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) but although the outcome may have some financial implications,
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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Principles and Practices of Insurance
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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Principles and Practices of Insurance
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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Principles and Practices of Insurance
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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Principles and Practices of Insurance
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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Principles and Practices of Insurance
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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Principles and Practices of Insurance
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.
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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.
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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.
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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?
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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.
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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
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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.
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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.
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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%.
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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.
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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.
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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.
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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.
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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
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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
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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
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