BCP Ch 3

Introduction to Insurance

Risk and Chance

• Risk: Uncertainty about an outcome, typically unfavorable (e.g., risk of an accident).

• Chance: Doubt about an outcome, usually favorable (e.g., chance of passing an exam).

• Risk is defined as the possibility of loss, encompassing injury, damage, liability, expenses, measured in monetary terms.

• Risk can be defined as the possibility or potential to lose as a result of an occurrence or event.

Risk Transfer Mechanism

• Definition: A means by which an individual or commercial organization passes on (transfers) the risk that it faces to another party.

• Insurance serves as a risk transfer mechanism.

• The insurer promises to pay for, repair, replace, or reinstate damaged property in the event of a covered peril (e.g., fire) during the insurance period, provided the peril is covered by the insurance policy.

Examples of Risks Associated with Owning a Car

• Accidental injuries to driver, passengers, and other road users.

• Accidental damage to the car itself, other cars, or property.

• Theft of the car or its accessories.

How Insurance Protects Against Financial Loss

• A comprehensive Motor Insurance policy can protect the owner of the car against the financial effects of any loss arising out of the risks of owning a car

• An unknown loss (the risk of injury, loss or damage) is then transferred to the insurer by paying a fixed premium.

• In the event of damage to the owner’s car, the insurance company will pay for the cost of repairs if all other terms and conditions of the policy are fully met.

What is Insurance?

Definition of Insurance

• Insurance is an equitable transfer of the risk of a loss from one entity to another in exchange for a premium payment.

• It's a form of risk management primarily used to hedge against the risk of a contingent, uncertain loss.

Key Parties in Insurance

• Insurer/Insurance Carrier: Company selling the insurance.

• Insured/Policyholder: Person or entity buying the insurance policy.

• Premium: The amount of money charged for a certain amount of insurance coverage.

Insurance Transaction

• The insured assumes a guaranteed and known relatively small loss in the form of payment to the insurer.

• In exchange, the insurer promises to compensate (indemnify) the insured in case of a financial (personal) loss.

• The insurance policy is an official document detailing the terms, exclusions, conditions, and circumstances under which the insured will be financially compensated.

How Insurance Works

Risk Pooling

• Insurance works by spreading the result of a financial loss among many persons, so that the cost to any one person is small.

• An insurer accepts the risk of financial loss of a large number of people.

• Only a small percentage of these people will actually suffer an insured financial loss during the period that the insurance is in force

• The premiums paid by a very large number of people who buy insurance covers, to pay the claims of a relatively small number of people in the same risk pool.

Types of Insurance Policies

• Policies protect against financial losses when property is damaged or legal liability to compensate third parties exists due to negligence.

• Life and health insurers protect against financial losses from personal risks like premature death or ill health.

• General insurers sell non-life policies (e.g., Property and Casualty Insurance, Marine Insurance).

Insurance and Gambling

Distinguishing Insurance from Gambling

• Money changes hands in both gambling and insurance based on chance events.

• In insurance, you pay a premium and the insurance company keeps the premium if no insured loss occurs and pays for the loss if an insured peril occurs.

Fundamental Differences

• Gambling creates a new speculative risk, where one can either make a profit or loss from the bet, while insurance handles an already existing pure risk.

• Gambling is socially unproductive because the winner’s gain comes at the expense of a loser, whereas insurance is socially productive, where neither insurer nor insured is placed in a position where the gain of the winner comes at the expense of a loser.

• Both insurer and insured have a common interest in the prevention of a loss; both parties win if the loss does not occur.

• Insurance contract restores the insured, in whole or in part, if a loss covered by the policy occurs, but a gambling transaction never restores the loser to his former financial position.

• In gambling, the parties involved are aware of when the event will take place (e.g., a football game), whereas in insurance, both the insured and the insurer will not know if and when an event like a fire will occur.

Types of Risks

• Not all risks are insurable.

