Insurance basics

In short

Insurance is a contract in which an insurer accepts a defined risk from a large number of policyholders in return for a premium, and pays an agreed sum if the insured event occurs — so an uncertain large loss for one person becomes a small certain cost for many. It works on risk pooling, the law of large numbers and the principles of a special kind of contract (insurable interest, good faith, indemnity). In India it is governed by the Insurance Act, 1938 and regulated by IRDAI, with life, general, standalone health and reinsurance as separate licence classes. Insurance basics carry marks in every B.Com paper on financial services and banking, and are asked in interviews for LIC AAO, NIACL/GIC AO, bank PO (bancassurance selling), insurance underwriting and claims roles, broking firms (Policybazaar, Marsh, Alliance), and actuarial entry tests.

Explained

Risk, risk management and what makes a risk insurable

• Risk is uncertainty of loss. A peril is the cause of loss (fire, accident, death); a hazard is a condition that increases the chance or size of loss (storing crackers in a godown).
• Pure risk has only loss or no-loss outcomes (fire, death) and is insurable; speculative risk can also produce gain (share trading, betting) and is not.
• Particular risk affects individuals (a theft); fundamental risk affects whole groups (earthquake, pandemic, inflation) and needs state or pool support.
• Ways of handling risk: avoidance, loss prevention and control, retention (self-insurance, deductibles), and transfer — insurance is the most common transfer device.
• Requisites of an insurable risk: large number of similar, independent exposures; loss accidental and unintentional; loss definite, measurable in money and verifiable; not catastrophic to the insurer; chance of loss calculable; premium economically affordable.
• Moral hazard — dishonesty or careless behaviour because one is insured (inflated claims). Morale hazard — mere carelessness. Adverse selection — those most likely to claim buy the most cover; both are controlled by underwriting, deductibles, co-pay, waiting periods and no-claim bonus.
• How pooling works: with *n* independent exposures the average loss per policy becomes increasingly predictable (law of large numbers), so the insurer can charge a premium close to the expected loss plus a margin.

Principles of an insurance contract

An insurance policy is a valid contract (offer and acceptance, consideration, capacity, free consent, lawful object) with extra features: it is aleatory (unequal exchange), a contract of adhesion (drafted by the insurer, so ambiguity is read against it), conditional, and personal. Seven governing principles:

1. Insurable interest — the insured must gain by the subject's survival/safety and lose by its loss. Presumed in one's own life, spouse and (within limits) children; must exist at inception in life insurance, at inception *and* at loss in general insurance, and only at the time of loss in marine cargo.
2. Utmost good faith (uberrimae fidei) — both parties must disclose all material facts. Non-disclosure or misrepresentation makes the policy voidable. In life insurance, Section 45 of the Insurance Act bars calling a policy in question after three years from issue, rider, revival or commencement of risk, whichever is later; within three years only on fraud or material misstatement, with grounds given in writing.
3. Indemnity — the insured is restored to the same financial position, never better. Applies to all general insurance; life and personal-accident policies are benefit policies (life cannot be valued), and valued marine/fine-art policies are an exception.
4. Subrogation — after paying, the insurer takes over the insured's rights of recovery against the party at fault, up to the amount paid.
5. Contribution — where two or more policies cover the same risk, each insurer shares the loss in proportion to the sum insured; the insured cannot recover twice.
6. Proximate cause (causa proxima) — the dominant, effective cause of loss decides liability, not the remote one.
7. Loss minimisation — the insured must act as a prudent uninsured person to reduce the loss.
8. Allied rules: average clause / condition of average (under-insurance makes the insured a co-insurer in proportion), excess/deductible, franchise, warranties and conditions.

Classification of insurance

• Life insurance: pays on death, survival or both. Products — term (pure risk, cheapest, no maturity value; return-of-premium variants), whole life, endowment (savings + protection), money-back (periodic survival benefits), ULIP (premium split into mortality charge and market-linked fund units, 5-year lock-in), par (with-bonus) vs non-par (guaranteed) plans, annuities/pension (immediate or deferred; life, guaranteed-period, joint-life, return-of-purchase-price options), group term and group gratuity, child and keyman plans.
• General (non-life) insurance: fire (standard fire and special perils policy; consequential loss / business interruption), marine (cargo, hull, freight; Institute Cargo Clauses A/B/C; Marine Insurance Act, 1963), motor, health, liability (public, product, professional indemnity, directors' and officers', employees' compensation), engineering (contractors' all risk, machinery breakdown), crop, cattle, fidelity guarantee, burglary, travel, cyber, title.
• Life vs general in a line: long-term contract, benefit basis, insurable interest at start only, savings element present — versus annual contract, strict indemnity, interest needed at loss, pure protection.
• Reinsurance — insurance of the insurer; spreads risk, increases capacity, protects solvency and catastrophe exposure. Facultative (case by case) or treaty (automatic). Proportional — quota share, surplus; non-proportional — excess of loss, stop loss. GIC Re is India's national reinsurer with a mandatory cession from every insurer (a small percentage, reviewed annually); foreign reinsurance branches (FRBs) and Lloyd's India also operate.
• Co-insurance (several insurers share one large risk at inception), double insurance (same risk insured twice, leading to contribution), self-insurance (a captive fund) are distinct from reinsurance.

