Introduction to

UNIT 1 INTRODUCTION TO INSURANCE Insurance

Objectives

After going through this unit, you will be able to:

 explain the concept of insurance

 understand the history of insurance

 discuss the theory of probability and the law of large numbers

 describe the principles of insurance

 explain different types of insurance

 explain the concept of reinsurance and

 discuss the functions, need and types of reinsurance

Structure

1.1 Introduction
1.2 Evolution of Insurance in India
1.3 Concept of Insurance
1.4 Contract of Insurance
1.5 Principles of Insurance
1.6 Types of Insurance
1.7 Moral Hazards
1.8 Reinsurance
1.9 Types of Reinsurance / Methods of Cession
1.10 Retrocession
1.11 Reinsurance Administration
1.12 Summary
1.13 Key Words
1.14 Self-Assessment Questions
1.15 Further Readings

1.1 INTRODUCTION
Insurance is a universal phenomenon, that has evolved out of man’s constant quest for
security. Insurance plays a pivotal role in all the activities of the world, without it the
wheels of industry will come to a grinding halt. It is believed to have been in existence,
in one form or other since 3000 BC. The Chinese traders travelling on rivers used to
distribute their goods among several vessels so that the loss from one vessel would be
partial and not total. The Babylonian traders would agree to pay additional sums to
lenders as the price for writing off the loans in case of the shipment being stolen. The
9
Indian Insurance Sector: Greeks had started benevolent societies in the late 7th century AD, to take care of the
An Overview
funeral expenses and families of members, who died. The friendly societies of England
were similarly constituted. The Great Fire of London in 1666 gave a boost to insurance
and the first Fire insurance company called Fire Office was started in 1680

An Insurer is a company designing, promoting and selling the insurance products and
services amongst the public. An insured or policyholder is the person or entity
purchasing the insurance products and services. Risk management, the practice of
appraising and controlling ever pervading risks, has evolved as a discrete field of study
and practice. The study of Insurance incorporates the discipline of Risk Management
which acts as a driving force.

Insurance is defined as a form of risk management primarily used to hedge against

unforeseen risks of contingent losses. Another definition for Insurance is the equitable
transfer of the risks from the possibility of occurrence of losses, from one entity to
another (or host of others), by the method of diversification in exchange for a premium.
As a result the ramifications of a large and devastating loss can be minimized to a great
extent.

1.2 EVOLUTION OF INSURANCE IN INDIA

In India, insurance has a deep-rooted history. It finds mention in the writings of
Manusmrithi, Yagnavalkya (Dharmasastra) and Kautilya (Arthasastra). The writings
talk in terms of pooling of resources that could be re-distributed in times of calamities
such as fire, floods, epidemics and famine. Ancient Indian history has preserved the
earliest traces of insurance in the form of marine trade loans and carriers’ contracts.
Insurance in India has evolved over time heavily drawing from other countries, England
in particular.

In India, Life Insurance came into existence in 1818 with the establishment of the
Oriental Life Insurance Company in Calcutta. In 1829, the Madras Equitable had
begun transacting life insurance business in the Madras Presidency. The Oriental Life
Insurance Company however failed in 1834. 1870 saw the enactment of the British
Insurance Act and in the last three decades of the nineteenth century, the Bombay
Mutual (1871), Oriental (1874) and Empire of India (1897) were started in the Bombay
Residency. This era, however, was dominated by foreign insurance offices which did
good business in India, namely Albert Life Assurance, Royal Insurance, Liverpool and
London Globe Insurance and the Indian offices were up for hard competition from the
foreign companies.

In 1914, the Government of India started publishing returns of Insurance Companies

in India. The Indian Life Assurance Companies Act, 1912 was the first statutory measure
to regulate life business in India. In 1928, the Indian Insurance Companies Act was
enacted to enable the Government to collect statistical information about both life and
non-life business transacted in India by Indian and foreign insurers including provident
insurance societies. In 1938, with a view to protecting the interest of the public, earlier
legislation was consolidated and amended by the Insurance Act, 1938 with
comprehensive provisions for effective control over the activities of insurers.
10
The Insurance Amendment Act of 1950 abolished Principal Agencies. However, there Introduction to
Insurance
were a large number of insurance companies and the level of competition was high.
There were also allegations of unfair trade practices. The Government of India, therefore,
decided to nationalize insurance business.

An Ordinance was issued on 19th January, 1956 nationalising the Life Insurance sector
and Life Insurance Corporation came into existence in the same year. The LIC absorbed
154 Indian, 16 non-Indian insurers as also 75 provident societies—245 Indian and
foreign insurers in all. The LIC had monopoly till the late 90s when the Insurance
sector was reopened to the private sector.

The history of general insurance dates back to the Industrial Revolution in the
west and the consequent growth of sea-faring trade and commerce in the 17th century.
It came to India as a legacy of British occupation. General Insurance in India has its
roots in the establishment of Triton Insurance Company Ltd., in the year 1850 in
Calcutta by the British. In 1907, the Indian Mercantile Insurance Ltd was set up,
which was the first company to transact all classes of general insurance business.1957
saw the formation of the General Insurance Council, a wing of the Insurance Association
of India. The General Insurance Council framed a code of conduct for ensuring fair
conduct and sound business practices.

In 1968, the Insurance Act was amended to regulate investments and set minimum
solvency margins. The Tariff Advisory Committee was also set up then. In 1972 with
the passing of the General Insurance Business (Nationalisation) Act, general insurance
business was nationalized with effect from 1st January, 1973. 107 insurers were
amalgamated and grouped into four companies, namely National Insurance Company
Ltd., the New India Assurance Company Ltd., the Oriental Insurance Company Ltd
and the United India Insurance Company Ltd. The General Insurance Corporation of
India was incorporated as a company in 1971 and it commenced business on January
1st1973.

This millennium has seen insurance come a full circle in a journey extending to nearly
200 years. The process of re-opening of the sector had begun in the early 1990s
and the last decade has seen it being opened up substantially. In 1993, the Government
set up a committee under the Chairmanship of R.N. Malhotra, former Governor of
RBI, to propose recommendations for reforms in the insurance sector. Following the
recommendations of the Malhotra Committee Report, in 1999, the Insurance Regulatory
and Development Authority (IRDA) was constituted as an autonomous body to regulate
and develop the insurance industry.

The IRDA was incorporated as a statutory body in April, 2000. The key objectives of
the IRDA include promotion of competition so as to enhance customer satisfaction
through increased consumer choice and lower premiums, while ensuring the financial
security of the insurance market. The IRDA opened up the market in August 2000
inviting applications for registration. Foreign companies were allowed ownership of up
to 26%. The Authority has the power to frame regulations under Section 114A of the
Insurance Act, 1938 and has from 2000 onwards framed various regulations ranging
from registration of companies for carrying on insurance business to protection of
policyholders’ interests.
11
Indian Insurance Sector: In December, 2000, the subsidiaries of the General Insurance Corporation of India
An Overview
were restructured as independent companies and at the same time GIC was converted
into a national Re-insurer. Parliament passed a bill de-linking the four subsidiaries from
GIC in July, 2002.

Insurance is a federal subject in India. It is a subject matter of solicitation. The legislations

that deal with insurance business in India are Insurance Act, 1938 and Insurance
Regulatory & Development Authority Act (IRDA), 1999.

1.3 CONCEPT OF INSURANCE

Human life is subject to various risks—risk of death or disability due to natural or
accidental causes. It is also prone to diseases, the treatment of which may involve huge
expenditure. When human life is lost or a person is disabled permanently or temporarily,
there is a loss of income to the household. In such a situation the family is put to
hardships, at times even survival itself is at stake for the dependents.

On the other hand, property owned by man is exposed to various hazards, natural and
man-made. When it comes to property, the loss or damage results in either whole or
partial loss in income to the person or entity. Death/disability or loss/damage could
occur at any time. Losses can be mitigated through insurance. Thus, Insurance offers
protection against various contingencies. An Insurer is a company designing, promoting
and selling the insurance products and services amongst the public. Whereas
an insured or policyholder is the person or entity purchasing the insurance products
and services.

