Learning Objective:
‘To introduce candidates to the need
for insurance, the principles of
insurance and the legal framework
that underpin its practice.’
Principles and Practices of
Insurance
Foreword
Improving knowledge, developing
skills, building careers
The insurance industry in the
Kingdom has arrived.
The success of the new industry will
rely on the knowledge and skills of the
people who work in the industry.
Professionalism in insurance is not
an option but is a must.
As a first step in the development
of Saudi Arabian insurance professionals,
the Institute of Banking has
developed this foundation course in insurance
which must be taken before all other
courses.
The Foundation Course has been
formed with individual modules covering
different subject areas within
insurance, protection and savings. During your
studies, your principal learning
resource will be yourself and this courseware.
However, the Institute of Banking
has also developed a classroom based
presentation to accompany and
support this book.
The instructor of this program will
guide your studies, develop your group
discussions and be able to fully
explain those issues which are particularly
complex. He will also answer your
questions on specific issues that you may
find difficult.
There are three knowledge ratings
used throughout the course which indicate
the depth of knowledge required for
each topic. These are i. To be aware of,
ii. To have knowledge of and iii. To
understand.
The courseware contains definitions
and explanations throughout together
with regular short questions to
check your understanding of the text. These
questions are given in a box and
will either test your understanding of the
topic or stimulate your thought
process and facilitate further discussion.
At the end of each module, there is
a series of questions to test your knowledge
of the module. It is strongly
recommended that these be completed before
moving on to the next module.
The IOB’s goal of developing
excellence amongst insurance professionals
in the Kingdom will only be achieved
if each of us strives for insurance
knowledge. This program is here for
your development. Use it!
Good luck, enjoy the Program and,
may it be the stepping-stone to an
interesting and rewarding career.
Icons
When you read the print materials,
you will find the following icons displayed in the
left hand margin.
Indicates key content to which you
should pay special attention.
Notes a website that may contain
additional information on a topic.
Directs you to other modules that
contains more information on a topic.
Questions to test your understanding
of the topic and/or for further discussion.
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Course Content & Syllabus:
Module 1: Risk and Insurance
1.1 Meaning of risk 007
1.2 Categories of risk 008
1.3 Insurable risks 012
1.4 Uninsurable risks 013
1.5 Insurance as a risk transfer
mechanism 015
1.6 Pooling of risk 016
1.7 Perils and hazards 019
1.8 Benefits of insurance 021
1.9 Reinsurance 025
1.10 Co-insurance and self-insurance
030
1.11 How an insurance company
operates 032
Progress Check 035
Module 2: Legal Principles of
Insurance
2.1 Utmost Good Faith 041
2.2 Insurable Interest 044
2.3 Indemnity 046
2.4 Subrogation 053
2.5 Contribution 055
2.6 Proximate Cause 058
Progress Check 061
Module 3: Risk Underwriting
3.1 Material facts 067
3.2 Physical and moral hazards and
the use of warranties 069
3.3 Proposal forms and broker’s
slips 074
3.4 Surveys 078
3.5 Quotations 080
Progress Check 084
Module 4: The Insurance Market
4.1 Components of the insurance
market 089
4.2 Intermediaries 092
4.3 Distribution channels 095
4.4 The role of ancillary players in
the insurance 097
Progress Check 100
Module 5: The need for documentation
5.1 Proposal Forms and policy
structure 105
5.2 Warranties and endorsements 109
5.3 Cover notes and certificates of
insurance 110
5.4 Claim forms 112
5.5 Renewal invitations 114
Progress Check 116
Module 6: Regulation of the
Insurance Industry in the Kingdom
6.1 Why the insurance and
protection/savings industry needs to be regulated. 121
6.2 The Historical Background of the
Insurance Industry in the Kingdom 123
6.3 Regulation of insurance in the
Kingdom of Saudi Arabia 127
Progress Check 148
Module 7: Market Code of Conduct
Regulation MCCR
7.1 Introduction 153
7.2 General Requirements 154
7.3 Standards of Practice 156
7.4 Appendix 163
Progress Check Answers
182
003
Module 1:
Risk and Insurance
Module 1:
Risk and Insurance
After studying this module, you
should be
able to:
- List the main components of risk
- Demonstrate how insurance relates
to risk
- Identify the categories of risk
-Compare insurable and uninsurable
interest
- Describe the relation between
frequency and
severity
- Distinguish between perils and
hazards
- Describe how insurance operates as
a risk
transfer mechanism
- Describe how the common pool
operates
-Identify the benefits of insurance
to individuals,
business and economy
- Understand co-insurance and self
insurance
Principles and Practices of
Insurance
Introduction
The first module introduces the
student to the broad principles that
govern how insurance operates. Risk
and insurance are linked and this
module provides a greater
understanding of the meaning of risk both
in its ordinary meaning and how it
relates to insurance and which risks
are insurable. We examine how
insurance operates to transfer risks
through the principal concept of the
‘Losses of the few, shared by
the many’. Perils and hazards, two
key aspects of insurance work are
distinguished.
Following our examination of risk
and insurance and the broad concepts
that enable insurance to operate, we
then look at why consumers buy
insurance and the additional
benefits that arise from its basic function.
We also look at why insurers
themselves need to insure and the
relationship between the original
insured, their insurer and the insurer
of the insurance company.
Finally, we look at other options
available to insurers when arranging
larger insurance risks and why some
businesses may choose not to use
insurance as a method of dealing
with some of their risks.
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1.1 –Meaning of risk
During this session, we will examine
the meaning of risk.
The Oxford English Dictionary lists
26 synonyms for the word ‘risk’.
How many can you list out?
Write your synonyms of risk here.
Reviewing the list of synonyms and
definitions suggests that risk
involves a lack of knowledge about
future events (‘uncertainty’, ‘doubt’,
‘possibility’, ‘unpredictability’)
and whether there will be a loss.
This idea of the unknown and loss is
borne out by the use of risk in
everyday language. You may have
heard or used some of the following
phrases:
• “The risk of losing a job”
• “What is the risk of an accident?”
• “The risks involved in a new
business venture”.
Several academics have attempted to
define risk, for example, ‘risk is
uncertainty of a loss occurring’.
Risk represents the possibility of an
outcome being different from the
expected.
We define the term risk as THE
POSSIBILITY OF ADVERSE
RESULTS FLOWING FROM ANY OCCURRENCE.
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Risks are with us every day – each
time we travel in a car there is a risk
of an accident but our individual
attitude to risk varies. Some people
are considered risk-seeking, they
enjoy risks perhaps it gives them a
sense of excitement while others may
be risk neutral. Finally, those who
actively avoid risk are risk-averse.
Which of the three groups are more
likely to buy insurance?
The term risk is used in insurance
business
to also mean either a peril to be
insured (fire
is a risk to which a building is
exposed) or a
person or property protected by
insurance
(young drivers are often not
considered
good risks for Motor insurance)
1.2 –Categories of risk
We have examined risks and peoples’
attitude towards risk. We are now
going to look at how risks can be
classified i.e. the placing of similar
risks into a group
Three categories of risks are:
• Financial or non-financial
• Pure or speculative
• Fundamental or particular
Financial or non-financial
If the outcome can be measured in
financial terms then the risk is
classified as financial. It follows,
therefore, that a non-financial risk is
one where the outcome cannot be
measured in financial terms.
Examples of financial risk include a
business
venture, which may show a profit, a
loss or
may break-even on its original
investment.
If a fire damages a building, the
cost of
rebuilding is the financial loss.
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Visiting a restaurant for the first
time may involve an element of risk as
to whether the outcome will be
disappointment or pleasure. Buying a car,
choosing a holiday, selecting a job
all involves a degree of risk (unknown
outcomes)butalthoughtheoutcomemayhavesomefinancialimplications,
a precise measurement in strictly
financial terms is not possible.
Measurement of the outcome of
non-financial risks is usually not
in monetary terms but by
characteristics that are more personal
disappointment, unhappiness, joy,
pleasure etc.
If a person had only one photograph
taken as a child with his father who
is no
more, then that photograph would, to
him,
have great value. However, that
value is an
emotional or sentimental value, a
value
that we cannot measure financially.
Which ty pe of risk, financial or
non-financial, is usually considered as
insurable and why?
Pure or speculative
A pure risk is one that has only two
possible outcomes.
1- a loss
2- or break-even (No loss).
A speculative risk has three
possible outcomes,
1- a loss
2- or break-even (No loss)
3- or gain/profit.
The distinction is important for
insurance and one that you must fully
understand.
Each time we travel in a car there
is a risk of an accident. If there is
no accident the position is
unaltered, a break-even situation. If there
is an accident a loss is suffered as
a result of damage to the vehicle,
injuries etc. There is no
possibility of gain (apart from arriving safely at
a destination) but there is a
possibility of a loss.
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Other examples of pure risk include
fire, theft, explosion, and storm
damage.
Can you think of other examples of
pure risk?
A speculative risk on the other hand
involves
the prospect of gain or profit. New
business
ventures, purchase of shares,
investments -
all have the prospect of loss and
break-even
but we usually make these decisions
for the
prospect of gain. It follows,
therefore, that a
speculative risk has three possible
outcomes, loss, break-even or gain.
Which type of risk, pure or
speculative is considered insurable and
why?
Fundamental or Particular
The categories of financial or
non-financial and pure or speculative are
concerned with the outcome of
events. This classification relates more
to the cause and effect of risks.
In its simplest description,
fundamental risks relate to those risks
that affect large groups of people.
Particular risks conversely affect
individuals or small limited groups
of people.
Examples of fundamental risks include
widespread natural disasters,
(earthquake,
hurricanes, flooding, famine and the
like),
a national economic disaster or
social
upheavals.
Japan Earthquake 2011
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Examples of particular risk include
fire
in the home, motor accidents,
personal
injuries.
It is the effect of the risk that
distinguishes
between fundamental and particular.
A
severe economic recession, causing
mass unemployment in a region is
a fundamental risk. It has affected
a nation’s economy and all, or many
of its citizens. As individuals
however many of us face the possibility of
unemployment for whatever reason.
The individual’s prospect of such
unemployment is considered as
particular.
Since fundamental risks are caused
by conditions more or less beyond
the control of individuals who
suffer the losses and since they are not
due to the fault of any one in
particular, it is held that society rather than
the individual has responsibility to
deal with them – social insurance
should be for fundamental risks –
private insurance for particular risks
though some fundamental risks like
earthquakes are covered by private
insurance.
Risks can be summarized in the
following diagram:
Risk
Financial
Risk
According to
Effect
Personal
Risk
Property
Risk
Liability
Risk
Speculative
Risk
Particular
Risk
Pure
Risk
General
Risk
According to
Source
According to
Need
Non Financial
Risk
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1.3 - Insurable risks
So far, we have developed an
understanding of the meaning of risk,
that it broadly involves a lack of
knowledge about future events and
whether there will be a loss. From
discussions and examining categories
of risk, you will be aware that not
all risks are insurable.
For a risk to be insurable, a number
of factors need to be present.
Financial Any loss suffered must be
measured financially.
Pure Risks Generally only pure risks
are insurable i.e. a loss or
break-even situation.
Fortuitous Fortuitous essentially
means accidental and in this
context means that any event must be
outside the
control of the insured. It must be
accidental as far
as he is concerned.
Insurable Interest We have already
established that any loss must be
capable of being measured
financially. Insurable
interest means that the party
receiving the benefit
of the policy must be the party who
suffered that
financial loss.
See Module 2: Legal principles of
insurance; Section 2.2 for a more
detailed discussion of Insurable
interest.
A theft is not accidental; it is a
deliberate act by the thief but is accidental
or fortuitous to the victim.
A disgruntled ex-employee, recently
dismissed by his employer, returns
to his employer’s premises and
deliberately starts a fire. Can this be
considered accidental?
Your friend recently bought a new
car and is well known as a terrible
driver. You feel sure he will have
an accident.
Would you insure his car if you are
an insurance company?
Give reasons for your answer.
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It will be recalled that fundamental
risks relate to those which affect
large segments of the population and
particular risks relate to those
which affect individuals or small
groups of the population.
It cannot be stated with certainty
that either is insurable – some
fundamental and particular risks
are; but some are not. Fundamental
risks that satisfy the above
criteria are usually insurable. Earthquake,
storms, hurricanes and other natural
disasters are, in most cases
considered by the insurance industry
to be insurable.
1.4 - Uninsurable risks
It has been established that to be
insurable a risk should, be a pure
risk, be capable of financial
measurement, be fortuitous (to the insured)
and there must be insurable
interest. It follows therefore that risks
that are the opposite i.e. primarily
speculative, not capable of financial
measurement, are not fortuitous and
where there is no insurable interest
are uninsurable.
We will now consider other factors
that may make a risk uninsurable
but before discussing and
understanding these issues, it is important
to bear in mind that society and the
business world are not static
environments. Attitude and
circumstances change over time and what
is uninsurable today may well be
insurable tomorrow.
An example of this is the notion
that to be insurable there must be a
large number of similar risks as the
absence of large numbers mean it
is impossible to forecast losses and
therefore calculate premiums. This
notion held good for many years but
it lost support when there was a
demand to insure the Olympic Games
for the first time and also the
early space satellites. Clearly
there were not a large number of these but
insurance was possible, perhaps due
to the entrepreneurial nature of
the industry but it demonstrates how
attitudes change.
Public policy is essentially
anything that involves the interests of the
public or society as a whole.
Situations that may be legally valid but may
be ethically or morally wrong are
against public policy, as they are not
in the public interest.
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It is possible to arrange insurance
against the paying of certain fines
(fortuitous, financial, pure,
insurable interest). However, a feature of a
fine is punishment for breaking the
law and such an arrangement would
be against public policy and not
therefore allowed. It could encourage
people to break the law and the
deterrent effect (a warning to others
not to do the same) would be lost.
Encouraging people to break the law
of another, friendly country could
also be against public policy
Try to think of a situation in KSA
that you consider may be against
public policy.
Certain kinds of fundamental risks
are also uninsurable usually because
their financial consequences are so
huge that the insurance industry could
not possibly pay for the damage. War
on land is an example. Nuclear
disasters are another example.
