What is insurance and why do people insure?

By C. T. A. Schaffter

Why is insurance such an indispensable feature of the developed world?

Why is it that, next to banking, the financial sector depends on insurance as the bulwark of financial organisations? Without insurance, business cannot exist. Business can exist without banks because banks merely take your money and lend it to others – or give it back to you. There is no real benefit to you in such a transaction.

What insurance does is completely different

It tells that if you are running a particular risk, and you pay the insurance company a fraction of the value of that risk (sometimes 100th, sometimes 1,000th and sometimes even less than that) the insurance company will make good your loss in its totality. They’ll do this even if you’ve paid them just 1,000th of the value of what you’ve lost, and they’ll do this even if you suffer that loss just a few days after taking out your policy.

Where else can you get such a bargain? Certainly not from your bankers, and that is why insurance is so important for the progress of commerce. Without it you cannot venture into business. It is insurance that gives you the confidence and the guarantee that, should something go wrong, the insurer will place you in the same position as you were before the loss occurred.

That is what insurance is all about.

Life insurance

Insurance, like many other things, was born out of a need. For instance, many years ago in the UK, if a father died the family would often have to go to the “poorhouse,” a place where they would have to live and work for the rest of their lives under extremely cruel conditions in order to maintain themselves. Therefore groups of workers got together and formed a mutual society to which they contributed on the basis that if any one of them died their families would be paid a certain sum of money from those contributions.

In theory this was good, but in practice it turned out to be a disaster. There were too many people and too little money in the fund to pay for those who had died. After a while the fund was exhausted, and subsequent claimants received nothing.

An extension of this was organisations called mutual societies which were formed to do virtually the same thing, however the difference was that they had a larger number of members. This spread the risk across more widely, enabling the society to collect adequate premiums to meet claims as well as leave a little something more for reserves and expenses.

The concept of mutual societies has grown in the world, and some of the largest life insurance companies today are mutual companies that began as mutual societies. The policy holders/members are also the shareholders.

Insurance has also played a great part in promoting trade, which may not have been possible if not for the availability of insurance cover. In the period before Christ, the Phoenicians traded with many parts of the world. Their ships were primitive and not built to withstand storms at sea. Therefore, the traders and merchants often lost not only their goods but also their vessels.

To counteract this loss, some of the richer merchants in Phoenicia agreed to reimburse both the ship owner and the owners of the goods in the event of loss. The risk taker was paid a certain sum of money from each merchant, who then carried the risk of the ships going to sea. This made it possible for the ship owners to venture more freely, and thereby trade was able to grow more and more.

Let’s now look at some practical examples as to why one should insure.

Imagine a man with a wife and children, who have just started school. He is 35 years old, with an income of about Rs. 50,000.

What happens if the man is suddenly removed from the scene, leaving his family completely un-provided for? Even if he had regular savings, the amount saved would undoubtedly be small. On his salary, he would hardly have been able to save anything substantial. This is where insurance steps in. If he had paid something like Rs. 500 per month from the time he began working he could have bought a life insurance policy for nearly two million, which would have given his wife a substantial sum which could be invested to keep the family going.

It certainly would not give her the same standard of living she was used to while her husband was alive, but it would provide adequate income to keep the “ship afloat”. That would never have been possible if her husband had not been prudent enough to take out life insurance.

It’s often hard to conceive of our own deaths, or of the responsibilities we leave behind when we die. But death is an unpredictable reality for us all. Of the 50,000 people or so who died in the tsunami, less than 5,000 were insured. 45,000 left their families bereft of a decent source of income. Since nearly all these families came from very low income backgrounds, they were therefore condemned to poverty for the rest of their lives. Had they had insurance, this would not have been the case.

For another example, think of what could happen if you buy a house on a loan. If you take out a loan of Rs. 10 m and die within a year or two of taking the loan, your widow would be faced with the formidable task of continuing to pay off your debt, and with very little income with which to do so. Here again it is possible to insure the outstanding loan under a life insurance contract, which would guarantee to pay the bank the full amount due should you die any time before the loan is repaid.