Insurance is thus, defined as a form of risk management primarily used to hedge against
unforeseen risks of contingent losses. Another definition for Insurance is the equitable
transfer of the risks from the possibility of occurrence of losses, from one entity to
another (or host of others), by the method of diversification in exchange for a premium.
As a result, the ramifications of a large and devastating loss can be minimized to a great
extent.

Insurance products available for life and non-life are many. In non-life, apart from
personal covers such as accident covers and health insurance, there are products
covering liabilities under a particular law and or common law. Various products are
designed to cater to different needs of an individual or industry such as fire insurance
policy on multi-storeyed building householder’s policy.

An insurance contract promises to make good to the insured a certain sum in

consideration for a payment in the form of premium from the insured.

Human life cannot be valued, hence the sum assured (or the amount guaranteed to be
paid in the event of a loss) is by way of a ‘benefit’ in the form of life insurance. Life
insurance products provide a definite amount of money to the dependents of the insured,
in case the life insured dies during his/her active income earning period or becomes
disabled on account of an accident, causing reduction or complete loss in his/her income
earnings. An individual can also protect one’s old age when s/he ceases to earn and
has no other means of income by purchasing an annuity product.
12
A Personal Accident cover provides protection in the event of death or disability, Introduction to
Insurance
permanent or temporary, of the insured. It provides for compensation which is either
the whole or a percentage of the Capital Sum Insured depending on the kind of loss. In
the case of Health Insurance, the policy seeks to cover expenses towards treatment of
diseases and or injury up to the Sum Insured opted for by the insured (details are given
in Unit- 7).

In respect of insurance relating to property, there are many products available. Property
may be covered against fire and perils of nature including flood, earthquake etc.
Machinery may be insured for breakdown. Goods in transit can be insured under a
marine cargo insurance cover. Insurance covers are also available for ships and other
vessels. A motor insurance policy covers third party damage as well as damage to the
vehicle.

Insurance of property is based on the principle of indemnity. The idea is to bring the
insured to the same financial position as s/he was before the loss occurred. It safeguards
the investment in the property. Where there is no insurance, losses can mar a project
or an industry. General Insurance offers stability to the economy and to the society.

Insurance offers security and so peace of mind to the individual. The concept of insurance
is that the losses of a few are made good by contribution from many. It is based on the
law of large numbers. It stemmed from the need of man to find a solution for mitigation
of losses. It also reflects the nature of man to find a solution collectively.

Insurance is, in actuality, a social vehicle for spreading the risk of financial
loss among a large group of people, thus making a loss manageable for any
one person of that group.

As per regulations, insurers have to give the various features of the products at the
point of sale. The insured should also go through the various terms and conditions of
the products and understand what they have bought, and met their insurance needs.
They ought to understand the claim procedures so that they know what to do in the
event of a loss.

1.3.1 Importance of Insurance

Insurance is important to all of us in one way or the other as mentioned below:

 It gives economic protection in the event of unexpected losses to the individuals,

property etc.

 In India, social security finds a place in our Constitution. Article 41 requires

the State within the limits of its economic capacity and development, to make
effective provision for securing the right to work, to education and to provide
public assistance in case of unemployment, old age, sickness and disablement.
Part of the State’s obligations to the poorer sections of the society is met
through the mechanism of Life insurance.

 As per the Law and the directions of the regulatory authorities, insurance
companies in India are obliged to extend insurance benefits to economically
weaker sections of the society in the unorganized sector.
13
Indian Insurance Sector:  It plays an important role in the Nation’s economic development. A Life
An Overview
insurance company is a major instrument for the mobilization of savings of
people, particularly from the middle and lower income groups. These savings
are channeled into investments for economic growth through five year plans.
The Insurance Act and IRDAAct have strict provisions to ensure that insurance
funds are invested in safe avenues like Government Bonds.

1.3.2 Advantages of Life Insurance

Some of the advantages offered by life insurance are:

 It gives protection to the family. A person supports the family financially as

long as he lives but the family needs the same as long as they live. This can be
secured only through life insurance.

 With the advancement through research in the field of medicine the longevity
has been increasing. Thus the risk of living too long is to be guarded against.
This again is possible only through life insurance which grants annuity policies.

 The moment an insurance policy is taken, wealth is created. In other forms of

savings only the amount saved along with some appreciation by way of interest/
dividend is available on death whereas in the case of life insurance the full
amount planned in advance is available on death of the person.

 Life insurance makes the dreams of a person come true in the sense that funds
will be made available for the marriage or education of children.

 Life insurance is useful as a collateral security for housing loans. In the event
of unfortunate premature death of the breadwinner of the family, the outstanding
loan is cleared out of the policy monies and the family gets a free house.

 A life insurance policy can be transferred to another person by effecting an

assignment under Sec 38 of Insurance Act 1938.

 Life insurance has liquidity. Loans can be availed from the Insurance Company
on the policies.

 Settlement of death claims can be easily done to the nominee or assignee.

 Income tax exemptions are available to the policyholders. As per the tax
provisions in vogue now(2007-08) premiums paid towards life insurance are
exempt from total taxable income up to a maximum of Rs 100000 under Sec
80© of Income tax Act, 1961. Also, the benefits received under the policies
are fully exempt from income tax under Sec 10(d) of Income Tax Act, 1961.

 Life Insurance companies handle huge funds which are invested in various
infrastructure development activities such as rural electrification, water supply
and sewerage schemes, housing boards and the like. Thus people’s money is
spent for people’s welfare.

Insurance is actuality, a social vehicle for spreading the risk of financial loss
among a large group of people, thus making a loss manageable for any one
14 person of that group.
1.3.3 Risk transfer mechanism, Theory of Probability and Introduction to
Insurance
Law of large numbers
Risk management, the practice of appraising and controlling ever pervading risks, has
evolved as a discrete field of study and practice. The study of Insurance incorporates
the discipline of Risk Management which acts as a driving force. Risk has the element
of unpredictability.

Risk transfer mechanism: Insurance is a complex mechanism and has in it two

fundamental characteristics:

(a) Transferring or spreading of a risk from one individual to a group

(b) Sharing losses, on some equitable basis, by all the members of the group.

To illustrate by way of an example, let us assume that there are 1000 houses in a given
community and for simplicity sake that the value of each house is Rs 100000. Each
owner faces the risk that his house may catch fire. If a fire breaks out, the financial loss
of up to Rs 100000 could result. Some houses will undoubtedly burn, but the probability
that all will, is remote.

Now let us assume further that the owners of these houses enter into an agreement to
share the cost of losses as they occur, so that no single individual will be forced to bear
an entire loss of Rs 100000. Whenever a house burns, each of the 1000 owners will
pay Rs 100 and thus the owner of the destroyed house will be indemnified by the
others in the group. Through the agreement to share the losses, the economic burden
that could be caused by fire is spread throughout the group. This is precisely the way
how insurance works.

Theory of probability and the law of large numbers: Insurance works on the basis
of Probability i.e, likelihood of an event occurring which again depends on large numbers
if the predictions should come true. Probability is that body of knowledge concerned
with measuring the likelihood that something will happen and making estimates on the
basis of this likelihood. It deals with random events and is based on the assumption
that, while some events appear to be a matter of chance, they actually occur with
regularity over a large number of trials revealing a measurable pattern as it were. The
frequency with which an event happens reflects the actual probability of the event
occurring more closely if the cases involved are larger.

The requirement of a large number has dual application:

(i) To estimate the underlying probability accurately, the insurance company must
have a sufficiently large volume of data. The larger the sample, the more accurate
will be the estimate of the probability.

(ii) Once the estimate of the probability has been worked out, sufficiently large number
of insurance contracts must be entered into to avoid possible losses. In making
the estimates on the basis of historical data, the insurance companies believe that
things would continue to happen in the future as they had happened in the past if
their estimates of past experience are accurate. But things may not happen in the
future as they did in the past. It is likely that the probability involved is constantly
changing. There may not be a good estimate of the probability. 15
Indian Insurance Sector: All this may mean that the things may not turn out as expected. Since the insurance
An Overview
company bases its premium rates on its expectation of future losses, it must be concerned
with the extent to which actual experience is likely to deviate from the estimated results.
For the insurance company, risk is measured by the potential deviation of actual from
estimated results.

