insurance chapter 1

OVERVIEW

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

• Importance of Insurance

• How Insurance Works

• What Insurance Is

• Functions of Insurance

• Classes of Insurance

• Historical Aspects of Insurance

• The Role of an Insurance Agent

1.1. INTRODUCTION

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

Some examples are:

• A sole breadwinner of a family is involved in an accident and dies prematurely. Undoubtedly, the dependents will face two immediate obvious forms of losses – emotional andfinancial.

• The premises of a factory may be destroyed by fire. The owners of the factory will face, besides other losses, the loss of income which the factory

Overview

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

1.5. Functions of Insurance

1.6. Classes of Insurance 1.7. Historical Aspects of Insurance

1.8. The Role of an Insurance Agent

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CHAPTER 1 - INTRODUCTION TO INSURANCE

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

We can give countless examples of events which lead tohumangrievancesandfinanciallosses.

The natural question to ask then is

“What arrangement(s) can be made to overcome or at least reduce the consequences of misfortune that may befall any one person?”

In answering the above question, we have to admit that not all forms of loss can be made good or be expressed in pecuniary terms. For instance, the emotional trauma arising from the death of loved one cannot be made good by any conceivable compensatory system.

Perhaps, what can be done is to devise a compensatory system which will at least seek

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

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

Onesuchpossiblearrangement,whereby thefinanciallossisinconsequenceofanunfortunateincidentsuchasdeathorafire,canbethroughthe purchase of insurance.

1.2. IMPORTANCE OF INSURANCE

The Need for Income

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

responsibilities. Who will bear these financiallosses and where will the funds be obtained from to offset such losses? Usually, in the absence of legal remedies, contract arrangements or cooperative efforts, losses will fall on the individual or business unit concerned. To solve this problem, an arrangement is introduced for coping with some of the risks and possible losses faced by individuals and business enterprises. This arrangement works on the law of large numbers, i.e. by spreading the risk of loss faced byaspecificpersonorenterprisetoallpartieswho pool their resources to pay for individual losses. This loss sharing arrangement is called insurance.

The insurer is the intermediary who manages this risk pool. The insurer holds and invests the premiums in trust for policyowners, and pays them in the event that these losses for which insurance protection is taken, occur.

Let us consider for a moment as to what would happen in modern society without insurance organization.

Living costs money. Money is required to buy essential needs like food, clothing and accommodation, as well as to acquire other comforts of life. If one wants to have a decent life,oneshouldhaveacontinuousflowofincomeaslongasoneisalive.Thiscontinuousflowofincome can be ensured only in two ways.

Sources of Income

A person may create his source of income by either setting up his own business or working for other people where, upon completion for the jobs done, he will receive payment in the form of a salary, wages, allowances or commissions.

The other means is through investment income by way of dividends, bonuses or interest on the capital invested.

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However, both sources are always at the risk of being affected by circumstances over which the individual has no control.

Unfortunate Events or Risks

Earning capacity may be ended abruptly due to death, old age, sickness or accident that may result in disability (permanent or temporary).

Likewise, the investments may suddenly depreciate in value or the goods in which capital isinvestedmaybedestroyedbyfire.

In any of these contingencies, the individual or the dependents have to bear the consequences of the financial or emotional losses. Thoseaffected have no other sources to which they can look for relief for sharing part or all of the loss.

The painful experience as a consequence of losses is obvious to anyone.

1.3 HOW INSURANCE WORKS

Let us next understand how insurance works to compensateforthefinanciallossesconsequentto the occurrence of a risk or perils.

Rather thanprovidingamoreformaldefinitionof the terms “risk” and “peril” now (see Chapter 2), we shall look at some instances where we can say that a risk or peril has occurred.

Some Forms of Risk

• Shipwreck at sea;

• Anoutbreakoffireresultingin material damage;

• Loss of income due to disability or premature death.

Pooling of Risks

It is not possible for an individual to predict or prevent such occurrences but through insurance, arrangements can be made to provide against theirfinancialeffects,i.e.lossofpropertyand/or earning.