Premium, underwriting and claims

• Rating steps (general insurance): classify the risk → estimate claim frequency and severity from past data → pure/risk premium = expected loss → add loading for commission, management expenses, reinsurance cost, contingency and profit → gross/office premium → add GST where applicable.
• Life premium is built from a mortality table (Indian Assured Lives Mortality, IALM 2012-14, is the standard Indian table), an assumed interest rate and expense/bonus loading; the net single premium is the present value of expected benefits, converted to annual premiums by an annuity factor. Section 64VB forbids assuming risk before the premium is received.
• Underwriting = deciding whether to accept the risk, on what terms and at what rate: proposal form, medical/financial underwriting (life), survey and inspection (property), moral hazard report. Decisions — accept at standard rates, accept with extra premium or exclusions/sub-limits, postpone, or decline.
• Policy documents: proposal form, cover note, policy schedule, endorsements, warranties, exclusions; nomination (Sec 39) and assignment (Sec 38) in life policies; free-look period to return a new policy (standardised to 30 days by the IRDAI Protection of Policyholders' Interests Regulations, 2024 — earlier 15 days for most and 30 for distance marketing); grace period (15 days for monthly mode, 30 days otherwise), lapse, paid-up value, surrender value, revival, policy loan.
• Claim process: intimation → registration → documents (claim form, FIR/post-mortem where relevant, bills, death certificate) → survey/investigation (licensed surveyor and loss assessor mandatory for general claims above a threshold) → assessment of liability and quantum → settlement, part-settlement or repudiation with reasons.
• Timelines were tightened by the 2024 regulations — broadly 15 days for a death claim needing no investigation and about 45 days where investigation is required; in health, cashless authorisation within 1 hour of request and final discharge authorisation within 3 hours. Exact timelines are revised by circular, so verify the current one.
• Grievance redressal: insurer's grievance officer → IRDAI's Bima Bharosa portal → Insurance Ombudsman (Rules, 2017 as amended, award limit ₹30 lakh) → consumer courts/civil courts.

Regulation and institutions in India

• Insurance Act, 1938 — the core statute. LIC Act, 1956 and General Insurance Business (Nationalisation) Act, 1972 created the public-sector structure; the IRDA Act, 1999 reopened the sector and created the regulator, now IRDAI (Hyderabad).
• FDI: 26% → 49% (Insurance Laws (Amendment) Act, 2015) → 74% (Insurance (Amendment) Act, 2021), → 100% under the Sabka Bima Sabki Raksha (Amendment of Insurance Laws) Act, 2025 (in force from 5 February 2026; 100% FDI in insurers notified by DPIIT), replacing the earlier Indian-owned-and-controlled conditions.
• Capital and solvency: minimum paid-up capital ₹100 crore (₹200 crore for reinsurers); solvency ratio must stay at or above the control level of 1.5 (150%). IRDAI is moving towards risk-based capital and an Ind AS 117 reporting roadmap.
• Investments are regulated: life insurers must hold broadly at least 25% in central government securities, at least 50% in government and other approved securities, and prescribed minimums in housing and infrastructure; general insurers have similar but lower floors.
• Other statutes: Motor Vehicles Act, 1988 (compulsory third-party cover, Sec 146; Motor Accident Claims Tribunals), Marine Insurance Act, 1963, Employees' Compensation Act, 1923, ESI Act, 1948, Public Liability Insurance Act, 1991 (mandatory cover for hazardous units), PFRDA Act, 2013 (NPS/pensions).
• Distribution: individual agents (IRDAI-licensed, trained and examined), corporate agents and bancassurance, brokers, web aggregators, insurance marketing firms, point-of-sales persons, Common Service Centres, and Bima Vahak (women-led village-level force). Separate commission caps were replaced in 2023 by an overall Expenses of Management (EoM) limit.
• IRDAI's "Bima Trinity" — Bima Sugam (electronic marketplace), Bima Vistaar (low-cost bundled life, health, accident and property cover), Bima Vahak — aimed at the mission of "Insurance for All by 2047".
• Market size: roughly 25 life insurers and over 30 non-life insurers (including standalone health) plus GIC Re; insurance penetration is about 3.7% of GDP (life about 2.8%, non-life about 1%) and density around US$95 — these figures move every year, so quote them as approximate.