The accuracy of estimates is better when they are based on large number of cases. If
the Actuaries and Underwriters of the Insurance Company are absolutely accurate in
their estimates, there would be no possibility of loss or profit for the Company, because
premium income would always be just sufficient to pay losses and expenses. In practice
the actuals may differ from estimates and hence there is risk to the Insurer. If the
accuracy is improved by taking as large a number as possible, the estimation can be
improved and risk reduced.

1.4 CONTRACT OF INSURANCE

A contract of Insurance is an Agreement between two parties enforceable at Law
where one party (the insured/assured) agrees to pay a sum of money either in a lump
sum or in installments in return for a lump sum (sum assured) to be paid by the other
party (the insurer i.e., the insurance co.) on the happening of an event (insured event).

Insurance are Contracts within the meaning of the Indian Contract Act, 1872. All the
essential elements of a valid contract as applicable to commercial contracts are equally
applicable to the Contracts of Insurance. In addition,because of the peculiar nature of
these Contracts, they are subject to some additional principles.

The following are the requirements for a life assurance contract to be legally valid:

(i) Offer

(ii) Acceptance

(iii) Consideration

(iv) Capacity to contract

(v) Insurable interest

(vi) Utmost good faith (uberrimae fides)

The additional requirements of general insurance contracts:

(vii) Indemnity

(viii)Subrogation

(ix) Contribution

(x) Proximate cause

(i) Offer: There must be a definite offer i.e., proposal to do or abstain from doing
anything. The Offer can be written or spoken. It can be either ‘express’ or ‘implied’.
The offer is ‘express’ when it is made in writing. It is ‘implied’ when offer can be
16 inferred by the circumstances or the conduct. For example, a Road transport
 company operating on a route accepts passengers for a fare and takes them to Introduction to
Insurance
their destination. There is an implied offer to the commuters. The offer must be
communicated to be complete. In respect of Life assurance, the proposal form
completed by the proposer is by law the offer.

(ii) Acceptance: For the emergence of the Contract, the offer must be accepted in
express or implied terms and must be communicated to the person making the
proposer. The assent (consent) given by the Proposer is known as Acceptance.
The acceptance should be unconditional and unqualified. A conditional acceptance
is not an acceptance but only a counter offer which again is to be accepted by the
proposer. The Acceptance can also be ‘express’ or ‘implied’ just like an offer. If
the insurer is prepared to accept the risk and issues a letter of acceptance stating
that it will issue a policy provided that the first premium is paid within a specified
time and subject to the state of health of the proposer remaining unchanged, such
a letter of acceptance is only a counter offer which the proposer has to accept by
paying the first premium.

(iii) Consideration: Consideration is the ‘act’ or ‘promise’ offered by one party and
accepted by the other as the price of that other’s promise. Consideration consists
of some profit or benefit accruing to one party or the other. It means “something in
return”. It is a right, interest, profit or benefit which has some value. It can be
positive or negative. If a car is purchased for a price the consideration is the car
for the purchaser and the amount received for the person selling the car. This is a
positive consideration. Suppose if “A” wants “B” to abstain from filing a legal suit
for the negligent act committed by him and offers to compensate him, it constitutes
a negative consideration. In the case of insurance contracts, the premium is the
consideration in return for the sum insured which is the consideration on the part of
the Insurance co. A contract entered into without “consideration” is ‘void’.

(iv) Capacity to contract: As per the Indian Contract Act every person is capable of
entering into Contracts except the following:

(a) Minors (who are below the age of 18 years) – They do not have proper
maturity of mind and cannot manage their affairs.

(b) Persons of unsound mind (mentally deranged/insane/lunatics) because they

are not responsible for the acts done by them.

(c) Legally disqualified persons such as Criminals, insolvents (bankrupts). An

insolvent person (bankrupt) is one whose liabilities exceed his assets and who
cannot satisfy his creditors in full.

(d) Drunken people during the period of intoxication are temporarily incapacitated
as they tend to lose their mental balance during that time.

(e) Alien enemies - If our country declares another country as enemy country,
our citizens cannot enter into contracts with the citizens of that country.

Contrast between Life Insurance and General Insurance Contracts

1. Life insurance contracts are long term in nature whereas General insurance
contracts are short term contracts which normally run for one year only and
17
Indian Insurance Sector: renewable thereafter. If the life insurance contracts are for one year and
An Overview
renewable every year, premium to be charged year after year will be more as
the age of the assured will be higher thus making the cost of insurance
prohibitive in the later part of his life because of which he may tend to discontinue
the contract when actually he needs insurance most. Therefore, these contracts
run for long terms.

2. In Life insurance contracts the event insured (death) is certain to happen, the
only uncertainty being its timing while in the case of General insurance, the
event may or may not happen (uncertain).

3. Life insurance contracts are not contracts of indemnity whereas the General
insurance contracts are contracts of indemnity i.e., the actual value of loss is
indemnified irrespective of the Sum insured.

1.5 PRINCIPLES OF INSURANCE

Let us now examine the principles of both life insurance and general insurance.

1.5.1 Insurable Interest

Insurable interest means that the assured must be in a legally recognized relationship to
what is insured so that he will suffer a financial loss on the happening of the event
insured and should benefit from its existence. It is the existence of insurable interest in
a Contract of insurance that distinguishes it from a wagering contract (The object of
wagering contracts is to earn speculative gains).

Wagering agreements are against public policy and VOID ‘ab initio’ (from the inception,
i.e., beginning). They are not enforceable at law. Therefore, a life policy cannot be
granted to a person unless that person has an insurable interest in the life to be assured.
The essence of insurable interest is that it must be an interest, recognizable by law, in
the life assured such that death would cause a loss capable of valuation in money
terms.

While the subject matter of insurance is the property having intrinsic value, the subject
matter of insurance contract is the insured’s pecuniary (financial) interest in that
property.Lack of insurable interest therefore renders the Contract of insurance VOID.

Essentials of Insurable interest:

(i) There must be property, right, interest, life or potential liability capable of
being insured

(ii) Such property, right, life etc., must be the subject matter of insurance and

(iii) The insured must bear a legal relationship to the subject matter whereby he
stands to benefit by the safety of the property, right, interest, life or liability
and stands to lose by any loss, damage, injury or creation of liability

How insurable interest arises:

(1) Ownership (ex: ownership of a building, motor vehicle, ship etc.)

18
 (2) Several interests in the property may exist (for example, a mortgagee who Introduction to
Insurance
advanced a loan to the mortgagor has insurable interest to the extent of the
loan. Hence partial interest is also insurable
(3) Interest arising from law (for example, a bailee is responsible to goods in his
possession, say warehouse keepers and in motor garages where vehicles are
kept)
(4) From contract (for example, if a building is let out on lease the lessee may
have to pay rent even if there is a fire. He can therefore insure loss of rent.
Contractors’ all risks policies arise out of contractual liabilities)
(5) From legal liability (for example, Employers have a legal liability to pay
compensation to employees for accidents occurring during the course of
employment as per Workmen’s compensation Act)
(6) Arising out of insurance i.e., the insurers themselves have interest in the risk
that they have covered. If the subject matter is damaged by a peril they stand
to lose. Hence they reinsure their liability either wholly or partially.
When should it exist?
In the case of Marine insurance, it should exist at the time of claim.
In life insurance it must be present at the time when insurance is affected.
In the case of other classes of insurance like Fire, Accident, Burglary etc. it should be
present both at the beginning and at the time of a claim
Specific Cases of insurable interest: In the following cases insurable interest is deemed
to exist:
(i) A person has unlimited interest in his own life and also in the life of his spouse.
No evidence is necessary as to the amount.
(ii) A creditor on the life of the debtor to the extent of the debt.
(iii) An employer in an employee for the value of services agreed to be rendered
or possibly on Key men.
(iv) A partner in business has insurable interest in other partners especially if there
is an agreement to buy the share of a deceased partner.
(v) A surety in the lives of co-sureties and the principal debtor.
Cases where there is no insurable interest:
(1) A parent has no insurable interest in their child as no financial loss would be
suffered on death of the child.
(2) A child has no insurable interest in its parent.
(3) A beneficiary under a ‘Will’ has no interest in the Testator (executor of the
Will) because the Will may be changed and there is only a hope of benefiting.
The presence of Insurable interest distinguishes a contract of Insurance from a wagering
contract. It differs in the following ways: 19
Indian Insurance Sector: (1) Insurable interest must be present in an insurance contract whereas the interest
An Overview
is limited to the stake to be won in the case of a wager which is not recognized
by Law

