Insurance

Insurance is a major pillar of the practice of risk management and of the financial services industry.  Most models of risk management follow a cycle through Risk Identification to Risk Evaluation to Risk Control, Elimination or Transfer. The primary function of insurance is to act as a ‘risk transfer’ mechanism.

Insurance is a big subject and covers many specialist areas.  It is almost impossible to do justice to the topic within the confines of one single Module.  This Module represents something of a compromise.  Our aim in this Module has been to serve the needs of a student with limited knowledge of the industry and to provide such a student with a clear grasp of general principles and a familiarity with some of the detail of practice.  This will be set within the context mainly of the UK marketplace and take notice of the current trends and changes being faced by the industry (with some consideration of how this mirrors changes taking place internationally).

•    Demonstrate a systematic understanding and application of knowledge in relation to the professional practice of insurance.

•    Evaluate the current problems of the insurance industry and of debates regarding their resolution.

•    Apply an understanding of established techniques of research and enquiry to evaluate critically current research in the discipline of insurance.

Topic

1.    Risk financing and management

2.    The role of insurance in risk management
Elements and principles of insurance

3.    The nature of insurance companies and the insurance market

4.    Forms and types of insurance

5.    Law and regulation of insurance in a global context

6.    Underwriting and pricing of general and life insurance

7.    The insurance claims process

8.    The international insurance market and contemporary issues

9.         Assessed presentations

All of Topics 1 – 8, with the exception of Topic 6, represent one week’s study. Topic 6 represents two weeks’ study. At the end of each topic there are a number of self-assessment questions. You should attempt these and then check your responses against what is in the recommended reading and any additional reading that you have done. Some of the questions have no right or wrong answer, but they require you to form an evidence-based view on a particular aspect of insurance.

Critically evaluate the role of insurance within a wider system of risk financing and management.

Topic 1:     Risk financing and management

Insurance is an integral part of risk management and, in many respects, the practice of risk management has developed due to issues and practices associated with the insurance market. This topic intends, therefore to introduce the concepts of risk and risk management and, crucially, to create a link between these insurance.

At the end of this Topic you will be able to:
•    Discuss how risk can be classified
•    Critically analyse recent developments in risk management
•    Explain the operation of the risk management process
•    Evaluate the risk financing options which an organisation may have

Topic 2:     The role of insurance in risk management. Elements and principles of insurance

Insurance is a commonplace product and few households or commercial organisations are without at least some form of insurance cover.   This topic begins our look at its advantages and disadvantages as part of wider risk management and what the basic concepts of insurance are.

At the end of this Topic you will be able to:

•    Discuss how insurance fits the wider context of risk management
•    Discuss the advantages and disadvantages of insurance
•    Evaluate insurance’s role in risk financing
•    Explain the fundamental operation of insurance
•    Analyse the operation of the ‘six principles’ of insurance

Insurance and the wider context of risk management

Insurance often gets a bad press.   Sometimes the bad press is richly deserved, but sometimes it is not.  It is however, widely regarded that a sound insurance market is an essential component to any successful economy.  Apart from individual peace of mind, insurance acts as a stimulus for the activity of business.  The insurance industry plays a major role in risk management generally and risk and loss control and risk financing specifically. It results in reduced cost of losses to individuals, industry and government.  Traditionally, insurers’ efforts were concentrated on property risks for which commercial insurance was available.  Increasingly, however, the services offered by insurers and insurance brokers have extended to include identification and control of all the risks faced by organisations i.e. a full risk management service.

The advantages and disadvantages of insurance are many, varied and often complex.  If is useful, however, to identify what some of these may be. A number of them will be discussed in more detail throughout the module:

Advantages
•    The concept of ‘pooling’
•    Some insurances are compulsory
•    Reinsurance support
•    Replaces uncertainty with a degree of certainty
•    Can facilitate better risk management, especially risk control
•    Provides money when it is needed and is not contingent on external market factors, e.g. commodity prices or exchange rates
•    Macro economic benefits

Disadvantages
•    Market volatility (the ‘insurance cycle’)
•    Losses need to be financially quantifiable
•    Might it encourage complacency?
•    Is insurance financially inefficient?
•    Insurers will look to include profit margin
•    High frequency / low severity events; do they simply result in ‘pound swapping’?
•    There is a counter-party risk
•    Large commercial buyers may be relying on insurers who are smaller than themselves
•    Cost of risk issues

Given that the primary function of insurance is to act as a risk transfer (or risk financing) mechanism, how do buyers assess the financing options that they have available to them? It is necessary to think about factors which will influence the cost of risks, for example:
•    Likely costs within a particular time period
•    Are these costs certain or possible?
•    If ‘possible’, how high is the probability?
•    What are the total costs and maximum cost for a single event?
•    Would funding be needed immediately?

