Life Insurance is something we all avoid in India. Isn't that right? But you will be surprised to know that it is one of the most important things in a person's life. It plays a vital role in financial planning.
In this module, we will learn the A2Z of Life Insurance. So, without any further ado, let us get started:
What is life Insurance?
Insurance is a contract between two parties whereby one party (known as insurer or assurer) agrees to bear the risk of another (known as insured or assured) in exchange for a consideration known as premium and promises to pay a fixed sum of money (called sum assured or cover) to the other party on happening of an uncertain event (death) or after the expiry of a certain period (called tenure of the policy).
The parties to the contract have legal recourse in the event of one of the parties not adhering to the terms of the contract. Insurance is structured to reduce the uncertainty risk and to protect the financial condition of an individual’s family in the case of unexpected loss of life. The insured individual pays a premium to the Life Insurance Company, which accepts the risk the insured is exposed to.
If the insured person will face any losses after this, the company will pay the sum assured to the insured individual.
How does life insurance work?
The underlying concept behind life insurance is the sharing of risks by the pooling of funds. Groups of people having similar risks come together and make a contribution towards a pool and the money so collected is used towards compensating for any losses suffered by members of the pool. When this pool of money is managed by a company it is called life insurance.
Let us consider an example where we have a life insurer, company A.
Company A has insured 5000 people of age 60, with good health status. It is assumed though, that each person is ordinarily exposed to the risk of death.
Suppose the number of people dying in this pool of people per year is 25, and each of the dead person’s families suffers an economic loss of ₹2,00,000.
Therefore, the loss suffered due to deaths is ₹(2,00,000 x 25) = ₹50,00,000.
Suppose each member contributes a premium of ₹1200. Therefore, the total value of all the premiums gotten will become ₹(1200 x 5000) = ₹60,00,000.
25 persons die in a year on an average, but company A pays only ₹2,00,000/- out of the pool to the family members of each of the 25 persons dying in a year.
Therefore, the risk of 25 persons is spread across 5000 people.
Two concepts emerge out of the above example - criteria for insurable Risk and Underwriting. We will cover both concepts going forward in this module. But before that, it is important to understand why life insurance is necessary for financial planning. So, let us discuss this in the next unit.