Chapter 2

Insurance is a contract. Here one

party the Insurance Company
called Insurer undertakes to
indemnify specified losses
suffered by the other party
called Insured for a special
consideration called Premium.
The term of the Insurance
contract is called Insurance
Policy.
 Some Important terms used in Insurance
Business:-

Insurance Policy: It is the document issued by the

insurance company containing terms of the insurance
contract. It specifies the losses that are covered by the
Policies and also the maximum amount that can be paid
out in the event of a loss/death. This is called Policy
Amount.

Premium: The payment made by the insured to the

Insurance Company in consideration of the contract of
Insurance. The premium is generally paid annually. In
some cases it may be paid at shorter intervals. A point to
be noted is the premium amount has to be paid
front end i.e. before the commencement of the
insurance cover/policy.
3. Claims: A claim occurs when a policy fall due for payment. In
Life Insurance it arises on death or on maturity of policy. In case of
General Insurance, the claim arises only when the loss occurs.
while calculating the claim outstanding at the end, the claim
intimated as well as the claim intimated and accepted both are
considered. The adjustment entry required for this will be as
follows:

Claims account Dr.

To Claims intimated and accepted but not paid account

To Claims intimated but not accepted and paid account

At the commencement of the next period a reverse entry is passed,

so that when these claims intimated are paid, they may not
influence the claims account of next year. However, if company
rejects any claim, such amount should be transferred to the
insurance fund account and not to the claims account.

Surrender Value: When the policy holder wishes to realise the amount of policy
before the expiry of the full period of the policy, he surrenders his right under the
policy and is paid an amount calculated by a fixed formula. Surrender Value
applies only to Life Insurance policies and comes into play only after two annual
premiums have been paid.

Commission: Generally, Insurance Companies get business through agents;

these agents receive commission on the basis of the amount of premium they
generate for the Insurance Company. Commission paid to Agents is shown as a
debit (expense) in the Revenue Accounts.

Bonus (applicable only to Life Insurance): A life insurance policy may be with
profit or without profits. The holder of a without profits policy is
entitled to receive on maturity only the amount specified in the policy;
but on a with profits policy he is entitled to receive in addition, the
amount of bonuses declared on each valuation. On each valuation, the
amount standing to the credit of Life Fund which is in excess over net liability, as
determined by the actuary, is distributed among the shareholders and the
policyholders. The share of the policyholders is paid to them as bonus, either in
cash on declaration or by reduction of future premiums, or on maturity of the
policy. Until the bonus is paid, it does not figure in the Revenue Account and is
not payable in cash immediately but is to be payable at the time of the claim; it
is described as Reversionary Bonus. The amount of Reversionary Bonus is
included in claims.
Principles of Insurance
There are several principles governing insurance business, the
important of which are discussed below.

Principle of indemnity: Insurance is a contract of indemnity.

The insurer is called indemnifier and the insured is the
indemnified. In a contract of indemnity, only those who suffer
loss are compensated to the extent of actual loss suffered by
them. One cannot make profit by insuring his risks.

Insurable interest: All and sundry cannot enter into contracts

of insurance. For example, A cannot insure the life of B who is a
total stranger. But if B. happens to be his wife or his debtor or
business manager, A has insurable interest i.e vested
interest and therefore he can insure the life of B. For every type
of policy insurable interest is insisted upon. In the absence of
such interest the contract will amount to a wagering contract.

 Principle of uberrimae fidei: Under ordinary law of

contract there is no positive duty to tell the whole
truth in relation to the subject-matter of the contract.
There is only the negative obligation to tell nothing but
the truth. In a contract of insurance, however there is
an implied condition that each party must disclose
every material fact known to him. This is because all
contracts of insurance are contracts of uberrima fidei,
i.e., contracts of utmost good faith. This is because the
assessment of the risk and the determination of the
premium by the insurer depend on the full and frank
disclosure of all material facts in the proposal form.
 Various Types of
Insurance

Insurance

Life insurance General

Insurance
 Life insurance policy
It covers the life-risk of the insured person. In
case of death, the nominee will get the
Insurance Policy amount. In life insurance the
amount is payable on the happening of an event
which is bound to occur i.e. death. So this form
of Insurance is also described as Assurance.