Once these factors are addressed, organisations need to consider whether they will finance them from internal resources, or if they will use external funding. Insurance falls into the latter category, especially for risks that would be categorised as pure and particular.

So, in the context of risk management, we can say that insurance is a form of risk management. More correctly,  it is a risk transfer mechanism where the buyer (the insured) is transferring the negative financial consequences of certain events (risks) to the seller (the insurance company).The insured is exchanging uncertainty (risk) with certainty (the premium). However, not all risks can be insured, and even those that can always have ‘residual risk’ that needs to be managed. In other words, the insurance will never cover all aspects of a possible loss. A consequence of this is that some risks which can be insured can be managed more effectively and economically by other means. Therefore, insurance works best as part of a wider, more integrated system of risk management

Elements and principles of insurance

The Common Pool

A useful way to think about the role of an insurance company and its officers is as ‘operators’ or ‘guardians’ of a common pool of policyholders’ premiums.  In this role they must determine the ‘rules’ of the pool, i.e. who may join and at what rate of contribution.  Insurers recognise that it is impossible for them to calculate the likely losses at the individual level, i.e. they cannot say with any accuracy that Policyholder A will have a loss on a given year. However, using their statistical data, and what is known as the ‘Law of Large Numbers’, they can calculate fairly accurately the likely level of losses across the common pool as a whole. This allows them to set equitable premiums for those contributing to the pool.

Equitable premiums

Although the pool might be ‘common’ that is not the same a saying that each member of the pool brings an equal level of risk it. It is necessary therefore for insurers to set contributions to the common pool in such a way that the premiums reflect the degree of hazard and the potential level of loss that an insured brings to the pool. We will discuss this in more detail when we look at insurance pricing.

Adverse selection

This represents a major challenge for the underwriting and pricing of insurance. It has been defined as:
“The tendency of persons with a higher-than-average chance of loss to seek insurance at standard (average) rates, which if not controlled by underwriting, results in higher-than-expected loss levels”

An example of this would be someone with a long family history of serious health problems attempting to purchase life insurance at standard rates. This person clearly represents a higher than average risk, and failure of the insurers to control for this would disrupt the idea of equitable premiums. We will look at one of the main methods of controlling for this, utmost good faith, later in this topic.

The ‘six principles’ of insurance
Insurance textbooks tend to treat the principles of insurance with some reverence. The fact is that, old-fashioned and arcane though they look, they do actually govern the day to day workings of the insurance business.  Much of the terminology we shall use in this unit when describing the six principles can actually be heard spoken on a daily basis in insurance offices.  In short, though they may look it, these principles are not simply a dusty old set of rules which everyone takes for granted and are no longer mentioned.

Utmost Good Faith (or ‘Information Disclosure’)
Most legal contracts are subject to the doctrine of caveat emptor (let the buyer beware).  Insurance, however, operates in a completely different way.
The law has evolved to a position where insurance has a special status. This is summed up succinctly in the following definition:
A positive duty to voluntarily disclose accurately and fully, all material facts being proposed, whether asked for or not.

One of the key expressions in the above definition is ‘material fact’. Over the years the courts have helped refine the meaning of ‘material fact’.  Currently the test is that in order to avoid paying a claim, the underwriter concerned must be prepared to show that he/she was influenced by the misrepresentation or non-disclosure.  Putting this another way, if the underwriter had known about the ‘material’ fact he/she would have either declined the cover or imposed special terms and conditions.

The duty to disclose material facts arises at each renewal.  This protects the insurer when the policyholder’s circumstances change mid-year and introduce some new and unacceptable feature of risk.  It ensures that the insurer is made aware of any such changes and can either decline to renew, or impose special terms and conditions.  Renewal Notices sent to policyholders usually warn the policyholder (in bold print) of their obligation to inform the insurer of material changes to the risk.