In life insurance, the insurer undertakes to pay a certain sum of money to the heirs of the deceased person in the event of his/her untimely death. Money can never bring back the lost one, but it can certainly fill the financial void which would have been caused by the death of a breadwinner if prudent financial planning is done.

There are very cheap forms of insurance, known as term insurance, where you pay a very nominal premium for comparatively high cover – particularly if you are young. You get nothing back if you survive, but you have the guarantee that, for a very small premium, you are providing substantial protection for your family. For those who cannot afford to save large sums of money out of their income, term insurance is the simplest way to provide protection for your family.

The important thing about life insurance is that if you take it while you are young, it is so much cheaper than if you take it when you are old. The other factor to be considered is that if you wait until you are older, the chances are that you could contract some ailment is more likely, and this likelihood makes you more unacceptable or unattractive to the life insurer, who will penalise you by charging you increased premiums for the risk.

So it is of utmost importance that life insurance is taken at a young age, when the individual is healthy, and continued until the policy holder’s responsibilities have all been dealt with and no longer has to worry about the financial future of his family.

It will therefore be seen that the primary purpose of life insurance is to provide protection to one’s dependents in a direct form, and also in an indirect form where the breadwinner has borrowed money for some purpose or another.

The basic fundamental reason why we are compelled to take out insurance, is because, nearly all of us with very few exceptions, do not have large sums of money of our own which can be set aside to provide for our dependents in the event of our untimely death. That is the crux of the matter.

Non-life insurance

Let us now look at non-life insurance. Non-life insurance includes different forms of insurance that is available both to individuals and corporates to protect their assets from a variety of risks.

Let’s first extend our thinking to householders and businessmen. If you own a house, there’s always a danger that the house could be destroyed by fire/storms/tsunami, floods, cyclones/earthquakes and a variety of other risks. These are what are known as catastrophic risks, which come unexpectedly and cause untold damage.

The fire insurance policy protects the house owner against the consequences of a fire, but can also be extended to include nearly all the other occurrences mentioned above. Very often, for a premium of less than 1,000th of the value at risk, a large amount of cover can be bought. This means that if your house is worth Rs. 10 m, including all its contents, the annual premium you pay for this protection is not even Rs. 10,000.

If one looks at it realistically, it is obvious that the cost of this protection is infinitesimal compared to what is at risk. Again, the concept can be extended further where protection is for valuables as well. Such valuables are very often in the home but many of them can also be carried around by the user. Insurance can protect those valuables not only at home and elsewhere but even if they are damaged accidentally. The insured therefore has the confidence that, whatever happens, the valuables are protected. He will obtain recompense in the event of an unforeseen occurrence – whatever it may be.

If a company sets out to construct a multi-storied building, and employs a contractor/engineer to do that for them, many things can happen during the course of the construction. Damage could be caused to the building under construction or it could be destroyed totally, should there be a catastrophic event.

The Contractors’ All Risk policy provides comprehensive protection both to the contractor as well as to their principals during construction of the building, and any loss or damage is fully reimbursed. Even once the building is constructed the owner faces risk. He is now in possession of a huge asset which is exposed to several possible dangers. This too can be dealt with by taking out insurance on a variety of risks including fire, riots & strikes, terrorism, storm & tempest, tsunami, earthquake, articles dropped from aircraft and many other risks.

Taking these insurances will ensure that the owner of the property will have sufficient funds to restore his property to the same condition it was in before the event took place.

An extension of this thought is that while the property is being repaired or restored, the income that the owner earned on the property is lost to the owner. This too can be protected by what is known as loss of profits or consequential loss insurance, which provides re-imbursement not only of the profits which would have been lost, but also of the standing charges, which will remain if the business is not operational. All this is only possible through insurance, which once again, for a minimal premium provides a massive extent of cover.

