Insurance chapter 1

CHAPTER 1 - INTRODUCTION TO INSURANCE



OVERVIEW

Overview

1.1. Introduction 1.2. Importance of Insurance 1.3. How Insurance Works 1.4. What is Insurance?

This chapter provides an introduction to the wide range of topics which the book covers. Emphasis is placed on the following areas:

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Importance of Insurance

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How Insurance Works

1.5.

Functions of Insurance

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What Insurance Is

1.6. 1.7.

Classes of Insurance

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Functions of Insurance

Historical Aspects of Insurance

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Classes of Insurance

1.8.

The Role of an Insurance Agent

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Historical Aspects of Insurance

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The Role of an Insurance Agent

1.1. INTRODUCTION

Human beings are exposed to various kinds of risks in their daily lives and activities and have to endure the consequences of such misfortune. Misfortune can arise in many forms which, inevitably, lead to different types and nature of losses. Some examples are:

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A sole breadwinner of a family is involved in an accident and dies prematurely. Undoubtedly, the dependents will face two immediate obvious forms of losses – emotional and financial. The premises of a factory may be destroyed by fire. The owners of the factory will face, besides other losses, the loss of income which the factory 1

CHAPTER 1 - INTRODUCTION TO INSURANCE

would have been able to generate if the fire had not occurred. On the other hand, those employed by the factory may face the prospect of redundancy and unemployment.

We can give countless examples of events which lead to human grievances and financial losses. The natural question to ask then is “What arrangement(s) can be made to overcome or at least reduce the consequences of misfortune that may befall any one person?” In answering the above question, we have to admit that not all forms of loss can be made good or be expressed in pecuniary terms. For instance, the emotional trauma arising from the death of loved one cannot be made good by any conceivable compensatory system. Perhaps, what can be done is to devise a compensatory system which will at least seek -

to reduce the impact of financial loss consequent to an unfortunate event; and

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to prepare or free oneself for the forthcoming and unexpected financial burden or losses.

One such possible arrangement, whereby the financial loss is in consequence of an unfortunate incident such as death or a fire, can be through the purchase of insurance.

1.2. IMPORTANCE OF INSURANCE

The Need for Income Every moment, individuals, families and business units are exposed to losses arising from their property, occupations, activities and

responsibilities. Who will bear these financial losses and where will the funds be obtained from to offset such losses? Usually, in the absence of legal remedies, contract arrangements or cooperative efforts, losses will fall on the individual or business unit concerned. To solve this problem, an arrangement is introduced for coping with some of the risks and possible losses faced by individuals and business enterprises. This arrangement works on the law of large numbers, i.e. by spreading the risk of loss faced by a specific person or enterprise to all parties who pool their resources to pay for individual losses. This loss sharing arrangement is called insurance. The insurer is the intermediary who manages this risk pool. The insurer holds and invests the premiums in trust for policyowners, and pays them in the event that these losses for which insurance protection is taken, occur. Let us consider for a moment as to what would happen in modern society without insurance organization. Living costs money. Money is required to buy essential needs like food, clothing and accommodation, as well as to acquire other comforts of life. If one wants to have a decent life, one should have a continuous flow of income as long as one is alive. This continuous flow of income can be ensured only in two ways. Sources of Income A person may create his source of income by either setting up his own business or working for other people where, upon completion for the jobs done, he will receive payment in the form of a salary, wages, allowances or commissions. The other means is through investment income by way of dividends, bonuses or interest on the capital invested.

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CHAPTER 1 - INTRODUCTION TO INSURANCE However, both sources are always at the risk of being affected by circumstances over which the individual has no control. Unfortunate Events or Risks Earning capacity may be ended abruptly due to death, old age, sickness or accident that may result in disability (permanent or temporary). Likewise, the investments may suddenly depreciate in value or the goods in which capital is invested may be destroyed by fire. In any of these contingencies, the individual or the dependents have to bear the consequences of the financial or emotional losses. Those affected have no other sources to which they can look for relief for sharing part or all of the loss. The painful experience as a consequence of losses is obvious to anyone.

1.3 HOW INSURANCE WORKS

Let us next understand how insurance works to compensate for the financial losses consequent to the occurrence of a risk or perils. Rather than providing a more formal definition of the terms “risk” and “peril” now (see Chapter 2), we shall look at some instances where we can say that a risk or peril has occurred. Some Forms of Risk

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Pooling of Risks It is not possible for an individual to predict or prevent such occurrences but through insurance, arrangements can be made to provide against their financial effects, i.e. loss of property and / or earning. Insurance in its various forms aims at safeguarding the interest of the individuals who are insured. This is achieved by having losses experienced by the unfortunate few compensated by the contributions, i.e. the premium, of the many that are exposed to the same risk. The Concepts of Insurance Explained The concept of insurance is illustrated in Figure 1.1 in relation to a house owner or a term life insurance portfolio. For the purpose of illustration, it is assumed that the portfolio consists of 1000 houses of identical value, say RM100,000 each or 1000 life assured with identical capital sum, and a premium of RM200 is charged for each or life assured per year. House owners or term life

Premiums Claims

#1 #2

RM 200

#3

RM 200

RM 200

1000 x RM200 =RM200,000

# 999 # 1000

Expenses and other Outgoes

Profits RM 200 RM 200

Figure 1.1. Concept of Insurance Illustrated

Shipwreck at sea;

The Fund has to meet:

An outbreak of fire resulting in material damage;

The contribution from the 1000 house owners or life assured results in the creation of an insurance fund of RM200,000. The insurer uses this amount of money to pay for claims, management expenses and other outgoes such as commission, taxes, etc. The balance, if any, constitutes the insurer’s profit.

