UNIT 2 BANKING, AFFORDABLE CREDIT AND INSURANCE

STRUCTURE
2.1 Introduction

2.2 Objectives

2.3 Banking

2.4 History of Banking

2.5 Activities of a bank

2.6 Business Model

2.7 Products of a Bank

2.8 Risks faced by Banks

2.9 Economic Functions

2.10 Banking in India

2.11 Three phases of Banking

2.12 Affordable credit

2.13 Affordable credit: What is it,and who has access?

2.14 Insurance

2.15 Risk and insurability

2.16 Indemnification

2.17 Insurer’s Business Model: Underwriting and Investing

2.18 Claims

2.19 Summing Up

2.20 Glossary

2.21 Answers to Check Your Progress Exercises

2.22 References

2.23 Questions for reflection and practice

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2.1 INTRODUCTION

In this Unit, we will discuss the organizations like banks, credit institutions and insurance
companies. We also look into the differences among theses institutions. A bank is a financial
institution that serves as a financial intermediary and India has a vibrant banking system that
not only hassle free but its also able to meet new challenges posed by the technology and any
other external and internal factors. We will also learn about the different phases in the history
on banking institutions in India.

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2.2 OBJECTIVES
After studying this Unit, you would be able to
 Know the banking institutions;
 Understand the history of banking institutions;
 Describe the affordable credits; and
 Explain the insurance model.

2.3 BANKING

A bank is defined as an organization, usually a corporation, chartered by a state or federal

government, which does most or all of the following activities: receives demand deposits and
time deposits, honours instruments drawn on them, pays interest on them; discounts notes,
makes loans and invests in securities; collects cheques, drafts, and notes; certifies depositor’s
cheques and issues drafts and cashier's cheques.

The term "bank" may refer to any one of several related types of entities. For example:
 A Central Bank circulates money on behalf of the government and acts as its monetary
authority by implementing monetary policy, which regulates the money supply.
 A Commercial Bank accepts deposits and pools those funds to provide credit, either
directly by lending, or indirectly by investing through the capital markets. Within the
global financial markets, these institutions connect market participants with capital
deficits (borrowers) to market participants with capital surpluses (investors and lenders)
by transferring funds from those parties who have surplus funds to invest (financial
assets) to those parties who borrow funds to invest in real assets.

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 A Savings Bank is similar to a savings and loan association (S&L). They can either be
stockholder owned or mutually owned, in which case they are permitted only to borrow
from members of the financial cooperative. The asset structure of savings banks and
savings and loan associations is similar, with residential mortgage loans providing the
principal assets of the institution's portfolio.
Because of the important role played by the depository institutions in the financial system, the
banking industry is highly regulated, and government restrictions on financial activities by
banks have varied over time and by location. In some countries, such as Germany, banks have
historically owned major stakes in industrial companies, while in other countries, such as
the United States, banks have traditionally been prohibited from owning non-financial
companies. In Japan, banks are usually the nexus of a cross-share holding entity known as the
"keiretsu". In Iceland, banks followed international standards of regulation prior to the recent
global financial crisis that began in 2007.

The oldest bank still in existence is Monte dei Paschi di Siena, headquartered in Siena, Italy,
which has been operating continuously since 1472. A Bank's main source of income is
interest. A bank pays out at a lower interest rate on deposits and receives a higher interest rate
on loans. The difference between these rates represents the bank's net income.

2.4 HISTORY OF BANKING

The first banks were the banks of merchants of ancient world which made grain loans to
farmers and traders who carried goods between cities. The records of such activity date back
around 2000 B.C. – in Assyria and Babylonia. Later in ancient Greece and during the Roman
Empire period lenders were based in temples. They would not only provide loans but also
accepted deposits. They also carried out the activity of changing money. During this period
there was similar evidence of the independent development of lending of money in ancient
China and ancient India.

The word bank was borrowed in Middle English from Middle French banque, from
Old Italian banca, from Old High German banc, bank bench, and counter. Benches were used
as desks or exchange counters during the Renaissance period by Florentine bankers, who used
to make their transactions atop desks covered by green tablecloths.

One of the oldest items found showing money-changing activity is a silver Greek drachm
coin from ancient Hellenic colony Trapezus on the Black Sea, modern Trabzon, c. 350–325
BC, present in the British Museum in London. The coin shows a banker's table (trapeza)

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laden with coins, a pun on the name of the city. In fact, even today in Modern Greek the word
Trapeza (Τράπεζα) means both a table and a bank.

2.5 ACTIVITIES OF A BANK

Banks act as payment agents by conducting checking of current accounts for customers,
paying cheques drawn by customers on the bank, and collecting cheques deposited to
customers' current accounts. Banks are also enable customers payments via other payment
methods such as telegraphic transfer, EFTPOS (Electronic Fund Transfer at a point of sale -
electronic payment system), and automated teller machine (ATM).

Banks borrow money by accepting funds deposited on current accounts, by accepting term
deposits, and by issuing debt securities such as banknotes and bonds. Banks lend money by
making advances to customers on current accounts, by making installment loans, and by
investing in marketable debt securities and other forms of money lending.

Banks provide almost all payment services, and a bank account is considered indispensable
by most businesses, individuals and governments. Non-banks that provide payment services
such as remittance companies are not normally considered as an adequate substitute for
having a bank account.

Banks borrow most funds from households and non-financial businesses, and lend most funds
to households and non-financial businesses, but non-bank lenders provide a significant and in
many cases adequate substitute for bank loans, and money market funds, cash management
trusts and other non-bank financial institutions. In many cases, Non- Bank lenders provide an
adequate substitute to banks for lending, savings too.