(2) The insured’s identity is known before the event in an insurance contract while
in the case of a wager either party may win or lose and the loser cannot be
identified until the event

(3) Full disclosure (‘Uberrimae fides’) is required by both the parties to an

insurance contract whereas no such disclosure is required by either party in a
wager

(4) In most of the cases an indemnity only is secured but in a wagering agreement
the stakes are not paid by way of indemnity. Payments are made without
suffering loss

(5) The insurance contract is enforceable at law whereas in a wagering contract

neither party has any legal remedy

1.5.2 Utmost Good Faith (Uberrimae fides)

The term means in complete agreement of mind. In any contract the parties must
be ad idem – of the same mind – as to the subject matter of the contract.

Ordinary commercial contracts are subject to the rule of “caveat emptor” i.e., ‘let the
buyer beware’. The duty of the seller does not go beyond observing good faith i.e., he
need not disclose any information about the subject matter of the contract to the buyer.
The seller cannot deliberately mislead the buyer. The word good faith means ‘absence
of fraud or deceit’. However, the contracts of insurance are treated by law on a
different basis. They are built on trust. Only one party knows the facts fully (the
proposer). Insurer is in the hands of the insured. There are certain facts which are in
the knowledge of the proposer only. No amount of physical inspection of the subject
matter can discover such information. Thus commercial contracts are contracts of
good faith whereas contracts of insurance are contracts of utmost good faith i.e.,
“uberrimae fides”

This is ‘consensus ad-idem’ regarding the subject matter of insurance and applies to
both the parties to the contract but to a greater degree to the proposer.

Duty of disclosure

The proposer must disclose all ‘material facts’ known by him to the Insurer. The
Marine Insurance Act, 1906(UK) describes a material fact thus: “every circumstance
is material which would influence the judgment of a prudent underwriter in fixing the
premium or determining whether he will take the Risk and if so on what terms and
conditions”. The duty is voluntary and the proposer cannot withhold any material
information because no question was asked. That is why the proposal form contains a
question at the end reading “Is there any other factor which may affect the risk on your
life?” Some examples of material facts are as follows:

Life insurance: Age, build, occupation & nature of duties, personal history of health
20 and habits, family history, etc.
Fire insurance: Construction of the building Introduction to
Insurance
Marine cargo insurance: Nature of goods to be transshipped and method of packing
the goods (whether professional packing or ordinary packing)

Accident insurance: Road worthiness of the Motor vehicle

Burglary insurance: Precise nature of articles to be covered

In addition to the above facts, as to previous losses if any, and whether the risk was
declined by any insurer previously are generally ascertained

Duration of the duty

The duty of disclosure continues until the completion of the contract; i.e., the payment
of the first premium and if any material fact becomes known to the proposer before
completion of the contract, it must be disclosed.

Consequences of breach of duty

If the proposer fails to disclose (reveal) a material fact this renders the contract voidable
at the option of the insurer. The burden of proving non-disclosure is on the Insurer.
However, if an insurer discovers a non-disclosed fact and still continues to accept the
premiums, it cannot afterwards repudiate (reject) liability on the grounds on non-
disclosure of that fact because by knowingly accepting premiums the Insurer is deemed
to have ratified the contract. Insurer has no right to damages for the breach of Utmost
good faith. The only remedy is to avoid the contract.

Breach of Utmost good faith (i.e., violation of the principle of ‘uberrimae fides’) may
occur in two ways:

(1) Non-disclosure

(2) Misrepresentation

In both the above cases they may be innocent or fraudulent. Innocent non-disclosure/
misrepresentation may be made inadvertently or thinking that the fact may not be material.
On the other hand, if intentional non-disclosure/misrepresentation is made with a view
to defraud the insurer, the contract becomes Void. In other cases, the contract is
voidable at the option of the Insurer. A voidable contract remains valid until it is treated
as Void by the aggrieved party. Where the assured does not make a full disclosure of
everything which is material to the Insurer to be known in order to judge (a) whether
he should accept the risk and (b) what premium he should charge, the insurer can
avoid the contract.

1.5.3 Indemnity
Indemnity means ‘compensation’ for loss or injury sustained (or) ‘security or protection
against loss or damage’. Insurance contracts promise to indemnify i.e., make good the
loss or damage. They are limited to the actual amount of loss or damage subject to the
sum insured. For example, if a house worth Rs 5 lakhs is insured for Rs 8 lakhs and if
it is sold during the period of insurance, no payment is made because there is no
21
Indian Insurance Sector: insurable interest after sale of the house. However, if the house is destroyed before it is
An Overview
sold; the insured will get Rs 5 lakhs only which is his actual loss.

It can be seen from the above that:

i) The insured must have insurable interest at the time of claim

ii) He can recover the loss only to the extent of his insurable interest (i.e., loss)

Thus the principle of insurable interest leads to the principle of indemnity.

The object of the principle of Indemnity is “to place the insured after a loss in the same
financial position, as far as possible, as he occupied immediately before the loss, and
not better”. The object is to prevent him from making a profit out of his loss or gaining
any benefit or advantage.

Need for the principle: If it is possible to make a profit the insured would be tempted
to deliberately cause the damage or loss. He will be careless in maintaining the property
by not taking safety precautions for prevention of the loss. Therefore the need for the
principle arises to prevent deliberate causing of loss which is against public interest and
results in destruction of National wealth. If this principle is not applied, the contracts of
Insurance would be mere gambling transactions which is against public interest

Application of the principle: It is applicable only where the loss is measurable in

terms of money. Thus it is applicable to physical property (Fire, Burglary etc.) or
Liabilities (public liability & Employer’s liability). It does not apply to Persons i.e., Life
insurance and personal accidents where the loss cannot be valued in monetary terms.
The amount of indemnity would be the actual loss/damage or the Sum insured whichever
is less.

1.5.4 Subrogation
Definition: We can define subrogation as”The right of one person, having indemnified
another under a legal obligation to do so, to stand in the pace of that other and avail
himself of all the rights and remedies of that other, whether already enforced or not”.

In the context of insurance, subrogation refers to the right of an insurer who has
indemnified an insured in respect of a particular loss (i.e. paid a claim) to recover all or
part of the claim payment by taking over any alternative right to indemnity which the
insured possesses. It follows that subrogation will arise only where the insured has
suffered a loss and has another means of recovering it, i.e. a claim on their insurance
policy and a legal right or claim against some other person for the same loss. If the
insured chooses the first option (a claim on their policy) then the alternative right, the
claim against another, passes to the insurers.

The effect is to prevent the insured from recovering twice for the same loss and so
preserve the principle of indemnity.

Taking a practical example, let us suppose that a house has been damaged in a fire
which was started by the negligence of a plumber who had come to repair a pipe. The
damage amounts to Rs. 5,00,000 and the house owner has a household policy which
22 covers fire damage. The house owner has two means of recovering this loss. First,
they can claim under their own household policy. Second, they can make a claim Introduction to
Insurance
against the plumber, based on negligence.

