All people whether investors or not are exposed to various types of risks. Risk is inherent in man’s life and activity. Why does an individual need protection? An individual is exposed to many types of risks that may adversely affect his own or his dependant’s welfare. Some of these risks can be:
(1) Risk of death, sickness and injury
(2) Risk of loss or damage to property one may own or for which one is responsible.
(3) Risks of incurring liability to compensate others for personal injury or damage to their properties arising from acts committed by him or by others for whom he is responsible.
The above risks can be set out as relating to
(1) Body and mind
(3) Financial wealth
The occurrence of property damage and liability risks will result in a reduction in individual’s wealth. Other risks may cause a loss of income, for example, the loss of earnings during periods of incapacity caused by sickness or accident. Sometimes additional expenses may be incurred to minimize such losses – for example, expenditure on medical treatment to hasten recovery from injury or sickness.
No matter how one lives, it is impossible to avoid all risks, and indeed, even to try to minimize the total risk to which one is exposed would involve foregoing many pleasures and benefits associated with various activities such as sports, travel and taking up occupations which are risky. So, how does one protect oneself against risk? While the individual can take steps to reduce risk to property and person by wearing protective clothing, making premises secure etc., The only way in which he can participate in the benefits of risk combination is by insuring.
What is insurance?
Essentially, insurance is a device for dealing with those risks which may cause severe financial difficulties. While there are social security schemes like provident fund, voluntary provident fund etc., to which compulsory contributions have to be made and which entitle the contributor to the benefits of the scheme, these provide only partial protection insurance can be bought to give additional protection, the cost of future income guarantees being the foregoing if current income. Whether the security provided by insurance will be judged worth the premium involved must be a personal decision in the detailed analysis of needs.
When should an individual or firm go for insurance?
When the individual feels that he can manage the risk on his own as it is within his control and limits, he does not seek to transfer the risk to an outside agency as he feels the cost of the transfer is not justified.
Once he decides to transfer the risks to an external agency, he can do it in two ways.
a) Transfer the activity that creates the risk
b) Transfer the financial losses arising from the occurrence of the risk
The first type arises out of the normal life of the individual during the work process, such as accident, sickness, death, residential house, vehicles, etc. The second one needs management, reduction and avoidance of risk depending on the behavioral aspects, psychology and preferences of the individual. The commonest example of (a) is the subcontracting of particularly hazardous activities to other agencies while insurance is the most important form of (b)
Before buying insurance an individual or corporate has to analyze the risk involved, and has to decide whether to buy insurance or not.
How Insurance Protects?
Insurance protects through any of the following ways:
1) Risk Transfer
2) Advisory Services
3) Claims Handling Services.
The price which someone will be prepared to pay in excess of the loss expectancy transferred to the insurer will depend on how risk averse he is, and this is an attitude of the mind that may vary according to the potential size of the loss. If the risk has a very low loss potential, then the premium required to be paid by the insurer which is being charged by the insurance company in order to cover the insurers’ administrative costs will be uneconomical for the insurer. No one seeks insurances against crockery breaking or theft of a waste paper basket. It is only when loss experience is subject to a lot of unanticipated fluctuations and maximum losses exceed a tolerable level that it becomes worthwhile to pay for insurance including premium.