CHAPTER 3 NATURE OF INSURANCE

CHAPTER OVERVIEW
NATURE OF INSURANCE
How Insurance Works
Introduction 3.1 Definition 3.2 How Does Insurance Work? 3.3 Concept of Common Pool 3.4 Law of Large Numbers 3.5 Insurance Premium 3.5.1 Breakdown of the Premium 3.6 Characteristics of Insurable Risks 3.6.1 Financial Value 3.6.2 Large number of similar risks 3.6.3 Pure risk only 3.6.4 No catastrophic loss 3.6.5 Fortuitous loss 3.6.6 Insurable interest 3.6.7 Legal and not against public policy 3.6.8 Reasonable premium 3.7 Function of Insurance 3.7.1 Primary function 3.7.2 Secondary function 3.7.3 Indirect functions

Characteristics of Insurable Risk

Function of Insurance

DEFINITION

Insurance is an agreement whereby a group of individuals facing similar risks can share the fortuitous losses of the unlucky few by the transfer of such risks to the insurer who agrees to compensate the losses.

HOW DOES INSURANCE WORK?

Insurance works because the insurer can collect premiums from a group of people in similar circumstances, not all of whom will suffer losses in any one year. These premiums are then pooled together, and used by the insurer to pay losses. Losses are thus shared out among all the policyholders rather than borne solely by the unlucky few.

CONCEPT OF COMMON POOL

Insurance uses a common pool concept. In a nutshell it involves contributions from many insured pooled together to pay for losses suffered by a few. The common pool mechanism involves the following:
An

insurance company sets itself up to operate the pool It takes contributions, in the form of insurance premiums from many insured's and pay for the losses of a few Law of large numbers the larger the group of similar risks, the closer the actual losses experienced by the

LAW OF LARGE NUMBERS

The application of the law allows the insurer to fix premium/contribution to the pool in advance. The effect of this is that the person insuring knows he will not have to pay any premium at the end of the period of insurance. In fixing the premium, the insurer has to assess the risk and fix a premium which reflects the hazard and value of the risk which an insured brings to the pool. In addition, insurer has to consider the other operating costs and the profit of the insurer in fixing the premium.

INSURANCE PREMIUM
Contribution from many insured
RM100

Common Pool

RM600

Contribution from many insured

The calculation of premium for insurance of nearly every kind is based upon the application of the principles of probability to past experiences The principle of probability is that chance may be represented by a fraction, the numerator of which express the number of time the event may posibly happen

A BREAK DOWN OF THE PREMIUM ( GROSS PREMIUM)

An insurance company has to incur expenses, pay out commissions, provide for variation in losses and earn a small profit in the course of assuming the risks, the premium rate actually charged for insurance is the gross premium rate Gross premiums or commonly known as office premium have 4 main components:
Pure Premium Rate Expense loading Contingency loading Profit loading

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RISK PREMIUM RATE

Risk premium: Portion of the office premium that insurance must recover from each policyholder in order to cover the expected claim costs in the period of insurans. Risk premium= Risk premium rate X Value at risk Risk premium rate:
Average total claims X 100 = $ % Average total value insured

CHARACTERISTIC OF INSURABLE RISKS

Financial value: an insurable risk should involve a loss that is capable financial measure Large number of similar risks: there must be large number of similar risks before any one of the risks is capable of being insured. Why?
To

enable the insurer to predict loss based on the law of large numbers If there are a few exposures the principle of losses of a few to be borne by many will not apply.

CHARACTERISTIC OF INSURABLE RISKS

Pure risk: Only pure risk can be insurable but not speculative risk. A pure risk exist when there is a chance of loss but no chance of gain Speculative risk are less predictable and therefore generally uninsurable No catastrophic loss: a catastrophic loss arise when a large number of exposures incur losses at the same time.

CHARACTERISTIC OF INSURABLE RISKS

Fortuitous loss(accidental): The happening of the event must be entirely accidental. It is not possible to insure against an event which will definitely occur, since it involve no uncertainty of loss and therefore no transfer of risk would be taking place. Insurable interest: A person cannot insure a risk in which he does not have any insurable interest or legally recognized financial interest in the subject matter of insurance.

CHARACTERISTIC OF INSURABLE RISKS

Legal and not against public policy: Common principle of law stated that contracts must not be contrary to what society would consider to be the right and moral thing to do. It is not acceptable to insure against the risk of criminal venture.

Reasonable premium: A risk that has a very high probability of loss or near certainty would involve a premium that may be unreasonable from the prospective insureds point of view. On the hand, the insurance premium required to cover a risk worth a few cents may be quite unreasonable in relation to the potential loss in view of the insurer;s claim handling expenses.