1.5.5 Contribution
An insured whose loss is covered by two or more policies cannot recover more than
an indemnity.
However, at common law, s/he can claim against the insurers in any order and for such
proposition of the loss as s/he thinks fit. In particular, s/he may choose to claim from
one insurer only and recover in full from that insurer. Having satisfied the loss, the
insurer who pays may then, and only then, claim a contribution from the other insurer(s).
Insurers have always regarded this as an unsatisfactory state of affairs, because the
insurer that is called upon to pay has the full burden of handling the claim and paying
the loss, plus the further inconvenience of claiming from another insurer, it may be
some time before the paying insurer is able to make a recovery and the process of
doing so may involve extra cost and, perhaps, even lead to a dispute with the other
office.
For this reason, in almost every case, insurers include contribution conditions in their
policies. A contribution condition is a clause that sets out how the loss is to be met if
the insured has another policy which covers it. The effect of the condition will be to
change or override the common law rules described above.
Contribution conditions
Contribution arises of common law when the following conditions are complied with.
 More than two policies of indemnity exist
 Covering of common interest in all policies
 Coverage of common subject matter in all policies
 Coverage of perils common to all policies, resulted into loss
 Policies contributing are valid on the day of loss
 All the contracts are legally enforceable and liable for loss
Non-compliance of any condition in the policy would not entitle to contribute to the
loss. At times there is an overlap of policy cover and would contribute to the loss.
Common Law Approach
When the insured has more than one policy and insured with two or more insurers, he
may restrict claiming from one insurer to recover in full. The insurer in turn recovers
from other insurers the net loss in proportion to the respective insured values.
Contractual modification
An expressed condition appears in the policy which modifies the operation of doctrine
of contribution. It states that the insurer is liable to compensate for its rateable
proportion of the loss and the customer shall make a claim against each insurer to be
fully indemnified. A condition in a Standard Fire and Special Perils Policy appears
as follows. 23
Indian Insurance Sector: “If at the time of any loss or damage happening to any property hereby insured thereby
An Overview
any other subsisting insurance or insurances, whether effected by the insured of by any
other person or persons covering the same property, this Company shall not be liable
to pay or contribute more than its rateable proportion of such loss or damage”.
Basis of Contribution
Where the properties are insured fully and no condition of average applied and complies
with all the conditions of contribution, the policies of the insurers contribute
proportionately to the sum insured.
One can understand the contribution from the simple example.
Insurer Sum Insured in Rs.
A 9, 00,000/-
B 12, 00,000/-
C 18, 00,000/-
The amount of Loss is Rs.3, 90,000/-
‘A’ would pay Rs.90, 000/- i.e.Sum Insured of A x Amount of loss
Total SI of A+B+C
‘B’ would pay Rs.1, 20,000 Sum Insured of B x Amount of Loss
Total SI of A+B+C
‘C’ would pay Rs.1, 80,000 Sum Insured of C x Amount of Loss
Total SI of A+B+C
Association of British Insurer’s (UK) Contribution procedures Part 4 of Section 4 of
ABI Claims Procedures are:
 Where there are two or more subsisting insurances in the names of parties
having different rights and interest covering the same loss
 Such loss shall as between insurers be apportioned rateably to the independent
liabilities of such insurances
 Without regard to the liabilities of the insured parties to each other
 Contribution would arise under all risks or accidental damage policy provided
the cause of loss was one of the perils specified above.
Important
Loss here means material loss or damage resulting from the perils, like fire, lightning,
explosion, aircraft, riot and civil commotion, malicious damage, earthquake, subterranean
fire, spontaneous fermentation, storm or tempest, flood, bursting or overflowing of
water tanks, apparatus or pipes, impact and sprinkler leakage.

1.5.6 Proximate cause

The doctrine of proximate cause: The assured can recover the loss only if it is
proximately caused by any of the perils insured against. This is called the rule of causa
proxima. The rule is causa proxima non remota spectator, i.e., the proximate or
24
immediate and not the remote cause is to be looked to, and if the proximate cause of Introduction to
Insurance
the loss is a peril insured against, the assured can recover the amount of the loss from
the insurer. Every loss that clearly and proximately results, whether directly or indirectly,
from the event insured against is within the policy.
The question, which is the causa proxima of a loss, arises only when there is
succession of causes. When a result has been brought about by two or more causes,
one has, in insurance law, to look to the nearest cause, although the result would, no
doubt, not have happened without the remote or other causes.
‘Proximate’ does not mean the ‘nearest in time’. The cause which is truly proximate is
that which is ‘proximate in efficiency’. If the loss is the result of such efficient cause,
it will be regarded as being caused by the ‘proximate cause’. The choice of the real or
efficient cause from out of the whole complex of the facts must be made by applying
common sense standards. But if the loss is brought about by any cause attributable to
the misconduct of the assured, the insurer is not liable.

1.6 TYPES OF INSURANCE

Insurance organisations have a valuable function to perform within society by insuring
the wealth of the country. It will come as no surprise that no two insurance organisations
are identical in their structure and outlook. However, within India, all the insurance
companies can be grouped into four broad types:
1. Life insurance company
2. General insurance company
3. Stand-alone health insurance company and
4. Reinsurance company
1. Life insurance companies: These insurance companies sell life insurance,
annuities and pension products. It mainly deals with long and short-term
monetary investments, children plans, and plans that provide maturity and
death benefits. Presently, 24 life insurance companies are transacting life
insurance business.
2. Non-life insurance companies: These companies are mainly concerned
with protecting property from many risks and natural acts like theft, fire,
lightning, typhoon, flood and earthquakes. Presently, 33 general insurance
companies are transacting general insurance business in India.
3. Standalone Health insurance companies: These companies exclusively
sell health insurance products. Presently, there are 6 companies transacting
healthcare business in India.
4. Reinsurance companies (Re-insurers): Reinsurance is also known as
“insurance for insurers”. It is the practice of insurers transferring portions of
risk portfolios to other parties by way of reinsurance arrangement. Reinsurance
serves to limit liability on specific risks, to increase individual insurer’s capacity,
to share liability when losses are too big for the primary insurer’s resources,
and to help insurers to stabilize business in the face of the wide swings in profit
and less margins inherent in the insurance business. 25
Indian Insurance Sector: The company that diversifies its insurance portfolio is known as the ceding or primary
An Overview
or direct insurer. The company that accepts a portion of the potential obligation in
exchange for a share of the insurance premium is known as the reinsurer or assuming
insurer.

1.7 MORAL HAZARD

Moral hazard refers to aspects of the risk that depend on the character and behaviour
of the insured himself, to try to benefit from an event that occurs.
Identity of the insured - The identity of the insured and their general background
may be material. Factors relating to the health, habits, personal history, family history,
occupation and so on, which form the basis of the life insurance contract, are known
only to the proposer. If the proposer does not disclose them, the insurer cannot know
them.
Insurers have long taken the view that a person’s occupation may indicate moral hazard
and have applied special terms to some occupational groups, for various classes of
insurance.
Matters which need not be disclosed
Some things need not be disclosed, even if they are material. They include thefollowing:
 Matters of law / Facts of Law: Everyone is deemed to know the law. The
facts of common knowledge which everyone is supposed to know need not
be disclosed.
 Factors which lessen the risk: There is no requirement to disclose factors
that reduce the risk-i.e. make it better than a normal risk of its type. Examples
include the installation of an alarm system for a theft risk or automatic sprinklers
for a fire risk.
 Facts which a survey would have revealed
 Facts known by the insurers: Rather obviously, there is no duty to tell
insurers things that they already know. The information does not have to
come from the proposer. In fact, it does not seem to matter where the
information comes from, provided the source is reliable. Facts which could
be reasonably discovered by ref. to previous policies and records available
with the insurer
 Facts which the Insurers ought to know:In some cases the courts take the
view that whilst the insurers might not have actual knowledge of the
circumstances they have constructive knowledge, that is, they ought to know
of them. This category covers a number of situations, including the following:
(i) Facts which are notorious (i.e. matters of common knowledge)
An insurer is deemed to know about things that are in the public domain,
such as the fact that a state of war exists in some countries.
(ii) Facts about the trade which the underwriters insure: Insurers are
deemed to be aware of the normal trade practices in the business they
26 insure and the usual risks associated with them.
  Information that is waived by the insurers: Some cases a court may rule Introduction to
Insurance
that it was unnecessary for the proposer to disclose certain material facts, the
actions of the insurers suggested that they were prepared to waive (i.e. do
without) disclosure of them.
 Facts which an inspection of the risk should have revealed: If the insurer
carries out a survey of inspection of the risk there is no duty to disclose fact
that should have been obvious to the surveyor, or which any reasonable
surveyor would have enquired about. However, this principle does not extend
to unusual features of a risk that a conventional inspection would not reveal.
Finally, it goes without saying that the proposer must not actively conceal
hazardous features of the risk.
 Facts covered by the terms of the policy: In some cases the need to
disclose information is made superfluous by reason of the terms of policy.
For example, if a personal accident policy excludes injury arising from
participation in winter sports the proposer would not be obliged to disclose
the fact that he went skiing regularly, unless specifically asked to do so. Similarly,
there is no need to disclose matters, however material, which are the subject
of an express or implied warranty in the policy.
 Facts which the proposer does not know: As a general rule, there is no
duty to disclose facts which the proposer does not know.