Insurance in its various forms aims at safeguarding the interest of the individuals who are insured. This is achieved by having losses experienced by the unfortunate few compensated by the contributions, i.e. the premium, of the many that are exposed to the same risk.

The Concepts of Insurance Explained

The concept of insurance is illustrated in Figure 1.1 in relation to a house owner or a term life insurance portfolio. For the purpose of illustration, it is assumed that the portfolio consists of 1000 houses of identical value, say RM100,000 each or 1000 life assured with identical capital sum, and a premium of RM200 is charged for each or life assured per year.

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Figure 1.1. Concept of Insurance Illustrated

The Fund has to meet:

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

#1 RM 200

RM 200RM 200

RM 200RM 200

House ownersor term life Premiums

1000x

RM200

=RM200,000

Claims

Expenses and other Outgoes

Profits

#3#2

# 999# 1000


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The Fund Can Become Deficit

Thus, in the situation illustrated earlier, the fund createdisjustsufficienttopayforamaximumof two claims and this leaves the expenses and other outgoes of the insurer uncovered. If more than two claims were to arise, the insurance fundwouldbeindeficitandclearly,theinsurerwould experience a loss on this portfolio.

Premiums have to be Adequate in a Competitive Business Environment

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

The Law of Large Numbers

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

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

• There are a large number of similar loss exposures.

• The loss exposures must be independent.

• There is a random or chance occurrence of loss.

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

1.4. WHAT IS INSURANCE?

Having seen the role of insurance and how it works in very general terms, it is now appropriate to put down in precise terms what insurance is all about.

Insurance, as an organization, seeks to provide protection against financial loss caused byfortuitous events.

Insurance Defined

Insurancecanthereforebedefinedas:

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

The insurance service, therefore, involves payment of contracted benefits or compensation to the insured or a third party against unforeseen losses.

Essential Features of Insurance

The essential features of insurance, therefore, are:

i. It is an economic institution.

ii. It is based on the principle of mutuality or cooperation.


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iii. Its objective is to accumulate funds to pay for claims that arise as a result of theoperationofspecificrisks.

iv. Only certain risks can be insured against, namely those whose occurrence can be confidently estimated with a certain degree of accuracy.

1.5. FUNCTIONS OF INSURANCE

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

1.5.1. Primary Function

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

1.5.2. Secondary Functions

• Stabilization of Costs

Through the purchase of insurance, business enterprises avoid the necessity of having to freeze capital to provide for financialprotectionagainstlosses.Thisprovides a means of stabilizing the costs involved in managing risks.

• Stimulation of Business Enterprise

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

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

• Provision of Security for Expansion of Business

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

• Reduction of Losses

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

• Provision of a Means of Saving

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

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

• Provision of Sources of Capital for Investment

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


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• Provision of Employment for Many

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

No. of PersonnelEmployed

20,6001,1621,84478,58739,165

Market Structure

1.Insurers2.Insurance Brokers 3.Adjusters4.Registered Life Agents5.Registered General Agents

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

1.6. CLASSES OF INSURANCE

The pooling of risk is the fundamental principle underlying the insurance business and it is useful to classify insurance business broadly into Life Insurance and General Insurance.

What is Life Insurance?

Life insurance can be defined as a contractwhich pays an agreed sum of money on the happening of a contingency (event), or of a variety of contingencies, dependent on a human life.

As we progress through the book, you may note thattheabovedefinitionisnotpreciseinrelationtowithprofitpolicies,forthereisnoagreedsumof money at the outset.

Life insurance contracts can be arranged to provide cover against the following forms of risks:

• Premature death

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

• Sickness or disability

What is General Insurance?

General insurance business can be taken to be all other forms of insurance business (including the reinsurance of liabilities under a policy in respect thereof) which is not life insurance business as definedintheInsuranceAct1996.