Insurable interest
Important points to note are, beginning with a brief definition:
The legal right to insure arising out of a financial relationship, recognised  at law between the insured and the subject matter of the insurance
Insurance companies do not have discretion to judge whether insurable interest does or does not exist in any particular case.  Ultimately, if there is a dispute about the existence of an insurable interest, a court of law will decide.
The interest must be financial. That is a much broader definition than it might initially appear. One only has to think about physical injuries or even death to consider how our legal system has devised a scale or table of financial values to attach to such losses. Less tangible losses such as emotional stress may also have a financial value attached in this way.  However, at the extreme, mere sentimental value is excluded.
The question of insurable interest is best sorted out at the outset of the insurance.  If the absence of a valid interest can be identified at the proposal stage the issue of a policy can be prevented.  This is clearly much better than raising the issue of insurable interest in the future at the time of a claim.
The following quotation from the judge in Castellain v Preston 1883 sums up what insurable interest is all about.
“What is it that is insured in a fire policy? Not the bricks and materials used in building the house but the interest of the insured in the subject matter of the insurance.”

An unusual but important difference exists between the 3 main classes of business as to when insurable interest must exist:-
•    Marine Insurance – it must exist at the time of claim
•    Life Insurance – it must exists at inception of the policy
•    All others – it must exist at both inception of the policy and at the time of the claim.
The question of insurable interest crops up when considering the transfer of a policy from one person to another.  There are some basic rules but as so often with the principles of insurance, there are some twists and turns.  Marine cargo insurances and life insurance policies are generally freely assignable. In most other cases insurers would either prefer, or insist, upon a new policy being taken out rather than assigning an existing one.

Indemnity
Indemnity is a way of compensating a person or organisation for the consequences of a loss. Indemnity puts the insured into the same financial position after a loss as he/she was in before the event occurred.  In short, the aim is to place the insured in the same position, as though the loss had never happened. The policyholder should neither gain nor lose.
Indemnity does not apply to all types of contracts. The test is whether or not it is possible to place a financial value on the loss.  For this reason, property insurance contracts lend themselves well to the principle of indemnity.
Indemnity and insurable interest are closely linked in the sense the indemnity will be provided up to the extent of the insurable interest.
There is a general rule that the measure for loss of property is determined by its value at the time of the loss rather than its original cost.  Theoretically this could be higher or lower than the original cost.
The cost of salvage must be taken into account.  If the insured retains the salvaged item its value will be deducted from the claim settlement.
The 4 main methods of providing indemnity are cash payments, repair, replacement, and reinstatement.

Average – This term is used when there is underinsurance on a policy, that is, when the sum insured does not represent the full value at risk, then the insurance company will apply what is known as the ‘pro-rata condition of average’.
There are other special types of Average for use in specific types of policy e.g. agricultural.
Policy wordings can modify the principle of Average, notably: agreed value policies; the reinstatement memorandum; and so-called ‘new for old’ in home insurances.

Subrogation
Subrogation is known as the ‘corollary of indemnity’* because without it, the principle of indemnity would be undermined.
(*The word ‘corollary’ simply means the effect or result.)
The classic definition of subrogation is that found in the judgement in the case of Castellain v Preston, 1883.
“The right of one person to stand in the place of another and avail himself of all the rights and remedies of that other whether already enforced or not”
Subrogation is intended to prevent the Insured from recovering more than a full indemnity by giving the insurers the benefit of the rights which the insured would otherwise be able to exercise.
For example, where decorators are working on premises and by their negligence set fire to them, the owner of the premises is entitled to make a claim against his insurers and the insurers in turn (in the name of the insured) claim against the negligent decorators. The common law position is that the insurers must admit the claim and pay it before they can use their rights of subrogation.  To avoid any possible delay this might cause, insurers include a condition in the policy to enable them to use subrogation rights before a claim is paid.
Insurers are not obliged to exercise their subrogation rights. They may waive the right if it appears to be either too costly or perhaps too unfair an exercise to reclaim their outlays in this way.

Contribution
This is the other corollary of indemnity.  The essence of this is that a policyholder cannot make a profit out of a loss by covering the event under more than one policy.   Although simple in principle, it can be extremely complex to work out in practice – particularly if there are more than two policies in existence.  The existence of more than one cover often happens by accident e.g. where goods in a transit warehouse are actually en route to a customer and are covered under a) an extension of the factory policy of the manufacturer, b) a goods in transit policy, or c) the warehouse keeper’s policy.
The text gives several examples to give you some feel for how it works.
Note that the principle can be modified by means of special policy clauses e.g. ‘non-contribution clause’ or ‘more specific’ insurance clause

Proximate Cause
This principle has been developed for the simple reason that:
a) Insurance policies cover specific causes of loss and exclude certain causes, and
b) Sometimes causes of loss operate very closely in time and in effect. This can make it unclear whether a loss is actually covered.