Types of Risks

• Pure Risk vs. Speculative Risk

• Fundamental Risk vs. Particular Risk

• Financial Risk vs. Non-Financial Risk

Pure Risk

• Involves the possibility of a loss only or at best a “no gain” situation.

• Example: Risk of collision for a car owner.

Speculative Risk

• Involves the possibility of either a loss or gain.

• Examples: Investing in stocks, betting on a race, real estate investment, venturing into a food business.

• Normally, insurers will not insure speculative risks, because they are generally created by the persons involved.

• Speculative risks are not insurable, whereas pure risks are.

Fundamental Risk

• Affects the entire economy or large numbers of people, arising from social, economic, political, or natural causes.

• Widespread in its effect.

• Examples: War, epidemic, drought, unemployment, high inflation, recession.

• Consequences are better addressed via governmental or international relief rather than commercial insurance.

Particular Risk

• Affects only a single or relatively few individuals, not the entire economy.

• Examples: Being robbed, bitten by a stray animal, assaulted, involved in a traffic accident.

Financial Risk

• The outcome must be capable of measurement in monetary terms to be insurable.

• Examples: Loss of/damage to a vessel, damage to glass in a shop front, loss of money through robbery.

• Exception: Human life insurance, where an agreed financial amount is determined at the time of effecting the insurance.

Non-Financial Risk

• The outcome is not measurable in monetary terms.

• Involves personal decisions with emotional outcomes.

• Examples: Choosing a life partner, selecting a school for a child.

• Such non-financial risks are uninsurable.

Characteristics of Insurable Risks

Large Number of Insureds

• There must be a large number of persons available for insurance having a similar potential for loss.

• The law of large numbers works only when there are sufficient numbers of potential insureds who have a similar chance for loss, to make the chance of loss predictable.

Accidental Loss

• The loss must be accidental in nature.

• It must generally be fortuitous, unexpected, unforeseeable, and not intentionally or wilfully caused by the insured.

• Example: Insurance companies can offer Personal Accident Insurance policies to provide protection against financial losses caused by such accidents.

Definite Loss

• The potential loss must be definite in terms of time and amount.

• An insurer must be able to know when the loss took place, and how much the claim will be.

• The insurer’s risk exposures are generally restricted to the period of cover granted to the insured.

• Three types of insurance contracts: contracts of indemnity, valued contracts, and benefit contracts.

Contracts of Indemnity

• General insurance contracts are generally contracts of indemnity

• The amount payable to an insured after a loss is based on the amount of the loss actually suffered by him.

• The insurer calculates the amount to be paid after an occurrence of a loss covered by the policy.

• A fire insurer will indemnify the insured based on the actual property damage and loss caused by the insured perils.

• The insurer will pay only the actual loss incurred, even if the sum insured exceeds the total value of the entire property.

Valued Contracts

• In a valued contract, the insured and the insurer agree to a specific value for the property, before the insurer issues the policy.

• If the property is lost or destroyed, the insured will collect the amount that has been agreed upon at the policy inception.

• Valued policies are commonly issued for items, such as paintings, sculptures, antiques and items of jewellery, where it is difficult to determine the property’s value after having been damaged or destroyed.

• The insurer may ask to see the original sales receipt, or may want to have the property appraised by a professional valuer.

Benefit Contracts

• These contracts pay a sum of money in the event of a contingency, irrespective of whether the insured suffers a financial loss.

• Examples: Accidental death, permanent disability, or sickness.

• The benefits defined in such policies are not related to the extent of financial loss resulting from the loss of life or health of the insured.

• Examples of benefit contracts are Personal Accident Insurance (covering accidental death and permanent total disablement), Critical Illness Insurance, Hospital Income Insurance, and most Life Insurance policies, such as Term, Endowment, Whole Life Insurance, etc.

Financial Burden

• The loss must be large enough to create a financial burden for the individual involved.