Several countries felt the consequences
of Chernobyl and many are still
suffering from the effects, particularly
to agriculture today.
Another possibility is that the risk
of the loss occurring is so high e.g.
natural disasters in certain areas,
that premiums become unsustainable.
We cannot be too dogmatic concerning
fundamental and particular risks.
In general, fundamental risks arising
from social, economic or political
causes would not normally be
insurable. However, a fundamental risk
that is uninsurable may be insurable
as a particular risk.
An example of this is an economic
recession
causing widespread unemployment that
is
beyond the scope of the insurance
industry
and therefore uninsurable as a
fundamental
risk. However, an individual may be
able, under
certain circumstances to purchase
insurance in
the event of him, as an individual,
becoming
unemployed. This would be a
particular risk.
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Can you think of a situation arising
from a social, economic or political
cause that may be uninsurable?
1.5 - Insurance as a risk transfer
mechanism
We have examined risk and can now
turn our attention to the role that
insurance plays in risk. It must be
emphasised that insurance does not
prevent, remove or cancel risks.
Cars will still collide and buildings catch
fire, with or without insurance. The
role of insurance is to transfer the
risk from one party, the insured to
another, the insurer.
In 1601CE, (yes, 1601, over 400
years ago!) the UK passed an Act of
Parliament laying down rules for the
conduct of Marine Insurance. It
included the phrase:
“The loss of any ship….followeth not
the undoing of any man….but
the loss alighteth easily upon many
men….than heavily upon few.”
The language is old fashioned and
therefore difficult to read but the
sentiments expressed are the basic
rationale behind insurance. A single
loss, which may cause financial ruin
to an individual, is not a problem
when shared by several hundred i.e.
the losses of the few, shared by the
many.
When people purchase insurance, they
are buying a promise that if
certain events happen (accident,
fire etc) which causes them financial
loss, they will receive
compensation. If the event does not happen
then no financial compensation is
required. That promise gives peace
of mind that arises from financial
security. In exchange, for a small
known amount (the premium) the
insured avoids the possibility of
incurring a much larger unknown
amount that could cause financial
ruin.
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There were a community of 1000
families each have a home. They
decided if any home was burned they
will contribute in equal shares to
pay the price.
Who are the few?
Who are the many?
1.6 - Pooling of risk
Insurers pay the losses of the few
and share it among the many by
operating a pool system. Insurers
receive contributions, in the form of
premiums, from all those who wish to
join. They place the money into
a pool and from this pool they make
payments to compensate those
who have suffered a loss. In
addition to the losses, the pool must be
big enough to pay all the costs and
expenses of operating the pool.
In order for the pool to operate
successfully everybody who joins must
pay a fair and reasonable
contribution according to the risk they transfer
into the pool. This will depend
partly on the size of the risk (value of a
building for example) and the degree
of risk i.e. the possibility of a loss
occurring. A car driver with a poor
accident record would need to pay
more than one with a good accident
record. A house owner having a
house of superior construction will
pay less than the one having slightly
inferior construction.
Assessing the level of risk is the
responsibility of the underwriter and is
a concept discussed in more depth
later in the course.
Consider once again our community.
They decide that instead of
collecting contributions from each
owner after the damage; it would
be better to collect from everybody
on a regular weekly basis. That way
they will be more certain that there
is money available immediately if
there is damage.
Their problem was how much to
collect from each owner. What is your advice?
(Think about the size and degree of
risk.)
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landed 7 times head and only 3 times
tail. But toss it 100,000 times and
we can predict with greater
certainty that the outcome will be very close
to 50% heads and 50% tails say 55/45
or 56/44 etc. Toss it 1,000,000
times and the situation could be
51/49 or 52/48 etc. That is bigger the
sample, the greater the accuracy.
Applying this principle to insurance
enables insurers to predict more
accurately the future probability of
losses and the degree of risk
presented by contributors to the
pool. It also helps to explain why
insurers are willing to exchange
statistical information as the greater
knowledge is of assistance to
everyone.
To assist insurers in determining
the correct degree of risk and therefore
level of premium insurers make use
of the law of large numbers. This
simply states that the greater the
number the more accurately results
can be predicted.
If a coin is tossed in the air the
probability
of its landing heads or tails is
equal, 50/50.
Despite knowing this it would be
difficult
to accurately predict, the
percentage of
heads or tails if the coin is tossed
10 times.
It is quite possible that the coin
would have
Our community plan has proved very
successful. They are however
concerned because in a certain year
five homes will be damaged. One
of the owners suggested that they
should ask other close communities
to join their scheme.
What would be the advantages of
extending the plan?
Can you think of any disadvantages?
Another aspect when assessing the
level of risk is to consider frequency
(how often events happen) and
severity (how serious when they do
happen). Risks considered by
insurers are either high frequency with
low severity or low frequency with
high severity.
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High frequency /
low severity refers to
incidents that occur often
but individually are not
financially severe. Most
car accidents, thefts, or
house fires would fall
into this category.
Low frequency /
high severity refers to
incidents that do not occur very
often but when they do, they may have
serious financial consequences.
Natural disasters such as earthquakes,
hurricanes or tropical storms, a
petrochemical fire etc fall into this
category.
How do you think an insurance
company would deal with a risk that is
high frequency and high severity?
How would you deal with a risk that
has low frequency and low
severity?
How would you categorise aircraft
accidents in terms of frequency and
severity?
How would you categorise our
community?
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1.7 - Perils and hazards
We have seen how an insurance pool
operates and how insurers use
the law of large numbers and the
frequency/severity profile to help
determine the degree of risk.
Perils and hazards take this process
a step further and permit a scrutiny
of individual risks. A peril is
cause of loss whereas a hazard is a condition
– that may create or increase the
chance of a loss arising from a given
peril or under a given condition.
An example should make the
distinction clear. Fire is a peril; it is
something that can cause loss or
damage. Construction of a building
is a hazard that can influence the
extent of damage if there is a loss.
If we have two buildings, one
constructed of brick and the other of
wood. Clearly, the wooden building
is the bigger risk for fire insurance.
However, neither brick nor wood
will, themselves cause damage but if
a fire (the peril) starts then the
wooden building will, all things being
equal, suffer greater damage.
The construction is a hazard; it
will influence the outcome but will not
cause a loss, while fire is a peril,
which will cause a loss.
Think about perils (things that will
cause a loss) under each of the
following Policy and list under each
the hazards (things that will influence
the extent of loss or damage)
associated with that peril.
Fire Insurance on a factory building
Theft Insurance on a retail shop
Insurers divide perils into three
kinds; insured, excluded (or excepted)
and unnamed.
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Insured perils are those specifically
mentioned in the policy and states
when the insurance will operate e.g.
‘loss or damage caused by fire’. Fire
is an insured peril.
Excluded perils are also
specifically mentioned in the policy but state
when the insurance will not operate
e.g., ‘loss or damage caused by fire
excluding fire caused by explosion’.
So if an explosion causes a fire, the
policy will not cover the loss as it
is an excluded peril.
Unnamed are perils not mentioned in
the policy and usually they are
not covered.
Insurers also divide hazards into
three kinds – physical, moral and
morale hazards.
Physical hazards are relatively easy
to understand. They arise from the
physical aspects of a risk, such as
construction of a building mentioned
earlier. Probably several of the
hazards listed in your answer to the
previous question you can classify
as physical hazards.
Moral hazards arise from the
immoral, unethical or illegal conduct
of people, usually the person
insured but in the event of a business
enterprise, it could be the
employees or management.
Moral hazard is always more
difficult to detect
becauseitisnotphysicalortangibleandcannot
be touched or seen. Examples of
moral hazard
include dishonesty by the insured,
or people
who do not consider deliberately
inflating an
insurance claim as dishonest.
In liability situations, third party
claimants often exaggerate their injuries and
property damage and sympathetic
physicians, lawyers, body shops and contractors
may support these exaggerations and
increase the cost of the claims.
Morale hazard is an increase in the
hazards presented by a risk arising
from the insured’s indifference to
loss because of the existence of
insurance. In other words, Morale
hazard arises from the insured’s
attitude and this differs from Moral
hazard as there is no conscious or
malicious intent to cause a loss.
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Poor morale hazard may eventually
lead
to physical loss or damage. A
company’s
management and employees who are
untidy,
or who do not clean the factory
floor or do
not follow correct safety procedures
(obey no
smoking signs for example) or leave
machinery
unguarded are all signs of poor
morale hazard
that could eventually lead to an
accident. Their
attitude and behaviour have
increased the risk
of a peril starting. Morale hazard
acts to increase both the frequency and
severity of losses when such losses
are covered by insurance.
1.8 - Benefits of insurance
Module 1.5 determined that the primary
function of insurance is to
transfer risk, from the insured to
the insurer. To facilitate the risk
transfer two other functions, the
common pool and fair and equitable
premiums have to be in place.
Insurers gather together parties who
want to share similar risks and set
up a common pool to fund these
risks. Insurers do not operate a single
pool as the factory owner would not
want contribute to losses caused
by motor vehicle owners and vice
versa. There is therefore not one
pool but a series of pools, one for
motor, one for houses etc. Although
in reality there may be some
transfer of money between pools for our
purposes we can consider each
separately.
Individual risks introduced into the
pool are not identical, each has a
different degree of risk according
to their individual hazards and the
size of each risk may be different.
It is important that every contributor
should make a fair and equitable
contribution, according to the degree
and size of their risk.
The scheme started by our Committee
has proved very successful. In
fact, it is so successful that
factories in the area asked to join. If you
admit them what factors do you need
to consider when deciding on
their contribution?
Write your answer here.
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Insurance is therefore a method of
transferring risk supported by the
common pool and equitable premiums.
From this primary function, a
number of other benefits arise to
policyholders.
Peace of mind:
The premium paid is a known expense
but in exchange for this,
policyholders receive a promise that
if certain events occur they will
receive financial compensation. They
are exchanging a relatively small
known expense in exchange for the
possible avoidance of a larger
unknown expense.
This provides policyholders with the
principal benefit of insurance
often described as, peace of mind
because they are comforted by the
knowledge that if a disaster should
happen e.g. a fire destroying their
home or business, financial
compensation will be available.
Risk Improvement
Insurance companies often
combine their resources and invest
considerable sums of money in
trying to reduce both the frequency
and severity of losses. They invest
in and examine new methods
of loss detection, testing and
developing fire fighting equipment,
new methods of repairs, the use
of inflammable materials in consumer
goods, methods of car repairs,
crash testing and so on. This may be
done in conjunction with other
interested parties (e.g.
manufacturers, governments, fire fighters) and
sometimes independently.
They share this knowledge when
advising their policyholders on how
to avoid or minimise their risks.
This results in lower claims costs and
lower premiums. It also has the
added advantage that less claims means
fewer accidents and therefore less
personal suffering and any loss of
output is reduced.
022
Principles and Practices of
Insurance
If insurers had not taken such an
active interest in risk improvement
what do you think would have been
the outcome for: a) them, b) their
policyholders and c) society
overall?
As well as direct benefits to
policyholders, insurance also benefits the
business community as a whole.
Avoids capital retention
If there were no insurance available
then businesses would need to
take into consideration the impact
of losses and the cost of rectifying
them. Instead of exchanging a small
known amount (the premium)
they would need to set aside “just
in case”, capital that could be more
advantageously used to expand and
develop the business.
Encouraging new enterprises
Starting a new business requires
capital investment
often raised from investors or
banks. The assets
and future profits of a business are
usually the
security for investors who would be
reluctant to
invest if insurance was not
available. A fire could
easily make a business unprofitable
and a new
business is even more vulnerable.
Investments
As custodians of the pool insurers
have large amounts of money in
their care. There is a time
difference
receiving premiums and paying
claims,
which in the case of life assurance
can
be several years. The funds are not
left
idle but are available for
investment.
023
Principles and Practices of
Insurance
Insurers invest these funds in a
wide range of investments, from direct
equity investment in companies
(stocks and shares), loans made to
industry and governments, property
and fixed interest securities. The
small premiums paid by thousands of
individuals and businesses are not
idle but circulate in the economy
helping to stimulate national growth.
Why do you think investors may be
reluctant to invest into a new
manufacturing company if the
property was not properly insured?
We have looked at the benefits
insurance brings to policyholders and
the business community and it also
brings benefits to the national
economy.
Import/Export
Insurance is a commodity that, like
other commodities is traded between
countries and therefore a country
that sells insurance is exporting
and
a country that buys insurance is
importing. As an intangible product,
i.e. it has no physical presence; it
is
classified as invisible earnings.
Other
invisible earners include tourism
and
banking.
A major business investing heavily
in plant and equipment will want to
protect that investment. If the
state has either no insurance industry or
one that is inadequate, that
business will arrange its insurances overseas.
Hence, that country will be an
importer of insurance services. The
overseas country that is providing
or selling the insurance cover will
receive the premiums and therefore
be an export of the service.
024
Principles and Practices of
Insurance
Foreign Exchange
International deals will be done in
the
currency of exporting country. Many
countries have a currency problem
and
foreign exchange is a valuable
commodity
the sale and purchase of which may
be
controlled. An established and
financially
sound insurance industry that can
retain its own risks will assist those
countries by reducing the level of
foreign currency needed.
A small, undeveloped country has a
nationalised insurance industry and
all insurance must be placed with
the state owned company, the only
available insurer. They reinsure 99%
with international reinsurers. What
effect do you think this arrangement
has on the nation’s economy?
1.9 - Reinsurance
Having accepted the risk from their
policyholders, an insurance
company has an interest in spreading
the risks that they have accepted
and transferring some of it to
others. It may seem strange that insurers
accept risks then transfer them on
to another insurance company but
there are sound commercial and
financial reasons for this practice.
A broker offers an insurer a risk
from a client who already has several
large policies, but it considers the
risk too large or too hazardous to
accept. It wants therefore to
decline to accept the insurance. What are
the disadvantages to the insurers in
refusing to accept the insurance?
025
Principles and Practices of
Insurance
Instead of refusing the business, an
insurer could decide to accept
the risk and arrange to transfer
some of the risk to another insurance
company – a process known as
reinsurance.