Banks offer many different channels to access their banking and other services:

 ATM is a machine that dispenses cash and sometimes takes deposits without the need for
a human bank teller. Some ATMs provide additional services.
 A branch is a retail location.
 Mail: most banks accept check deposits via mail and use mail to communicate to their
customers, e.g. Sending account statements to the customers.
 Mobile banking is a method of using one's own mobile phone to conduct banking
transactions.
 Online banking is a term used for performing transactions, payments through Internet.

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  Relationship Managers of the private bank or business bank often visit customers at their
homes or business place to provide banking and other financial services.
 Telephone banking is a service which allows its customers to perform transactions over
the telephone without speaking to a human.
 Video banking is a term used for performing banking transactions or professional banking
consultations via a remote video and audio connection. Video banking can be performed via
purpose built banking transaction machines (similar to an Automated teller machine), or via
a videoconference enabled bank branch.
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2.6 BUSINESS MODEL
A bank can generate revenue in a variety of different ways including interest, transaction fees
and financial advice. The main method is to charge interest on the capital it lends out to
customers. The bank profits is from the differential between the level of interest it pays for
deposits and other sources of funds, and the level of interest it charges in its lending activities.

This difference is referred to as the spread between the cost of funds and the loan interest
rate. Historically, profitability from lending activities has been cyclical and dependent on the
needs and strengths of loan customers and the stage of the economic cycle. Fees and financial
advice constitute a more stable revenue stream, and banks have therefore placed more
emphasis on these revenue lines to smooth their financial performance.

In the past 20 years American banks have taken many measures to ensure that they remain
profitable while responding to increasingly changing market conditions. First, this includes
the Gramm-Leach-Bliley Act, which allows banks to merge with investment and insurance
houses. Merging banking, investment, and insurance functions allows traditional banks to
respond to increasing consumer demands for "one-stop shopping" by enabling cross-selling of
products (which, the banks hope, will also increase profitability).

Second, they have expanded the use of risk-based pricing from business lending to consumer
lending, which means charging higher interest rates to those customers that are considered to
be a higher credit risk and thus increased chance of default on loans. This helps to offset the
losses from bad loans, lowers the price of loans to those who have better credit histories, and
offers credit products to high risk customers who would otherwise be denied credit.

Third, they have sought to increase the methods of payment processing available to the
general public and business clients. These products include debit cards, prepaid cards, smart
cards, and credit cards. They make it easier for consumers to conveniently make transactions
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and smooth their consumption over time (in some countries with underdeveloped financial
systems, it is still common to deal strictly in cash, including carrying suitcases filled with
cash to purchase a home).

However, with convenience of easy credit, there is also increased risk that consumers will
mismanage their financial resources and accumulate excessive debt. Banks make money from
card products through interest payments and fees charged to consumers and transaction
fees to companies that accept the credit- debit - cards. This helps in making profit and
facilitates economic development as a whole.

2.7 PRODUCTS OF A BANK

The following section will explain you the products of the bank. The banks in general offer
the following products. Products of banks are divided into retail and wholesale. With regard
to retail, the following products are offered by the banks.
Retail

 Business loan; Cheque account; Credit card; Home loan; Insurance advisor; Mutual fund;
Personal loan and Savings account.

The wholesale products are dealt by the bank.

Wholesale

 Capital raising (Equity / Debt / Hybrids); Mezzanine finance; Project finance; Revolving
credit; Risk management (FX, interest rates, commodities, derivatives) and Term loan
2.8 RISKS FACED BY BANKS
Banks face a number of risks in order to conduct their business. We will also explain in this
Unit, how well these risks are managed and understood which serves as a key driver behind
profitability, and how much capital a bank is required to hold. Some of the main risks faced
by banks include:

 Credit risk: risk of loss arising from a borrower who does not make payments as
promised.
 Liquidity risk: risk that a given security or asset cannot be traded quickly enough in the
market to prevent a loss (or make the required profit).
 Market risk: risk that the value of a portfolio, either an investment portfolio or a trading
portfolio, will decrease due to the change in value of the market risk factors.

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 Operational risk: risk arising from execution of a company's business functions.

The capital requirement is a bank regulation, which sets a framework on how banks and
depository institutions must handle their capital. The categorization of assets and capital is
highly standardized so that it can be risk weighted.

2.9 ECONOMIC FUNCTIONS OF BANKS

The economic functions of banks include the following:

 Issue of money, in the form of banknotes and current accounts subject to cheque or
payment at the customer's order. These claims on banks can act as money because
they are negotiable or repayable on demand, and hence valued at par. They are
effectively transferable by mere delivery, in the case of banknotes, or by drawing a
cheque that the payee may bank or cash.
 Netting and settlement of payments – banks act as both collection and paying agents
for customers, participating in interbank clearing and settlement systems to collect,
present, be presented with, and pay payment instruments. This enables banks to
economize on reserves held for settlement of payments, since inward and outward
payments offset each other. It also enables the offsetting of payment flows between
geographical areas, reducing the cost of settlement between them.
 Credit intermediation – banks borrow and lend back-to-back on their own account as
middle men.
 Credit quality improvement – banks lend money to ordinary commercial and personal
borrowers (ordinary credit quality), but are high quality borrowers. The improvement
comes from diversification of the bank's assets and capital which provides a buffer to
absorb losses without defaulting on its obligations. However, banknotes and deposits
are generally unsecured; if the bank gets into difficulty and pledges assets as security
to raise funding to continue to operate, this puts the aacount holders and depositors in
an economically subordinated position.
 Maturity transformation – banks borrow more on demand debt and short term debt,
but provide more long term loans. In other words, they borrow short and lend long.
With a stronger credit quality than most other borrowers, banks can do this by
aggregating issues (e.g. accepting deposits and issuing banknotes) and redemptions
(e.g. withdrawals and redemptions of banknotes), maintaining reserves of cash,
investing in marketable securities that can be readily converted to cash if needed, and

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 raising replacement funding as needed from various sources (e.g. wholesale cash
markets and securities markets).
 Money creation – whenever a bank gives out a loan in a fractional-reserve
banking system, a new sum of virtual money is created.