Social, government and tax aspects

• PMJJBY — ₹2 lakh life cover, premium ₹436 a year, ages 18-50. PMSBY — ₹2 lakh accidental death/total disability (₹1 lakh partial), premium ₹20 a year, ages 18-70.
• Ayushman Bharat PM-JAY — ₹5 lakh per family per year of secondary and tertiary hospitalisation for eligible families, extended to all citizens aged 70 and above.
• PMFBY (crop) — farmer pays 2% of sum insured for kharif, 1.5% for rabi and 5% for commercial/horticultural crops; the rest is subsidised. Weather-based crop insurance and livestock insurance run alongside.
• Atal Pension Yojana and NPS cover old-age income; ESIC covers sickness and maternity for organised-sector workers.
• Tax (old regime): Sec 80C — life premium up to ₹1.5 lakh, subject to premium not exceeding 10% of sum assured for policies issued after 1 April 2012. Sec 80D — health premium up to ₹25,000 (₹50,000 if senior citizen), plus preventive health check-up within the limit. Sec 10(10D) — maturity proceeds exempt, but not if annual premium exceeds ₹5 lakh (non-ULIP policies issued on or after 1 April 2023) or ₹2.5 lakh (ULIPs from 1 February 2021); death benefit is always exempt. These deductions are not available under the default new regime. (Section numbers are those of the 1961 Act; from tax year 2026-27 80C and 80D are ss. 123 and 126 of the Income-tax Act, 2025.)
• GST: general insurance and most products attract 18%; individual life and health insurance premiums were exempted from GST with effect from 22 September 2025. Indirect-tax rates change often — state them as "as currently notified".

Key points

• Insurance - a contract transferring a pure, measurable risk to an insurer for a premium; it pools risk, it does not remove it.
• Law of large numbers - the more similar, independent exposures pooled, the closer actual losses come to expected losses.
• Insurable interest - financial stake in the subject; needed at inception in life, at inception and loss in general insurance.
• Utmost good faith - duty to disclose all material facts; breach makes the policy voidable (life: barred after three years, Sec 45).
• Indemnity - restore, never enrich; life and personal accident are benefit (not indemnity) contracts.
• Subrogation - insurer steps into the insured's shoes to recover from the wrongdoer after paying.
• Contribution - two policies on one risk share the loss in the ratio of sums insured.
• Proximate cause - the dominant effective cause decides whether the loss is covered.
• Average clause - under-insurance means the claim is scaled by sum insured ÷ actual value.
• Moral hazard and adverse selection - behavioural risks controlled by underwriting, deductibles, co-pay and waiting periods.
• Pure vs gross premium - expected loss versus expected loss plus expenses, commission, contingency and profit.
• Reinsurance - insurance of insurers; facultative or treaty, proportional or non-proportional; GIC Re is the national reinsurer.
• Solvency ratio - available solvency margin ÷ required margin; regulatory minimum 1.5 (150%).
• Combined ratio - loss ratio + expense ratio; below 100% means an underwriting profit, above 100% means profits must come from investments.
• Free look and grace - 30 days to return a new policy (2024 regulations); 15/30 days to pay a late premium before lapse.
• IRDAI - the regulator under the IRDA Act, 1999; FDI cap raised from 74% to 100% by the 2025 amendment Act (in force February 2026).
• Government schemes - PMJJBY ₹436, PMSBY ₹20, PM-JAY ₹5 lakh, PMFBY 2%/1.5%/5% farmer share.
• Ombudsman - free, quasi-judicial redressal for policyholder complaints, award limit ₹30 lakh.

Formulas and examples

Example 1 — pure premium and loading (fire). An insurer covers 20,000 similar godowns. Past data: annual probability of a fire 0.5%; average loss ₹4,00,000. Expenses and commission are 20% of gross premium and the profit/contingency margin is 5%.

