. Risk can be controlled if proper measures are taken to control it. On the other hand, uncertainty is beyond the control of the person or enterprise, as the future is uncertain.
5. Minimization of risk can be done, by taking necessary precautions. As opposed to the uncertainty that cannot be minimised.
6. In risk, probabilities are assigned to a set of circumstances which is not possible in case of uncertainty.
Conclusion
There is an old saying, “No risk, No gain”, so if any enterprise wants to survive in the long run, it has to take calculated risks where the probability of loss is comparatively less, and the chances of gains are higher. Uncertainty is inherent in every business which cannot be avoided, and the business person has no idea about what will happen next, i.e. the outcome is unknown
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