Check Your Progress Exercise 1

Note: i. Use this space given below to answer the question.
ii. Compare your answer with the one given at the end of this unit

1. What is banking?

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2. What are the activities of a bank?

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3. What are the risks faced by banks?

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2.10 BANKING IN INDIA

Effective and sound banking system need to have a healthy economy. The banking system of
India is not only hassle free but it is able to meet new challenges posed by the technology and
any other external and internal factors.

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For the past three decades India's banking system has several outstanding achievements to its
credit. The most striking is its extensive reach. It is no longer confined to only metropolitans
or cosmopolitans in India. In fact, Indian banking system has reached even to the remote
corners of the country. This is one of the main reasons of India's growth process.
The government's regular policy for Indian bank since 1969 has paid rich dividends with the
nationalization of 14 major private banks of India.

Not long ago, an account holder had to wait for hours at the bank counters for getting a draft
or for withdrawing his own money. Today, he has a choice. Gone are days when the most
efficient bank transferred money from one branch to other in two days. Now it is simple as
instant messaging or dialing for a pizza. Money has become the order of the day.
The first bank in India, though conservative, was established in 1786. From 1786 till today,
the journey of Indian Banking System can be segregated into three distinct phases. They are
as mentioned below:

 Early phase from 1786 to 1969 of Indian Banks

 From nationalization of banks in India to 1991- This phase is prior to Indian banking
sector Reforms.
 New phase of Indian Banking System with the advent of Indian Financial & Banking
Sector Reforms after 1991.

This scenario may be elaborated as Phase I, Phase II and Phase III.

2.11 THREE PHASES OF BANKING

The following section describe different phases of banking in India
PHASE I
The General Bank of India was set up in the year 1786. After that Bank of Hindustan and
Bengal Bank was setup. The East India Company established Bank of Bengal (1809), Bank of
Bombay (1840) and Bank of Madras (1843) as independent units and called it Presidency
Banks. These three banks were amalgamated in 1920 and Imperial Bank of India was
established which started as private shareholders banks, mostly Europeans shareholders.

Allahabad Bank was established exclusively by Indians in 1865 and it is the first of kind
exclusively set up by the by the Indians. Punjab National Bank Ltd. was set up in 1894 with
headquarters at Lahore. Between 1906 and 1913, Bank of India, Central Bank of India, Bank

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of Baroda, Canara Bank, Indian Bank, and Bank of Mysore were set up. Reserve Bank of
India came in to existence in 1935.

During the first phase, the growth was very slow and banks also experienced periodic failures
in the period between 1913 and 1948. There were approximately 1100 banks during this
period and most of them are small. To streamline the functioning of the commercial banks,
the Government of India brought The Banking Companies Act, 1949 which was later
changed to Banking Regulation Act 1949 as per amending Act of 1965 (Act No. 23 of 1965).
Reserve Bank of India was vested with extensive powers for the supervision of banking in
India as the Central Banking Authority.
Before Independence, general public had less confidence on the banks. As a result, deposit
mobilization was slow. At the same time, savings bank facility provided by the Postal
department was considered as comparatively safer. Moreover, funds were largely given to
traders by the bank.

PHASE II
Government took number of major steps in the banking Sector after the independence as
reform measures. Imperial Bank was nationalized in 1955 with extensive banking facilities to
the rural and semi-urban areas. Imperial bank established State Bank of India to act as the
principal agent of RBI and to handle banking transactions of the Union and State
Governments all the country.

Seven subsidiary banks of State Bank of India were nationalized in 1960 on 19th July. In
1969, another major process of nationalization was carried out. It was the effort of the then
Prime Minister of India, Mrs. Indira Gandhi, 14 major commercial banks in the country were
nationalized.

Second phase of nationalization of banks with reforms in India was carried out in 1980 with
seven more banks. This step brought 80% of the banking segment in India under Government
ownership.

The following are the major steps taken by the Government of India to regulate banking
institutions in the Country:

 1949: Enactment of Banking Regulation Act.

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  1955: Nationalization of State Bank of India.
 1959: Nationalization of SBI subsidiaries.
 1961: Insurance cover extended to deposits.
 1969: Nationalization of 14 major banks.
 1971: Creation of credit guarantee corporation.
 1975: Creation of regional rural banks.
 1980: Nationalization of seven banks with deposits over 200 crore.

After the nationalization of banks, the branches of the public sector banks in India rose to
approximately 800% in deposits and advances took a huge jump by 11,000%. Banking in the
sunshine of Government ownership gave the public implicit faith and immense confidence
about the sustainability of these institutions.

PHASE III
This phase has introduced many more products and facilities in the banking sector reforms. In
1991, under the chairmanship of M Narasimham, a committee was set up in his name, which
worked for the liberalization of banking practices. During this period, Country witnessed
flooding of foreign banks and their ATM stations. Efforts are being made to give a
satisfactory service to customers. Phone banking and net banking has been introduced. The
entire system became more convenient and the major shift has happened. Timely transactions
in the banking system gained priority.

The financial system of India has shown a great deal of resilience. It is sheltered from any
crisis triggered by any external macro-economics shock as other East Asian Countries
suffered. This is all due to a flexible exchange rate regime: the foreign reserves are high, the
capital account is not yet fully convertible, and banks and their customers have limited
foreign exchange exposure.