Loss of income due to disability or premature death.

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CHAPTER 1 - INTRODUCTION TO INSURANCE The Fund Can Become Deficit Thus, in the situation illustrated earlier, the fund created is just sufficient to pay for a maximum of two claims and this leaves the expenses and other outgoes of the insurer uncovered. If more than two claims were to arise, the insurance fund would be in deficit and clearly, the insurer would experience a loss on this portfolio.

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The operation of the law of large numbers will ensure better prediction of future losses. This is important to insurers because they must charge a premium (based on predicted future losses) that will be adequate for paying losses for the period of insurance.

Premiums have to be Adequate in a Competitive Business Environment It becomes clear from the above that for the insurer to operate profitably in a competitive environment, premiums have to be fixed at adequate levels, and management and other expenses controlled. It is beyond the scope of this book to explore the question of what could constitute an adequate premium for a given risk; however, we will look at the basics of the techniques and the terminology involved in subsequent chapters. For now, let us acquaint ourselves with the law of large numbers.

There is a random or chance occurrence of loss.

1.4. WHAT IS INSURANCE?

Having seen the role of insurance and how it works in very general terms, it is now appropriate to put down in precise terms what insurance is all about. Insurance, as an organization, seeks to provide protection against financial loss caused by fortuitous events. Insurance Defined

The Law of Large Numbers

Insurance can therefore be defined as:

Insurance as a device for spreading the loss of a few among many can only work when insurers are able to underwrite a large number of similar risks. When insurers are able to write a large number of similar risks, the law of large numbers operates.

An economic institution based on the principal of mutuality, formed for the purpose of establishing a common fund, the need for which arises from chance occurrences of nature, whose probability can be fairly estimated.

The law of large numbers states that as the number of loss exposures increases, the predicted loss tends to approach the actual loss. Although the law of large numbers is a simple concept, it can only operate efficiently if the following requirements are fulfilled:

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There are a large number of similar loss exposures. The loss exposures must be independent.

The insurance service, therefore, involves payment of contracted benefits or compensation to the insured or a third party against unforeseen losses. Essential Features of Insurance The essential features of insurance, therefore, are: i.

It is an economic institution.

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It is based on the principle of mutuality or cooperation.

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CHAPTER 1 - INTRODUCTION TO INSURANCE iii. iv.

Its objective is to accumulate funds to pay for claims that arise as a result of the operation of specific risks. Only certain risks can be insured against, namely those whose occurrence can be confidently estimated with a certain degree of accuracy.

if the owners were not able to transfer their risks through insurance.

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Insurance helps to remove the fears and worries of losses of individuals and business executives. This removal of fears and worries helps to establish confidence and enables the forwardplanning of economic activities.

1.5. FUNCTIONS OF INSURANCE

In this section we will look at the various functions of insurance.

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An endowment insurance is a combination of protection plus savings. The investment part of the contract is a savings accumulation. By combining the two features in a single plan, endowment assurance provides both protection and savings to the insured.

Stabilization of Costs Through the purchase of insurance, business enterprises avoid the necessity of having to freeze capital to provide for financial protection against losses. This provides a means of stabilizing the costs involved in managing risks.

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Stimulation of Business Enterprise The risk transfer mechanism provided by insurance has made possible the present-day large-scale commercial and industrial enterprises. These largescale enterprises would not have started

Provision of a Means of Saving Insurance functions as a means of saving, primarily through the use of endowment insurance.

1.5.2. Secondary Functions

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Reduction of Losses Insurers help to reduce losses (both in frequency and security) through their actions and recommendations in rating, survey, inspection services and salvage.

1.5.1. Primary Function

The primary function of insurance is the equitable distribution of the financial losses of the few who are insured among the many insured. This immediately leads to the secondary functions stated below.

Provision of Security for Expansion of Business

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Provision of Sources of Capital for Investment Insurers accumulate large funds which they hold as custodians and out of which claims and losses are met. These funds are usually invested (to earn interest) in the public and private sectors. Such investments help considerably in the overall development of the economy.

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CHAPTER 1 - INTRODUCTION TO INSURANCE

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Provision of Employment for Many The insurance industry in Malaysia has created various categories of employment opportunities. Following are the statistics for 2007:

Market Structure

1.Insurers 2.Insurance Brokers 3.Adjusters 4.Registered Life Agents 5.Registered General Agents

No. of Personnel Employed 20,600 1,162 1,844 78,587 39,165

While the nature of jobs for brokers and adjusters are independent and more of specialized roles, the various job functions in an insurance company such as underwriting, claims handling, accounts, audit/compliance, human resource/ administration, electronic data processing, marketing and servicing, investment and other support functions are inter-dependent.