Fortunately we have some rules to help sort out such problems.  Under UK law there is no single piece of legislation that we can point to.  Instead, we find that the rules have been built up over the years on the bases of ‘case law’.  In effect, insurers and policyholders who are in dispute on this issue have gone to court to seek a legal judgement on the matter.  These judgements have given us a body of ‘case law’ to guide us (and the courts) as to how any new dispute should probably be settled.
This is primarily (but not exclusively) an issue for property insurance policies.
Do not worry too much if you are confused about proximate cause. Even if you do not immediately grasp all the intricacies of the problem you will at least have an ability to be ‘on alert’ to the potential problems associated with proximate cause.

Self-assessment questions
1.    How would you respond to the view that the disadvantages associated with insurance result in it being an ineffective part of a risk management strategy?

2.    Why might adverse selection a problem for motor insurers and how can they overcome it?

3.    Consider and briefly respond to the following statement:
a.    How can insurers claim that their contracts are ones of indemnity when they provide ‘new for old’ cover?

4.    In your opinion, why have insurers encountered so much difficulty with the question of genetic testing and information disclosure?

Topic 3 – The nature of Insurance Companies and the Insurance Market

Preview

This topic will consider the nature of insurance companies and some detail on the main players in the market place.

Learning outcomes

At the end of this Topic you will be able to:

•    Describe the insurance marketplace and the key players
•    Evaluate the different methods of insurance distribution and
•    Understand and explain the reinsurance process

Indicative reading:

Thoyt (2010), Chapter 5 pp101 – 106, 6 and 8

Introduction

The insurance market developed in from the need to protect shipowners against loss of ship and cargo and records of marine insurance in London date back to 1547.  Insurance has developed in the UK and many other developed nations since this time to respond to the needs of individuals, businesses and the wider economy to allow development and protect against loss.   Developing countries all over the world have insurance markets at quite different stages of development and these will be considered later in the module but for the purpose of this section we will be looking at the UK insurance market, which despite being UK based is of global importance.

The structure of the UK Insurance market

The market is made up of several key groups.  Figure 5.1 in Thoyt gives an illustration of some of these groups.  The key players in most insurance markets will include:

•    Insurance buyers
•    Intermediaries
•    Primary Insurers
•    Lloyds syndicates
•    Reinsurers
•    Captive insurance companies
•    Insurance service providers
•    Market organisations
•    Rating agencies

This lecture will examine these key players in some more detail and discuss the vital roles they play in the insurance market.

The Buyers

As you would expect, purchasers of insurance come from three main sources:
•    Private individuals, the largest group in terms of numbers of policies but not necessary premium income.  Individuals are likely to need cover for home insurance, motor insurance and private travel insurance.  Some may also choose to take personal accident insurance and private medical insurance.  All covers most if not all of us are familiar with.
•    Industry and commerce, a smaller market in terms of numbers but in terms of both cost and complexity much greater than personal lines of insurance.  This can range from fairly straightforward policies for small businesses looking for cover for property damage, business interruption, liability or commercial vehicle cover to large multi-national organisations with often complex insurance needs.
•    Public sector organisations, in the form of local government, NHS trusts and some other secondary or tertiary levels of government are also significant purchasers of insurance requiring similar cover to private organisations with some additional specific needs depending on the nature of the organisation.

The Intermediaries

Primary insurers may sell their products direct to customers, which is more common the case of personal lines but also increasingly in popularity for small business customers where insurance can be sold as a straightforward package.  However, for most commercial business and certainly for any business where complexities may exist intermediaries are used.    The range of intermediaries has expanded over the years and consists of professional brokers and consultants to organisations which specialise in other areas but will offer insurance as a complimentary product to their main business, for example airlines will also offer their customers travel insurance.  There are therefore two broad categories of intermediary:

Insurance agents

Those organisations whose primary activity is not selling insurance but they gain the opportunity to earn commission and broaden the service they provide to their customers by also selling insurance.  These type of organisations range from lawyers, estate agents, vehicle sales and travel agents.  The insurance sold would compliment the product being sold.  The most important agents in the UK market and those with most influence over the market are as follows:

•    Banks – in recent years there has been a substantial growth in the number of banks offering insurance products.  They are in an ideal position to do this, they have (relative to insurers) better brands, frequent customer contact and often warmer relationships.  They also have a wider portfolio of products that gives the opportunities for cross selling.  In countries where regulation has allowed some banking organisations have purchased their own insurance companies to also benefit from any profits.  Companies which sell both banking products and insurance are known as Bancassurers.  Bancassurance has been less successful in the UK than other European countries and certainly than in France where it was pioneered. Largely due to different buying patterns of customers, a less trusting and deferential view of and due to there being strong independent distribution channels in the UK.