With years, banks are also adding services to their customers. The Indian banking industry is
passing through a phase of customers market. The customers have more choices in choosing
their banks. A competition has been established within the banks operating in India. With stiff
competition and advancement of technology, the services provided by banks have become
more easy and convenient. Earlier, one had to wait an hour to withdraw cash from one’s
account, and a cheque from the north of the country took a month to clear in the south. Due to

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advance in technology and reforms in the banking sector, banking transactions made easy
with less time.

Check Your Progress Exercise 2

Note: i. Use this space given below to answer the question.
ii. Compare your answer with the one given at the end of this unit

1. Briefly describe the process of banking in India?

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2. What are the achievements during the different phases of banking?

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3. What is the effect of liberalization on Indian banking?

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2.12 AFFORDABLE CREDIT

Credit is the trust which allows one party to provide resources to another party where the
second party does not reimburse the first party immediately (thereby generating a debt),

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instead arranges will be made either to repay or return those resources (or other materials of
equal value) at a later date. The resources provided may be financial (e.g. granting a loan), or
they may consist of goods or services (e.g. consumer credit). Credit encompasses any form of
deferred payment. Credit is extended by a creditor, also known as a lender, to a debtor, also
known as a borrower.

Credit does not necessarily require money. The credit concept can be applied in barter
economies as well, based on the direct exchange of goods and services (Ingham 2004 p.12-
19). However, in modern societies credit is usually denominated by a unit of account. Unlike
money, credit itself cannot act as a unit of account.

Movements of financial capital are normally dependent on either credit or equity transfers.
Credit is in turn dependent on the reputation or creditworthiness of the entity which takes
responsibility for the funds. Credit is also traded in financial markets. The purest form is the
credit default swap market, which is essentially a traded market in credit insurance. A credit
default swap represents the price at which two parties exchange this risk – the protection
"seller" takes the risk of default of the credit in return for a payment, commonly denoted in
basis points (one basis point is 1/100 of a percent) of the notional amount to be referenced,
while the protection "buyer" pays this premium and in the case of default of the underlying (a
loan, bond or other receivable), delivers this receivable to the protection seller and receives
from the seller the par amount (that is, is made whole).

The word credit is used in commercial trade in the term "trade credit" to refer to the approval
for delayed payments for purchased goods. Companies frequently offer credit to their
customers as part of the terms of a purchase agreement. Organizations that offer credit to their
customers frequently employ a credit manager. On the other hand, credit is sometimes not
granted to a person who has financial instability or difficulty.

Consumer debt can be defined as ‘money, goods or services provided to an individual in lieu
of payment.’ Common forms of consumer credit include credit cards, store cards, motor
(auto) finance, personal loans (installment loans), consumer lines of credit, retail loans (retail
installment loans) and mortgages. This is a broad definition of consumer credit and
corresponds with the Bank of England's definition of "Lending to individuals". Given the size
and nature of the mortgage market, many observers classify mortgage lending as a separate
category of personal borrowing, and consequently residential mortgages are excluded from

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some definitions of consumer credit - such as the one adopted by the Federal Reserve in the
United States(US).

The cost of credit is the additional amount, over and above the amount borrowed, that the
borrower has to pay. It includes interest, arrangement fees and any other charges. Some costs
are mandatory, required by the lender as an integral part of the credit agreement. Other costs,
such as those for credit insurance, may be optional. The borrower chooses whether or not they
are included as part of the agreement.

Interest and other charges are presented in a variety of different ways, but under many
legislative regimes lenders are required to quote all mandatory charges in the form of an
annual percentage rate (APR). The goal of the APR calculation is to promote ‘truth in
lending’, to give potential borrowers a clear measure of the true cost of borrowing and to
allow a comparison to be made between competing products. The APR is derived from the
pattern of advances and repayments made during the agreement. Optional charges are not
included in the APR calculation. So if there is a tick box on an application form asking if the
consumer would like to take out payment insurance, then insurance costs will not be included
in the APR calculation (Finlay 2009).

2.13 AFFORDABLE CREDIT: WHAT IS IT, AND WHO HAS ACCESS?

There has been significant policy concern in recent years about the level of access of the
lower income households to have affordable credit, which led the efforts by government and
others to expand credit union and lending. More recently, the Office of Fair Trading’s in the
United States issued irresponsible lending guidance due to recession in 2000 and 2010 has
highlighted the need for lenders to make better use of affordability assessments in order to
ensure that credit agreements are sustainable and do not risk causing people to become over-
indebted.

However, the term ‘affordable’ has never been officially defined and is often simply used to
mean ‘less expensive’ than forms of high cost credit such as home credit or payday lending.
Although these lenders may be providing credit at prices which reflect high operating costs
and default risks, these may not be affordable even at low levels of credit use for some
households once the costs of other essential outgoings are taken into account.

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Therefore, attempts are being made to determine levels of disposable household income
which are available for credit repayments after taking account of essential expenditure, and to
determine how much credit lower to middle income households can realistically afford to take
on. Further to this, it is being explored how price rises in areas of the household budget
including food and fuel will impact on the ability of households to make credit repayments.

This study will draw out the implications for future credit provision, including by looking at
how credit could be used to help lower income households reduce future levels of expenditure
or invest in activities which could increase disposable income levels over time.

Check Your Progress Exercise 3

Note: i. Use this space given below to answer the question.
ii. Compare your answer with the one given at the end of this unit

1. What is credit?

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2. What is the difference between trade credit and consumer credit?

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3. What is affordable credit? Who has access to affordable credit?