• Insignificant losses (e.g., umbrellas, key pouches) are not normally insured because it would cost more to administer the insurance program.

Affordable Insurance

• The insurance must be affordable in relation to the value of the insured item.

• The cost of the insurance should generally be a small fraction of that item’s value.

• Insurers must have a sufficiently large pool of similar risks to be insured for the law of large numbers to operate properly, in order to offer insurance coverage at an affordable level.

• Insurers face “anti-selection” or “adverse selection” when those who seek to purchase insurance tend to be those risks where the probability of loss is higher than average.

Particular Risk (Insurable)

• The loss must not routinely happen to a large number of insureds at the same time.

• Catastrophic or fundamental risks are not insurable.

• Catastrophic losses can result in a massive and rapid accumulation of losses that can threaten the financial solvency of an insurance company.

• Governments often accept responsibility for risks like property damage caused by war and nuclear risks.

• Fundamental risks arising out of some natural causes, such as earthquake, hurricane, typhoon and flood, may be insurable, depending on the geographical location of the property.

Pure Risk (Insurable)

• The risk to be insured must be a pure risk, as opposed to a speculative risk.

Perils and Hazards

Perils

• An event or occurrence which causes injury, loss, or damage.

• Examples: Fire, collision, lightning, windstorm, flood, earthquake, theft, burglary.

Hazards

• A condition that creates or increases the chance (risk) of loss.

• Can be sub-divided into moral hazards or physical hazards.

Moral Hazards

• Arise from the attitude, conduct, or behavior of people.

• Carelessness or irresponsible actions can increase the possibility of a loss.

• Examples: Leaving a car unlocked because one feels protected by insurance, an employee smoking while working in a petrol station.

• Involves engineering a loss on purpose to make a fraudulent claim.

Physical Hazards

• Arise from the condition, occupancy, or use of the property itself.

• Relate to the measurable dimension and physical characteristics of the risk.

• Examples: Security protection at a jewelry shop, the construction of the property.

Methods of Handling Risks

Four Major Methods

• Avoidance

• Control

• Retention

• Transfer

Avoidance

• Avoiding the risk altogether.

• Examples: Never driving a car, not traveling in an aircraft.

• Advantage: Reduces the chance of loss to zero.

• Disadvantage: May not be possible or practical to avoid all risks.

Control

• Reducing both the frequency (loss prevention) and severity (damage reduction) of losses.

• Examples:

  • Loss prevention: Strict enforcement of safety rules in construction sites by forbids workers from smoking in an area where flammable materials are stored.

  • Loss reduction: Installing a fire sprinkler system in an office, or placing flammable materials in a separate confined area

Retention

• Retaining the risk, i.e., paying for the loss oneself if it occurs.

• Sometimes, people retain only a portion of risk

• Active Retention: Consciously deciding to retain the risk.
  *Example: A motorist may wish to retain the risks of minor accidents to his car, by buying an insurance policy with a deductible (usually known as an excess in Motor Insurance) in exchange for a reduced premium

• Passive Retention: Unintentionally retaining a risk because of indifference, ignorance, or laziness.
  *Example: A golfer does not know that he runs the risk of lightning strikes while playing golf in bad weather.

Self-Insurance

• A form of retention where a firm self-funds losses.

• Applicable for high-frequency, low-severity losses.

• A fund is created to meet losses.

• Organizations self-insure when they are financially capable and the cost is lower than commercial premium rates.

Transfer

• Transferring the risk to another party, the most common method of transferring risk is insurance.

• purchasing an insurance policy the insured transfers certain risks to the insurer

• The losses of the few are met by the contributions of many (law of large numbers).

• Insurers gather premiums from insureds to create a pool, then compensate the losses of the few out of this pool.

Non-Insurance Transfer

• Methods other than insurance by which a risk and its potential financial consequences can be transferred to another party. These are common in the building-construction business.
  *Including a “hold-harmless” clause in a contract by which one party assumes legal liability on behalf of another party.