• Expected number of claims = 20,000 × 0.005 = 100.
• Expected total claims = 100 × ₹4,00,000 = ₹4,00,00,000 (₹4 crore).
• Pure premium per godown = ₹4 crore ÷ 20,000 = ₹2,000.
• Pure premium is 100% − 25% = 75% of gross → gross premium = 2,000 ÷ 0.75 = ₹2,666.67 per godown (plus GST as notified).

Example 2 — average clause, contribution and subrogation. Stock actually worth ₹80,00,000 is insured for ₹30,00,000 with Insurer X and ₹20,00,000 with Insurer Y. Fire destroys stock worth ₹40,00,000.

• Total sum insured = ₹50,00,000 on a value of ₹80,00,000 → the insured is under-insured.
• Admissible claim (average clause) = 40,00,000 × (50,00,000 ÷ 80,00,000) = ₹25,00,000; the insured bears ₹15,00,000.
• Contribution: X pays 25,00,000 × (30 ÷ 50) = ₹15,00,000; Y pays 25,00,000 × (20 ÷ 50) = ₹10,00,000.
• Subrogation: if ₹6,00,000 is later recovered from a negligent contractor, it goes to the insurers in the same 3:2 ratio — ₹3,60,000 to X and ₹2,40,000 to Y.

Example 3 — life insurance net single premium. 10,000 lives aged 35 take a one-year term cover of ₹10,00,000 each. Mortality rate q = 0.0012; assumed interest 6%; loading 20% of gross premium.

• Expected deaths = 10,000 × 0.0012 = 12; claims payable at year end = 12 × ₹10,00,000 = ₹1,20,00,000.
• Present value = 1,20,00,000 ÷ 1.06 = ₹1,13,20,754.72.
• Net single premium per policy = ₹1,13,20,754.72 ÷ 10,000 = ₹1,132.08 (check: 0.0012 × 10,00,000 ÷ 1.06 = ₹1,132.08).
• Gross premium = 1,132.08 ÷ 0.80 = ₹1,415.10 per policy.

Example 4 — motor insurance premium and claim. A car with a listed price of ₹10,00,000 is 2.5 years old (depreciation slab 30% for 2-3 years). OD rate 3.2%, NCB 25%, owner-driver personal accident cover ₹750, statutory third-party premium (illustrative, as notified) ₹3,416, GST 18%.

• IDV = 10,00,000 × (1 − 0.30) = ₹7,00,000.
• OD premium = 7,00,000 × 3.2% = ₹22,400; less NCB 25% → 22,400 × 0.75 = ₹16,800.
• Premium before tax = 16,800 + 3,416 + 750 = ₹20,966; GST = ₹3,773.88 → ₹24,739.88 payable.
• Claim: repair bill ₹1,00,000 = metal parts ₹50,000 (15% depreciation for 2-3 years), plastic/rubber parts ₹20,000 (50% flat), labour ₹30,000 (no depreciation); compulsory deductible ₹1,000.
• Payable = (50,000 × 0.85) + (20,000 × 0.50) + 30,000 − 1,000 = 42,500 + 10,000 + 30,000 − 1,000 = ₹81,500; the owner bears ₹18,500 and loses the NCB at the next renewal (a zero-depreciation add-on would have avoided the ₹17,500 depreciation).

Example 5 — health claim with room-rent cap and co-pay. Sum insured ₹5,00,000; room rent capped at 1% of sum insured per day; 10% co-pay. The insured stays 5 days in a ₹10,000-a-day room. Bill: room rent ₹50,000; associated medical expenses (nursing, doctor visits, OT, investigations) ₹1,50,000; implants and consumables not linked to room category ₹50,000; non-medical items (gloves, attendant charges) ₹10,000. Total ₹2,60,000.

• Eligible room rent = 1% × 5,00,000 = ₹5,000/day × 5 = ₹25,000.
• Proportionate factor = 5,000 ÷ 10,000 = 0.50 → associated expenses payable = 1,50,000 × 0.50 = ₹75,000.
• Implants payable in full ₹50,000; non-medical items nil.
• Subtotal = 25,000 + 75,000 + 50,000 = ₹1,50,000; co-pay 10% = ₹15,000 → insurer pays ₹1,35,000, the patient pays ₹1,25,000 out of pocket on a ₹2,60,000 bill despite a ₹5,00,000 sum insured.