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2.14 INSURANCE
Insurance is a risk management technique primarily used to hedge against the risk of a
contingent, uncertain loss that may be suffered by those individuals by transferring the
possibility of this loss from one interested person, persons, or entity to another. The scarce
resources referred to here, fall into three divisions: human resources, financial resources, and
capital, or tangible resources.
In the context of insurance, scarce resources are also known as "exposures," because they are
"exposed" to perils, those things, or forces, which cause destruction or reduction, in the
usefulness, or value, of an exposed resource. Human resources are thus exposed to perils such
as illness or death; financial resources to legal judgments that may result from negligent acts,
and capital resources to physical perils such as fire, theft, windstorm, and vandalism, to name
but a few.
A hazard is the cause of a peril. It is that thing or condition which increases the likelihood of
a peril. Thus perils and hazards are identified by the exposure that they threaten. For example
a slippery roadway could be viewed as a financial hazard, capital hazard, or human hazard by
automobile owners, and rightly so, since this condition increases the likelihood of an
automobile accident that might result in an unfavorable legal judgment, automobile damage,
and bodily injury.
In the context of commercial trade, insurance is further defined as the equitable transfer of the
risk of a loss, from one entity to another, in exchange for consideration or payment, in the
form of a risk premium. The insurance premium develops at an actuarially-determined rate.
This rate is a factor used to determine the amount of premium to charge for a certain limit,
and type, of insurance on the scarce resource. The premium can further be viewed as a
guaranteed, known, relatively small financial loss to the insured, paid to the insurer, in
exchange for the insurer's promise to compensate (indemnify) the insured in the case of a loss
to the insured resource(s). The insured receives a contract, called the insurance policy, which
details the conditions and circumstances under which the insured will be indemnified.

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Process of insurance: Insurance involves pooling funds from many insured entities (known as
exposures) to pay for the losses that some may incur. The insured entities are therefore
protected from risk for a fee, with the fee being dependent upon the frequency and severity of
the event occurring. In order to be insurable, the risk insured against must meet certain
characteristics in order to be an insurable risk. Insurance is a commercial enterprise and a
major part of the financial services industry, but individual entities can also self-insure
through saving money for possible future losses.

2.15 RISK AND INSURABILITY

Risks which can be insured by private companies typically share seven common
characteristics:

1. Large number of similar exposure units: Since insurance operates through pooling
resources, the majority of insurance policies are provided for individual members of
large classes, allowing insurers to benefit from the law of large numbers in which
predicted losses are similar to the actual losses. Exceptions include Lloyd's of London,
which is famous for insuring the life or health of actors, sports figures and other
famous individuals. However, all exposures will have particular differences, which
may lead to different premium rates.
2. Definite loss: The loss takes place at a known time, in a known place, and from a
known cause. The classic example is death of an insured person on a life insurance
policy. Fire, automobile accidents, and worker injuries may all easily meet this
criterion. Other types of losses may only be definite in theory. Occupational disease,
for instance, may involve prolonged exposure to injurious conditions where no
specific time, place or cause is identifiable. Ideally, the time, place and cause of a loss
should be clear enough that a reasonable person, with sufficient information, could
objectively verify all three elements.
3. Accidental loss: The event that constitutes the trigger of a claim should be fortuitous,
or at least outside the control of the beneficiary of the insurance. The loss should be
pure, in the sense that it results from an event for which there is only the opportunity
for cost. Events that contain speculative elements, such as ordinary business risks or
even purchasing a lottery ticket, are generally not considered insurable.

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 4. Large loss: The size of the loss must be meaningful from the perspective of the
insured. Insurance premiums need to cover both the expected cost of losses, plus the
cost of issuing and administering the policy, adjusting losses, and supplying the
capital needed to reasonably assure that the insurer will be able to pay claims. For
small losses these latter costs may be several times the size of the expected cost of
losses. There is hardly any point in paying such costs unless the protection offered has
real value to a buyer.
5. Affordable premium: If the likelihood of an insured event is so high, or the cost of
the event is so large, that the resulting premium is large relative to the amount of
protection offered, it is not likely that the insurance will be purchased, even if on
offer. Further, as the accounting profession formally recognizes in financial
accounting standards, the premium cannot be so large that there is not a reasonable
chance of a significant loss to the insurer. If there is no such chance of loss, the
transaction may have the form of insurance, but not the substance.
6. Calculable loss: There are two elements that must be at least estimable, if not
formally calculable: the probability of loss, and the attendant cost. Probability of loss
is generally an empirical exercise, while cost has more to do with the ability of a
reasonable person in possession of a copy of the insurance policy and a proof of loss
associated with a claim presented under that policy to make a reasonably definite and
objective evaluation of the amount of the loss recoverable as a result of the claim.
7. Limited risk of catastrophically large losses: Insurable losses are ideally
independent and non-catastrophic, meaning that the losses do not happen all at once
and individual losses are not severe enough to bankrupt the insurer; insurers may
prefer to limit their exposure to a loss from a single event to some small portion of
their capital base. Capital constrains insurers' ability to sell earthquake insurance as
well as wind insurance in hurricane zones. In the U.S., flood risk is insured by the
federal government. In commercial fire insurance it is possible to find single
properties whose total exposed value is well in excess of any individual insurer's
capital constraint. Such properties are generally shared among several insurers, or are
insured by a single insurer who syndicates the risk into the reinsurance market

Legal requirement for insurance: When a company insures an individual entity, there are
basic legal requirements. Several commonly cited legal principles of insurance include:

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 1. Indemnity – the insurance company indemnifies, or compensates, the insured in the
case of certain losses only up to the insured's interest.
2. Insurable interest – the insured typically must directly suffer from the loss. Insurable
interest must exist whether property insurance or insurance on a person is involved.
The concept requires that the insured have a "stake" in the loss or damage to the life or
property insured. What that "stake" is will be determined by the kind of insurance
involved and the nature of the property ownership or relationship between the persons.
3. Utmost good faith – the insured and the insurer are bound by a good faith bond of
honesty and fairness. Material facts must be disclosed.
4. Contribution – insurers which have similar obligations to the insured contribute in the
indemnification, according to some method.
5. Subrogation – the insurance company acquires legal rights to pursue recoveries on
behalf of the insured; for example, the insurer may sue those liable for insured's loss.
6. Causa proxima, or proximate cause – the cause of loss (the peril) must be covered
under the insuring agreement of the policy, and the dominant cause must not be
excluded
7. Principle of loss minimization - In case of any loss or casualty, the asset owner must
attempt to keep the loss to a minimum, as if the asset was not insured.

2.16 INDEMNIFICATION
To "indemnify" means to make whole again, or to be reinstated to the position that one was
in, to the extent possible, prior to the happening of a specified event or peril. Accordingly, life
insurance is generally not considered to be indemnity insurance, but rather "contingent"
insurance (i.e., a claim arises on the occurrence of a specified event). There are generally two
types of insurance contracts that seek to indemnify an insured:
1. an "indemnity" policy, and
2. a "pay on behalf" or "on behalf of" policy.

The difference is significant on paper, but rarely material in practice.

An "indemnity" policy will never pay claims until the insured has paid out of pocket to some
third party; for example, a visitor to your home slips on a floor that you left wet and sues you
for Rs 50,000 and wins. Under an "indemnity" policy the homeowner would have to come up
with the Rs 50,000 to pay for the visitor's fall and then would be "indemnified" by the
insurance carrier for the out of pocket costs Rs 50,000.

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Under the same situation, a "pay on behalf" policy, the insurance carrier would pay the claim
and the insured (the homeowner in the above example) would not be out of pocket for
anything. Most modern liability insurance is written on the basis of "pay on behalf" language.

An entity seeking to transfer risk (an individual, corporation, or association of any type, etc.)
becomes the 'insured' party once risk is assumed by an 'insurer', the insuring party, by means
of a contract, called an insurance policy. Generally, an insurance contract includes, at a
minimum, the following elements: identification of participating parties (the insurer, the
insured, the beneficiaries), the premium, the period of coverage, the particular loss event
covered, the amount of coverage (i.e., the amount to be paid to the insured or beneficiary in
the event of a loss), and exclusions (events not covered). An insured is thus said to be
"indemnified" against the loss covered in the policy.

When insured parties experience a loss for a specified peril, the coverage entitles the
policyholder to make a claim against the insurer for the covered amount of loss as specified
by the policy. The fee paid by the insured to the insurer for assuming the risk is called the
premium. Insurance premiums from many of the insured are used to fund accounts reserved
for later payment of claims — in theory for a relatively few claimants — and for overhead
costs. So long as an insurer maintains adequate funds set aside for anticipated losses (called
reserves), the remaining margin is an insurer's profit.

Effects

Insurance can have various effects on society through the way that it changes who bears the
cost of losses and damage. On one hand it can increase fraud, on the other it can help
societies and individuals prepare for catastrophes and mitigate the effects of catastrophes on
both households and societies.

Insurance can influence the probability of losses through moral hazard, insurance fraud, and
preventive steps by the insurance company. Insurance scholars have typically used moral
hazard to refer to the increased loss due to unintentional carelessness and moral hazard to
refer to increased risk due to intentional carelessness or indifference. Insurers attempt to
address carelessness through inspections, policy provisions requiring certain types of
maintenance, and possible discounts for loss mitigation efforts. While in theory insurers could
encourage investment in loss reduction, some commentators have argued that in practice

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insurers had historically not aggressively pursued loss control measures - particularly to
prevent disaster losses such as hurricanes - because of concerns over rate reductions and legal
battles. However, since about 1996 insurers began to take a more active role in loss
mitigation, such as through building codes.

2.17 INSURERS' BUSINESS MODEL: UNDERWRITING AND INVESTING

The business model is to collect more in premium and investment income than is paid out in
losses, and to also offer a competitive price which consumers will accept. Profit can be
reduced to a simple equation: Profit = earned premium + investment income - incurred loss -
underwriting expenses.

Insurers make money in two ways:

1. Through underwriting, the process by which insurers select the risks to insure and
decide how much in premiums to charge for accepting those risks;
2. By investing the premiums they collect from insured parties.

The most complicated aspect of the insurance business is the actuarial science of ratemaking
(price-setting) of policies, which uses statistics and probability to approximate the rate of
future claims based on a given risk. After producing rates, the insurer will use discretion to
reject or accept risks through the underwriting process.

At the most basic level, initial ratemaking involves looking at the frequency and severity of
insured perils and the expected average payout resulting from these perils. Thereafter an
insurance company will collect historical loss data, bring the loss data to present value, and
comparing these prior losses to the premium collected in order to assess rate adequacy.

Loss ratios and expense loads are also used. Rating for different risk characteristics involves
at the most basic level comparing the losses with "loss relativities" - a policy with twice as
money policies would therefore be charged twice as much. However, more complex
multivariate analyses through generalized linear modelling are sometimes used when multiple
characteristics are involved and a univariate analysis could produce confounded results. Other
statistical methods may be used in assessing the probability of future losses.

Upon termination of a given policy, the amount of premium collected and the investment
gains thereon, minus the amount paid out in claims, is the insurer's underwriting profit on that
policy. Underwriting performance is measured by something called the "combined ratio"

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which is the ratio of expenses/losses to premiums. A combined ratio of less than 100 percent
indicates an underwriting profit, while anything over 100 indicates an underwriting loss. A
company with a combined ratio over 100% may nevertheless remain profitable due to
investment earnings.

