Unit-6

Risk and Insurance

Risk can be defined as uncertainty concerning the

occurrence of a loss.

Insurance is a financial mechanism to reduce or eliminate

the financial loss due to loss.

Terms of Insurance:
- Insured : The party who seeks protection against a
particular risk is known as insured. (Aabhith Shrestha)
- Insurer : The party who undertakes to protect the
insured is known as insurer. Insurance companies are
insurers. ( Suryalife Insurance Co.)
- Premium : It is the amount paid by the insured as the
consideration of the insurance contract. (Rs. 98,142/-)
- Insured Amount: It is the amount for which the risk is
insured. (Rs. 15,00,000)
- Insurance Policy: It is a written contract between the
insurer and the insured containing details of the terms and
conditions agreed upon.
- Duration: It is the time period for which the insurance
policy is done.

Importance of Insurance:

1. Financial Security: Insurance provides financial security

to an insured. It guarantees protection against large and
uncertain losses in return of premium. Different types of
insurance are there to give different kinds of protection.
Insurance provides certainty of payment in case of loss.
Thus, insurance gives a feeling of security against the
possible occurrence of uncertain events
2. Risk reduced: People are exposed to various kinds of risk
and uncertainty. It is impossible to eliminate risk and
uncertainty completely. Insurance is a co-operative effort
of sharing risk. Thus , the effect of risk can be reduced
through the distribution of risk.

3. Mental peace: It provides mental peace to the insured.

It removes the tension, fear and anxiety associated with
the future uncertainty.

4. Encourage saving: The insured has to pay a premium

regularly. Thus, it encourages the habit of saving.

5. National development: Insurance companies take premium

in consideration to compensate loss. They keep a part in a
fund for this purpose and rest of the money is invested in
different industries and government projects for the
development of the country.

6. Basis of credit (loan): Insured can get loan by putting

insurance policy as a security. Financial institutions grant
credit facilities on behalf of property or insurance policy
only if they are insured.

7. Promotes foreign trade: Foreign trade is more risky.

Chances of fire and marine dangers are more in the field.
Insurance takes away these risks and promotes foreign
trade. Thus, it helps to earn foreign exchange.

8. Employment opportunities: Thousands of people are

engaged in insurance business. Thus, insurance provides and
generates employment opportunities.
*Notes:
i. Insurance is a contract between the insurer and the
insured for compensating losses.
ii. Insurance is a contract by which one party in a
consideration called premium takes over a particular risk of
the other party.
iii. Insurance covers only such risk that can be measured in
monetary terms that is financial risk.
iv. The contract of insurance requires good faith on the
part of the parties of the contract.
v. Insurance is a contract for mutual benefits.
vi. The occurrence of the loss must be accidental not
intentional.

Essentials (Requirements ) of Insurance Contract

The following essentials of a general contract should be
fulfilled in an insurance contract:

1. Offer and Acceptance

2. Legal Consideration
3. Competent to Contract
4. Free Consent (Mutual Agreement)
5. Legal Object (Lawful)
6. Certainty (Understandable)
7. Writing and Registration

An agreement enforceable by law is called a contract.

Insurance is a contract in which two parties-insured and
the insurer are involved. The insured is the person who
takes up the insurance protection and he/she pays the
premium and shifts his risk to the other party insurer. The
insurer is the person who agrees to compensate/cover for
the loss suffered by the insured who gets the premium.
The valid insurance contract should satisfy all the essential
requirements of contract act. The following essentials of a
general contract should be fulfilled in an insurance
contract:

1. Offer and acceptance: There must be two parties in a

contract. The first step in the formation of a valid
contract is starting at an agreement between two
parties by means of offer and acceptance. Filling up
the proposal form by the insured include the offer and
the notice of acceptance of the proposal by the
insurer is a valid acceptance.

2. Legal consideration: In every contract, there should

be a legal consideration. In insurance contract,
payment of premium is taken as a valid
consideration. Without payment of premium, the
insurance contract cannot be started.

3. Competent to contract: The parties to the contract

should be competent(able) to enter into the policy.
Every person is competent to contract who is of the
age of majority according to the law and who is of
good mind and is not disqualified from any law.
Thus, minors and persons of unsound mind cannot
enter into insurance contracts. Contract made by
incompetent parties will be void
(disqualified/cancelled/rejected).