Where it is used

• Insurers and reinsurers: LIC, SBI Life, HDFC Life, ICICI Prudential, Max Life; New India Assurance, United India, National, Oriental, ICICI Lombard, Bajaj Allianz, TATA AIG; Star Health, Niva Bupa, Care Health; GIC Re — roles in underwriting, actuarial, claims, product and reinsurance.
• Banks and NBFCs: bancassurance selling of life, health and motor policies; credit life and mortgage-redemption cover attached to home and personal loans; hypothecation endorsement on vehicle and plant insurance.
• Broking, TPAs and insurtech: Policybazaar, Marsh India, Alliance Insurance Brokers, Medi Assist, Vidal Health — advisory, claims administration, cashless networks, digital distribution.
• Corporate risk and HR: group mediclaim and group term cover, employees' compensation, directors' and officers' liability, product recall, marine cargo cover on exports, CAR policies for projects; fire and consequential-loss cover demanded by lenders.
• Government and rural finance: PMFBY crop insurance through insurers and banks, PMJJBY/PMSBY through bank accounts, PM-JAY empanelled hospitals, Public Liability Insurance for hazardous industry.
• Exams and careers: LIC AAO/ADO, NIACL AO, GIC AO, IRDAI Assistant Manager, Institute of Insurance and Risk Management and III (Licentiate/Associate/Fellowship) papers, and the Institute of Actuaries of India entrance.

Interview questions

• Q: Why is insurance not gambling, when both involve uncertainty? A: Gambling creates a new speculative risk for gain, while insurance transfers an existing pure risk and only restores the insured's position; insurable interest and indemnity make the difference.
• Q: What is insurable interest and when must it exist? A: A legally recognised financial stake in the subject matter — needed at inception in life insurance, at both inception and loss in general insurance, and only at the time of loss for marine cargo.
• Q: Why is life insurance not a contract of indemnity? A: Human life has no measurable money value, so the policy pays a pre-agreed benefit (sum assured) rather than measured loss.
• Q: A property worth ₹10 lakh is insured for ₹6 lakh and suffers a ₹5 lakh loss. What is payable? A: Under the average clause, 5,00,000 × 6/10 = ₹3,00,000; the insured is treated as self-insuring 40% of the risk.
• Q: Distinguish subrogation from contribution. A: Subrogation is the insurer's right to recover from the third party responsible for the loss; contribution is the sharing of one loss among several insurers covering the same risk.
• Q: What is the significance of Section 45 of the Insurance Act? A: A life policy cannot be questioned after three years from issue, rider, revival or commencement of risk; within three years it can be repudiated only for fraud or material misstatement, with written reasons.
• Q: What is adverse selection and how do insurers manage it? A: The tendency of higher-risk people to buy more cover; managed through underwriting and medicals, risk-based pricing, waiting periods, exclusions, deductibles and co-pay.
• Q: What does a combined ratio of 105% mean? A: Claims plus expenses exceed earned premium by 5%, so the insurer has an underwriting loss and must rely on investment income to be profitable.
• Q: What is reinsurance and why do insurers buy it? A: It is cover taken by an insurer from a reinsurer to limit its retention per risk or per event — it increases underwriting capacity, stabilises results and protects solvency against catastrophes.
• Q: Which motor cover is compulsory in India and what are its limits? A: Third-party liability under the Motor Vehicles Act, 1988; liability for death or bodily injury is unlimited as awarded by the tribunal, while third-party property damage has a statutory minimum of ₹7.5 lakh.
• Q: Why is a term plan usually better value than an endowment plan? A: The whole premium buys risk cover, so the sum assured per rupee of premium is many times higher; savings can be invested separately at a lower cost and better transparency.
• Q: What does a solvency ratio of 1.80 tell you? A: The insurer holds available solvency margin 1.8 times the regulatory requirement, comfortably above the 1.5 control level, indicating capacity to meet liabilities.

Common mistakes

• Applying the average clause, contribution or subrogation to a life policy — they belong to indemnity (general) insurance only.
• Forgetting to scale a property claim for under-insurance, or applying the ratio to the sum insured instead of to the loss.
• Computing the gross premium as pure premium × (1 + loading) when the loading is expressed as a percentage of gross premium — it must be divided by (1 − loading).
• Confusing sum insured (maximum liability) with IDV (agreed market value of a vehicle), and treating the whole repair bill as payable despite depreciation on parts and the compulsory deductible.
• Mixing up reinsurance, co-insurance and double insurance, or calling self-insurance a form of insurance contract.
• Ignoring the co-pay, deductible, room-rent sub-limit and proportionate deduction when computing a health claim, and so overstating what the insurer pays.
• Quoting tax deductions (80C, 80D) or GST rates without noting the regime and the conditions — they do not apply under the default new tax regime and the rates have changed recently.

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