Fundamentals of Life Insurance

There had been various risks acting on the human life as well as on his assets. Every asset has a value. The asset may generate income or provides facility, comfort and convenience. There is an expected life of every asset i.e. the duration for which the asset is supposed to perform. Hence it is necessary to look out for a substitute of the asset by the end of its lifetime. However if the asset is destroyed / lost unexpectedly / becomes inefficient, there may be a substantial loss to the owner of the asset. The loss may be due to an accident or an unfortunate event. In such circumstances there is no option but to suffer the loss of performance of the asset.

It is not possible to protect the asset or prevent its loss but is possible only to replace or reinstate the asset, which involves cost and hence is burdensome for the owner. The business of Insurance is related to the protection of such economic value of assets.

Insurance works on the principle of sharing of risk. A group of people exposed to similar kind of risk contributes towards the loss suffered by one of or many of the members.

  • Risk

    Risk is defined as the possibility of adverse results flowing from any occurrence. The risk may be defined as the possibility of loss. It may or may not happen. In other words if there are two possible outcomes of an occurrence out of which one is undesirable, we say risk exists.

    The risk can be categorized into:

    • Pure Risk

      where deviation from expected result is only loss. For example driving a vehicle – undesirable is accident

    • Speculative Risk

      where there is a possibility of gain in case of deviation from expected result. For example investing in shares – possibility of profit OR loss

    The risk is uncertain, unpredictable, may or may not happen and is fortuitous in nature. i.e. if there is uncertainty, there is risk. The degree of risk can be measure like, the higher the uncertainty, the greater is the risk.

    There is always a cause due to what risk exist like Fire, Hailstorms, Earthquakes, Lightning, Burglary, Death, Accident, Theft, Critical Illness, Disability etc. The cause of risk thus is called a PERIL. In insurance parlance Risk and Peril are same.

  • Major Risks for an Individual

    • Early Death,
    • Dependent old age,
    • Sickness or disability,
    • Unemployment,
    • Loss or damage of property,
    • Liability-Unintentional injury of other person or damage to their property
  • Insurance

    Conceptually, the mechanism of insurance is very simple. People who are exposed to similar kind of risk come together and create a pool of funds out of which those who suffer are paid. i.e. Those who do not suffer from loss do well to those who suffer by contributing towards the loss.

    The sharing of losses can be on a pre-decided formula, which is evaluated on basis of the size of group, nature of risk the group is exposed to and the likely proportion of loss. i.e. the total amount of compensation is divided between the groups. Insurance neither protect the asset nor prevent its loss. What insurance can only do is to protect from impact of loss i.e. compensate the financial value of loss. For example, a person loses his motorcycle; he can be compensated with the current market value less depreciation.

  • Classification of Insurance

    Insurance can be broadly classified into Life Insurance and Non-Life (General) Insurance

    • Life Insurance (Covers Human Life): Assurance: Not a Contract of Indemnity, Amount Assured is paid irrespective of the existing financial scenario at the time of loss.
    • Non-Life Insurance (Covers everything except Human Life However Accidental Death and Medical Insurance are part of Non-Life Insurance): Insurance: Contract of Indemnity, Only actual loss is compensated within the limits of Insured value.
  • Life Insurance

    A contract of life insurance is that in which one party agrees to pay a given sum on happening of a particular event contingent upon the duration of human life, in consideration of the immediate payment of a smaller sum or certain equivalent periodical payments by another.

  • Need and Advantages of Life Insurance

    • Protection against risk of untimely death:

      Life Insurance is a product, which offers protection against risk of death. In case of death, the full sum assured is made available under a life assurance policy, whereas under other savings schemes like NSC, Mutual Funds etc., the total accumulated savings alone will be available.

    • Protection during old age:

      Life Insurance can also be used as a means of saving for one’s future. There are a number of Life Insurance policies, which in addition to life cover also provide the means of investing one’s income. The sum as per the policy will be received only after a period of time. This amount thus provides for old age.