4. Free Consent: Parties entering into contract should

enter into it by their free consent (wish/desire).
The consent will be free when it is not caused by
 any kind of coercion (force), influence, fraud or
misrepresentation.

5. Legal object: The object (matters) of the contract

should be lawful. It should not be illegal or against
to the public policy. Thus, legality of the object is
an essential requirement of a valid contract.

6. Certainty: A contract should not be uncertain and

complicated. The terms and conditions of the
contract should be clearly understood by both
parties to the contract. In insurance, the insurance
company gives printed policy document which
contains all the terms and conditions of the policy.

7. Writing and registration: The contract must be in

writing properly signed, stamped and registered.
This condition is fulfilled as the proposer signs in a
printed proposal form. The insurance company issues
the policy document properly signed and stamped.

Procedures of effecting life insurance: Any person who

desire of taking a life insurance policy has to follow the
following procedure.
1. Submission of proposal form: The proposal form is
actually a printed questionnaire which contains a number of
questions regarding the following informations:
- name, address and occupation of the proposer/ insured.
- family history and health of the proposer.
- facts about the income of the proposer.
- date of birth of the proposer.
- mode of payment of premium.

2. Certificate of age:
The proposer must submit the certificate of his actual age
with the proposal form. The risks of life insurance depend
upon the age of the proposer. The people of higher age are
required to pay higher rate of premium.

3. Medical examination:
After submitting the proposal form with certificate of age
in the insurance company, the proposer is required to get
himself medically examined from the doctor approved by
the insurance company. The medical report is very
important in life insurance because the company evaluates
risk of life on the basis of this report.

4. Submission of agent’s report:

The agent is required to make a confidential(secret) report
about the proposer particularly regarding the health,
character, financial position and other important personal
information relevant to the contract of insurance.

5. Acceptance of the proposal:

On the basis of the information given in the proposal form,
agent’s report and medical report, the insurance company
decides to insure or not to insure the life of the proposer.

6. Payment of first premium:

On the receipt of acceptance letter and demand for the
first premium, the proposer should pay the premium amount
to the company. After the payment of first premium, the
policy comes into operation and the risk is covered then
onward.

7. Issue of policy:
On the payment of first premium, the contract of life
insurance comes into existence. Insurance policy is not
issued immediately. It takes some time to prepare in proper
form completely stamped. The life insurance policy contains
all details, terms and conditions of life insurance
contract.It also contains details of risks covered and other
rules regarding the validity of the policy.

Procedures of effecting fire insurance:

For taking a fire policy, the owner of the company should
follow the following procedures:

1. Selecting the insurance company:

First of all, the person who wants to take fire insurance
policy should select the company which is financially strong
and efficient. The company that provides terms of
insurance and lesser formalities for taking a policy is always
preferred.

2. Proposal form:
The proposal form can be obtained from the insurance
company or agent and filled up carefully and correctly. It
requires to give details such as name, address, occupation
of the proposer, value and nature of property to be
insured, type of policy required, amount of insurance to be
insured,etc. The information given should be true and
correct because the fire insurance is the contract of
complete good faith. The proposal form should be signed
properly and sent to the company for acceptance.

3. Evidence of respectability:
There is much difficulty in fire insurance because
sometimes the insured himself can destroy the property by
fire. Thus, the insurance company collects an evidence of
honesty, integrity and financial position of the insured from
the third parties. However, it is not necessary to collect
fresh evidence (proof) of respectability every time if the
company already knows the insured.

4. Survey of the property:

The insurance company usually accepts and issues policies on
the basis of proposal form. If the risk is high and the
amount insured is large or huge, the company sends it’s
surveyors for a proper survey and to determine the real
nature of the risk involved. Otherwise, considering the
proposal form and surveyor’s report, the insurance company
can either accepts or rejects the proposal.

5. Acceptance of proposal:
When the insurance company is satisfied with the
formalities completed and willing to undertake the risk
accepts the proposal. It will inform the insured about the
acceptance of the proposal. The rate of premium is also
mentioned in the acceptance letter.

6. Payment of first premium:

On payment of first premium, the fire insurance contract is
said to have entered upon and the risk commences(starts).
The risk will start only when the premium has been paid.