1.8 REINSURANCE
Reinsurance enhances the fundamental objective of insurance, which is to spread risk
so that no single entity finds itself saddled with a financial burden beyond its ability to
pay.
Essentially, reinsurance is a transaction in which one insurance company
indemnifies, for a premium, another insurance company against all or part of
the loss that it may sustain under its policy or policies of insurance.
Reinsurance is a mechanism used by the insurance industry to spread the risks it assumes
from policyholders. Through it, the industry’s losses are absorbed and distributed among
a group of companies so that no single company is overburdened with the financial
responsibility of offering coverage to its policyholders. Catastrophes, unexpected
liabilities, and a series of large losses that might be too great for an individual insurer to
absorb are able to be handled through reinsurance. Without reinsurance, most insurers
would be able to cover only the safest of ventures, leaving many risky but worthwhile
ventures without coverage.
Reinsurance is best thought of as “insurance for insurance companies,” a way for a
primary insurer to protect against unforeseen or extraordinary losses. Reinsurance
serves to limit liability on specific risks, to increase individual insurers’ capacity, to
share liability when losses are too big for the primary insurer’s resources, and to help
insurers stabilize their business in the face of the wide swings in profit and less margins
inherent in the insurancebusiness.
In a reinsurance contract one insurance company (the reinsurer, or assuming insurer)
charges a premium to indemnify another insurance company (the primary insurer or the 27
Indian Insurance Sector: direct insurer or the ceding insurer) against all or part of the loss it may sustain under its
An Overview
policies. Reinsurance contracts may cover a specific risk or a broad class of business.
Reinsurance is a global business. Its International nature reflects a further spreading of
risk and access to broader capital markets to help cover losses.
The well-known axiom for the informed use of insurance is to “retain the predictable,
frequent losses up to your financial capacity to do so, and insure the unpredictable,
infrequent and severe losses.” Just as insurance buyers select deductibles, and a self-
insurer purchases excess insurance above some self-insured retention, most insurers
transfer to reinsurers some of the risk assumed from policyholders. Reinsurers
may, in turn, transfer risk on to other reinsurers, known as “retrocessionaires.”
The consequence of this, for example, is that, even if the reinsurer would fail to meet its
obligations to the direct insurer for one reason or another, the direct insurer would still
be liable to the insured. It would be no excuse to say that the reinsurer had failed as the
reinsurance contract is not part of the contract between the insured and the insurer. In
fact, the vast majority of ordinary insureds will have absolutely no knowledge
that reinsurance exists
The basic function of reinsurance is to provide:
1. Stability
2. Capacity/Retention
3. New business strain
4. Catastrophe protection
5. Financial relief
6. Expertise and services
Reinsurance creates a mechanism for the primary carrier to exit a particular segment of
business. Each of these functions is explained below.
1. Stability:The primary insurer, despite the best forecast of losses may yet find
the loss ratio to be erratic with high unexpected losses in one year and
unusually low losses in another. Not unlike the vagaries of nature, the insurance
business is also subject to highs and lows which make the business unprofitable.
By transferring certain layers of coverage or classes of risk to several
other companies, an insurer can avoid radical fluctuations in loss ratios,
stabilize underwriting results, and undertake more medium and long-
range planning.
When a primary insurer buys Reinsurance, his losses are limited to the retention.
With Reinsurance when the losses exceed the retention limit, the Reinsurer
steps in and the primary insurer’s losses get stabilized.Though the reinsurance
is arranged on individual risks basis, insurer in addition arranges for multiple
losses arising out of single events like catastrophic and conflagration. Besides
the Insurer shall take care of fluctuations which may upset the financial position
by other causes like economic conditions, liability losses etc.
2. Capacity/Retention: Every insurance company has an upper limit on sum
assured they would hold under any one life. This is known as the insurer’s
28
 capacity or Retention limit. This limit differs from company to company Introduction to
Insurance
depending upon the size. It is low in the case of substandard and old lives. If
a policy with a very high sum assured becomes a claim it would impair the
basic principle of spreading the risk. Hence each company sets its retention
limit. With passage of time the retention limit increases and reinsurance
decreases. The office may accept a sum assured higher than its retention, but
only if it can reassure the excess. The reason for retention is that although an
office can forecast fairly accurately how many claims it can expect for any
given age group, it cannot forecast which individual policies will become claims.
If a policy with a very high sum assured became an early claim, this would
affect the results adversely and would also impair the basic principle of spreading
the risk. Hence each company will set its retention limit, which will be revised
from time to time to reflect both the growth of the life fund and the effects of
inflation.
3. New business strain:Reinsurance is a necessity for an office which has just
started to transact insurance. A new office will wish to keep its new business
strain within tolerable limits. New business strain can occur as a result of
unexpected early claims before the life fund can build up large reserves which
the long established offices have. A new life insurance company’s level of
reserves will be low. Initial expenses like commission and underwriting will
be very high.
4. Catastrophe protection: Insurance has always been a business characterized
by variability in the frequency and severity of claims, year by year, particularly
the property /Liability sector. One of the contributing factors to this
variability is the nature of risks assumed by insurers. When a natural
catastrophe strikes, aadverse social or economic condition occurs, or
legal interpretation of liability changes or expands, massive losses
can be generated.
To the extent that the responsibility for indemnifying losses is shared via reinsurance
among many insurers, loss exposure is diversified and loss ratios are stabilized. This is
particularly true with excess of loss reinsurance, wherein a reinsurer assumes liability
for losses that exceed some normal threshold. In this case, the reinsurer absorbs
much of the variability of underwriting losses, leaving the primary carrier with a
smoother pattern of loss ratios over time.
5. Financial relief: In many countries, the expenses associated with issuing an
insurance policy, such as agent commissions, administrative expenses, and
taxes are charged against a company’s current income, rather than amortized
over the expected life of the policy.
This results in a reduction of net equity. Moreover, the insurance premium
does not flow through to the bottom line but is held in, unearned premium
reserve (sometimes called “the reserve for unexpired risks”), to be released
over time rather than fully recognized as an asset at the outset, thereby
exacerbating the net equity situation. The more rapidly an insurer grows, the
greater the drain on net equity and capacity to write further business is
diminished.
29
Indian Insurance Sector: Reinsurance is able to remedy this situation somewhat, because a ceding insurer shares
An Overview
its expenses with its reinsurer. Indeed, the reinsurer will typically give the ceding insurer
a ceding commission to reimburse it for expenses associated with writing the business
being reinsured. The ceding commission can then be added directly to the ceding
company’s net equity. Because ceding commissions are generally considered to be
fully earned when paid, they may immediately increase the net equity of the primary
carrier.
6. Expertise and services: Finally, reinsurers may require strict underwriting
and claims standards and provide expertise to insurers, to help them
conduct their business more effectively and profitably. To the extent
that the good business results of insurers are passed through - decreasing
prices, increasing availability, and providing risk management expertise -
insureds are directly affected by reinsurance. Obviously, to the extent that
insurer and reinsurer business performance deteriorates, the insured suffers.
The Indian Insurance Regulator, the IRDAI has issued the following comprehensive
regulations on reinsurance.
1. The IRDAI (Life Insurance – Reinsurance) Regulations, 2013
2. The IRDAI (General Insurance – Reinsurance) Regulations, 2016
Essential aspects of a reinsurance contract
 Contract of reinsurance is a contract of Insurance
 It is a separate contract distinct from the original contract of insurance.
 It is a contract of indemnity on the same risk as the original contract of
insurance and the principle of indemnity of the insured risk apply automatically on
Reinsurance.
Both contracts are in existence at the same time.However the reinsurance contracts
can be modified during discussions between the primary insurer and the reinsurer.
Activity 1.
Visit the website of IRDAI and bring out the important aspects of Reinsurance.
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1.9 TYPES OF REINSURANCE / METHODS OF

CESSION
There are three methods of ceding risks or policies to a reinsurer. They are by:

1. Reinsurance Treaty

2. Facultative reinsurance

3. Hybrid agreements
30
1.9.1 Reinsurance Treaty Introduction to
Insurance

Treaty reinsurance is an agreement, wherein, a reinsurer will agree to assume the liabilities
associated with a portion or all of the ceding company’s business for one or more
specific lines of business (e.g., casualty, marine, property) and the reinsurer is obligated
to reinsure any policies the company issues within these categories. Additional conditions
and limits are often placed in the treaty dealing with the size of a single risk, type of risk,
location of exposure, etc. Reinsurance treaties generally remain in force for long periods
of time and are easily renewed.