Other simple examples where insurance steps in are:

(i) cash in transit insurance which protects cash while it is carried from one place to another;

(ii) burglary insurance provides protection against theft and burglary of one’s property;

(iii) fidelity insurance – protects an organisation against dishonesty of its employees;

(iv) motor insurance protects all motor vehicles against damage and more importantly 3rd parties’ are reimbursed in the event of death or bodily injury caused by the users of the motor vehicles.

This concept advanced even more when several merchants met in a coffee house in London, owned by Thomas Lloyd and agreed to pool their resources to carry the risk of merchant vessels belonging to Great Britain which went out to trade. That was how the first underwriters at Lloyds started their business, which has now grown into a huge conglomerate known globally for its flexibility and integrity. The great fire of London in 1666 was another spur for insurance, and a scheme to insure houses was devised by the property developer Nicholas Barbon and was adopted in 1680 to ensure that those who wished to insure had the opportunity to do so, in order to protect their assets.

The important fact to remember is that, except in one or two instances such as third party motor insurance, insurance is not compulsory. The prudent insure and the imprudent hope that it will not happen and later pay the price.

Just as much as you spend money on many frivolities, which bring you back nothing, it is always prudent to put aside some money for insurance, to budget for it, and to ensure that you are protected. In developed countries this is a standard practice, where houses and businesses are insured. Very few people from the Western world would leave their homes to go abroad without travel insurance. The very comprehensive nature of the cover protects them from any form of eventuality including missing one’s flight, loss of travellers cheques, or falling ill/hospitalisation for a serious operation. The result is that they have peace of mind and enjoy their holiday knowing that should anything go wrong, the insurer steps in.

The cost is sometimes high but so is the risk, and the price paid will always commensurate with the risk carried by the insurer. The traveller ultimately will realise that it is a small price one pays for the satisfaction of knowing, should something go wrong, somebody else would step in and make good that loss.

Old age pensions

Let us now look at the hazards of old age. As the quality of our lives improve, so does our longevity, and one of the biggest fears looming ahead for most of us is “what do we do in retirement?” In many companies the retirement age is 55, but people are now living until 75-80 and more. So most people are faced with the prospect of a very long period of retirement with little to do and, more importantly, no income.

Pension planning with built-in insurance cover is again perhaps one of the most important priorities for each and every individual. It is as equally important as life insurance. Lifestyles are changing, and children do not look after their parents because they have neither the time nor the means to do so. It is left to each one of us to plan our retirement. Pension planning is therefore very important.

It is standard practice in the West, even in countries with social security, to provide for one’s old age. It can sometimes be a greater responsibility than death.

In Sri Lanka there is nothing by way of social security. So pension planning is even more important. One can never save enough towards one’s retirement, and even to obtain a modest pension at retirement one must save a minimum of 20% of one’s earnings over a 30-year period to achieve that. Even then, you will only get only about 50% of what you have been earning at retirement. That too, to some extent, would have been affected by inflation. So the outlook is bleak, particularly in countries like Sri Lanka which are seriously affected by galloping inflation and falling interest rates.

One can never save enough, and anybody who gives retirement any thought will understand the bleak future ahead unless they start saving now.

At present, there are 21 insurance companies in Sri Lanka, three of them only life insurance, four only non-life insurance. The balance 14 do both. The former are called special companies, the latter composite companies.

The companies employ agents and other types of sales persons to market their products and are generally available for advice and service. By and large, the insurance industry in Sri Lanka is well regulated, and very well managed.

 

Often referred to as the ‘Father of Insurance’ in Sri Lanka, Chandra Schaffter has been a vivid and vital figure in the industry for over 60 years. In 1994 he founded Janashakthi Insurance PLC – one of the country’s largest and most successful insurers. Having formerly represented the nation at cricket and hockey and serving as Manager of the National Cricket Team, he is now Deputy Chairman on Janashakthi’s Board of Directors.



(Next week: Life Insurance)