7. Issue of insurance policy:

Finally, the insurance company issues a complete stamped
policy containing all the terms and conditions. It is a legal
and formal document of insurance contract. The policy
contains the name and address of the insured, the subject
matter of insurance, the amount insured, the amount of
premium, period of insurance, etc.

Principles of Insurance

Insurance contracts are based on certain principles which

are special to this class of contract. These principles are
as follows:

1. Good faith:

Insurance contracts are based on complete good faith of

insured as well as an insurer. Good faith requires each
party to tell the other party ‘the truth, the whole truth
and nothing but the truth’.This means each party to other
party must supply full information so that much important
information can be achieved. It is the duty of the insured
that he should disclose all necessary facts about the
subject matter of insurance. This may help insurer to know
the risk and the rate of premium. Similarly, the insurer has
the duty to disclose the scope and all necessary facts
relating to insurance contract.

2. Insurable Interest:

The insurance contract will be valid only if the insured has

insurable interest in the subject matter of insurance.
Interest means a relationship between insured and the
subject matter of insurance. This relationship should involve
monetary gain from the existence of the subject matter or
loss from it’s destruction. If the insured does not suffer a
loss out of the destruction of the subject matter, he has
no interest. In the absence of this provision, anybody can
get a property insured and may claim the compensation for
loss from an insurance company by destroying the property.

3. Indemnity( Protection against future loss/compensation

for loss):

Indemnity means ‘security against loss or damage’ or

‘compensation for loss’. According to this principle of
indemnity, the insurer promises to the insured to
compensate the actual loss to the subject matter up to the
amount of the insurance. The compensation can be equal but
never more than the value of loss to give a margin of
profit. This principle is applicable to all insurance contracts
except personal insurance contract (life, personal accident
and medical) where the loss of individual life cannot be
measured in terms of money. Therefore, a person may
insure his own life for any amount. This principle is
observed more strictly in property insurance.

4. Proximate cause (Nearest cause of loss):

It means nearest cause. This principle is the most

fundamental for deciding payment of compensation. The
object of insurance is to provide compensation only for
those loss caused by insured reasons. For example, if
property is insured against the fire and if a fire damage
the property, compensation is paid. When the loss is
produced by two or more causes then it becomes necessary
to choose the most important, the most effective or the
most powerful cause which has brought about the loss.

5. Subrogation (The act of substituting of one credit for

another):
This principle of subrogation is applicable to property
insurance. It is the transfer of rights and remedies of the
insured in the subject matter to the insurer after the
compensation. It means that on paying the amount of loss
to the insured, the insurer (insurance company) becomes
entitled (gets rights and power) which were available to the
insured. For example, “A” suffers a loss of Rs. 50,000 by
fire due to the negligence of his neighbour. “A” has two
options: (i) recover the amount from his insurance company,
or (ii) recover the damage from his neighbour by filing a
case. If “A” prefers to recover the amount from insurance
company, he cannot ask third party for compensation. But
the insurance company can recover the damage from the
neighbour because the company gets the right of “A” after
paying him compensation.

6. Contribution( sharing loss between co-insurer):

Contribution refers to sharing of loss between co-insurers.

It applies to all the contract of indemnity(compensation).A
person can get the subject matter insured with several
insurers. But the insured will be entitled (authority/rights)
to recover only the actual amount of loss faced by him and
nothing more. Thus,in the event of loss, he cannot recover
claims from all the insurers. In such cases, the total loss
suffered by the insured is contributed by different insurers
in the ratio of the value of policies issued by them for the
same subject matter.It prevents the insured from making
profit out of his misfortune(bad luck).If one insurance
company paid up the amount of compensation fully, then it
can recover the portion of the amount as contribution from
other insurers who are liable(responsible) for the same loss.
However, this principle of contribution is not applicable to
personal insurance.
7. Mitigation of loss (Minimize as possible or be very
careful):

Mitigation of loss literally means to make loss less violent

or destructive.Thus, it is the duty of insured to make
every effort and to take all such steps to minimize the loss
in the event of some destruction or accident. He should not
be the only an onlooker(audience) of the loss. He must do
his best to minimize the damage, save the property from
the damage. He must act as a rational human being. If he
does not do so, the insurer can avoid the payment of claim.
This principle of mitigation of loss provides only a check on
the behaviour in the event of loss. However, the insured
need not risk his life to reduce the loss.