However, the life insurance policy also provides

for payment of the policy value at maturity or by
installments and an agreed bonus. This
payment may either be in lump sum on
maturity of the policy or may be paid in
installments called annuity.
 The uses of the terms "insurance"
and "assurance" are sometimes
confused. Insurance" refers to
providing cover for an event that
might happen (fire, theft, flood,
etc.), while "Assurance" is the
provision of cover for an event
that is certain to happen like
death and so Life insurance is
actually Life Assurance
Life Insurance can be further classified into 3 types:
Whole Life Assurance: In whole life assurance, policy amount
is paid only on the death of Insured.

Term Assurance: Here the policy amount is paid in lump-sum

on maturity of the term of the Life Insurance Policy (say 20
years).

Annuity: On maturity of the policy, instead of a one shot

lump-sum payment the policy amount is disbursed in
installments, generally monthly.

Life
Insurance

Annuity
Whole Life Term
Assurance Assurance
1. Paid Up Policy (Applicable only to Life Insurance): If an insured is
unable to continue to paying premiums on his life policy, he may discontinue the
payment and convert the policy into a Paid-up policy. The insured amount in
that case will be reduced to a figure ascertained according to the following
formula:

Paid-up value = No. of premium paid Sum assured / Total No. of premium payable

Other conditions of the policy, however, will remain unchanged.

Annuity: It is a contract that provides an income for a specific period of time to

say for a number of years or for life. The person receiving the payment is called
an annuitant. Annuity payments are usually made monthly but can be quarterly,
semi-annually, or annually.

Catastrophic Loss: A loss (or related losses) which is unbearable i.e. it causes
severe consequences such as bankruptcy to a family, organization, or insurer.

Bonus in Reduction of Premium: In all the cases of general insurance the

policy is always taken for one year and it is to be renewed after the expiry of the
policy. Whether the policy is renewed with the same company, or a fresh policy is
taken with some other company, it is a standing practice that the company
usually grants a reduction in premium at the prescribed rate if the insured has
not made any claim. This rate of reduction increases every year for usually three
years if the insured does not make any claim continuously year after year.
In fact this transaction should be divided into two parts-first, the total
premium (without any reduction) should be assumed to be received
and then reduction granted should be assumed to be paid separately.

Thus, total premium (without reduction) should be treated as income

and bonus which is subtracted should be treated as an expense.
Thus-

If net premium received is ` 12,600

Bonus in reduction of premium is ` 1,400

The revenue account on the credit side will show ` 14,000 (` 12,600
+ ` 1,400) as income and on the debit side ` 1,400 as an expense.

The journal entry is :

Bonus in reduction of premium account Dr.

To Premium account
General insurance
It means insurance other than life insurance
Section 2(6B) of the Insurance Act defines
General Insurance Business as fire, marine or
miscellaneous insurance business whether
carried on singly or in combination with one or
more of them.

Some common types of miscellaneous

insurance in India are: exchange risk
insurance, motor vehicle insurance, credit
insurance, burglary insurance, workmens
compensation insurance, professional liability
insurance, cash in transit insurance, fidelity
insurance, etc.
General Insurance is broadly classified into
three major categories:

Fire Insurance

Marine Insurance

Miscellaneous Insurance

In general insurance, the policy is taken for

one year at a time and can be renewed
yearly or a fresh policy can be taken with
some other insurance company.
 Fire Insurance
A fire insurance contract may be
defined as an agreement whereby
one party, for a consideration,
undertakes to indemnify the
other party up to an agreed
amount against financial loss of
goods or property which the
latter may suffer because of fire.
Fire insurance thus covers the risk of
loss of property by accidental and
non-intentional fire.
Types of Fire Policies