Reinsurance treaties are broad contracts that cover a block of the ceding company’s
book of business. For instance, the treaty insurance may cover the ceding insurer’s
entire property book of business. The reinsurance treaty automatically covers all the
risks of the ceding insurer that are within the specified business class, unless those risks
are specifically excluded.

A reinsurer entering into a treaty typically will not review all of the individual risks being
accepted; rather, it will review the underwriting philosophy and standards of the ceding
company as well as its historical experience.

The reinsurer is entitled to copies of any medical evidence, but this is for information
only, as cover is automatic. Many offices have reassurance treaties which are specially
designed for new offices to provide automatic cover against new business strain. Treaties
usually stay in force until renegotiated.

Types of Treaty Reinsurance

Reinsurance coverage is structured in two broad forms:

1. Proportional

2. Non-proportional

Each of these forms, in turn, has specialized variations, as shown below.

TREATY

PROPORTIONAL NON-PROPORTIONAL

QUOTA SURPLUS EXCESS STOP

SHARE TREATY OF LOSS LOSS

In this Section we discuss the forms and variations for structuring coverage
provided by reinsurance contracts.

31
Indian Insurance Sector: (1) Proportional Reinsurance
An Overview
The earliest reinsurance agreements were almost invariably made on a proportional
basis. In proportional reinsurance, the ceding company and the reinsurer share risks
and premiums on a proportional basis of some sort. Proportional reinsurance agreements
are used extensively in property insurance. A proportional basis reinsurance contract,
prorates all premiums and losses between the ceding insurer and the reinsurer on a
pre-arranged basis.
Two varieties of proportional reinsurance are in common use today. They are:
a. Quota share treaty
b. Surplus share treaty
a. Quota share treaty: Quota share agreements are a type of proportional
reinsurance that indemnifies the ceding company for a specified percentage of
loss on each risk covered in the agreement, in return for receipt of a similar
percentage of net premium paid to the ceding company. These agreements
are the simplest type of proportional reinsurance, because each policy is shared in
fixed proportions.
b. Surplus Share treaty: Surplus share agreements are another type of proportional
reinsurance. All the premiums and claims are shared in a predetermined proportion
bought with the original (Direct) insurer and the Reinsurer/s.With surplus share, a
ceding company decides what level of liability it wishes to retain on a given risk
and then reinsures multiples of that level through the reinsurer. In a surplus share
agreement, it is not unusual for there to be a maximum monetary limit on the
amount of liability that can be ceded to the reinsurer for any given risk. Administered
primarily through treaty arrangements, the surplus share form of risk sharing is
more flexible than the quota share form. It allows the ceding company to better
manage its retention, bringing a level of homogeneity to its exposures. But it can
also be used by the cedent as a further underwriting tool, whereby it retains a
much smaller share of undesirable risks. To this extent, a surplus share agreement
allows for some degree of anti-selection. Obviously this opportunity cannot be
abused or the reinsurance facility might disappear on renewal.
Ceding commissions are common in reinsurance. In proportional reinsurance
agreements, a reinsurer often will agree to split the net premium (as opposed to the
gross premium) and losses according to a fixed percentage basis. The net premium
has removed from it the marketing, administrative, and soles commission costs as well
as premium taxes incurred by the primary carrier in writing the policy. In this way the
primary carrier is reimbursed for its additional costs.
(2) Non-proportional reinsurance
Non-proportional reinsurance contracts have also been known for a long time, but
these forms of reinsurance become widely used only after World War II. The two
most common forms include:
 Excess of loss contracts

 Stop loss contracts

32
Below we describe each. Introduction to
Insurance
Excess of loss- Excess of loss contracts require the ceding company to pay all losses
associated with an insurance claim up to some maximum amount. If losses exceed
that amount, the entire excess will be paid by the reinsurer, up to the limits of the
contract. Excess of loss contracts are sometimes purchased in layers. In this arrangement,
a primary carrier may purchase reinsurance from several reinsurers, with each of the
reinsurers obligated to assume a particular layer of losses. Then when a claim comes
due, the reinsurers respond in predetermined order until the total loss is covered.
Through layering, the primary carrier may secure the type and amount of reinsurance
protection desired, and not be restricted to the willingness of a single reinsurer to
provide it.
Stop loss - Stop loss contracts are similar to excess of loss contracts, except that stop
loss contracts apply to a portfolio of insurance contracts. This kind of contract is
simple to administer, and in some sense better meets the needs of most insurers, because
it is the total of all losses that is typically of greater concern, not the loss payments
under a single contract. Stop loss contracts are used by the newly established company
and by subsidiaries from a foreign parent company. Such a company may have a quota
share treaty as its first line of defense against major claims problems. Using this part of
their reinsurance package, it could protect itself against the probability of a single very
large claim. However, it remains exposed to the risk that the number of claims
would become excessive. It is just as bad for an insurer to have to pay 10 claims of
Rs 100,000 each as it is to pay one claim of Rs. 10 lacs.
This is where stop loss contracts, as a supplement to quota share treaties, can be most
helpful. For certain lines of business, such as hail insurance or extended warranty,
variance in severity is not a problem. However, significant variance in frequency can
easily overwhelm an insurer. The stop loss contract is the only effective way of providing
reinsurance protection in these cases. If the treaty is at arm’s length, then many conditions
will apply.
Reinsurance pool
Pool is an organisation of insurers or reinsurers through which particular types
of risks are underwritten with premiums, losses, and expenses shared in agreed
ratios.
Reinsurance pool is a risk financing mechanism used by insurance companies to increase
their ability to underwrite specific types of risks. The insurer cedes risk to the pool under
a treaty reinsurance agreement. The insurer may be a part owner of the pool and may
assume a quota share of the pool risk. A captive reinsurance pool may be owned by
the original insureds. Some pools are operated by states to provide capacity for hard-
to-place risks.
Pool takes various forms but often a quota share or surplus reinsurance arrangement
between participating members. According to the rules agreed, insurance accepted by
members are ceded to the pool which in turn arranges retrocessions to members. The
pool may retain some part of each risk for its own account. It is used for proportional
reinsurance. The pool may protect itself by purchasing non- proportional reinsurance
from outside reinsurers.
33
Indian Insurance Sector: 1.9.2 Facultative reinsurance
An Overview
Under this system, each risk is dealt with individually. The principal company
makes a proposal to the Reinsurer who is free to accept or reject the offer.

In a facultative reinsurance agreement, the ceding company cedes the risks associated
with individual policies to the reinsurer, but not for all policies within a given business
line. For each transaction sought to be reinsured, the reinsurer reserves the “faculty”
to accept or decline all or part of any insurance policy presented, and the cedant
chooses whether to secure reinsurance for a particular policy. This kind of agreement
is designed to reduce the exposure of an insurer to losses associated with a given
contract, but not for all contracts within a line of business.

 Facultative reinsurance is for a specific risk of the ceding insurer. It is generally

used to cover catastrophic risks,

 It covers underlying, individual policies and it is written on a policy specific

basis.

 The parties negotiate the terms and conditions in each individual contract.