It is important to remember that
there is no relationship between the
insured and the reinsurer. There is
a contract of insurance between the
insured and the insurer and a
similar arrangement between the insurer
and the reinsurer but there is no
legal or contractual relationship between
the insured and the reinsurer. In
fact, in most cases, the insured is not
aware that there is any reinsurance.
Factory
Ins A
Re-Ins B
Re-Ins C
Re-Ins D
As there is no relationship between
the insured and the reinsurer, what
do you think would be the financial
consequences for the Factory and
the Insurance Company A if the
Reinsurance Company C went into
liquidation and was unable to pay
any claims?
In addition to commercial
considerations, there are also financial reasons
for arranging reinsurance. Insurers
are custodians of the common pool,
which means that they are guardians
of the funds that belong to their
policyholders. They therefore have a
duty to safeguard that pool of
money and reinsurance is a way of
protecting the interests of their
policyholders and their pool of
money.
026
Principles and Practices of
Insurance
Peace of Mind
In the same way that a policyholder
secures peace of mind by buying
insurance, insurers have the same
objective. They would not want one
single disastrous event or bad risk
to jeopardize the common pool, which
would cause financial problems to
other policyholders. Reinsurance
achieves this objective by providing
protection, particularly against
catastrophic losses.
Underwriting Stability
A major expense for insurers is the
cost of claims and an individual
insurer would not like to have these
costs fluctuating wildly from year to
year. Reinsurance provides a method
of ensuring that the underwriting
results (premium minus claims equals
underwriting result) and the loss
ratio (claims ÷ premium) are stable
each year.
Underwriting Result
Underwriting Result
027
Principles and Practices of
Insurance
Consider the above figures of two
insurance companies. In which one
would you prefer to insure and why
do you think it is important that
an insurance company does not allow
its loss ratio and underwriting
results to fluctuate wildly from
year to year?
Reinsurance contracts are either
proportional or non-proportional.
Proportional means the insurer and
reinsurer share the risk, the
premiums and claims, usually on a
percentage basis. For example, the
reinsurer may agree to accept, say
25% of the risk receiving 25% of the
original premium and paying 25% of
all claims.
Non-proportional reinsurance means
that the insurers and reinsurers
do not share premiums and claims
equally. Typically, it involves a
deductible, usually quite
substantial that the insurer must pay before the
reinsurer will contribute to any
claim. For example, a reinsurance policy
issued with SR10M excess only
requires reinsurers to contribute when
a loss exceeds this amount.
Reinsurers agree to accept 15% of a
risk. If the premium received by the
insurance company is SR150M how much
reinsurance premium will
reinsurers receive?
Reinsurers agree to reinsurer all
losses that exceed SR15M. The insurance
company settles a claim for SR25M.
How much will they recover from
reinsurers?
There are two main forms of
reinsurance, facultative and treaty.
Facultative was the original method
of arranging reinsurance but today
the vast majority of reinsurance is
treaty.
028
Principles and Practices of
Insurance
Although a specialist reinsurance
broker can help, the process is still time
consuming, administratively
expensive and there is always uncertainty if
the reinsurance will be at
acceptable terms.
It may be required however when:
• The treaty is full
• The risk is outside the treaty
terms
• The risk is unusual
Facultative
Facultative is a French word that
means optional or by request and
insurers have to request facultative
reinsurance when they need it. This
means that the insurer has to
contact the reinsurer, give details of the
original risk, together with all
material facts concerning the risk. If the
reinsurer refuses or the terms are
too high, the insurer will need to find
another reinsurer.
Why do you think the time delay and
uncertainty cause problems for
the insurer?
Treaty
A treaty is an agreement between insurers
and reinsurers. Under the
treaty, reinsurers are obliged to
accept all the risks that are within the
defined limits of the treaty.
Treaties typically are signed for one year and
then if both parties agree can be
renewed. Reinsurers therefore agree
in advance to accept reinsurance
business given to them by the insurer.
The major benefit to insurers is
that they know they have reinsurance
protection and they know the cost of
that protection immediately they
accept a risk from a client.
029
Principles and Practices of
Insurance
The insurancecompany has a
treatywitha reinsurer inwhichthe reinsurers
agree to accept 25% of all fire
policies issued by the insurance company.
The reinsurer notices that the
insurance company has agreed insurance
on a particular term that they did
not wish to reinsure. Can the reinsurer
refuse to accept the reinsurance?
Give reasons for your answer.
1.10 - Co-insurance and
self-insurance
Co-Insurance
For the risk that is either too
large or too hazardous for an insurer
to accept, there is a second option
apart from reinsurance. Instead of
accepting 100% of the risk and then
arranging reinsurance the insurer
can accept a lower percentage of the
risk, an amount which is within its
capacity and the insured, or his
advisers will need to find another local
insurer (or insurers) to accept the
balance.
The insurers who share the risk,
usually along percentage lines are coinsurers
and the practice known as
co-insurance. It is a common practice
in many insurance markets and
usually involves the insurance of larger
risks, often arranged through an
intermediary, typically an insurance
broker.
The broker would probably prefer to
place all the business with one
insurer but if this is difficult, he
will arrange co-insurance. It will be his
responsibility to place the
insurance 100% and not leave the insured
with only partial cover. The broker
will also handle a great deal of the
administrative work.
The process usually operates by the
broker approaching an insurer
whom he thinks will want to do the
business. This first company decides
the premium and other terms, may
arrange an inspection and survey of
the insured’s premises, will issue
the policy and is the lead insurer. The
broker will then approach other
insurers who will have to decide whether
they are prepared to follow the
terms and conditions agreed by the lead
company. The broker continues until
the insurance is covered 100%.
030
Principles and Practices of
Insurance
It is important to note that each
insurer is in contract with the insured
but only up to his specified
percentage.
See Module 2: Legal principles of
insurance; Section 2.5 for a more
detailed discussion of Co-insurance
and Contribution.
Insured
Co-Insurer A 50%
Co-Insurer B 25%
Co-Insurer C 15%
Co-Insurer D 10%
If, in the case outlined above
Insurer ‘C’ went into liquidation what
effect do you think this will have
on the insured and on the remaining
three co-insurers?
Self-Insurance
Insurance provides peace of mind
because by transferring risk the losses of
the few are shared by the many and
therefore a loss that may be disastrous
for an individual is acceptable when
shared by several hundred.
There may however be circumstances
when an individual or business
may choose to retain the risk. This
is self-insurance and should not be
confused with no insurance. No
insurance occurs when a person or
business simply ignores the risk,
does nothing and does not arrange
to pay for any losses that may
occur. Self-insurance is a deliberate and
conscious decision to retain risk.
A business faced with a risk that it
considers small and well within
its financial ability may choose to
retain such a risk. The risk may
be low severity/low frequency but
even with high frequency, a wide
geographical spread may bring it
within their capacity to manage the
risks themselves.
031
Principles and Practices of
Insurance
The business may decide to
self-insure possibly by putting the equivalent
of the premium aside, which can then
be used to pay for losses. It
should save on the insurer’s
administration costs and premiums and the
funds could also generate a return
if invested sensibly.
A clothing store has 250 shops,
nationwide situated in all principal
towns and shopping centres. Each
shop has a plate glass front which if
broken would cost at least SAR5,000
to replace. Why may this company
choose not to insure?
What disadvantages, if any are there
in choosing to retain the risk?
See Module 4: The insurance market;
Section 4.1 for a more detailed
discussion of Captive insurance
company which is a type of self
insurance.
1.11 -How an insurance company
operates
The business models (see diagrams
below) for insurance companies,
whether general insurers or
protection and savings insurers, shows that
insurers seek to make a profit in
two ways: (1) through underwriting, the
process by which insurers select and
price the risks they insure, and (2)
from investment income arising from
the investment of the premiums
they collect from their
policyholders.
032
Principles and Practices of
Insurance
The General Insurance
Business Model - Cash Flow
In
OUT
Claims
Expenses
Return on Invested
Taxes
Premiums
Premiums Paid
Within these models are several key
operational functions. These
include:
1. Rate making:
Is the process of calculating the
premium for a risk so that the money
obtained by the insurance company
for the risk is adequate, reasonable
and not unfairly discriminatory.
See Module 3: Risk Underwriting;
Section 3.2 for a more detailed
information on the Rate making
process.
2. Underwriting
Selecting a risk and deciding the
price for the risk
See Module 3: Risk Underwriting for
a more detailed discussion of the
Underwriting process.
033
Principles and Practices of
Insurance
3. Production
(Sales and Marketing) – generating
new business
See Module 4: The insurance market;
Section 4.3 for a more detailed
discussion of the different
Marketing and Distribution channels.
4. Claim settlement
See Module 5: The need for documentation;
section 5.4 for a more
detailed discussion of Claim forms.
5. Reinsurance
6. Maintaining a fund
See Module 6: Regulation of the
Insurance Industry in the Kingdom;
section 6.3 for a more detailed
discussion on Maintaining funds.
7. Investments
See Module 6: Regulation of the
Insurance Industry in the Kingdom;
section 6.3 for a more detailed
discussion of Investments.
8. Distributing surpluses
See Module 6: Regulation of the
Insurance Industry in the Kingdom;
section 6.3 for a more detailed
discussion on Distributing surplus.
034
Principles and Practices of
Insurance
Progress Check
Directions: Choose the best answer
to each question.
1. Which of the following examples
is speculative risk?
a. A situation that has three
possible outcomes, either loss, break-
even or gain.
b. A widespread natural disaster
c. A situation which has only two
possible outcomes, loss or break-
even
d. A loss which affects only a few
people
2. Insurance deals with risk through
a system of
a. Risk prevention
b. Risk avoidance
c. Risk transfer
d. Risk removal
3. The law of large numbers assists
insurers because:
a. It helps to make reliable claim
predictions
b. It helps to determine overheads
c. It helps to make reliable income
predictions
d. It helps to forecast the level of
new business
4. To be insurable a risk must, as
far as the insured is concerned be
a. Speculative and fortuitous
b. Pure and fortuitous
c. Inevitable and pure
d. Speculative and inevitable
5. Insurable interest can be defined
as:
a. More than one insurance policy
covering same risk
b. Putting back the insured in same
financial position at inception of
policy
c. Putting back the insured in same
financial position just before the
loss
d. The person benefits from
insurance is the same person who suffers
the financial loss
035
Principles and Practices of
Insurance
6. Public policy can be described
as:
a. The financial relation with the
subject matter insured
b. The conditions in the policy
c. The laws of the country
d. The exclusions in the policy
7. What is meant by “a peril”?
a. Increase the damage
b. Decrease the damage
c. Cause the damage
d. Has no effect on the damage
8. What is meant by “a hazard”?
a. Affect the extent of damage
b. Cause the damage
c. Decrease the damage
d. Does not affect the damage
9. The difference between, moral and
morale hazards is that
a. Moral is intentional while morale
can be seen
b. Moral is intentional while morale
is unintentional
c. Moral is unintentional while
morale is intentional
d. All of the above
10. Why is it necessary for a risk
to be capable of financial measurement
before it can be considered as
insurable?
a. To be indemnified
b. To have insurable interest
c. To be pure risk
d. All of the above
11. What do you think would be the
effects on a nation’s economy if a
country had no insurance industry
but despite this allowed overseas
companies to invest?
a. It will be exporting insurance
b. It will be importing
c. It will support the local
currency
d. It will keep all the investment
inside the country
036
Principles and Practices of
Insurance
12. A factory is seeking insurance
for $100M on its buildings. Insurance
Company “A” accepts the risk and
reinsures with, “B”, “C”, “D” and
“E” who each take 20% of the risk. A
claim is submitted and agreed at
$10M. How much will company “D” pay
and whom will they pay?
a. 2M to the factory
b. 10M to the factory
c. 8M to company A
d. 2M to company A
13. The same factory approaches
insurance company “L” who will only
take 20% of the insurance but
insurance companies “M”, “N”, “O” and
“P” all agree to accept 20% each. A
claim is submitted and agreed at
$10M. How much will company “N” pay
and whom will they pay?
a. 2M to the factory
b. 10M to the factory
c. 8M to company A
d. 2M to company A
14. Mr. Ali buys a car. He does not
arrange insurance because he has
never heard of insurance. This is
example of:
a. Self insurance
b. No insurance
c. Retaining risk
d. Self risk management
15. The difference between
facultative and treaty reinsurance is:
a. Facultative is optional while in
treaty the reinsurer accept all the risks
that are within the defined limits
b. Facultative is less costly than
treaty
c. Facultative is usually for a year
d. All of the above is correct
16. What is The difference between
proportional and non-proportional
reinsurance?
a. Proportional is agreeing on a
certain amount while non proportional
is agreeing on a certain percentage
b. Proportional is usually treaty
while non proportional is facultative
c. Proportional
is agreeing on a certain percentage
while non
proportional is agreeing on a
certain amount
d. Non Proportional is usually
treaty while proportional is facultative
037
Module 2:
Legal Principles of Insurance
Module 2:
Legal Principles of Insurance
After studying this module, you
should be able
to understand the following legal
principles:
Utmost good faith
- define utmost good faith
- define a material fact and
describe its importance
- describe the consequences of
non-disclosure
or misrepresentation
Insurable interest
- define insurable interest
- understand when insurable interest
commonly
arises in different classes of
insurance
Indemnity
- define indemnity
- identify the policies that modify
indemnity
Subrogation
- define subrogation
- understand when subrogation is
applied
Contribution
- define contribution
- identify different methods of
contribution
Proximate cause
- define proximate cause
- distinguish between insured,
expected and
uninsured perils
After studying this module, you
should be able
to understand the following legal
principles:
Utmost good faith
- define utmost good faith
- define a material fact and
describe its importance
- describe the consequences of
non-disclosure
or misrepresentation
Insurable interest
- define insurable interest
- understand when insurable interest
commonly
arises in different classes of
insurance
Indemnity
- define indemnity
- identify the policies that modify
indemnity
Subrogation
- define subrogation
- understand when subrogation is
applied
Contribution
- define contribution
- identify different methods of
contribution
Proximate cause
- define proximate cause
- distinguish between insured,
expected and
uninsured perils
Principles and Practices of
Insurance
Introduction
Insurance developed several hundreds
of years ago in response to a
basic human need, to avoid hardship
and suffering. Since that time it
has grown into a major worldwide
industry and as it has developed, so
have a number of principles that
govern its workings.