•    Brandassurers – in a similar way to banks other organisations have seized the opportunity to cross sell insurance with other products.  This has seen a growth of high street stores selling insurance at their outlets.  In a similar way to banks they utilise their existing brand, customer loyalty and frequent customer contact in addition to their own purchasing power with the supplying insurer to benefit from insurance sales.

•    Affinity groups – an affinity group is a collection of people with a common interest and regular communication. This may include  motoring organisations, professional institutions or any large clubs or societies.  These groups sell insurance to their members, often branded and offering discounted prices as a result of membership.

•    Insurance agents of this type are often tied into an agreement with one insurer and are therefore classed as tied agents. They enter into agency agreements with single insurers and will then only offer than insurers products.

Insurance brokers

Brokers sell insurance as a full time occupation rather than as an add-on to their primary activity.  They will have often have built up an expertise in certain areas or classes of business.   You will see in the discussion at the start of Chapter 8 of the Thoyt textbook that although brokers is the phrase more commonly used to describe this type of insurance intermediary it no longer has any legal or regulatory meaning and so taking the lead of Thoyt the phrase intermediary will be used here also.

Independent intermediaries are firms that are as established independently and operate independently from the insurer.  They provide advice to the policyholder and place cover on their behalf.  They will either enter into a number of agency agreements with insurers to permit them to place cover, making profit through commissions on the premium or on a fee payable by the policyholder.  These firms are usually called brokers and their ability to place cover with a range of insurers and their independent advice is their distinguishing feature.   The market as developed in such a way it has become harder for small businesses to maintain a wider range of agency agreements (regulation in particular has played a part in this – see Thoyt page 200) and many have merged or become tied agents.

Occasionally insurers will also give intermediaries the ability to write cover for them.  They effectively delegate underwriting responsibility to the intermediary and all policy administration, other than claims handling, is carried out by the broker. This tends to be done in relation to specific scheme, where specialised bespoke products are offered and is especially common at Lloyds for this reason.

The Role of Brokers

Larger more complex risks often require the involvement of more than one insurer and it was this need that primarily led to the involvement of brokers.  They was a demand for individuals with the necessary expertise to be coordinate insurance cover on behalf of the policy holders.  Brokers therefore have several functions:

•    Expertise – knowledge of insurance products, requirements and particularly policy wordings means that negotiation can be made with underwriters on an equal footing.
•    Market awareness – knowledge of what companies offer what products, their capacity and appetite for taking on certain risks and the reliability of cover and service provided.
•    Price – an awareness of current pricing and therefore the ability to negotiate better deals.  They may also have access to better discounts due to the large volumes of business placed with certain insurers.
•    Service – they can advise customers on the cover required, assist them with the preparation of risk details needed to underwrite the risk, review the cover annually and assist with claims processes should they arise.

A brokers role is very much based on relationship building, both with the client and the insurer to ensure they are providing the best service possible. Further details on the duties expected of the intermediary can be found in Thoyt on pp 187 to 193 and you should read through this in your own time.

The Insurers

Insurance providers can be categorised as proprietary insurance companies, mutual insurance companies or Lloyds Syndicates:

Mutulisation

Mutual insurance companies tend to have grown out of risk pools established for a particular group (i.e. National Farmers Union, Municipal Mutual).  While many mutual insurance companies are still in existence as far as their name is concerned, most have merged with or been purchased by proprietary firms.  They were an important part of the emerging insurance market but have less importance now as they once did.

What distinguishes a mutual from other companies is that the profits belong to the policyholders and should reserves be sufficient they may be used to reduce premiums or returned to the policyholders.

According to Thoyt there are several theoretical advantages to the mutual structure:

•    Profit or surplus will be returned to policyholders, reducing insurance costs.
•    They usually had a narrow focus which meant greater knowledge of the risks being underwritten.  However this could also restrict the opportunity for growth, using NFU as an example, if most of the farmers in the UK have their insurance with NFU then this would potentially reduce the number of future policyholders they are likely to attract.
•    The close relationship between the policyholder and the company means great loyalty and greater stability,

Proprietary Insurance Companies

Proprietary companies can be public liability companies.  The structure of the organisation is different to that of mutuals and this can bring with it different theoretical advantages:

•   &