 The reinsurer is free to accept or reject the cession and the terms are set on
an ad hoc basis.

 Facultative reinsurance is often used to cover catastrophic or unusual risk

exposers.

 A reinsurer entering into a facultative agreement will typically expend

substantial resources in examining the individual risks covered, because the
contract often exposes the reinsurer to substantial risk.

 Underwriting must be carefully done in order to ensure adequate pricing

Uses of facultative reinsurance include:

 When an insurer is offered a risk that exceeds its standard underwriting

or reinsurance limits for that class, facultative reinsurance can permit the
ceding company to accept the risk.

 Insurers can fill gaps in coverage caused by reinsurance treaty exclusions

by seeking separate facultative coverage for a specific policy or group of
policies.

 A reinsurer can issue facultative reinsurance to participate in a market in

the short term to minimize risk and take advantage of favorable rates.

 A treaty reinsurer may purchase facultative reinsurance to protect itself and its
treaty reinsurers.

The facultative reinsurance has some drawbacks.

 Dealing with individual cases is expensive.

 Copies of Proposals and medical reports are to be submitted in each case to

34 the Reinsurer.
  Acceptance of the proposal by the direct insurer is delayed and cannot be Introduction to
Insurance
conveyed to the applicant until and unless reinsurance is accepted.

Insurers sometimes purchase both facultative and treaty reinsurance to cover the same
risk.

Unless there are contract terms to the contrary, the facultative reinsurance
will perform first and completely before any of the treaty reinsurance performs.

Sometimes the facultative reinsurance only applies to the ceding company’s net retention;
other times facultative coverage also benefits the treaty reinsurers. Ideally, the wording
of the facultative certificate will make this clear. As a general matter, whether the
facultative reinsurance benefits the treaty reinsurers will depend on whether the treaty
reinsurers paid a portion of the premium for the facultative coverage. If not, the facultative
reinsurance likely will not benefit the treaty reinsurers.

1.9.3 Hybrid Contracts

Reinsurance contracts that involve some combination of proportional and non-
proportional reinsurance are known as hybrid contracts. For example, a reinsurer
may accept liability for losses exceeding some threshold, but only up to some upper
limit. Beyond that upper limit, the reinsurer may pay a proportion of further losses or
indeed nothing at all. Alternatively, a reinsurance contract may provide for reinsurance
payments to begin if losses exceed some threshold, but where the reinsurer may pay
only a portion of losses above that threshold, but without an upper limit on total losses.
Numerous other arrangements are made, but most are, some variation on these themes.

1.10 RETROCESSION
A reinsurance contract is essentially an insurance policy issued by one company
assuming insurer or reinsurer - to –another company, usually called the ceding company,
primary carrier, or the direct underwriter. The ceding company is the insurer that
underwrites the policy initially, and then later shifts part or all of the liability for
coverage to a reinsurer by purchasing reinsurance. This reinsurance provides
reimbursement to the ceding insurer for claims payments covered by the reinsurance
agreement. It does not alter the underlying reinsured policies or the obligations created
by those policies. However, it does provide protection to the ceding insurer against
frequent or severe losses. Nonetheless, the ceding company remains obliged to pay
policyholder claim without regard to its reinsurer’s performance or financial condition.
Typically, the policyholder has no direct claim on the reinsurer - i.e., the policyholder
does not “look through” to the reinsurer as the source of indemnification.

The quantity of insurance ceded to a reinsure is called the cession. If, more of the risk
is shifted to the reinsurer than it desires, the reinsurer may in turn reinsure with yet
another reinsurer a portion of the risk. This reinsurance purchased by reinsurers is
known as retrocessions. The retrocession of risks often proceeds in a chain-like fashion,
spreading exposure to risks throughout the international reinsurance community.

Reinsurers can also purchase their own reinsurance, known as a Retrocession. The
reinsurers purchasing the reinsurance become known as retrocessionaires, and the 35
Indian Insurance Sector: reinsurers selling the reinsurance to other reinsurers become known as retrocedents.
An Overview
Retrocessions further spread the risk of reinsurance, and it is quite common for a
reinsurer to buy reinsurance protection from other reinsurers. Reinsurers providing
proportional basis reinsurance may need to protect their own exposure to catastrophes,
or reinsurers providing excess of loss reinsurance protection may need to protect
themselves against accumulated losses.

Buyers and sellers - Most reinsurance occurs with specialist reinsurers, like earthquake
and hurricane reinsurers, that operate on a global basis. Most reinsurance transactions
involve numerous reinsurers sharing risk. Because reinsurance is an indemnification
contract, the reinsurance is payable only after the ceding insurer pays losses under its
own insurance or reinsurance contracts.

Catastrophic losses - Reinsurance works just like insurance, but on a bigger scale.
For example, say a fire burns down one house, but not 500 others. For regular insurance,
the premium paid by the 500 policyholders would cover the cost of rebuilding the
house that burned down. However, if a catastrophe, like a hurricane, destroyed all the
homes in a certain county, the premium paid by the 500 policyholders would not be
enough to cover all the destroyed homes. Reinsurance protects against that
situation in that there would likely not have been a catastrophe in another
county.

1.11 REINSURANCE ADMINISTRATION

Reinsurance is sometimes more difficult to arrange if it is on a with profit basis on
original terms. This is because the reinsurer is accepting a future liability over which he
has no control. It will have to be sure that it can follow the principal office’s Bonus
rates. Occasionally with profit policies are reinsured on a non-profit basis so that the
principal office is fully responsible for the bonuses.

A new life office with little experience in underwriting may sometimes require the
assistance in underwriting sub-standard lives. In such circumstances, a treaty may be
arranged under which proposal papers are sent to the reinsurer who decides on what
terms the proposal can be accepted. The existence of Reinsurance must be borne in
mind by the administrative staff of the principal life office throughout the term of a
policy. If the policy is altered to any material extent, the principal office will need to
obtain the consent of the reinsurer.

It is important to remember that on a claim the principal office is directly responsible to

the policyholder. It must pay the claimant (subject to normal requirements) the whole
sum assured whether it has yet received the reinsurer’s proportion or not. The present
trend is that Reinsurance is administered by electronic data transfer between the
companies.

1.12 SUMMARY
The study of Insurance incorporates the discipline of Risk Management which acts as
a driving force. Insurance is defined as a form of risk management primarily used to
hedge against unforeseen risks of contingent losses. In this unit it has been discussed in
36
detail. The various aspects to be covered in the insurance contract have been elaborated. Introduction to
Insurance
The various types of insurance are discussed at length. The concept of reinsurance and
its functions are given in detail. Here we have also discussed the different types of
reinsurance and its administration.

1.13 KEY WORDS

Insurance : is, in actuality, a social vehicle for spreading the risk of
financial loss among a large group of people, thus
making a loss manageable for any one person of that
group.

Insurance Contract : A contract of Insurance is an Agreement between two

parties enforceable at Law where one party (the insured/
assured) agrees to pay a sum of money either in a lump
sum or in installments in return for a lump sum (sum
assured) to be paid by the other party (the insurer i.e., the
insurance co.) on the happening of an event (insured
event).

Indemnity : Indemnity means ‘compensation’ for loss or injury

sustained (or) ‘security or protection against loss or
damage’. Insurance contracts promise to indemnify i.e.,
make good the loss or damage.

Reinsurance : It is a transaction in which one insurance company

indemnifies, for a premium, another insurance company
against all or part of the loss that it may sustain under its
policy or policies of insurance.

1.14 SELF-ASSESSMENTQUESTIONS
1. Explain briefly the concept of Insurance? Discuss the essentials of a valid Insurance
contract.

2. Write a critical note on the Theory of Probability and the law of large numbers?

3. Describe the principles of Insurance?

4. Explain the importance of duty of disclosure of material facts in Insurance?

5. What is ‘moral hazard’ and name the facts which need not be disclosed by the
applicant for insurance?

6. What is reinsurance? Explain the need for reinsurance?

7. Explain the basic functions of reinsurance?

8. Explain the different types of reinsurance. Discuss in detail the different types of
treaty reinsurance.

9. Write a note on ‘Ceding commissions’? 37