    • Forced Savings

      Life Insurance brings about forced savings. Payment of life insurance premiums is compulsory and becomes a habit. Savings in other schemes can be easily withdrawn and may be used for less worthy purposes. Termination of a life insurance policy by the policyholder usually results in a substantial loss in benefits under the policy to the policyholder. One is thus encouraged to save and keep one’s policy alive.

    • Educational requirements and charity

      In certain cases, the object of insurance may be to serve as security to educational funds in respect of loans advanced for educational purposes or to provide donations to charitable institutions like hospitals & schools.

    • Nomination and Assignment

      The Life insured can name the person or persons to whom the policy moneys would be payable in the event of his death. The proceeds of a Life Insurance policy can be protected against the claims of the creditors of the Life Insured by effecting a valid assignment of the policy. The beneficiaries are fully protected from creditors except to the extent of any interest in the policy retained by the insured.

    • Marketability and suitability for borrowing

      After a period of 3 years, if the policyholder finds that he is unable to continue payment of premiums he can surrender a policy for a cash sum. A life insurance policy is also acceptable as a security for a commercial loan.

    • Superior over traditional Saving Products (Save & Create Vs Create & Save):

      A traditional saving product works on the principle of Save & Create i.e. you save money at regular interval over a period of time, you create an asset or fund at the end of term. But one condition for fulfillment of such plan is survival of the investor till the end of term. Life Insurance works on the principle of Create and Save i.e. you decide a figure of sum for your family and save accordingly. At the end of term you create an asset or fund. Here even if investor does not survive, the targeted sum will still be available because it was already created when investor started investing into.

  • Important Terms

    • Premium

      Premium is the consideration paid by the policyholder to avail the benefits of life insurance contract. Premium rates are devised by the appointed actuary of the insurer after complete study of the mortality tables (tables indicating the death rate for a particular age group), projected expenses of the insurer within the limits of the regulations by a competent authority (i.e. IRDA and Insurance Act), prevailing interest rates and a component of contingency (also called as bonus loading). The premium needs to be paid in advance by the insured. However insurers allow the facility of payment of premium in Half Yearly, Quarterly or even monthly mode instead of required Annual Premium.

    • Sum Assured

      Sum Assured is defined as the guaranteed amount payable in the event of death of insured because of the reasons not excluded in the policy contract. In other terms we can say it is the Face Value of the policy.

    • Grace Period

      A policyholder is expected to pay the premiums regularly on a specified date Annually / Half Yearly / Quarterly till the end of term of policy or otherwise agreed onto. However policyholder is allowed to pay the premiums without any charges / penalty for a specified period called as Grace Period. It is usually 30 days from the due date in the all the mode of payment specified above and 15 days if monthly mode is allowed. The risk cover continues in the Grace Period.

    • Lapse

      If policyholder does not pay the premiums in the days of grace or Grace period, the benefits under the policy cease and the policy is called LAPSED Policy.

    • Revival

      Under a lapsed policy, the policyholder looses all his rights and benefits. However if policyholder wishes to reinstate the policy with full benefits (Full Force), he can do so by payment of due premiums with a penalty as decided by the company. This procedure is called Revival. Revival is possible within 5 years from the date of lapse.

    • Surrender Value

      Surrender value of a policy can be understood as the cash value of a Life Insurance policy at any given point of time. Insurance is a long term contract and the policyholder has entered with a targeted term of say 20 years. It may happen that the policyholder requires cash and is not in a position to wait upto the end of term of policy. In such cases policyholder can surrender the policy / encash the policy.

    • Assignment

      Assignment is a means whereby the beneficial interest, right and title under a policy get transferred from the assignor to the assignee. ‘Assignor’ is the policy holder who transfers the title and ‘Assignee’ is the person who derives the title from the assignor. Assignment can be made only after acquiring the policy. Assignment can be done only for consideration- for money or money’s worth or good, moral and meritorious consideration like, love and affection.