In this module, we study the
insurance principles. This is an important
module because the principles are
the foundations for the business of
insurance as it is practised. A
proper understanding of these principles
will enable you to understand why
many insurance practices are done in
the manner they are done.
Utmost good faith is a legal
principle governing the formation of the
contract and we take another closer
look at insurable interest. Indemnity
and its supporting principles, subrogation
and contribution control how
much the insured can receive as
compensation and finally proximate
cause is used to assist in
determining the cause of loss.
The principles relate to all classes
of insurance, (Marine, Life and
General) although there are
variations in the way they are applied to
each.
040
Principles and Practices of
Insurance
2.1 - Utmost good faith
When buying a product, a car, TV
etc, the buyer can examine the goods
and the seller does not have to say
anything although any question from
the buyer must be truthfully
answered. The legal principle governing
such contracts is caveat emptor -
let the buyer beware - it is up to the
two parties (but mainly the buyer)
to ensure that they are satisfied with
the terms. Neither party is under
any obligation to volunteer any facts
or information to the other. This is
not the case with insurance.
In insurance, the insurer must rely
on the truthfulness and integrity of
the proposer. In return, the insured
must rely on the insurer’s promise
to pay future claims. Further only
one party (the proposer) knows all the
facts about himself and the ‘thing’
to be insured. Insurance is therefore
subject to a much stricter duty than
let the buyer beware it is the duty
of Utmost Good Faith.
Utmost Good Faith is a duty of
disclosure because each party must
voluntarily disclose all
information; they cannot remain silent. Utmost
Good Faith applies to both insurer
and insured although it is a more
onerous duty on the proposer.
An insurance company is aware that
the insured is entitled to a discount
on his premium, as he has made no
claims for the previous year. The
insured does not ask for his
discount and the insurance company
remains silent. Is this a breach of
the duty of utmost good faith?
Utmost Good Faith is a duty of
disclosure and all parties to the contract
are obliged to disclose all material
facts.
A material fact is defined as a fact
that would influence the judgement
of a prudent insurer in deciding
whether to accept a risk for insurance
and if so the terms and conditions
that should apply, e.g. premium,
conditions, deductibles etc.
041
Principles and Practices of
Insurance
The duty of disclosure begins at the
start of negotiations and continues
until the contract is in force.
After
that, both parties are subject to
the
terms and conditions of the
contract.
However, even if there were changes
after inception, the insured should
disclose them. Most policies contain
a condition that the insured must
disclose any alteration that increases
the possibility of loss. Even
without this condition, the insured should
disclose any such alteration because
the essential terms of contract
have altered.
Insurance contracts are issued for a
period of time, 12 months being
the most common. At expiry insurers
usually offer to renew the policy.
The terms and conditions may change
but even if renewal is on existing
terms, the renewal is a new
contract. The duty of utmost good faith,
therefore, revives at renewal and
both parties must voluntarily disclose
any changes.
A landlord takes out a fire policy
on his building. Two months after the
contract the tenant who used the
building as a warehouse for storing
groceries moves out and a new
tenant, who is using the building as a
garage and motor repair shop moves
in. Do you think the landlord
should notify his insurers of the
change in risk? Give reasons for your
answer.
A material fact is one that influences
the decision of the insurer to
accept or decline risks or continue
with an existing risk. Determining
exactly what a material fact is can
be difficult especially for proposers
who are new to insurance. A proposal
form normally asks for those facts
generally considered material by
insurers. However, if there are other
facts not covered by the proposal
then the proposer should voluntarily
disclose them; staying silent is not
an option. Many insurance companies
remind the proposer to disclose any
other information that may be
relevant to the insurance. The
general rule is, if in doubt regarding the
relevance, disclose the information.
042
Principles and Practices of
Insurance
Some of the information disclosed
will relate to the subject matter of the
insurance and these are primarily
physical hazards. Others relate to the
person taking out the insurance and
are primarily be moral hazards.
Facts that require disclosure include:
• A full description of the subject
matter of the insurance. The car,
property, liability etc.
• Any other policies covering the
same risk
• Previous insurances. Especially
relevant if an insurance company has
declined insurance or imposed
special or restrictive terms.
• Details of previous losses and
insurance claims.
• Any fact that increases the risk
from normal. For example, a car
engine modified to make it go
faster.
There are some facts that do not
need disclosing. These include:
• Facts of law. The assumption is
that everyone knows the law and
ignorance is not a defence.
• Facts of public or common
knowledge. This could include well-
known flood or crime areas,
earthquake zones, war areas, trade and
industrial processes.
• Facts that lessen the risk.
Additional fire or security precautions for
example.
• When further information has been
waived. If there is a blank or
inadequate answer on a proposal that
insurers do not follow up the
assumption is they have accepted the
position and cannot later rely
on facts they do not like.
A question on the proposal form
asks: ‘Have you ever suffered any
previous losses?’ The proposer
answers with a dash ( -). Later, when
investigating a claim, insurers
discover that the proposer had a history
of losses. Do you think they could
refuse to pay the claim? Give reasons
for your answer.
043
Principles and Practices of
Insurance
A breach of utmost good faith is
typically either non-disclosure i.e.
failing to disclose a material fact
or misrepresentation i.e. incorrect or
inadequate disclosure. A breach that
is a deliberate misrepresentation of
the facts may be fraudulent and
referred to as concealment.
The breach leaves the injured party,
typically the insurance company
with the option to:
• Cancel the contract from the
beginning – almost as if it never existed.
• Insurers usually discover breaches
at the time of a claim and refusing
to pay the claim is an option.
• Insurers may choose to charge
additional premium or impose
additional terms on the policy.
• They may choose to ignore the
breach and just continue with the
insurance.
Although unlikely, in the event that
the insured suffers a breach, he will
be able to recover any damages that
he has suffered.
Khalid bought an old building to
store his stock. The previous owner
told him that the building suffers
from flood damage from a nearby
river because every time it rained
the river flooded. He does not tell
insurers. Later the river floods,
stock damaged and a claim submitted.
Could insurers refuse to pay the
claim? Give reasons for your answer.
Insurable Interest means that the
person receiving the benefit of the
insurance policy must have suffered
a financial loss when the insured
item suffers loss or damage.
To emphasise the importance of
insurable
interest, in a fire policy, it is
not the building
that is insured but the insured’s
interest in
that building. This is insurable
interest and
is the legal right to insure.
Without insurable
2.2 - Insurable Interest
interest, an insurance policy
becomes invalid as it ceases to be an
insurance contract but almost a
gambling contract.
044
Principles and Practices of
Insurance
Note that the owner of the property
also has insurable interest and it is
possible for both parties to insure
these items.
It follows that a legal
relationship, between the person affecting the
insurance and the ‘thing’ being
insured, must exist. The most common
of these is ownership. Clearly if a
piece of property, car, house, camera,
watch, gold pen or whatever is
damaged the owner will suffer financially.
Consequently, the owner has insurable
interest in his property.
It is also possible to have an
insurable interest in property that is
not owned but is in another person’s
possession. Although with that
possession should be responsibility
for the property. Garages, laundries,
hotels, airlines, repair shops and
warehouses are just a few examples of
people who are in possession of
property not belonging to them but
because they are responsible for its
safety they have insurable interest.
You are leaving for a month’s
holiday touring Europe. You borrow
a camera from your friend. Do you
have insurable interest in the
camera?
We have referred to the ‘thing’
being insured and given property as an
example but the ‘thing’ can be an
individual’s life or limb. We all have an
insurable interest in our own life
to an unlimited extent but we can also
have insurable interest in the life
of others.
Being a relative does not
necessarily create insurable interest, as there
must be a financial loss on the
death of the life insured. There might
be emotional loss on the death of a
relative or close friend but not
necessarily a financial loss.
Families do however have insurable
interest in the life of the
‘breadwinner’; business partners may
have interest in each other’s lives;
a bank has insurable interest to the
extent of the amount of any loan
they make.
Insurable interest varies slightly
depending on the branch of insurance
- Marine, Life or General.
045
Principles and Practices of
Insurance
Marine
In marine insurance, there must be
insurable interest at the time a
loss occurs
and not necessarily at policy
inception.
The nature of marine business is
such
that goods can be in transit for
several
months and its ownership could
change
during the journey. Therefore, the
person who may have taken out the
insurance may not be the person who
suffers the loss.
Life
It has been established that in life
insurance insurable interest has
only to be
present when the policy is taken out
and
not necessarily when the loss occurs
- the
opposite of Marine Insurance. This
may
seem a strange position but is not
really
a problem. If for example a bank
requires a life policy as a condition
for a substantial loan, the debtor
takes out the insurance on his life and
names the bank as the beneficiary
for the proceeds. If the loan is paid,
the insured can simply change the
beneficiary, or cancel the insurance.
General Insurance
For all other policies, insurable
interest
must exist at policy inception,
during the
currency of the policy and when the
loss
occurs. If there is an absence of
insurable
interest when the insurance starts
then
the contract may be considered
invalid
and if there is no insurable
interest at the time of the loss then there
will be no loss to the insured.
2.3 - Indemnity
Indemnity in many ways is linked to
Insurable Interest. Insurance
contracts to be valid must have
Insurable Interest i.e. the insured must
suffer financially from the loss or
damage to the ‘thing’ insured but that
Insurable Interest is limited to the
financial interest.
046
Principles and Practices of
Insurance
An owner has Insurable Interest in
his own property but only to the
extent of the value of that property.
Recover more and he would be
financially better off after a loss
than before a loss. This would breach the
principle of indemnity and render
insurance a gambling proposition..
The Principle of Indemnity is to put
the insured in the same financial
position after a loss as he was in
immediately before the loss. In theory,
he should be neither better off nor
worse off but the same. In practice,
this is very difficult to achieve
but it does not detract from the basic
principle, which many consider the
foundation of insurance.
Indemnity is therefore the maximum
financial interest that the insured
has in the insured item. However, it
is not possible to place a monetary
value on a human life and we all
have an unlimited interest in our own
life and limbs.
Therefore, life insurance and
personal accident policies (excluding
medical expenses) are not policies
of indemnity and the principle of
indemnity does not apply to them.
If the insured is to be in the same
financial position after a loss as he
was before the loss, it is necessary
to establish the value of any items
lost or destroyed at the time of
loss.
Example:
Ali has a car model 2008 insured
with a comprehensive insurance policy.
He had a car accident that damaged
the head lights and the radiator
If Ali is given the new replacement
price he would be able to purchase
new items whereas before the loss he
had old items, so he would be
better off. To arrive at indemnity
it is necessary to make a deduction
from the new price to make
allowances for the age and previous use of
these items, known as wear and tear
and depreciation.
Indemnity should not include any
element of profit. Therefore, a
shopkeeper who has his stock damaged
should be indemnified with the
cost price to replace that stock –
it is not the selling price, which would
include his profit.
047
Principles and Practices of
Insurance
In liability insurance the amount of
indemnity would be limited to the
damages suffered by the third party
with his costs.
Having established Indemnity, the
insurance contract states that the
method of providing the Indemnity is
at the option of insurers. The
typical policy lays down four
options and insurers will normally elect
the option that is most convenient
and least costly to them.
Monetary payment
In the majority of cases, this is
the
most convenient method and insurers
reimburse the insured by cheque.
Repair
Insurers may arrange for a damaged
item to be repaired at their
expense.
Collision damage to motor vehicles
is a common example where insurers
arrange repairs. In some cases,
insurance companies own or have a
financial interest in repair shops,
which
help them to control costs.
Alternatively, they may receive discounts
from repairers due to the volume of
business.
Replacement
Insurers may choose to replace an
item that has either been lost or
damaged beyond repair. Glass
insurance, jewellery, house contents are
examples of replacement, again the
insurance company usually gets the
benefit of discounts for the volume
of business they supply.
Reinstatement
Reinstatement tends to refer to
buildings or
machinery and is similar to repair.
Insurers
may choose to undertake to rebuild
the
damaged building themselves. An
option
rarely exercised because of the
problems it
can cause insurers. They would
normally
expect the insured to arrange the
work and
limit their role to verifying that
the work is in order and within the
policy terms. They then reimburse
their insured.
048
Principles and Practices of
Insurance
A vehicle is damaged in an accident.
The insured takes it to a garage who
estimates the cost of repairs as
SR1,000. He submits a claim to his insurers
but due to their bulk purchasing
power insurers can have the vehicle
repaired for SR 850. The insured
states that he does not want to have the
vehicle repaired. He requests a cash
settlement of SR1,000. Does he have
the right to this? Who chooses the
type of compensation?
Indemnity is a principle
underpinning insurance but in order to satisfy the
needs of policyholders it must be
flexible. Insurers have policies that alter
slightly the strict principle of
indemnity but achieve the overall objective of
attempting to put the insured in the
same financial position after the loss as
he was immediately before the loss.
Agreed Value
In some cases it may be difficult to
assess the value of an item on the
day
of loss, especially if that item is
rare e.g.
an antique work, a master’s
painting. In
these circumstances, insurers offer
an
agreed value policy. In these
contracts,
the value to be paid in the event of
a
total loss is agreed at inception of
the
policy. Note only the total loss
value is
agreed, any partial loss would be
handled
in the usual manner e.g. cost of
repairs.
It does mean however that if the
value
changes between inception and loss
date
(which could be up to a year later)
the
agreed value that is paid may differ
from the indemnity value on the day
of the loss.
Agreed value policies are rarely
used in non-marine insurance but are
very common in marine insurance
where the value of cargo can fluctuate
during a long voyage and replacing
the goods may be difficult in view of
the time and distances involved.
049
Principles and Practices of
Insurance
A painting insured for SR100,000 on
an agreed value policy is destroyed
in a fire. Its value on the day of
the loss was SR75,000. How much will
the insured receive?
Give reasons for your answer.
First Loss
A situation may arise when the
insured feels the probability of a total
loss is so remote that full
insurance is not necessary. For example, in a
large warehouse containing heavy
goods it is unlikely that thieves could
remove all the contents in a single
loss. In these circumstances a first
loss policy, which permits less than
full value insurance, is appropriate.