Valued policy - A policy in which the value of the property is ascertained and/or
agreed upon which the insurer undertakes to pay in the event of destruction of
goods/property by fire is known as valued policy.
Specific policy - It is a policy which insures a risk for a specific amount. In case of
any loss under this policy, the insurer pays whole loss provided it is not more than
the sum specified in the policy. Thus, the value of the goods/property is not
considered for this purpose.
Average policy - An average policy contains the average clause which lays
down that if the property is under-insured, i.e. insured for a sum smaller than the
value of the property, the insurer will bear only that proportion of the actual loss
which the sum assured bears to the actual value of the property at the time of loss.

Floating policy - It is the policy which covers several types of goods lying at
different locations under one amount and for one premium. The premium normally
charged under this policy is the average of the premium that would have been paid
if each lot of the goods had been insured under specific policies for specific sums.
Excess policy - Where the stocks of the insured fluctuate he may take out a
policy for the amount below which his stocks normally do not fall and another
policy to cover the maximum amount of stocks which may be reached at times.
The former type of policy is known as the First Loss Policy and the latter as the
Excess Policy.

Blanket policy - A blanket policy is that which covers all assets -

fixed as well as current - under one policy.

Comprehensive policy - A policy which covers risks such as fire,

flood, riots, strikes, burglary etc. upto a certain specified amount is
known as the comprehensive policy.

Consequential loss policy - The objective of this policy is to

indemnify the insured against the loss or profit caused by any
interruption of business due to fire. It is also known as Loss of Profit
Policy.

Re-instatement policy - It is a policy under which the insurer

pays the amount which is sufficient to re-instate assets or property
destroyed.

Open declaration policy - It is a policy whereby the insured

makes a deposit with the insurer and declares the value of the
subject matter in respect of which risk is covered.
 Marine Insurance

Marine insurance is perhaps the

oldest type of insurance. Under a
contract of marine insurance, the
insurance company or the
underwriter agrees to indemnify
the owner of a ship or cargo
against risks which are
incidental to marine adventure
such as sinking or burning of the
ship and its contents, stranding
of the ship, collision of ship,
Types of Marine Insurance - The common types of marine
insurance are as follows :

(i) Cargo insurance - This type of marine insurance covers

risks to the cargo on the ship. The cargo on the ship is
exposed to risks arising from an act of God, enemies, fire etc.

Hull insurance - The ship is also exposed to the perils

described in (i) above. Therefore, the owner of the ship may
effect hull insurance to cover such perils.

(iii) Freight insurance - Where the owner of goods promises

or undertakes to pay the freight when the cargo is safely
delivered at the port of destination and the cargo is destroyed
on the way, the shipping company would lose the freight. The
shipping company can cover this risk by taking out a freight
insurance policy
 Total Loss : When the subject
matter of insurance, i.e., cargo, ship,
freight etc. is totally lost, it is known
as a total loss. Total loss is also of
two types:

Actual Total Loss - When the

subject-matter of insurance is absolutely
destroyed or totally lost to the insured,
it is known as actual total loss.
 Constructive Total Loss - When the subject matter is
not actually totally lost but is lost for all practical purposes
e.g., where the ship or cargo is reasonably abandoned and
taken as lost or expenses to be incurred for saving the cargo
or the ship are expected to be more than the value thereof, it
is known as constructive total loss.

Partial Loss : When only a part of the subject matter

is lost, it is known as partial loss. This loss may also be
of two types as discussed below :

General Average Loss - Such a loss is caused by

extraordinary voluntary sacrifice made or expenditure
incurred with the objective of protecting the interests of all
owners in a voyage. An example of this type of loss is when
the ship has run aground and part of the cargo is to be
jettisoned to lighten the ship to save it as well as the cargo
from total loss.
Types of Marine Insurance Policies - Generally a standard form for all
policies is used for all marine insurance policies to cover various types of
risks. However, differing needs of the insured have led to the evolution of a
variety of marine insurance policies, the main among which are:

Time policy - It is that policy which covers the risk of the subject matter for
a specified period of time. It is generally used for hull insurance though it can
be taken out also for cargo.