1.6. CLASSES OF INSURANCE

The pooling of risk is the fundamental principle underlying the insurance business and it is useful to classify insurance business broadly into Life Insurance and General Insurance. What is Life Insurance? Life insurance can be defined as a contract which pays an agreed sum of money on the happening of a contingency (event), or of a variety of contingencies, dependent on a human life.

As we progress through the book, you may note that the above definition is not precise in relation to with profit policies, for there is no agreed sum of money at the outset. Life insurance contracts can be arranged to provide cover against the following forms of risks:

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Premature death



Loss of a continuous stream of income during retirement (i.e. during old age)

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Sickness or disability

What is General Insurance? General insurance business can be taken to be all other forms of insurance business (including the reinsurance of liabilities under a policy in respect thereof) which is not life insurance business as defined in the Insurance Act 1996. Risks Covered by General Insurance General insurance contracts, to mention a few, can be arranged to provide cover against the following forms of risk to the insured and/or third parties in respect of

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loss or damage to property, e.g. to motor vehicles, ships, buildings, stocks-in-trade; legal liability caused by products or goods sold, or the process carried out; death or injury to a person by an accident.

More about the basis underlying the conduct of the Life Insurance and the General Insurance classes of business is provided in Part B and Part C of this book.

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CHAPTER 1 - INTRODUCTION TO INSURANCE

1.7. HISTORICAL ASPECTS OF INSURANCE

This section will provide a brief introduction to the historical aspects of insurance. The earliest beginnings of insurance were in the field of marine insurance. Men engaged in trade by sea attempted to minimize their losses which resulted from the perils of the sea, by spreading the losses amongst all who were similarly engaged. In the normal course of events, many ships arrived safely in port and only a few suffered losses. The many who were successful thus contributed to overcome the suffering of those who were unsuccessful. In other words, the misfortune of the unfortunate few was borne by the many. This was achieved by the payment of a premium into a common fund. So much benefit followed this action that traders adopted the idea in many countries and gradually there came into existence groups of men who specialized in managing the fund and who studied the rates of loss which occurred in different types of maritime adventure. This was the beginning of marine insurance. At a much later date came life insurance and other modern forms of insurance, all of which worked on the principle of spreading the losses of the few over the fund created by the contribution of the many. Initially life insurance policies were sold as shortterm policies, cover being renewed at the option of the insurer at the end of the period. Such an approach had disadvantages and perhaps, was the only possible one that could be adopted when there were no mortality tables. The year 1706 marked the emergence of the Amicable Society for a Perpetual Assurance, which adopted a scheme under which each member was required to contribute a fixed sum annually. The accumulated contributions were divided at the end of the year among

the dependents of the members who had died during the year. Membership was open to persons between the ages of 12 and 45 and members’ contributions were uniformly fixed at £5 per annum (which was increased to £6.20 later on). In the early years of its operation the company did not guarantee a definite sum assured but after 1757 a minimum sum assured at death was laid down. A variable premium based on age was fixed only in 1807. An important landmark in the development of life insurance related to the use of the Mortality Table in conjunction with compound interest rates, when in 1762 The Equitable Assurance for the first time fixed premium rates based on modern lines, adopting the level premium system.

1.7.1. Insurance in Malaysia

The beginning of insurance in Malaysia can be traced to the colonial period between the 18th and 19th centuries when British trading firms or agency houses established in this country acted as agencies for the UK-based insurance companies, among which were Harrison & Crossfield, Boustead, and Sime Darby. The insurance industry in Malaysia had been largely patterned on the British system whose influence still continues to be felt. Even as late as 1955, it was reported that foreign insurance domination of the local insurance market was as much as 95% of the total business transacted. After independence in 1957, however, concerted efforts were made to introduce domestic insurance companies. The early 1960s witnessed the growth of a few life insurance companies which wound up soon after because of their unsound operations and inadequate technical background.

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CHAPTER 1 - INTRODUCTION TO INSURANCE Control of Insurance Business

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These unhealthy features culminated in the Government’s intervention through the enactment of the Insurance Act 1963 to regulate the insurance industry. This 1963 Act has since been replaced by the Insurance Act 1996. Since January 1997, the Insurance Act 1996 has become the principal legislation governing the conduct of insurance business in Malaysia

1.8. THE ROLE OF AN INSURANCE AGENT

The roles of an insurance agent are:

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to bring financial relief to aggrieved dependents of insured people who may meet with untimely death;

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to bring financial relief in the event of property loss; to inculcate the discipline of saving amongst the working population; to provide other forms insurance-related services to public.

of the

To be an effective agent, one should be able to recognize the insuring needs of one’s clients. Clients should be advised of the right type of products so that they meet their insuring needs and the policies do not lapse. Insurance agents are expected to provide, in a sense, the best possible advice to their clients. It is greatly hoped that the reader will persevere through the rest of this book and acquire the technical and sales-related knowledge to achieve success in his or her career.

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