The insured selects the amount they
feel is the
maximum they could suffer from any
one loss
and this becomes the first loss sum
insured and
is the maximum payable in respect of
any one
claim. The full value of the
property is noted
but only for information and to aid
in premium
calculation. It does mean that if
the insured has
made a mistake and does suffer a
loss in excess
of the first loss sum insured he
would not be
able to receive a full indemnity.
AlMuttahida have a first loss policy
for SR500,000 although they have
property valued at SR2M in their
warehouse. While closed during
a holiday period thieves break in
and remove property valued at
SR600,000. What is the maximum the
insurer can pay?
Give reasons for your answer.
In addition to these two types of
policy, many other policies contain
conditions that can affect the
amount the insured can receive as
indemnity.
050
Principles and Practices of
Insurance
Average
It was stated earlier in the course
that insurance is based upon the
common pool and that all
contributors must contribute to the pool
according to the degree and size of
the risk being introduced.
In the event that somebody
undervalues his property, he will not be
making a fair and equitable
contribution, as he will be paying less
premium than his risk demands.
Insurers, therefore, penalise the insured
for any underinsurance by reducing
his claim at the same proportion
that the sum insured is to the full
value.
Unless there is a claim the
underinsurance may not be discovered and it
will be too late to recover unpaid
premiums possibly going back several
years.
Example
If a shopkeeper insures his stock
for SR 50,000 but at the time of the
loss, the full value of his stock
was SR100,000 then the claim will be
reduced by the same proportion –
50%. If the claim was SR15,000 he
will receive SR 7,500. It can be
expressed as follows:
Replacing these with figures above:
If average applies then the insured
will not receive a full indemnity.
Al Ikhlas Foods has a fire policy
insuring their factory for SR1M. There is
a fire and the cost of repairs is
agreed at SR 240,000. The loss adjuster notes
that the actual value of the factory
at the time of the loss was SR1.5M.
How much can Al Ikhlas receive under
the terms of the policy?
Show your calculation.
051
Principles and Practices of
Insurance
For example, house insurance may
have a limit any one item or a limit
in respect of valuables.
Sums Insured
The sum insured is insurer’s maximum
indemnity and they cannot pay
more than this amount. In the event
the insured suffers a total loss
of a property that is underinsured
he will not receive a full indemnity.
However, some policies have sub
limits or inner limits.
Deductibles
Also known as ‘excess’
These are the first amounts payable
by the insured and are deducted
from any claim payment. Some
deductibles are voluntary, which means
that the insured has elected to have
the deductible usually in return
for a reduced premium. Others are
compulsory because insurers have
imposed them, usually to encourage
the insured to be careful.
Reinstatement
This condition simply states that
indemnity will be the full cost of
replacement without any deductions
for wear and tear i.e. he will receive
the value of new goods.
The condition is quite common in
policies covering commercial
buildings and machinery where
deductions in any event may be quite
small but where huge funds are
needed to continue the business.
The reinstatement condition is
available in house insurance policies and
referred to as ‘new for old’. The
reason is to avoid hardship when if the
homeowner loses a substantial part
of his home indemnity only cover
may not provide enough to refurnish
the home. Although not common
in KSA, in other parts of the world,
notably the UK almost every home
policy is on this basis.
Why do you think an insurance
company will give a discount from the
premium if the insured voluntarily
agrees to pay the first SR 2,500 of any
claim instead of 1500 SAR?
052
Principles and Practices of
Insurance
2.4 - Subrogation
Subrogation supports the Principle
of Indemnity and does not apply to
insurance policies that are not
contracts of Indemnity.
Identify two policies that are not
contracts of indemnity. Explain why
they are not contracts of indemnity.
The principle of indemnity is to
place the insured in the same financial
position after a loss as he was in
at the time of the loss. There are
circumstances, however, when an
insured has the possibility to claim
from more than one party. If he did
so successfully, he would receive two
payments and make a profit from his
loss. This breaches the principle
of indemnity.
Example: “A” is waiting in his
car at a red traffic light. “B” is
approaching the red light but failed
to apply break in time and crashes
into the rear of A’s car causing
serious damage. Fortunately, “A”
has an insurance policy that will
pay
for the repairs to his car. However,
he also has the option to make a
claim against “B”. What he cannot do
is make two claims, one against his
own insurance company and the
other against B’s.
In this example, if A chooses to ask
his insurance company to pay his
claim (which is the sensible option
as “B” may not be willing to pay
him) then the insurance company can
act in Ahmed’s name and try to
recover from “B” (or his insurers).
This is the principle of
subrogation, and means that an insured cannot
recover his loss a second time from
another party if his insurer has
settled his claim. Those rights of
recovery pass to the insurer.
053
Principles and Practices of
Insurance
Subrogation exists as a right but
only after the Insurers have settled the
claim. Many claims can however take
several months if not years to settle,
very serious fire claims for example
or major bodily injury. Insurers would
not want to wait before attempting a
recovery neither would they want
their insured to start actions that
could spoil their chances of success.
Insurance policies, therefore, have
a policy condition that states insurers
may pursue a claim against another
party in the insured’s name before
payment. Effectively insurers can
start recovery actions immediately
after they are aware of the loss.
In addition to legal rights against
a negligent party, Subrogation rights
can also happen under a contract
e.g. tenancy or warehouse agreements.
A breach of a contract term may
entitle one party to compensation. If
appropriate, these rights could pass
to insurers.
Following a theft from Ahmed’s shop,
his insurers pay him SR 5,000
in full indemnity. The thief
following his arrest repays to Ahmed the
SR 5, 000 he has stolen. What should
Ahmed do with the SR 5, 000?
In the same example above, the
insurers pay Ahmed only SR 3,000
whereas the sum insured under the
policy is SR 5,000 as Ahmed is unable
to substantiate his claim for full
amount. The Police, however, recovers
full amount from the thief and
passes on the same to the insurers as they
hold the subrogation rights.
What should insurer do with the SR
5, 000?
When insurers agree to pay a total
loss
claim, e.g. when a car is so badly
damaged
that repairs are impossible, there
may
be some salvage value in the damaged
property. As the insured has
received a
full indemnity, if he kept the
salvage he
would be in an improved position.
054
Principles and Practices of
Insurance
Therefore, the rights in the salvage
pass to insurers as part of their
subrogation rights.
Adel’s car is irreparable following
an accident. Its value is SR100, 000
and he receives this from his
insurers. A dealer says he can break up the
old car for spare parts and offers
Adel SR10, 000 for the wreck, which
Adel accepts. Should Adel keep the
money?
Insurers have subrogation rights
only in respect of losses for which
they have provided an indemnity. If
there are uninsured losses such as
loss of wages, car hire then the
insured can still attempt to claim these
from the third party.
In many of the larger insurance
markets insurers enter into agreements
not to recover from each other. The
reasoning is the principle of
‘swings and roundabouts’ (what we
gain on the swings we lose on
the roundabouts and the result is
stalemate). This is due to the large
number of claims and consequently
the large number of times insurers
are trying to recover from each
other. It becomes more cost effective
not to recover.
In some countries, in Motor
insurance, the insurers have an agreement
called «knock for knock» under which
each insurer pays the claim for the
motor vehicle under their policies
and refrain from proceeding against
the insurer of the opposite vehicle.
2.5 - Contribution
If an insured takes out two
insurance
policies covering the same risk, he
would have dual or double insurance.
To allow recovery from both
insurance
companies would breach the principle
of indemnity. Contribution is
similar
to subrogation; it exists to support
the
Principle of Indemnity and like
Subrogation, applies only to contracts
of indemnity.
055
Principles and Practices of
Insurance
Dual insurance is not usually intentional
but may happen through a
misunderstanding. Examples include:
• The company secretary and
financial manager both believing it is
their responsibility to deal with
the company’s insurance.
• The owner of goods and the owner
of the warehouse both insure
goods stored in the warehouse.
• Cover under two policies overlap
e.g. holiday insurance and a house policy.
Insurers allow for dual insurance by
a contribution condition in their
policies, which states that in the
event of more than one policy they will only
pay their share. This is the
contribution or other insurance condition.
The share that each insurer agrees
to pay is their rateable proportion
of any loss. There are two methods
of calculating an insurers’ rateable
proportion, based on either sums
insured or independent liability.
Sums Insured Method
In this method, the contribution to
be paid by each insurer is calculated
by apportioning it according to the
sums insured under each policy.
Each insurer pays according to the
formula
Example
Policy “A” has a sum insured of SR
100,000.
Policy “B” has a sum insured of SR
400,000
The loss is SR10,000
Therefore: Policy “A” pays
Policy “B” pays
Insured Receives SR 10,000
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Principles and Practices of
Insurance
The method is adequate for property
insurance when the policies in
contribution are identical in the
cover they provide.
Independent Liability Method
The alternative method is suitable
for policies that are not identical;
they may include deductibles, loss
limits or when average applies. They
are also suitable for non-property
policies e.g. liability insurances.
The independent liability is arrived
at by calculating how much each
policy would have paid had it been
the only policy issued. Each policy
is calculated and then the claim is
apportioned according to the total of
independent liabilities.
The formula is:
Example
Policy “A” has a sum insured of SR
100,000 and a deductible of SR 500.
Policy “B” has a sum insured of SR
400,000 and a deductible of SR 1000
The loss is SR 10,000.
Independent Liability of Policy “A”
is SR 9,500 (10,000-500)
Independent Liability of Policy “B”
is SR 9,000 (10,000-1000)
Policy “A” pays
Policy “B” pays:
Insured receives SR 10,000
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Principles and Practices of
Insurance
The correct method is the one that
is most appropriate for the
circumstances.
Similar to subrogation, larger
insurance markets have agreements on
contribution. The method to use,
when contribution is not appropriate
(if less than a certain amount only
one insurer will pay), which policy
should take preference. A policy
that is more specific would pay first. For
example, if one policy covers
jewellery and another a diamond ring. If
the policies are in contribution
then diamond ring is more specific than
jewellery. The diamond ring policy
will pay and not seek contribution.
2.6 - Proximate Cause
When a loss occurs before making
a decision concerning settlement, it
is necessary to determine the cause
of the loss. In the majority of
cases,
there is one cause of loss but there
are occasions when there is more
than
one event. In these circumstances,
the rules of proximate cause assist
in determining the cause of loss.
After establishing the cause, it is
necessary to interpret the policy wording
to see if the loss is insured or
not. The cause will fall under one of the
following three headings:
An Insured Peril
This is a peril specifically
mentioned in the policy as covered by the policy. A
fire policy will specifically
mention that losses caused by fire are insured.
An Excluded Peril
This is a peril specifically
mentioned in the policy as not covered. A
fire policy specifically mentions a
fire caused by an earthquake is not
covered.
Other Unnamed Perils
These are perils not mentioned in
the policy. If the cause of loss is an
unnamed peril, it is not covered.
The fire policy does not mention the
peril of theft. It is therefore
neither an insured nor an excluded peril but
simply an unnamed peril.
058
Principles and Practices of
Insurance
An earthquake knocks over a burning
oil-stove. The building catches fire
which spreads to the adjacent
building. A third building 5000 meters
away catches fire due to wind
blowing in that direction. The owners of
the third building submit a claim.
The policy covers fire (an insured
peril) but not losses caused by
earthquake (an excluded peril).
Do you think insurers should pay the
claim or does the exclusion apply?
Give reasons for your answer.
If there is a series of events there
must be a direct link between the
cause and resulting loss. Each
action should be the natural consequence
of the previous with nothing new
intervening to change the effect. The
proximate cause is not necessarily
the first or the last cause but is usually
the dominant cause. The cause that
has set in motion a chain of events
that results in a loss.
Khalid falls from his horse and
breaks his leg. Unable to move he remains
alone for several hours, exposed to
the cold weather, eventually catches
an infection and dies. He had a
policy that insured against accidental
death but not death caused by
illness. Do you think insurers should pay
the claim?
In order to determine the answer we
need to identify the proximate
cause of the loss. Is it an insured
peril (fall from the horse) or an excluded
peril (the infection).
What do you think? Remember the
proximate cause is the one that sets
in motion a train of events without
any new and intervening event.
059
Principles and Practices of
Insurance
Consider now the same circumstances,
but this time Khalid’s riding
companion is able to call for
assistance and Khalid goes immediately
to the hospital. Several days later,
still in the hospital Khalid catches an
infection and dies.
What do you think is the proximate
cause? What is different from the
question above? Has something new
happened?
Ahmed is cleaning windows in the
third floor of building. He suffers a
heart attack and falls down from the
third floor and dies.
Ahmed’s family claims under personal
accident policy.
What do you think is the proximate
cause? Is the claim payable?
Consider now the same circumstances;
Ahmed is cleaning windows in
the third floor of a building. He
slips from the ladder and falls down.
Due to shock he suffers a heart
attack and dies.
What do you think is the proximate
cause? Is the claim payable?
060
Principles and Practices of
Insurance
Progress Check
Directions: Choose the best answer
to each question.
1. Utmost Good Faith can be defined
as:
a. The financial relationship
between the insured and subject matter
b. The right to claim from third
party
c. The duty of disclosure of all
material facts
d. All of the above
2. Indicate which of the following
is correct. Utmost Good Faith applies to:
a. The proposer only
b. The insurance company only
c. Both the proposer and the
insurance company
d. Non of the above
3. A Material Fact is the fact that:
a. Should not be disclosed
b. Affect the premium
c. Affect the conditions
d. Affects the decision of the
underwriter to accept or reject the risk
4. The age of the policy holder is a
material fact in:
a. Fire policy on a building
b. Theft policy on a retail shop
c. Private car policy
d. Contractors all risk
5. In the proposal of comprehensive
motor insurance; some of material
facts that may help an underwriter
assess moral hazard
a. The model of the car
b. The usage of the car
c. The age of the proposer
d. The previous losses
6. Insurable Interest can be defined
as:
a. The financial relationship
between the insured and subject matter
b. The right to claim from third
party
c. The duty of disclosure of all
material facts
d. All of the above
061
Principles and Practices of
Insurance
7. Indicate when Insurable Interest
must exist in General Insurance?
a. At the beginning
b. During the policy
c. At the time of loss
d. All of the above
8. A shopkeeper has 1000 pairs of
shoes in stock. He buys them for SR50
each and sells them for SR100 each.