      Assignment can be done by mere endorsement on the policy or by a separate duly stamped deed. Assignment can be done by the proposer, policy holder, or the absolute assignee.

      Assignor must be a major. Assignor must have an absolute right over the policy. Assignment must be in writing. Assignor’s signature along with a witness is a must. Notice of assignment is to be submitted to the insurer.

      There are 2 kinds of assignments.

      • Conditional Assignment
      • Absolute Assignment

      Conditional Assignment is usually effected for consideration of natural love and affection. Absolute assignment is usually affected for valuable consideration.

      The rights of an assignor and assignee

      • On assigning the policy, the assignor (life assured/policy holder) loses his right over the policy and the assignee gets the right and becomes the owner of the policy. The assignee can further re-assign the policy and he also has a right to sue under the policy

      • A valid Assignment once made cannot be cancelled. It is only another valid assignment the earlier assignment gets cancelled. In all the cases, Assignment automatically cancels the nomination. However, when the policy is assigned to the insurer, nomination gets affected and it does not get cancelled.

      • Under conditional assignment, if the conditional assignee dies, the benefit under the policy goes back to the life assured if surviving. Otherwise, the benefit goes to policyholder’s nominee. Under absolute assignment, if the absolute assignee dies, the benefit under the policy goes to the legal heirs of the assignee.

    • Nomination

      Nomination is the process of identifying a person to receive the policy money in the event of the policyholder's death. Nomination can be done either at the inception of the policy by providing details of nominee in the proposal form, or at a later date. Nomination has to be effected by giving notice in a prescribed form to the insurer and getting it endorsed on the Policy Bond.

      Change of Nomination can be done by the Policyholder any time during the term of the Policy and any number of times. For this, the policyholder has to give a notice in a prescribed form to the insurer and getting it endorsed at the back of the Policy. Further, Nomination can be changed any time by the Policyholder without giving prior notice to the Nominee.

      Nomination can be done only by a policyholder who is a major holding Policy Bond in his own name. In the case of Children’s Policies, Nomination is not allowed until the Child becomes major, which then can be affected by the child who is the insured since all the child policies are with an “Automatic Vesting Clause” where all the rights under the policy vest in the favor of insured child on his attaining the age of majority.

      Under Nomination, the Nominee gets only the right to receive the policy money in the event of the death of the Policyholder. Nomination does not pass on the property in the Policy. If Nominee dies when the Policyholder is still surviving then the nomination would be ineffective. Nomination has no effect if the Policyholder is surviving. If Nominee dies after the death of the policyholder but before receiving policy money, then also Nomination becomes ineffective and only the Legal Heirs of the Policyholder can claim money.

    • Proposal Form

      Proposal Form is nothing but application for insurance. It forms basis of life insurance contract. It contains personal details of the policyholder and the life to be insured like name, address, and date of birth, age, personal history, family history, details of occupation and other material information.

      Proposal Form being the only document signed by the proposer is of great importance for the insurer. The assessment of risk is based on the details provided in the proposal form.

      Any misrepresentation or non-disclosure of material in the proposal form may lead to termination of contract and forfeiture of premiums paid subject to provisions of section 45.

    • Underwriting

      The prime objective of Life Insurance Company is to accept proposals after assessment of risk at appropriate premium rates. Underwriting is the process of assessment of risk before acceptance of proposal of life insurance.

      To ensure that premium rates are appropriate for the lives concerned, the company will break down the lives into \ groups homogeneous with respect to mortality or any risk and price accordingly. This division into risk groups would be done when the product is developed and would be reviewed periodically to incorporate actual experiences.

    • First Premium Receipt (FPR)

      First Premium Receipt confirms the commencement of risk. It indicates that that the proposal has been accepted and contract of life insurance commences. The policy document may reach the insured later to the date of FPR but the risk will commence from the date indicated on the FPR.