Attitude Towards Risks

Individual Risk Perception

• The decision on which method that an individual adopts, to some extent, depends on the individual’s attitude towards risks.

• An individual must recognize that risks exist, before he is able to handle them adequately.

• People who are risk-seeking may voluntarily assume risk.

• People who are risk-averse prefer to transfer risk.
  *Value getting the risk off their hands, so they will rather have the security of the policy coverage.

Benefits of Insurance

Provides Financial Stability

• Mitigates financial impact or alleviates hardship when losses occur.

• Maintains lifestyle and future plans.

Provides Peace of Mind

• Knowing that insurance exists reduces anxiety and worry.

• Relieves businesses from the worry and anxiety that they may have on how to meet the cost of risk.

Stimulates Business Enterprise

• Businesses can free up funds for productive investments instead of setting aside large sums of money as a contingency, should such potential risks materialise.

• Insurance provides financial security and certainty.

Encourages Loss Control

• Insurers employ risk surveyors to assess and reduce risks.

• Surveys often suggest ways in which the likelihood of some risks occurring may be reduced.

Encourages Investments

• Insurers invest premiums in financial instruments.

• Supports governments, industry, and commerce through loans and share purchases.

• Supports sustainable and green finance.

Enhances Provision of Credit Facilities

• Insurance provides security for bankers and financial institutions.

• Fire Insurance makes it possible for mortgages on property to be granted, without fear of loss of property by fire.

• Enhances a borrower’s credit, because it guarantees the value of the borrower’s collateral, or gives greater assurance that the loan will be repaid in the event of an insured peril occurring during the period of insurance.

Classification of General Insurance Products

Broad Classification

• Personal General Insurance

• Commercial General Insurance

Personal General Insurance

• Purchased by individuals to protect against non-commercial risks and meet statutory requirements.

• Examples: Private Motor Insurance, Houseowner’s Insurance, Personal Accident Insurance.

Commercial General Insurance

• Purchased by businesses to protect against risks arising from business activities.

• Examples: Business Interruption Insurance, Professional Indemnity Insurance, Marine Hull Insurance.

Classes of General Insurance

• Classes Of General Insurance:

  • Personal lines provide insurance cover for various risks faced by individuals and families:

    • Private Motor Car Insurance: Insures the risks associated with the ownership of private motor cars.

    • Private Motorcycle Insurance: Insures the risks associated with the ownership of private motorcycles.

    • Houseowner’s Insurance: Insures the structure of the building of private homes.

    • Householder’s Insurance: Insures the household contents of private homes.

    • Packaged Household Insurance: Insures private home buildings and household contents, but also provides other benefits as well.

    • Valuable Articles Insurance: Insures the insured’s antiques, paintings, sculptures, ceramics, clocks, and any such items of high monetary value.

    • Personal Accident Insurance: Insures the risks of accidents resulting in accidental death, permanent disablement or bodily injuries.

    • Travel Insurance: Insures the risks associated with travelling for business and/or leisure.

    • Personal Liability Insurance: Provides coverage for legal liability to third parties.

    • Foreign Domestic Worker Insurance: Insures the risks commonly associated with hiring a foreign domestic worker.

    • Golfer’s Insurance: Provides comprehensive insurance coverage for golfers.

    • Electrical Protection Insurance: Covers accidental damage to or theft of the insured’s electrical equipment (such as a camera, notebook or mobile phone).

    • Pet Insurance: Covers the insured’s veterinary bill and surgical treatment costs incurred arising from injuries, illnesses, emergencies, specified genetic condition relating to the insured’s pets.

    • Personal Mobility Device Insurance: Covers a user of a mobility device, such as a bicycle, electric scooter, hoverboard, rollerblade or unicycle, against accidental death, permanent disability, medical expenses against injuries, and third-party liability arising from an accident while riding, mounting or dismounting from such an insured mobility device.