Insurance companies earn investment profits on "float". Float, or available reserve, is the
amount of money on hand at any given moment that an insurer has collected in insurance
premiums but has not paid out in claims. Insurers start investing insurance premiums as soon
as they are collected and continue to earn interest or other income on them until claims are
paid out.

Naturally, the float method is difficult to carry out in an economically depressed period. Bear
markets do cause insurers to shift away from investments and to toughen up their
underwriting standards, so a poor economy generally means high insurance premiums. This
tendency to swing between profitable and unprofitable periods over time is commonly known
as the underwriting, or insurance, cycle.

2.18 CLAIMS
Claims and loss handling is the materialized utility of insurance; it is the actual "product" paid
for. Claims may be filed by insured’s directly with the insurer or through brokers or agents.
The insurer may require that the claim be filed on its own proprietary forms, or may accept
claims on a standard industry form, such as those produced by ACORD.

Insurance company claims departments employ a large number of claims adjusters supported
by a staff of records management and data entry clerks. Incoming claims are classified based
on severity and are assigned to adjusters whose settlement authority varies with their
knowledge and experience. The adjuster undertakes an investigation of each claim, usually in
close cooperation with the insured, determines if coverage is available under the terms of the
insurance contract, and if so, the reasonable monetary value of the claim, and authorizes
payment.

The policyholder may hire their own public adjuster to negotiate the settlement with the
insurance company on their behalf. For policies that are complicated, where claims may be
complex, the insured may take out a separate insurance policy add on, called loss recovery
insurance, which covers the cost of a public adjuster in the case of a claim.

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Adjusting liability insurance claims is particularly difficult because there is a third party
involved, the plaintiff, who is under no contractual obligation to cooperate with the insurer
and may in fact regard the insurer as a deep pocket. The adjuster must obtain legal counsel for
the insured (either inside "house" counsel or outside "panel" counsel), monitor litigation that
may take years to complete, and appear in person or over the telephone with settlement
authority at a mandatory settlement conference when requested by the judge.

If a claims adjuster suspects under-insurance, the condition of average may come into play to
limit the insurance company's exposure.

In managing the claims handling function, insurers seek to balance the elements of customer
satisfaction, administrative handling expenses, and claims overpayment leakages. As part of
this balancing act, fraudulent insurance practices are a major business risk that must be
managed and overcome. Disputes between insurers and insured over the validity of claims or
claims handling practices occasionally escalate into litigation.

Insurers will often use insurance agents to initially market or underwrite their customers.
Agents can be captive, meaning they write only for one company, or independent, meaning
that they can issue policies from several companies. Commissions to agents represent a
significant portion of an insurance cost; therefore some insurers sell policies directly via mass
marketing campaigns offering lower prices. The existence and success of companies using
insurance agents (with higher prices) is likely due to improved and personalized service.

Check Your Progress Exercise 4

Note: i. Use this space given below to answer the question.
ii. Compare your answer with the one given at the end of this unit

1. What is insurance? Describe the process of insurance?

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2. Describe the process of insurance?

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___________________________________________________________________________
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2.19 SUMMING UP
In this Unit we learnt about the Banking and financial institutions. We also understood the
difference between credit and insurance and how Credit is the trust which allows one party to
provide resources to another party where that second party does not reimburse the first party
immediately, while Insurance is a risk management technique primarily used to hedge against
the risk of a contingent, uncertain loss that may be suffered by those individuals by
transferring the possibility of this loss from one interested person to another.

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2.20 GLOSSARY

ATM: Automated Teller Machine. ATM is a machine that dispenses cash and sometimes
takes deposits without the need for a human bank teller.

Trade credit: The term trade credit is used to refer to the approval for delayed payments
for purchased goods.
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2.21 ANSWERS TO CHECK YOUR PROGRESS EXERCISE

Check Your Progress Exercise 1

1. A bank is defined as an organization, usually a corporation, chartered by a state or federal

government, which does most or all of the following: receives demand deposits and time
deposits, honors instruments drawn on them, and pays interest on them; discounts notes,
makes loans, and invests in securities; collects cheques, drafts, and notes; certifies depositor’s
cheques and issues drafts and cashier's cheques.

2. Banks act as payment agents by conducting checking or current accounts for customers,
paying cheques drawn by customers on the bank, and collecting cheques deposited to
customers' current accounts. Banks also enable customer payments via other payment
methods such as telegraphic transfer, EFTPOS, and automated teller machine (ATM).

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Banks borrow money by accepting funds deposited on current accounts, by accepting term
deposits, and by issuing debt securities such as banknotes and bonds. Banks lend money by
making advances to customers on current accounts, by making installment loans, and by
investing in marketable debt securities and other forms of money lending.

3. Banks face a number of risks in order to conduct their business, and how well these risks
are managed and understood is a key driver behind profitability, and how much capital a bank
is required to hold. Some of the main risks faced by banks include:

 Credit risk: risk of loss arising from a borrower who does not make payments as
promised.
 Liquidity risk: risk that a given security or asset cannot be traded quickly enough in the
market to prevent a loss (or make the required profit).
 Market risk: risk that the value of a portfolio, either an investment portfolio or a trading
portfolio, will decrease due to the change in value of the market risk factors.
 Operational risk: risk arising from execution of a company's business functions.
Check Your Progress Exercise 2

1. The banking system of India is not only hassle free but it is able to meet new challenges
posed by the technology and any other external and internal factors.
During past three decades India's banking system has several outstanding achievements to its
credit. The most striking is its extensive reach. It is no longer confined to only metropolitans
or cosmopolitans in India. In fact, Indian banking system has reached even to the remote
corners of the country. This is one of the main reason of India's growth process.