Voyage policy - This is a policy whereby the subject matter in transit is

insured from one place to another. It is generally carried out for cargo which is
exposed to marine risks in transit.

Mixed policy - This is also known as time and voyage policy as under this
the subject matter on a particular voyage is insured for a specified period of
time.

Floating policy - This policy is taken out by cargo owners who make regular
shipments of cargo to insure the shipments expected to be shipped for a
certain time by one policy. At the time the cargo is shipped, the insured
declares the value of the shipment and the total value of the policy is reduced
by that amount.

Blanket policy - This policy is taken for a specified amount, the premium
in respect of which is paid for the entire policy at the beginning itself and is
adjusted at the end of the specified period for the value of risks covered
during this period.

Fleet insurance policy - This policy insures the whole fleet of ships.

Open policy - This type of policy is taken out without specifying the value
where at the time of insurance, the insured is not aware of the value of the
subject matter to be insured, which is ascertained and declared to the
insurer later. The insurance cover is subject to the limit of the sum assured.

Port policy - This policy covers the ship when it is docked/stationed at a

port.
 Important amendments made to the earlier Act by the IRDA Act, 1999

It is mandatory for every Insurer on

or after the commencement of this
Act, to prepare a balance sheet, a
profit and loss account, a separate
receipts and payments account, a
revenue account in respect of
insurance business transacted by
him and in respect of his
shareholders funds. The accounts
are to be prepared for every
Every insurer must keep separate accounts relating to funds of
shareholders and policyholders.
Insurers are prohibited from investing either directly or indirectly
their funds outside India.

The Regulatory Authority has the power to direct the insurers to

invest funds in infra structure and social sectors subject to
certain conditions. The authority in general has the power to
direct the time, manner and other conditions of investment with
a view to protect the interests of policyholders. The amendment
raises commission on fire and marine policies from the previous
10% to 15%.

There is a necessity for insurers to keep a required solvency

margin. The margin refers to the excess of assets over liabilities.
If an insurer does not maintain such a margin, he has to submit
a financial plan indicating a plan to correct the deficiency. If
these requirements are not met to the satisfaction of the
Authority, the insurer may be deemed to be insolvent and the
company may be wound up by the court.
 Every insurer must submit to the Authority a
prescribed return certified by an actuary in the
case of life business and certified by an auditor
in the case of general insurance business to
show that the required solvency margin has
been maintained.

Every insurer carrying on general insurance

business is required to create a Catastrophe
Reserve to meet the future potential liability
against the insurance policies in. force. This
reserve is not created for any specific or known
purpose. Creation of this reserve should be in
accordance with the regulations issued by the
Authority. So far the Authority has not issued any
regulation in this regard.
 No. Type of investment Percentage of

Investment
Assets

Not less than

(i) Central Government Securities 20%

Central Government Securities, State Not less than

(ii) Government Securities 30%

(including (i)
and other approved securities above)

Approved investments as specified in Section 27B Not exceeding

(iii) of the Act and 70%

and Other Investment as specified in Section

27B(3) of the Act and

Schedule II to these Regulations, (all taken

together) subject to

Exposure /Prudential Norms as specified in

Regulation 9.

Other investments as specified under Section 27B Not more than

(iv) (3) of the Act, 25%

subject to Exposure I Prudential Norms as

specified in Regulation 9.

Housing and loans to State Government for Total Investment

(v) Housing and Fire in

Fighting equipment, by way of subscription or

purchase of housing (i.e.,)

investment in
A. Investments in Housing

categories (i),