Insurance : An Important Risk Transfer Mechanism - Part I

Insurance is a risk management tool used by individual or families to limit their financial exposure to a peril. A peril refers to an event causing potential loss that will have a hazardous impact whenever it occurs. This future event is beyond control of any individual or family. At time of buying insurance it is unclear as to if and how much the individual or family will be affected by this future event. Thus buying insurance policy acts as an effective risk transfer mechanism.

Insurance is a contractual agreement in which one party (insurance company) agrees to compensate for the loss or damage sustained by another party (the insured) for a definite amount, in exchange for an adequate consideration called premium. This contractual agreement is called an insurance policy. Let us understand these terms better with an example – an insurance company [A] promises to pay the insured [B] a compensation of Rs. 10 lacs (promise) if B is diagnosed with critical illness (peril or future event) after 6 months from start of policy (terms) for upfront payment of Rs. 20000 (premium).

An insurance Policy is for a defined period and has a start and end date. One needs to periodically renew their insurance policy before policy end date or within 15 days grace period after policy end date to ensure continuity of insurance coverage.

How Insurance Work?

Insurance works on the following concept –

1. 1. Pooling large number of people together with similar risk to collect numerous individual contributions,
   2. This pool of funds is used to compensate the unlucky few who might suffer losses due to peril.

Which insurances to buy?

Insurance policies are designed such that although we cannot stop unfortunate future events from occurring, we can protect ourselves financially against them. There are four must have insurance policies for any individual or family. They are –

1. 1. 1. Life Insurance – Life insurance is important if you have people who are dependent on you financially. If you were to die unexpectedly then your income will not be available to cover regular household expenses such as monthly bills, education expenses and loan EMI’s. As a result your family will suffer financial hardships. During these difficult times, proper life insurance helps your family by reducing the financial burden in your absence. Thus having life insurance is a must.
      2. Health Insurance – Private medical care is very expensive. Hospitalization can burn a hole in your pocket and derail your finances. Thus having a family health insurance is very important.
      3. Disability Insurance – Many of us doubt that we will ever become disabled, and therefore we omit to take long term disability insurance. However, figures show that three in ten workers become disabled due to various reasons before they reach retirement age. Thus having proper disability insurance is important.
      4. Vehicle Insurance – As per law one needs to assume financial responsibility in case of an accident. In addition, your vehicle is often one of the most valuable asset, and if it is damaged in an accident you may struggle to pay for repairs, or for a replacement. Thus having a vehicle insurance is a must.

When to buy insurance?

Underlying analysis is to be done when considering insurance are –

Let us detail it out a bit more using four must have insurances as examples –

1. 1. One should by life insurance at an early age as soon as you start earning. You can increase and decrease your insurance cover depending on changes in your personnel responsibilities. For example, Review your life insurance cover when your child is born or when you buy a new house on EMI.
   2. One should have a family floater health insurance for the entire family. However as soon as a person turns 25 or above they should buy individual health insurance cover for themselves.
   3. One should buy an individual disability insurance for each person in the family as soon as they start driving on roads and/or working in offices. It is a must have for key earning members in the family. You can include the disability rider into the life insurance policy of key earning members.
   4. Vehicle Insurance to ensure that each vehicle is insured at all times as per legal requirements.

Thus one should buy appropriate insurance as soon as your exposure to a particular risk increases beyond a certain threshold or look at other ways for risk mitigation.

Why is insurance important?

By purchasing an insurance policy, an individual or family receives many benefits. Most important benefits are –

1. 1. Insurance provides an effective risk transfer mechanism from an individual or family to the insurance company in lieu for premium paid.
   2. Insurance company provides payment for losses covered as per policy. This helps an individual or family in managing financial uncertainty by covering for losses whenever they occur.
   3. Buying Insurance helps in complying with legal and regulatory requirements. For example for driving your own car you must have a third party motor insurance in India.
   4. Insurance policies provide incentives to implement risk control programs due to policy requirements and by giving premium saving incentives.
   5. Purchase of insurance policy helps in efficient use of funds. After buying insurance one does not need to set aside large sums of money to pay for financial consequences of the risks that are insured.
   6. Insurance companies provides a source of investment funds. Insurance companies collect premium upfront. They then invest these premiums in variety of investment vehicles and pay claims – as they occur.

How to buy insurance?

An individual or family, can buy insurance from any of these three channels- Online directly from Insurance provider, Insurance agent,  or Corporate agent or Broker.

There are a vast number of different insurance policies available on the market, and all insurers try to convince us of the merits of their particular products. So much so that it can be difficult to decide what is really necessary and what is not. Whenever you buy insurance through whatever channel you choose – please ensure you are dealing with authorized personnel, ask questions, get information and clear your doubts.

What are the tax benefits on Insurance?

An individual or family, on buying insurance is eligible for income tax benefits as listed below –

1. 1. Life insurance premium of up to INR 1.5 Lacs can be claimed as tax savings deduction under Section 80C.
   2. Medical insurance premium up to INR 25,000 for yourself and family, and INR 25,000 for your parents can be claimed as tax-saving deduction under section 80D.

These tax benefits have to be claimed at the time of filing income tax returns.

Conclusion

In this article, we have introduced you to insurance, its importance as risk management tool, along with suggestions on various insurances for an individual or family, when and how to buy them. Further, It should help you in having a more detailed conversation with your financial planner or investment advisor. For more information please feel free to reach out to us via email at – enquiry@taptoprosperity.com or by phone – 91-9515475381.

Next Article – Life Insurance : An Important Risk Transfer Mechanism – Part II

Editorial Note: The editorial content on this page is not provided or commissioned by any financial institution. Any opinions, analyses, reviews, statements or recommendations expressed in this article are those of the author’s alone, and have not been reviewed, approved or otherwise endorsed by any entity prior to publication.