How much should he insure them?
a. 1000
b. 5000
c. 50000
d. 100000
9. Following a fire, damage amounts
to SR15,000 in respect of stock
insured for SR100,000. The loss
adjuster advises that the value of stock on
the day of loss was SR150,000. How
will insurers calculate the settlement?
a. (100,000/150,000) *15,000
b. (150,000/100,000) *15,000
c. (100,000/15,000) *150,000
d. (150,000/15,000) *100,000
10. A policy has a SR1,000
deductible. A loss is agreed at SR10,000.
How much will the insured receive?
a. 1000
b. 9000
c. 10000
d. 11000
11. Define Indemnity.
a. The financial relationship
between the insured and subject matter
b. The right to claim from third
party
c. The duty of disclosure of all
material facts
d. Putting back the insured in the
same financial position before the loss
12. What are the options available
to provide Indemnity?
a. Paying cash
b. Repair
c. Reinstate
d. All of the above
13. Who has the authority to choose
the option of indemnity?
a. The policyholder
b. The third party
c. The insurance company
d. None of the above
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Principles and Practices of
Insurance
14. The difference between
‘Indemnity only’ cover and ‘Reinstatement’
or ‘New for Old’ cover is:
a. In reinstatement there is no
deductable
b. In indemnity there is no
depreciation
c. In reinstatement there is no
depreciation
d. In reinstatement there is large
deductable
15. Following a claim insurers pay
SR100,000 to the policyholder and
allow him to keep the salvage valued
at SR10,000. How much can they
claim from the third party?
a. 10,000
b. 90,000
c. 100,000
d. 110,000
16. A loss agreed at SR10,000 but
after allowing for the deductible
insurers pay SR 9,000 to the
insured. How much can insurers claim
from the third party?
a. 1000
b. 9000
c. 10000
d. 11000
17. What principle does Contribution
and Subrogation support?
a. Insurable interest
b. Indemnity
c. Proximate cause
d. Utmost good faith
18. Proximate Cause is the:
a. First cause
b. Last cause
c. Main cause
d. Physical cause
19. What is the purpose of Proximate
Cause?
a. To determine the indemnity amount
b. To determine the deductable
c. To determine if the loss is
covered
d. All of the above
063
Module 3:
Risk Underwriting
Module 3:
Risk Underwriting
After studying this module, you
should be
able to:
- Understand the proposal form
- Identify the three main function
of an
underwriter
- Understand what is a warranty and
deductable
- Describe the role of surveyor
- Understand the maximum probable loss
and
relation to reinsurance
Principles and Practices of
Insurance
Introduction
It is the duty of the underwriter to
decide whether to accept a risk
and if so on what terms. In this
module, we look at the steps taken by
an underwriter and how he gathers
information in order to reach that
decision.
Previous modules discussed the duty
of utmost good faith, the
importance of material facts and
explained physical and moral
hazards. In this module we refer
again to these subjects, place them
into a practical context and their
importance to the underwriter when
he assesses the risk.
The use of proposal forms, brokers’
slips and surveys to obtain
information are considered. Finally,
we look at how an underwriter
presents a quotation.
066
Principles and Practices of
Insurance
3.1 - Material facts
It is the job of the underwriter to
decide whether to accept a risk
for insurance and if so he must then
decide the applicable terms and
conditions. In order to do this he
needs all material facts.
See Module 2: Legal principles of
insurance; Section 2.1 for a more
detailed discussion of Material
facts.
Do you remember the definition of a
material fact?
Amaterialfactisanyfactthatincreases
the risk or makes it more hazardous
than others in a similar category.
It is
also any fact that has a bearing on
the
morals or character of the insured
or
his manager or employees
Without all material facts, the
underwriter is unable to fully
assess the risks presented to him. The
importance of material facts in the
insurance contract cannot be
underestimated and failure to
disclose will have serious consequences.
What are the options available to an
insurance company who
subsequently discovers that their
insured has failed to disclose a material
fact?
The duty of disclosure applies
equally to both proposer and insurers
but the duty is more onerous for the
proposer who must disclose all
material facts without being asked.
In practice, although this may not
be a problem for a larger commercial
organisation, clearly an individual
taking out insurance for the first
time cannot possibly know those facts an
underwriter would consider material
and those which are immaterial.
067
Principles and Practices of
Insurance
Insurance companies therefore ask
the appropriate questions, typically
in a proposal form to obtain those
facts they consider material. The
point remains however that without
full disclosure of material facts it is
not possible to accurately assess
the risk. If a proposer is in any doubt
as to whether a fact is material or
not the advice must be to disclose the
information.
2.1 listed types of fact that the
proposer must disclose and types of
fact that he need not disclose. For
ease of reference, those lists are
repeated here.
Facts requiring disclosure include:
• A full description of the subject
matter of the insurance
• Any other policies covering the
same risk
• Previous insurances
• Details of previous losses and
insurance claims
• Any fact that increases the risk
from normal.
Facts not requiring disclosure
include:
• Facts of law
• Facts of public or common
knowledge
• Facts that lessen the risk
• When further information has been
waived.
In deciding whether a fact is
material or not the type of insurance is
relevant. The age of the proposer is
material for life assurance (older
person) but is not relevant to fire
insurance on a building.
068
Principles and Practices of
Insurance
Using the above as a guide decide,
giving your reasons, whether the
following facts should be disclosed
or not.
Age of the proposer (Motor):
Existing medical conditions (Medical
Expenses):
Installation of a new fire sprinkler
system (Fire):
Age of the proposer (Fire):
Outstanding loan on a car (Motor):
Type of stock (Theft):
Distance from the nearest police
station (Fire):
The proposer’s claims record
(Motor):
3.2 - Physical and Moral Hazards and
the use of Warranties
After gathering the material facts
the underwriters’ first decision is
whether to accept the risk or not.
Some types of risk, possibly because
of a particular trade or type of
property or location may be unacceptable
to an individual underwriter.
If the risk is acceptable, the next
decision of the underwriter will
be to decide on the terms he will
offer. In making this decision the
underwriter will consider the physical,
morale and moral hazards
presented by the risk.
See Module 1: Risk and Insurance;
Section 1.7 for a more detailed
discussion of Moral and physical
hazards.
069
Principles and Practices of
Insurance
Explain hazards and the difference
between physical hazard, morale
hazard and moral hazard.
In deciding terms, the underwriter
must ensure that the insured makes a
fair and equitable contribution to
the common pool. The underwriter will
have an average rate for a
particular risk, often referred to as the ‘book’
rate based on the many years
experience of underwriting that particular
class of business. To this book
rate, he will make adjustments to take into
consideration the good and bad
features of a risk.
As an example, the fire book rate
for office building is 0.1% but if a
particular building has a car
parking area, with a small workshop where
the insured stores petrol. The
storing of petrol is clearly hazardous for
fire insurance. To take this risk
the underwriter might increase the rate,
to say 0.15%. However, if the
building has adequate fire extinguishers
the underwriter might then reduce
the rate, by say 10% making the net
rate 0.135%. By adjusting the rate,
the underwriter makes allowances
for the bad and good features of a
risk.
The underwriter, therefore, adjusts
the rate of premium to recognise the
differences that an individual risk
has from the standard or normal risk
for that class and consequently the
contribution the insured makes to
the common pool. The terms, however,
are not just the premium to be
paid. There are occasions when no
amount of additional premium will
compensate for a bad risk. Another
option available to the underwriter
is to impose an excess (also known
as a deductible).
An excess is the first amount
payable by the insured towards any claim.
The insured pays for any claim up to
the specified amount of the excess
and the excess is deducted from all
claims that exceed it.
If a loss is agreed at SR750.00 but
there is SR100 excess then the insured
will receive SR650.00 (750-100 =
650). A loss of SR 75.00 will be borne
by the insured himself because it is
below the excess.
070
Principles and Practices of
Insurance
A policy has an excess/deductible of
SR 2,000. How much will the
policy pay for the following claims?
a) SR 500
b) SR1, 500
c) SR 2,100
d) SR10, 500
Excesses are particularly useful for
eliminating small claims, which can
be administratively expensive to
deal with and of course, the excess
reduces the size of all claims, even
large ones.
If the underwriter decides to impose
the excess as part of his terms
for accepting the insurance, this is
called compulsory excess. There
are occasions, especially for
personal insurances when the insured may
request an excess in return for a
discount from the premium. This is
known as voluntary excess.
In trying to ensure that the insured
makes a fair and equitable contribution
to the pool of premiums for the risk
introduced the underwriter can
amend the premium rate and decide
whether to apply an excess as part
of the terms for accepting the risk.
There is a third option - that of
imposing a warranty on the insured.
The use of warranties by an
underwriter is a valuable part of his
overall terms. It enables him to
ensure that good features of a risk are
maintained throughout the period of
a contract. It is also valuable in
controlling poor physical hazards.
The office building referred to
earlier had
petrol stored in a small workshop.
The
underwriter may decide he wants to
limit this
hazardous feature of the risk by
restricting
the amount of petrol kept on the
premises.
He will do so by including the
following warranty in the policy: It
is warranted that the quantity of
petrol in the workshop other than in
parked vehicles shall not exceed 50
litres at any one time.
071
Principles and Practices of
Insurance
The insured received a discount on
the rate because of his fire
extinguishers. The underwriter will
want to ensure that these are working
satisfactorily and are in place
throughout the insurance period. He may
therefore include the following
warranty:
It is warranted that
fire-extinguishing
appliances kept on the premises are
maintained in efficient working
order
during the currency of this policy.
In the event that the insured breaks
either
of these warranties (by exceeding 50
litres
of petrol or if the fire
extinguishers are
not maintained properly) the
insurance
contract itself is jeopardised.
A warranty is a condition written
specifically into an individual policy
stating that:
• Either a certain state of affairs
does or does not exist
Or
• That something shall or shall not
be done.
The warranty when applied to
insurance contracts is a condition that
goes to the heart of the contract.
Insurers consider a breach extremely
serious and a breach of a warranty
makes the whole contract avoidable
at insurer’s option.
A breach can reflect the attitude of
the insured that ignores or breaks
rules that can lead to physical
damage. Therefore, a breach could allow
insurers to avoid payment under a
policy even if the breach is not
relevant to the loss suffered. If
our office owner keeps too much petrol
or fails to service his fire
extinguishers, his insurance contract will be in
jeopardy.
However, unless there are other
factors involved most reasonable
insurance companies do not avoid
paying claims when the breach has
no connection to the cause of the
loss.
072
Principles and Practices of
Insurance
Breaching a warranty gives insurers
the option to repudiate a claim and
possibly cancel the whole contract.
Insurers rarely enforce the option to
cancel but why do you think the
penalty for breaching a warranty can
be so severe?
The underwriter when assessing the
risk wants to ensure that the
insured makes a reasonable contribution.
He also needs to ensure that
any hazardous features of the risk
are under control and good features
maintained. The main terms that he
can use to achieve these objectives
are the premium, excess and
warranties.
Far more difficult for the
underwriter is the assessment of moral hazard.
In an individual risk, it is the
conduct of the person insured. The dishonest
person who may make a fraudulent or
exaggerated claim clearly presents
a greater moral hazard than the
honest person. However, recognising
this in advance can be difficult and
so can the decision whether an
exaggerated claim is dishonest or
merely a negotiating tool.
In addition to the individual,
social attitudes can be important. There
may be sectors of a society that,
possibly because there is no personal
victim, do not regard cheating
insurers as dishonest.
Morale hazard in a business
organisation can be recognised by the attitude
of management and employees.
Premises that are untidy, lack supervision or
where the insured ignores safety
rules suggest an attitude from management
or employees that they will not
respect the insurance rules.
There is an overlap between morale
and physical hazard as poor morale
hazard may lead to increasing the
physical hazard that can cause or
increase the size of a loss. A no
smoking rule not enforced can lead
to a discarded cigarette starting a
fire. Untidy premises can cause
accidents and injuries to employees
or visitors. Safety rules leading to
overcrowding or machinery not
guarded correctly can cause damage.
The losses are physical but all
originate from the insured’s attitude and
poor morale hazard.
073
Principles and Practices of
Insurance
A motor proposal form indicates that
the proposer has a history of
minor accidents. Could the cause of
these accidents be poor morale
hazard?
3.3 - Proposal forms and broker’s
slips
Offer and acceptance are essential
ingredients in an insurance
contract.
The proposal form is the most usual
way the offer is made by the Insured
and the insurance company obtains
information about the risk. They
are usually designed in order to
present the information in a convenient
and easy to understand format that
can speed up the underwriter’s
work. They will provide information
concerning the physical hazards
and clues as to the moral hazard.
There is a variety of proposal forms
issued by all companies covering
a whole range of policies and
therefore their look and appearance can
differ greatly. Questions however,
usually fall into two types those that
that are general in nature, name,
address etc and those that relate to
the insured risk. We shall
categorise proposal forms between personal
insurance and commercial insurance.
Personal policies are those issued
for individuals e.g. private car,
house, travel etc. General questions
will relate to the proposer and will
include:
• Name, age, address, occupation
• Details of previous insurance
policies
• Details of previous losses or
claims
• Whether any other insurance
company has refused to give cover
The answers to these questions will
help to build up a ‘picture’ of the
proposer.
Other questions will refer
specifically to the type of insurance. Examples
include:
074
Principles and Practices of
Insurance
Private Car
• Vehicle details
• Driving experience of proposer
• Details of other drivers
• Use of the vehicle
House Insurance
• Location of property
• Value
• Construction
Commercial policies are those issued
for businesses.
General questions may include:
• Business name and postal address
• Business locations
• Exact description of trade
• Details of previous insurances
• Previous losses and claims
Examples of specific questions
include:
Third Party/Liability Insurance
• Contracts entered into
• Estimated turnover or sales
• Limit required
• Details of any machinery used
Theft
• Nature of goods
• Details of locks, bolts etc
• Value of goods
• Unoccupancy times of premises
After completing the form, the
insured will sign and date the form. As
part of the form, he will also be
signing a declaration at the foot of the
form. The declaration is an
important part of the form as it confirms
that the information supplied by the
proposer is true and correct usually
to his best knowledge and belief.