Risks Covered by General Insurance

General insurance contracts, to mention a few, can be arranged to provide cover against the followingformsofrisktotheinsuredand/orthirdparties in respect of

• loss or damage to property, e.g. to motor vehicles, ships, buildings, stocks-in-trade;

• legal liability caused by products or goods sold, or the process carried out;

• death or injury to a person by an accident.

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


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1.7. HISTORICAL ASPECTSOF INSURANCE

This section will provide a brief introduction to the historical aspects of insurance.

The earliest beginnings of insurance were in the field of marine insurance. Men engagedin trade by sea attempted to minimize their losses which resulted from the perils of the sea, by spreading the losses amongst all who were similarly engaged. In the normal course of events, many ships arrived safely in port and only a few suffered losses. The many who were successful thus contributed to overcome the suffering of those who were unsuccessful. In other words, the misfortune of the unfortunate few was borne by the many.

This was achieved by the payment of a premium intoacommonfund.Somuchbenefitfollowedthis action that traders adopted the idea in many countries and gradually there came into existence groups of men who specialized in managing the fund and who studied the rates of loss which occurred in different types of maritime adventure. This was the beginning of marine insurance.

At a much later date came life insurance and other modern forms of insurance, all of which worked on the principle of spreading the losses of the few over the fund created by the contribution of the many.

Initially life insurance policies were sold as short-term policies, cover being renewed at the option of the insurer at the end of the period. Such an approach had disadvantages and perhaps, was the only possible one that could be adopted when there were no mortality tables.

The year 1706marked the emergence of theAmicable Society for a Perpetual Assurance, which adopted a scheme under which each member was required to contribute a fixedsum annually. The accumulated contributions were divided at the end of the year among

the dependents of the members who had died during the year.

Membership was open to persons between the ages of 12 and 45 and members’ contributions were uniformly fixed at £5 perannum(whichwasincreasedto£6.20lateron).In the early years of its operation the company did not guarantee a definite sumassured butafter 1757 a minimum sum assured at death was laid down. A variable premium based on agewasfixedonlyin1807.

An important landmark in the development of life insurance related to the use of the Mortality Table in conjunction with compound interest rates,when in1762TheEquitableAssurancefor the first time fixed premium rates basedon modern lines, adopting the level premium system.

1.7.1. Insurance in Malaysia

The beginning of insurance in Malaysia can be tracedtothecolonialperiodbetweenthe18thand19thcenturieswhenBritishtradingfirmsoragencyhouses established in this country acted as agencies for the UK-based insurance companies, among whichwereHarrison&Crossfield,Boustead,andSime Darby.

The insurance industry in Malaysia had been largely patterned on the British system whose influencestillcontinuestobefelt.Evenaslateas 1955, it was reported that foreign insurance domination of the local insurance market was as much as 95% of the total business transacted.

After independence in 1957, however, concerted efforts were made to introduce domestic insurance companies. The early 1960switnessed the growth of a few life insurance companies which wound up soon after because of their unsound operations and inadequate technical background.


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Control of Insurance Business

These unhealthy features culminated in the Government’s intervention through the enactmentoftheInsuranceAct1963toregulatetheinsuranceindustry.This1963ActhassincebeenreplacedbytheInsuranceAct1996.

Since January 1997, the InsuranceAct 1996has become the principal legislation governing the conduct of insurance business in Malaysia

1.8. THE ROLE OF AN INSURANCE AGENT

The roles of an insurance agent are:

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

• tobringfinancialreliefintheevent of property loss;

• to inculcate the discipline of saving amongst the working population;

• to provide other forms of insurance-related services to the public.

To be an effective agent, one should be able to recognize the insuring needs of one’s clients. Clients should be advised of the right type of products so that they meet their insuring needs and the policies do not lapse. Insurance agents are expected to provide, in a sense, the best possible advice to their clients.

It is greatly hoped that the reader will persevere through the rest of this book and acquire the technical and sales-related knowledge to achieve success in his or her career.


insurance chapter 1

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