THE BENEFITS OF INSURANCE

Peace of mind: The knowledge that insurance exist to meet the financial consequences of certain risks provides a form of peace of mind Loss control Insurers do have an interest in reducing the frequency and severity of losses not only to enchance their own profitability but also to contribute to a general reduction in the economics waste that follows from losses Social benefits The fact that the owner of a business has the funds available to recover form a loss, provides the stimulus to business activity It also means that jobs may not be lost and goods or services can still be sold

THE BENEFITS OF INSURANCE

Investment of funds
Insurers

invest in a wide range of different forms investment (securities,shares etc) By having spread of investments, the insurance industry helps national and international governments in their borrowing

Invisible earnings
Insurance

is a source of invisible earning to Malaysia. It helps the domestic economy to achieve a surplus in the balance of trade

THE FUNCTIONS OF INSURANCE

Risk transfer mechanism

Insurance

provide some form of financial security It will not prevent any of the risks from occuring The owner can transfer the financial consequences of the risk to the insurer in return for paying a premium

THE FUNCTIONS OF INSURANCE

Creation of the common pool

An

insurance company sets itself up to operate a pool It takes contributions, in the form of insurance premiums form many insured and pays losses of a few Based on the Law of Large Numbers (the larger the group of similar risk, the closer the actual losses experienced by the group will approach the expected losses The greater the number of similar risks, the more accurate the insurer can be in predicting future

THE FUNCTIONS OF INSURANCE

Equitable premiums
Individual

pool are organized for different types of risk. Even when risks of a similar type are brought together in common pool, they do not represent the same degree of risk to the pool itself This is differing magnitude of risk or hazard and this will be reflected in the contributions which each will make to the pool No subsidization of risk and each person must be prepared to make an equitable contribution to the pool they represent

SECONDARY FUNCTION
Releasing funds otherwise tied up in reserves Through the purchase of insurance, business enterprises and others are able to avoid the necessity of freezing capital to provide financial protection against losses. The fund released would be available for investment. Stimulate business enterprise The risk transfer mechanism provided by insurance has made possible and has helped to maintain the present day large scale industrial and commercial organizations.

SECONDARY FUNCTIONS

Insurance also stimulates business in other ways:

It

facilitates financing of property by banks and other financial institutions: and It facilitates overseas trade

Remove fear and worry Insurance helps to remove fear and worry for losses of individuals and business executives. The removal of fear and worry of such losses helps to establish confidence and improve personal efficiency of business executives.

SECONDARY FUNCTIONS

Reduction of losses Insurers help to reduce losses both in frequency and severity through their actions and recommendation in rating, survey, inspection and salvage activities. Savings By protecting the individual against unforeseen events, insurance provides a climate in which savings are encouraged. Life insurance (endowment assurance)is often used as a means of savings.

SECONDARY FUNCTIONS

Social benefits
Insurance benefits the society indirectly through: compensation paid by insurers to insurers which reduced the cost of social services; and workers of a factory destroyed by fire might have to face unemployment had the factory been uninsured.

INDIRECT FUNCTIONS

Investment of funds Insurers accumulate large funds which they hold as custodians and out of which claims are met. These funds are usually invested (to earn interest/income) in the public and the private sector. Invisible exports Insurance can contribute considerably to a countrys balance of payments as an invisible exports. For example, whilst Britain is a net exporter of insurance, Malaysia is a net importer of insurance.

INDIRECT FUNCTIONS

Source of employment The insurance industry in Malaysia has generated numerous employment opportunities. Classes of insurance
Insurance business is broadly classified into (1) Life Assurance and (2) General Insurance.

INDIRECT FUNCTIONS

Risk Covered By Life Assurance

Premature death Continuous stream of income during retirement (i.e. old age) Sickness or Disability

Risk Covered By General Insurance General Insurance contracts can be arranged to provide cover against the following forms of risk to insured and third parties for damages arising in respect of:

Motor vehicles Marine and aviation Products or goods sold

DIFFERENCE BETWEEN LIFE AND OTHER FORM OF INSURANCE

Life assurance

General Insurance

The event that is contemplated in life assurance is a certain event The contract may be terminated by the insured, cannot canceled by the company and therefore usually a long term contract which include a savings or investment features In life insurance principle of indemnity is not applicable.

In general insurance, a house insured under a fire policy may or not be lost. Most form of general insurance the contract is for a term of one year and is cancelable, by either party, before the term has expired.

General insurance subjected to the principle of indemnity.

Under-insurance: a situation which the subject matter of insurance is under insured. In other word, the value insured is inadequate or insufficient to cover for a particular loss or damage. Insurer will take a reasonable step to overcome such case by applying average when loss occurred. Example: any property or subject matter which the insured value is less than the actual value Sum insured<cmv

Over-insurance: a situation which the subject matter of insurance is over insured. In other word, the value insured is excessive to compare with the actual value of such subject matter. Regardless the excess condition, normally insurer will pay claim in full when such claim arises. Example: any property or subject matter which the insured value is more than the actual value. Sum insured>CMV

Razlan insured his bungalow under a standard fire insurance policy with sum insured of RM525,000. Eight months later, fire occurred and his bungalow is partially damaged. After investigation carried by loss adjuster, the loss suffered is worth RM125,000. At the time of loss the value of the house is RM650,000. Calculate the claim amount payable (4 marks) Explain why Razlan would not get the full amount of loss. (3 marks)

Calculate the claim amount payable and explain why Razlan would not get the full amount of loss.

Claim amount payable:

Sum Insured : RM 525, 000 Current MV at time of loss: RM 550, 000 Loss : RM 125, 000 Value of house : RM 650, 000

Claim Payable : loss X (Sum insured / value of house) RM 125,000 x (525,000 / 650,000) = 100,962 Razlan , will not receive the full amount because under insurance exist. Basically, in settling a claim, especially fire insurance, insurer will take into consideration the market value of the subject matter rather than sum insured. In this case, average is applied in settling the claim because the insured will not be placed greater than what he enjoyed immediately before the loss occurred.