075
Principles and Practices of
Insurance
Many proposals also contain a
warning regarding the duty of disclosure.
It may be part of the declaration or
more prominently included
on the form. The note contains a
warning as to the importance of
disclosing all material facts,
defines a material fact and suggests that
if the proposer is in any doubt as
to whether a fact is material or not
he should disclose it.
Whilst the majority of insurances
require the completion of a proposal,
there are times when they are not
used. In larger fire risks, the details
may be so complex that it would not
be possible to provide all details in a
single form. Many insurers therefore
do not use them, whilst others will
always ask the insured to sign the
form as it includes the declaration.
A proposer submits a proposal form
with all questions properly
answered. He encloses full payment
of the premium and requests that
cover starts immediately. You note
that the proposer has not signed the
form. What action would you take?
Marine insurance developed at
Lloyd’s of London and the practice at
Lloyd’s is not to use a proposal
form but for the broker to present
details on a broker’s slip. Today,
apart from small pleasure boats it is not
common practice to use proposal
forms for marine insurance.
The use of the broker’s slip has
grown and it is now usual for brokers to
present larger commercial business
to insurers on a slip. The broker a is
full time insurance professional and
is aware of the information needed
by the underwriter to prepare a
quotation. The broker’s slip will contain
all the necessary details including
possibly even a guide to the rate and
conditions they expect.
A simple broker’s slip for the
previously mentioned office building may
look as follows:
076
Principles and Practices of
Insurance
Professional Insurance Brokers Ltd
Quotation Slip
Proposer ABC Property Company
Business Building Owners
Period of Insurance 12 months from
1.1.2002
Cover required Fire
Location 125 High Street, Anytown
Sum Insured SR100M
Description 5-storey office block
built 1995
Occupation Rented as offices to some
10 tenants
Previous Claims None
Previous Losses None
Other Information Underground car
parking for 50 cars
Includes storage area for petrol
Fire extinguishers located on each
floor
Rate Please advise
Commission Normal terms apply
If the business is accepted,
insurers may choose to accept the slip and
dispense with the requirement of a
proposal. When presenting the
information the broker is acting as
the agent for his client.
A broker’s slip states that the
insured has never suffered a previous loss.
The insurance is prepared based on
the information contained in the
slip. Later the investigation of a
claim reveals that the insured has had
previous claims, although he states
that he advised the broker. What is
the position of:
a) The Insurance Company
b) The Insured
c) The Broker
077
Principles and Practices of
Insurance
3.4 - Surveys
In respect of a simple personal
insurance a proposal
form may provide sufficient
information to enable the
underwriter to assess the risk and
make his decision as to
whether to accept the risk and if so
the terms to apply.
For larger risks and where possible
for the majority of
commercial insurances a survey is
required.
The surveyor is often referred to as
the eyes and ears of the underwriter,
he will visit the premises to be
insured and complete a report to be
submitted to underwriters to assist
him to assess the risk.
The reasons for requesting surveys
include:
• To obtain a full description of
the risk. Particularly if the proposal is
inadequate for this purpose.
• To check that the details on the
proposal are correct.
• Assess the physical hazards.
• Assess the morale hazard. Looking
for such features as employee
attitude, tidiness, and cleanliness.
• Recommendations on risk
improvement and loss prevention.
The shape of the report will depend
largely on the complexity of the
insurance. An insurance company may
have pre-printed short survey
forms covering most lines of
business for smaller risks. The surveyor will
simply complete this in much the
same way that the insured completed
his proposal form. For larger risks,
the surveyor may need to prepare
a written report. Whether it is a lengthy
printed report or a short form
the information in the report will
contain the following:
• A full description of the risk.
This may include a plan of the premises,
photographs, type of work
undertaken, details of neighbouring
buildings.
• An assessment of the level of
risk, taking into account all the physical
and morale hazards.
• An opinion on the management or
housekeeping at the insured’s
premises.
• Recommendations on loss
prevention.
• Adequacy of the insurance
requested to ensure that it is reasonable
and not too high (over insurance) or
too low (underinsurance).
078
Principles and Practices of
Insurance
Underinsurance is a problem for
insurers because it means the insured
is not contributing sufficient funds
to the common pool for the risk he
is introducing. Slight over
insurance is being cautious but insurers view
excessive over insurance with
suspicion. Why do you think this is so?
The underwriter’s job is in three
parts. We have already discussed two of
them (first whether to accept a risk
and then the terms), the third aspect
is how much of the risk to retain
for his account and how much to
reinsure. To help make a decision he
will rely on his surveyor’s opinion
of the worst possible scenario; the
maximum loss that can be suffered
from one single event.
This maximum loss from any one event
is the MPL (Maximum Probable Loss)
or sometimes the EML (Estimated
Maximum Loss). It is a very important
figure to enable the underwriter to
complete his job and an important aspect
of the surveyor’s report is his
opinion on the amount of EML.
The sum insured is insurer’s maximum
liability and
they can never pay more than this
amount but the
EML may be lower than this. If for
example, the
insured owns two buildings each
insured for SR1M
then the total sum insured and
insurer’s maximum
liability is SR2M. However, if the
two buildings
are in separate locations, insurers
cannot suffer a
total loss on this policy from one
event: a single fire
cannot destroy both buildings. The
surveyor may
estimate the EML at SR1M. The
underwriter will decide his retention
based on the EML of SR1M and not the
total sum insured of SR2M.
TheEMLisimportantindecidingthereinsurance
arrangements. If the surveyor
estimates the
EML too high then the insurers will
retain less
risk than warranted and reinsure the
balance thus
paying more towards reinsurance
premiums. If
he estimates it too low then insurer
will retain more than warranted i.e
expose themselves to a higher risk
and possibly a claim in excess of their
capacity though reinsurance outgo
will be less.
079
Principles and Practices of
Insurance
An insured owns a building valued
and insured for SR10M. He advises
that he has purchased the
neighbouring building that is identical. He
adds the second building to his
policy making two buildings each
insured for SR10M and a total sum
insured on the policy of SR20M.
How do you think this will affect
the rate? Will it:
a) Increase
b) Decrease
c) Stay the same
Give reasons for your answer
An underwriter’s job is in three
parts. What are they?
3.5 - Quotations
On receipt of all the facts, an
underwriter is in a position to assess the
risk. He will decide his terms and
the next step to effecting cover is to
offer his terms to the proposer as a
quotation. The proposer or his broker
may have approached several insurance
companies for quotations.
The quotation by insurers is an
offer that if the proposer accepts creates
a contract. It is important
therefore for the underwriter to prepare his
quotation accurately, as it may be
difficult to alter or correct any errors
at a later stage.
If the proposer accepts the
quotation then insurance cover is in force
from the inception date required on
or after the date of receipt of
premium. However, circumstances
change and a quotation must be valid
for a fixed period, typically 30
days but could be less. At the end of this
time, the quotation is invalid and
the underwriter has the opportunity
to change the terms.
080
Principles and Practices of
Insurance
What could the consequences be if an
insurance company issued a
quotation with no date and no time
limit?
It must be emphasised that there is
no cover in force during the period
of the quotation. This is simply the
time allowed for the proposer to
decide whether to accept the
underwriter’s quotation.
If the quotation is acceptable,
cover will be in force from the required
date and insurers will make steps to
issue a policy. This may take several
days but cover is in force during
this period. The policy is the written
evidence of the contract; it is not
the contract and is not a prerequisite
for insurance.
If the insured requires evidence of
the insurance, perhaps for a
contractor, bank or employee then
insurers issue a cover note. This is
a document confirming that cover is
in force. It may be a simple letter
from insurers or a more formal
document. Once the policy is prepared
and issued, the cover note is no
longer necessary.
To prepare the quotation accurately
would require a completed proposal
form and a survey but for commercial
reasons insurers may need to
prepare quotations before these are
completed. The underwriter will
prepare the quotation but with
conditions attached.
The underwriter will offer the
quotation but ‘subject to completion of
a satisfactory proposal’ and if, the
underwriter feels the risk requires a
survey (almost certainly for any
reasonable sized commercial risk) he
will add ‘subject to completion of a
satisfactory survey’.
081
Principles and Practices of
Insurance
A quotation for ‘office’ owners
could look as follows:
New World Insurance Co Ltd
To: Professional Insurance Brokers
Ltd
Date: 5th December 2001
Quotation No 1234/ABC
Proposer ABC Property Owners Ltd
Business Building Owners
Period of Insurance 12 months from
1.1.2002
Cover required Fire
Location 125 High Street, Anytown
Sum Insured SR100M
Description 5-storey office block
built 1995
Occupation Rented as offices to some
10 tenants
Previous Claims None
Previous Losses None
Fire Rate .135%
Rate Subject to 1. Satisfactory
Proposal Form
2. Satisfactory Survey
Warranties 1.Max 50 litres petrol
(excl in parked cars)
2. Fire appliances serviced and
maintained
Commission Standard
Quotation Valid for 30 days from
date of issue
If the subsequent survey or proposal
reveals any unsatisfactory aspects,
the underwriter has an opportunity
to change his terms. If the insured
asks for immediate cover i.e. before
the proposal or survey is completed,
the normal practice is to hold covered
but again subject to the proposal
or survey being satisfactory.
082
Principles and Practices of
Insurance
An insurance company issues a
quotation that the proposer accepts.
Insurers issue the policy and later
the insured submits a claim. Realising
they have no proposal the company
request one. On arrival, there are
several unsatisfactory features.
Do you think insurers have any
grounds for refusing to consider the
claim? What should they have done?
Write your answer here.
083
Principles and Practices of
Insurance
Progress Check
Directions: Choose the best answer
to each question.
1. If the insurance company surveys
the premises this will:
a. relieve the insured of the duty
of good faith
b. lower the deductable
c. lower the premium
d. none of the above
2. Which of
the following is not a material fact
in relation to
comprehensive motor insurance?
a. Chassis number
b. Make and model of the vehicle
c. Value of the vehicle
d. Number of children the proposer has
3. Which of the following documents
provides an underwriter with a
fast, effective and convenient
method of obtaining material facts?
a. Quotation
b. Proposal Form
c. Policy
d. Certificate of insurance
4. An insurer issues a quotation on
15th January, which the insured
accepts with cover to commence on
1st February. A loss occurs on
29th January but the insured does
not inform the company as the loss
happened before cover started. After
paying the claim, the insurers
discover that the loss occurred
before inception.
What action can insurers take?
a. No action cause they already paid
b. They can ask the insured to pay
back the claim to them
c. Cancel the policy
d. None of the above
5. Why do insurers use warranties?
a. To decrease the deductable
b. To control bad hazard and
maintain good ones
c. To determine the premium
d. To determine the conditions
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Principles and Practices of
Insurance
6. What is the difference between a
voluntary excess and a compulsory
excess?
a. Voluntary excess is chosen by the
policyholder while compulsory by
the underwriter
b. Voluntary excess is chosen by the
underwriter while compulsory by
policyholder
c. Compulsory excess is more than
the voluntary
d. There is no difference
7. The main function of the surveyor
is to:
a. Decide the premium
b. Put the warranties
c. Visit the site to be insured and
report to underwriter
d. Give advices to reduce the risk
8. EML (Estimated Maximum Loss) is:
a. The maximum loss in one year
b. The maximum loss in one claim
c. Less than the sum insured
d. Greater than the sum insured
9. When does insurance cover
commence?
a. During the period of the
quotation
b. After paying the premium
c. After accepting the quotation
d. From inception date after
accepting the quotation
085
Module 4:
The Insurance Market
Module 4:
The Insurance Market
After studying this module, you
should be
able to:
- Discuss the operation and
structure of
insurance market
- Identify the different types of
insurance
companies
- Identify the different types of
intermediaries
- Identify the types of insurance
buyers
- Outline the different distribution
channels
used for buying and selling of
insurance
Principles and Practices of Insurance
Introduction
A market is broadly defined as a
place where buyers and sellers meet
to exchange goods and services.
Insurance is a market and although
there may be no physical meeting
place it is still a market where
buyers and sellers are brought
together often with the assistance of
intermediaries.
In this module, we shall examine the
structure of the insurance market
and the different groups of buyers,
sellers and intermediaries that
together make the market place.
Reinsurers’ role in the market is also
considered
Finally, we shall look at the role
played by other parties who supply a
service to the insurance industry.
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4.1 - Components of the insurance
market
A market is where buyers and sellers
meet to conduct business but
this does not necessarily have to be
a physical meeting place. Modern
technology has made communications
between parties much easier and
business is done at a time and place
more convenient to everyone.
The insurance market includes three
publicly known groups with a
fourth group known primarily by
those within the industry.
The three publicly known groups are
the buyers of insurance, the
intermediaries (middlemen), and the
sellers of the service, collectively
known as insurers. The fourth group
are the reinsurers who support
insurers.
In this section, we shall become
familiar with the sellers or providers of
insurance, the insurers. The most
well known are insurance companies,
who provide insurance to the public.
These are classified according to
their ownership structure or type of
business written.
Proprietary Companies
Shareholders who have either supplied
the share capital or purchased
shares in the company own
proprietary companies. It is to the
shareholders that any profits
belong, in the form of dividends. The
shareholders would however endure
the cost of any losses and could
lose their entire investment.
Mutual Companies
Policyholders own mutual companies
and who share any profits, usually
either a bonus (mainly life
assurance) or lower premiums for other types
of insurance.
Specialist/Composite
A specialist insurance company
(either mutual or proprietary) is, as its
name implies one that specialises in
a particular class of business. A
composite company on the other hand
is one that deals with all, or
certainly the majority of classes of
business.
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Let us take a look at the concept of
self –insurance, when a business
will make a conscious and deliberate
decision to retain risk for itself. In
order to facilitate this process a
business enterprise may form a captive
insurance company.
A parent company, typically a
substantial national or multi-national
organisation, will form a subsidiary
captive insurance company to insure
its own risk. Originally, designed
as a tax efficient method of retaining
risks, though many of the original
tax incentives have closed they are
still a very popular method of
self-insurance for a company.