      Policy Document: Policy document is the evidence of the contract, which is issued against the proposal form submitted by the insured. It describes the details of the terms and conditions of the policy including the details like name, address, date of birth, Sum Assured, Premium payable, frequency of premiums, benefits promised, exclusions, nominations etc.

      The policy document is stamped and is the legal document confirming the life insurance contract.

    • Free-look Period

      Insurance policy is a contract and the insured comes to know about the actual terms of contract only when he receives the policy document. However if insured feels that the terms and conditions indicated in the policy documents are not to his satisfaction and is not happy, he can return the policy document within the Free Look Period. In such case, the premium collected is returned to the insured after deducting nominal charges such as the cost of medicals, stamp fees & risk premium for the no. of days the risk on the insurer.

      Free look period is usually 15 Days from the date of receipt of Policy Document by the Policyholder.

      • The Indian Income Tax Act provides tax concessions to the policyholder both on payment of premium and on the maturity amount.
  • Life Insurance Contracts

    All contracts in India are governed by the Indian Contract Act 1872. A contract may be defined as an agreement between two or more parties to do or to abstain from doing an act, with an intention to create a legally binding relationship. Life Insurance is also a contract where the parties are insured and insurer.

    The essentials of a valid contract which do apply to life insurance contract as well are:

    • Offer and Acceptance- Proposal and Acceptance of proposal
    • Consideration- Premium paid by policyholder, Claim by Insurer
    • Capacity to contract- Proposer should be of Sound mind and Not a minor
    • Consensus ad idem- Proposal and Policy Doc. reflect mutual consent
    • Legality of object- Financial protection of family/self

    The facts related to insurance contract are intangible. The important characteristic is that the situation surrounding the subject matter is known by one of the parties, viz. the proposer. Only the proposer knows all the related facts about the risk being proposed for insurance. Hence an insurance contract requires two additional principles to be followed in order to be a valid insurance contract. Utmost Good Faith (Uberrimae Fides) and Insurable Interest (Financial Interest)

    • Utmost Good Faith (Uberrimae Fides)

      As the Insurer does not know anything and the person who comes to him for insurance knows everything, it is the responsibility of the proposer to make a complete disclosure to the Insurer (underwriter), whether asked or not, of all material facts relevant to the subject matter of insurance (Risk). This is called principle of utmost good faith. However the principle works for both the parties and imposes reciprocal duty. Means insurer is also responsible to disclose all the material information related to insurance plans like insurer is not supposed to make any untrue statements during the negotiations for the contract.

    • Material Fact

      ‘Facts, which would affect the decision of a prudent insurer or underwriter in fixing the premium or determining whether to accept the risk and on what terms.’

      In other words all the facts, which directly or indirectly influence the decision of an underwriter (on behalf of an insurer) to accept the proposal of Insurance, are called Material Fact. Such facts are required to be disclosed at the time of proposal for fair assessment of the proposal.

  • Facts which must be disclosed:

    • Facts, which show that the particular risk stand for a bigger exposure than, would be anticipated from its class;
    • External factors, which make the risk higher than, would normally anticipated;
    • Previous losses and claims under other policies;
    • Any declination or special conditions imposed on previous proposals by any other insurers.
    • The existence of other policies.
    • Full facts relating to the description of the subject matter of insurance.
  • Examples of such facts are:

    • Fire insurance- Construction of building, use of building, firefighting equipment etc;
    • Theft insurance- Nature of stock, value of stock in monetary terms, type of safety measure arranged etc.
    • Motor insurance- Type of car, details of usage etc.
    • Marine insurance- Type of packing, terms of sale etc.
    • Life insurance- Age, past medical history, occupation, habits, hobbies, family history etc.
    • Personal accident insurance- Age, past medical history, occupation, etc.
  • Facts need not to be disclosed:

    There are some facts that are material but need not to be disclosed like

    • Facts of Law. Everyone is believed to know the law;
    • Facts of common knowledge. An insurer is believed to know about normal trouble within a particular trade or life.
    • Facts that lessen the risk. Setting up of automatic sprinkler system in factory premises for fire insurance.
    • Facts that could reasonably be discovered. The most general example of this would be where a proposer put expression ‘see your records’ instead of completing fully the previous claims history with same insurer.
    • Facts that a survey should have revealed. Any material facts which are apparently detectable or which any sensible surveyor would enquire about do not need to be disclosed by the proposer.
    • Facts covered by policy conditions. Facts not required disclosing because of an express or implied warranty in policy. For example the burglar alarms are regularly maintained.
  • Breach of Utmost Good Faith

    Breaches of utmost good faith arise by one or both the below mentioned ways;

    Misrepresentation: False information of fact provided by one party to another during negotiating the contract that encourages the other party to enter into the contract. Misrepresentation may be either innocent or deceptive.

    Non-Disclosure: Failure of one party to disclose a material fact known to him during negotiation that would effect upon the decision of other party whether or not to enter into the contract. It can also be called suppression of a material fact. It may be innocent or deceptive. Deceptive nondisclosure can also be identified as concealment.

  • Insurable Interest (Financial Interest)

    It happened long ago in around 18th century in England. At that time to enter into an insurance contract the person insured not necessarily is informed about it. Therefore there were third parties insuring a person for a certain sum without the knowledge of insured. One could insure a third party and get the insured killed and benefit financially from the proceeds. Misuse such as this shocked the nation and in 1774, the English Parliament took action to end this type of gaming. It enacted a statute that made null and void all insurance policies ‘wherein the person or persons for whose use, benefit, or on whose account such policy or policies shall be made, shall have no interest or by way of gaming or wagering.'

    Insurable interest can be defined as, “The legal right to insure takes place from a financial relationship identified under law, between the insured and the subject matter of insurance.” Insurable interest exists if the owner of the policy or the nominee is expected to benefit financially if the insured continues to live and is likely to suffer from a monetary loss if the insured dies. In other words there has to be some property, right, interest, life, limb or potential liability competent of being insured, which is a subject matter of insurance, the insured must stand in a link with the subject matter of insurance.

  • Application of Insurable Interest

    Insurable interest is said to exist in the following cases:

    • Every person has an unlimited insurable interest in his/her own life subject to his/her premium paying capacity.
    • For a married person, there is an automatic unlimited insurable interest in the life of a spouse. However it is to be noted that the parents have insurable interest in the life of a child till they attain age of majority.
    • Employers have an insurable interest in the life of an employee. Likewise a creditor has an insurable interest in the life of a debtor subject to the limit of financial transaction they entered in.
    • Business partners can have insurable interest in the life of each other to the extent of Capital Investment + goodwill.
  • Section 45 of Insurance Act (Indisputability of the policy) Section 45 of Insurance Act

    “No policy of life insurance effected before the commencement of this act shall after expiry of two years from the date of commencement of this act and no policy of insurance effected after the coming into force of this act shall, after expiry of two years from the date on which it was effected be called in question by an insurer on the ground that a statement made in the proposal for insurance or in any report of a medical officer, or referee, or friend of the insured, or in any other document leading to the issue of the policy was inaccurate or false, unless the insurer shows that such statement was on material matter or suppressed facts which it was material to disclose and that the policyholder knew at the time of making it that the statement was false or that it suppressed facts which it was material to disclose. Provided that nothing in this section shall prevent the insurer from calling for proof of age at any time if he is entitled to do so, and no policy shall be deemed to be called in question merely because the terms of the policy are adjusted on subsequent proof that the age of the life assured was incorrectly stated in the proposal.”

    In other words, “All benefits under the policy cease and all moneys get forfeited if life assured, at the time of proposal has made any untrue or incorrect statements either in the proposal form or in the personal statement or has not disclosed any material information. However, this penalty is subject to Section 45 of Insurance Act, 1938, which provides that after the policy has been in force for two years, it cannot be disputed on the ground of misrepresentation or nondisclosure unless it is proved intentional and fraudulent.”