With years, banks are also adding services to their customers. The Indian banking industry is
today passing through a phase of customers market. The customers have more choices in
choosing their banks. With stiff competition and advancement of technology, the services
provided by banks have become more easy and convenient. The government's regular policy
for Indian bank since 1969 has paid rich dividends with the nationalization of 14 major
private banks of India.

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2. The first bank in India, though conservative, was established in 1786. From 1786 till today,
the journey of Indian Banking System can be segregated into three distinct phases. They are
as mentioned below:

 Early phase from 1786 to 1969 of Indian Banks

 Nationalization of Indian Banks and up to 1991 prior to Indian banking sector
Reforms.
 New phase of Indian Banking System with the advent of Indian Financial & Banking
Sector Reforms after 1991.

During the first phase the growth was very slow and banks also experienced periodic failures:
between 1913 and 1948. There were approximately 1100 banks, mostly small. During the
second phase, the Government took major steps in this Indian Banking Sector Reform after
Independence. In 1955, it nationalized the Imperial Bank of India, with extensive banking
facilities, on a large scale especially in rural and semi-urban areas. It formed State Bank of
India to act as the principal agent of RBI, and to handle banking transactions of the Union and
State Governments all over the country. Seven subsidiary banks of State Bank of India were
nationalized in 1960 on 19th July. In 1969, another major process of nationalization was
carried out. 14 major commercial banks in the country were nationalized. The third phase is
known as the phase of liberalization where the many more products and facilities in the
banking sector reforms. In 1991, under the chairmanship of M Narasimham, a committee was
set up in his name, which worked for the liberalization of banking practices.

3. Since 1991, we have seen a tremendous growth in the banking industry. The country is
flooded with foreign banks and their ATM stations. Efforts are being made to give a
satisfactory service to customers. Phone banking and net banking has been introduced. The
entire system became more convenient and swift. With years, banks are also adding services
to their customers. The Indian banking industry is passing through a phase of customers
market. The customers have more choices in choosing their banks.

With stiff competition and advancement of technology, the services provided by banks have
become more easy and convenient. Earlier, one had to wait an hour wait before withdrawing
cash from one’s account, and a cheque from north of the country took one month to be
cleared in the south. Now, this happens within a matter of minutes.

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Check Your Progress Exercise 3

1. Credit is the trust which allows one party to provide resources to another party where that
second party does not reimburse the first party immediately (thereby generating a debt), but
instead arranges either to repay or return those resources (or other materials of equal value) at
a later date. The resources provided may be financial (e.g. granting a loan), or they may
consist of goods or services

2. The term "trade credit" refers to the approval for delayed payments for purchased goods.
Companies frequently offer credit to their customers as part of the terms of a purchase
agreement.

Consumer credit can be defined as ‘money, goods or services provided to an individual in lieu
of payment.’ Common forms of consumer credit include credit cards, store cards, motor
(auto) finance, personal loans (installment loans), consumer lines of credit, retail loans (retail
installment loans) and mortgages.

3.Though the term ‘affordable’ credit has never been officially defined and is often simply
used to mean ‘less expensive’ than forms of high cost credit such as home credit or payday
lending. Although these lenders may be providing credit at prices which reflect high
operating costs and default risks, these may not be affordable even at low levels of credit use
for some households once the costs of other essential outgoings are taken into account.

Therefore, attempts are being made to determine levels of disposable household income
which are available for credit repayments after taking account of essential expenditure, and to
determine how much credit lower to middle income households can realistically afford to take
on.

Check Your Progress Exercise 4

1.Insurance is a risk management technique primarily used to hedge against the risk of a
contingent, uncertain loss that may be suffered by those individuals by transferring the
possibility of this loss from one interested person, persons, or entity to another. The scarce
resources referred to here, fall into three divisions: human resources, financial resources, and
capital, or tangible resources.

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2. The process of insurance involves pooling funds from many insured entities (known as
exposures) to pay for the losses that some may incur. The insured entities are therefore
protected from risk for a fee, with the fee being dependent upon the frequency and severity of
the event occurring. In order to be insurable, the risk insured against must meet certain
characteristics in order to be an insurable risk. Insurance is a commercial enterprise and a
major part of the financial services industry, but individual entities can also self-insure
through saving money for possible future losses.

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2.22 REFERENCES

1. Cameron, Rondo et al. International Banking 1870–1914 (1992)

2. The History of Banks, Richard Hildreth- Batoche Books, Kitchener, 2001
3. http://www.indianbanks.org/
4. Reserve Bank of India (RBI). Retrieved 20 November 2010.
5. Sunil Kumar, Rachita Gulati: Did efficiency of Indian public sector banks converge
with banking reforms? International Review of Economics, Volume 56, Issue 1, pp
47-84, 2009.
6. Consultative Group to Assist the Poor (CGAP). 1996. Microcredit Interest Rates.
Occasional Paper No. 1. Washington DC: CGAP.
7. 2000. Financial Innovation: Key to Microfinance Development. Finance for the Poor
1(2): 4–6.
8. Regulation of General Insurance in India, Insurance in India, accessed on 29 April
2006 http://finance.indiamart.com/investment_in_india/banking_in_india.html

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2.23 QUESTIONS FOR REFLECTION AND PRACTICE

1. What is a bank and what are the economic functions of a bank?

2. How has liberalization changed the face of banking in India?
3. Why is affordable credit not being offered to all individuals?
4. How does the process of Insurance work? What is the connection between
underwriting and investing in the insurance business model?

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