The captive insurer is not
registered as an insurance company (even though
it may have the title in its name)
and cannot do business with the public.
Trading sectors of the parent
company pay premiums to the captive
who issue policies and deal with
claims as a commercial insurer. Like a
commercial insurer, it will also
protect its fund by using reinsurance.
Lloyd’s of London
A unique institution Lloyd’s began
as
a marine insurer in the 1600’s. At
that
time, Edward Lloyd’s coffee house in
London was a meeting place for
people
generally interested in shipping
that
gradually became a centre for marine
insurance. They increasingly wrote
other classes of business and in 1871,
Lloyd’s Corporation was set up to
govern and administer their affairs.
Lloyd’s is not an insurance company
and does not itself transact business.
It provides the facilities
(building, administrative support etc) for its
members who transact business. For
many years, these were individuals,
operating on an unlimited liability
basis, who formed themselves into
syndicates. The syndicate would
appoint an underwriter to accept
risks on behalf of the syndicate. At
one time Lloyd’s had some 30,000
individuals (known as names) grouped
into some 400 syndicates.
Following a series of disasters in
the 1980s and early 1990s, a large
number of these names lost their
life savings. In some cases, family
fortunes built up over several
generations were lost. Since that time the
number of names have reduced and
Lloyd’s have allowed corporate
members with limited liability to
join.
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It is a feature of Lloyd’s that it
does not deal directly with members of the
public. They only accept business
from Lloyd’s brokers (insurance brokers
who have been approved by the
Council of Lloyd’s) and only Lloyd’s
brokers are permitted on to Lloyd’s
trading floor (known as the ‘room’)
Lloyds website: www.lloyds.com
The State
In many territories the state will
also act as an insurer. This may be because
insurance is a nationalised industry
or where the state has declared a
certain type of insurance compulsory
(workmen’s compensation or
third party motor for example) and
then insures that class of business.
There are several other examples of
types of insurers but these are
formed due to legislative or tax
consideration in particular countries.
Friendly Societies, Mutual Indemnity
Associations, Industrial Life are
examples from the UK of insurers who
exist because of a tax and
legislation advantages.
In any typical market place, sellers
compete with each other for business.
Think of a market with which you are
familiar e.g. local vegetable market,
a market for consumer goods, say a
TV or newspapers. List the various
methods that the suppliers of these
goods use to attract customers.
Now consider the suppliers of
insurance. Do they use the same methods
you have outlined above or do you
think there are differences?
Buyers of Insurance
Buyers of insurance are usually
classified into two broad groups, private
individuals and commercial
organisations. The needs of each group
are different and the types of
policies arranged for each group are
different.
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Private individuals usually referred
to as personal insurances or personal
lines and the bulk of the market is
in respect of private motorcars and
houses insurance.
Other insurances in this sector
include travel, life and personal accident.
Individually the premiums are not
large but together the personal lines
market can produce a large volume of
business.
It is however the commercial sector
that supply the bulk of the premium
income for insurers. Most insurance
companies are organised on the
lines of personal and commercial
with possibly the commercial sector
sub-divided according to size or
type of insured.
A third category occasionally used
is that of public bodies or not for
profit organisations. These
organisations provide a public or voluntary
service, charities, government
departments, schools, hospitals, sports
clubs etc.
What do you think is the advantage
to insurers of classifying buyers
into personal and commercial?
4.2 - Intermediaries
Introduction
In general, the term agency
describes a situation when one party (the
principal) authorises another party
(its agent) to act on its behalf. The
rights and duties of each party are
subject to the law of agency. In
insurance, the term agent has a
different meaning and therefore to avoid
confusion between the insurance
agent and the general law of agency
it has become customary to use the
term intermediary when referring
to insurance.
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It is quite possible and in many
cases
quite common for buyers to go direct
to an insurance company and purchase
insurance. They will consider and
decide
their insurance requirements, find
the
correct insurer and negotiate
accordingly.
Others may decide they need someone
to act on their behalf, provide
impartial
advice, and consequently visit an
insurance intermediary.
The intermediary is a middleman
whose role is to bring buyers and
sellers together into a contractual
relationship. He receives payment in
the form of commission deducted from
the premium that is payable to
the insurer. Although insurers pay
the commission and it is with insurers
that he may have a close and long
term professional relationship, it is
the insured who is the client and
the insured for whom the intermediary
is acting.
One of the problems when considering
the intermediary sector of the
market is its fragmentation, with a
variety of people doing the role and
many with different titles although
they may be effectively doing the same
job. Brokers, consultants, agents
and advisers are titles intermediaries
may call themselves. Some countries
have tried to regulate this sector
of the market by using legislation
to control who may use titles or who
may perform certain functions.
Intermediaries in KSA
The implementing regulations of the
Saudi Arabian Cooperative
Insurance Companies Control Law have
defined the participants in this
sector into three types.
SAMA is still introducing the
regulations and their impact on the
structure of the market is unknown.
Before the regulations, it was a
fragmented sector comprising
Brokers, Agents, Consultants and others,
many of whom are professional but
others less so and simply using the
title to give themselves status.
Within the industry professional could
recognise each other but to the
insuring public their competence is
unknown.
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Brokers
Traditionally an insurance broker is
an individual or firm whose full
time occupation is insurance. Use of
the term broker implies that
they are holding themselves out to
be experts in insurance. They are
knowledgeable about insurance and
can give independent and impartial
advice to a policyholder on their
professional needs. They know the
insurance companies in the market
and which offers the most appropriate
product for their client’s need at
the most favourable terms.
In KSA there are local companies
operating nationally often with
international connections and they
compete with multi-national
companies who operate in many
territories and employing several
thousands of staff. The larger multi
nationals have in excess of 50,000
employees, over 500 offices in more
than 120 countries and enjoy
revenues in excess of US$8Billion.
The regulations make it clear that a
broker is representing his client
whose interests should be of primary
importance.
Agents
Traditionallyaninsuranceagentiseitherafulltimesalespersonrepresenting
a single insurance company or a part
time insurance salesman who has
other business interests that
provided an opportunity to sell insurance.
Typical would be the car dealer who
sells a car and insurance to go
with it. Estate agents, accountants,
legal personnel are other examples.
These part time agents normally
confine their activities to introducing
the business; they do not claim to
be experts in insurance and will not
offer guidance except in the most
general way
The new regulations make it clear
that an insurance agent represents
the insurance company and can only
give advice on, or recommend the
products for that one company.
Advisor
The regulations introduce the
advisor as someone who provides
consultative services. Brokers and
agents receive a commission on the
products they recommend to the
policyholder but it appears that this
category of insurance service
provider will be paid by charging a fee,
based on the service provided for
giving consultation and advice that
may not necessarily result in the
purchase of an insurance product.
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Your friend has asked your advice
about buying insurance. He wonders if there is
any advantage in visiting a broker.
What would you reply?
4.3 - Distribution channels
The distribution channel of a
product describes the methods used
to bring a product from its
manufacturer to the final consumer. In
insurance, the ‘manufacturer’ is the
insurer and in order to distribute
his product there are two principal
routes; either, direct to the consumer
or indirect, using intermediaries.
Each has their benefits and drawbacks.
Some companies prefer to deal with
one method exclusively whilst
others use a combination of the two.
Direct Business:
Direct business involves the insurer
selling his product direct to the
insuring public without any
independent intermediary being involved.
A traditional method of direct
selling is to employ a direct sales force and
although paid on a ‘commission only’
basis, they are employees of the
company. This system is very popular
especially with life assurance.
There has been a great expansion of
direct business in the last decade
or
two mainly in personal lines
business.
Improvements in communications
and the use of computers makes it
possible to do business from a
central
processing office (a call centre)
with
quotations and cover given instantly
over the telephone. These direct
companies pay no commission but need
to advertise heavily. This type
of business is mainly suited to
personal lines insurance, primarily car
and house insurance.
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Principles and Practices of
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Indirect Business:
Intermediaries introduce business to
the insurance company in return
for which they receive commission.
The insured receives the benefit of
independent and impartial advice
from the broker who will place the
business with the company that
offers the best terms and conditions for
his client’s business. The broker
may also assist his client in dealing with
claims or any other problem with the
insurance. Intermediaries, usually
insurance brokers arrange the
majority of commercial business.
The insurer will have to pay
commission to the broker but has no
major advertising expense. The
relationship with the broker can be long
standing and because the brokers are
themselves professionals, insurers
can entrust a great deal of the
administrative work to them.
Many brokers do not wish to handle
too much personal lines insurance,
as the individual premiums can be
relatively small for work involved.
With the improvements in technology,
the trend has been for personal
business to be handled direct and
commercial insurances indirect. This
trend may continue as the future
makes communication easier in the
form of WAP mobile telephones,
Interactive Digital TV, the Internet
and whatever else the future may
bring.
Why do you think that direct
business is more suited to personal lines
insurance e.g. private car insurance
than to commercial business?
Reinsurance
Reinsurers are part of the supply
chain
as they support and extend the
supply
of insurance. They accept business
only
from insurers, i.e. insurance
companies
(including captives), Lloyds and
other
reinsurers, often dealing through an
intermediary, the reinsurance
broker.
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Principles and Practices of
Insurance
Reinsurers may be a specialised
reinsurance company i.e. they do not
transact business with the insuring
public. Insurance companies also act,
as reinsurers, through either a
separate division or subsidiary company.
Lloyd’s syndicates are also active
in reinsurance.
Reinsurance also has a ‘jargon’ of
its own such as retrocession, cedant,
ceding office. (See Glossary for
explanation of these terms). Reinsurance
is an international business and
risks shared in many parts of the world
by co-reinsurers are spread over
several reinsurance companies.
Insurance operates because it shares
the losses of the few by the many by
transferring risk. How does
reinsurance fit into this broad concept?
4.4 The role of ancillary players in
the insurance market.
We have looked at the insurance
market and the various roles
of the parties involved in the
industry -the buying public,
intermediaries, insurers and
reinsurers. There are also other
businesses working in the
industry, not directly involved
with the supply of the product
but providing services and
support to the industry. We shall
consider the principal ones.
Actuary
Actuaries use mathematical and
statistical techniques to solve business
problems by predicting future
events. They have been used in life
assurance for many years but are
more and more being used in general
branch insurance.
Companies may employ actuaries or
use the services of an external
actuarial consultancy company.
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Loss Adjusters
Loss adjusters are employed by
insurers to handle and process claims
on their behalf.
Some companies employ loss adjusters
to
handle the majority of their work
and others
prefertohandleallclaimsinternally.However,
even these companies will need the
services
of a loss adjuster at some stage
either for a
particularly large claim that
requires detailed
investigation and negotiation or
when there
are a large volume of claims to be
dealt with.
A loss adjuster specialises in
insurance claims. He will investigate the cause
of the loss, check that policy conditions
have not been breached, negotiate
with the insured and make a final
recommendation, which should be fair
and reasonable to both the insured
and insurers, for settlement.
Loss adjusters hold themselves to be
independent but insurers who
appoint them pay their fees.
Loss Assessors
Loss assessors are appointed by the
insured to prepare, present and
negotiate a claim on their behalf.
It is the duty of the loss assessor
to negotiate the maximum entitled
settlement under the terms and conditions
of the policy and to provide
support to the claimant during the
processing of a claim. He is paid by the
insured usually based on an agreed
percentage of the final settlement.
As far as it is known, there are no
loss assessors operating in the Kingdom
although the service of assisting in
the preparation, presentation and
negotiation of a claim may be
offered by some intermediaries.
Risk Management:
Industry and commerce employ risk
managers although insurance
brokers may offer a risk management
service on a fee basis. There are
three steps in risk management,
first risk identification followed by a
risk analysis and finally risk
control.
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Principles and Practices of
Insurance
The first stage is to identify the
risks that a business enterprise is exposed.
This could be physical, financial or
monetary. Having identified the risk,
it will be analysed possibly using
past data, examining the frequency and
severity profiles, and trying to
predict the future outcome. Finally, the
risk manager will try to control the
risk preferably by eliminating it (e.g.
changing work practices) reducing it
(locks and bolts to prevent theft)
or by transferring it (insurance).
Risk management and insurance are
closely linked but insurance is only
one option available to a risk
manager when deciding on risk control.
Insurers employ loss adjusters to
investigate claims and loss assessors
by policyholders to prepare and
present a claim on their behalf. They
operate in only area i.e. they are
either a loss adjuster or loss assessor. It
would be unusual for one business or
person to work in the area of the
other. Why do you think this is so?
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Progress Check
Directions: Choose the best answer
to each question.
1. The company owned by its
shareholders is a
a. proprietary company
b. mutual company
c. reinsurance company
d. captive company
2. The company who insures insurers
is a
a. proprietary company
b. mutual company
c. reinsurance company
d. captive company
3. The company that distributes its
surplus profits to its policyholders is
known as a
a. proprietary company
b. mutual company
c. reinsurance company
d. captive company
4. The company that does not provide
insurance to the general public is
called a
a. proprietary company
b. mutual company
c. reinsurance company
d. captive company
5. What is the difference between a
specialist company and a composite
company?
a. Specialist deal with one type of
insurance while composite in many
b. Composite deal with one type of
insurance while specialist with one
type
c. Specialist cannot be mutual
d. Composite cannot be captive
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Principles and Practices of Insurance
6. What is the difference between a
broker and an agent?
a. Broker deal with one insurance
company while agent with many
b. Broker deal with many
policyholders while agent with one
c. Broker deal with many insurance
companies while agent with one
d. Broker deal with one policyholder
while agent with many
7. Insurance may only be placed at
Lloyd’s through a Lloyd’s
a. Agent
b. Underwriter
c. Loss adjustor
d. Broker
8. An insurer doing only direct
business will claim to have lower costs
because;
a. They pay no commission
b. They do not advertise
c. They pay lower salaries
d. They take less reserves
9. A loss adjustor:
a. Assesses the financial impact of
future uncertain events
b. Investigates claims on behalf of
insurers
c. Prepares and presents a claim on
behalf of an insured
d. Advises a manufacturer on safety
and loss control
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