  • Financial lines provide insurance cover for various risks faced, which will result in a monetary loss, rather than a physical loss of or damage to the property:

    • Card Protection Insurance: Covers unauthorised or fraudulent use of the financial card by someone other than the cardholder.

    • Extended Warranty Insurance: Covers the cost of the insured’s product repair or replacement for a set number of years beyond the manufacturer’s own warranty period.

    • Identity Theft Insurance: Covers monetary loss suffered as a result of identity fraud.

    • Business Interruption/ Consequential Loss Insurance: Insures against loss of profit, overheads, wages and extra expenses incurred to minimise disruption and restore normal business condition owing to interruption as a result of fire and other extraneous perils.

    • Professional Indemnity Insurance: Insures professionals such as lawyers and doctors against professional negligence.

    • Directors’ and Officers’ Liability Insurance: Insures against wrongful acts committed by the company’s directors or officers.

    • Libel and Slander Insurance: Insures the damages and costs associated with libel and slander.

    • Errors and Omissions Insurance: Insures against errors and omissions liability.

    • Cyber Risk Insurance: Covers a variety of risks resulting from the use of technology within the business, such as electronic fraud and identity theft, computer virus and hacking, and breach of data, among others.

    • Contingency Insurance: Provides coverage for financial loss resulting from cancellation, abandonment, postponement, interruption, curtailment or relocation of any type of indoor or outdoor event, such as a musical concert or trade show.

    • Fidelity Guarantee Insurance: Covers employee’s defalcation, forgery or fraudulent acts.

    • Crime Insurance: Offers a wider coverage alternative compared to the traditional Fidelity Guarantee Insurance.

    • Credit Insurance: Provides credit risks protection.

    • Insurance Bond: Provides guarantee for one party’s financial protection against a contractor failing to perform in accordance with the terms and conditions of a contract.

  • Health Insurances: purchased to provide benefits following the diagnosis of a critical illness, or to provide cover such as fixed benefits and/or medical expenses incurred by the insured arising out of hospitalisation and/or surgery:

    • Hospital Cash (Income) Insurance: Provides daily cash benefit for hospitalisation.

    • Critical Illness/Dread Disease Insurance: Provides cash benefit upon the diagnosis of a specified critical illness/dread disease.

    • Hospital & Surgical Insurance: Provides inpatient and outpatient benefits as a result of being hospitalised and/ or undergoing surgical operations.

  • Property Insurances: provide cover for the risks of damage to tangible or physical property, such as buildings, contents and fixtures & fittings:

    • Fire Insurance: Insures property destroyed or damaged by fire, lightning and other extended extraneous perils, such as explosion, earthquake, flood, typhoon, windstorm, riot and strike.

    • Theft/Burglary Insurance: Insures the business against theft on a full value or first loss basis.

    • Electronic Equipment Insurance: Provides a comprehensive cover for damage to electronic equipment, such as computers.

    • Glass Insurance: Insures all kinds of fixed glass against breakage within the business premises.

    • Commercial All Risks Insurance: Insures items such as machinery and equipment against unforeseen and sudden damage subject to exclusions.

    • Industrial All Risks Insurance: Provides a combination of Material Damage (on all risks basis) coverage and Business Interruption Insurance covering buildings, plants, machinery, stocks and others.

    • Terrorism Insurance: Insures property against physical loss or damage caused by act of terrorism or sabotage as defined in the policy.

    • Contractors’ All Risks (CAR) Insurance: Covers all insurable loss or damage involved in a construction project.

    • Erection All Risks (EAR) Insurance: Covers the risks in the installation and erection of ready-built engineering projects, such as power plants.

    • Boiler and Pressure Vessel Insurance: Covers the risks from using boilers and pressure plants.

    • Machinery Breakdown Insurance: Covers machinery from unforeseen and sudden damage caused by breakdown.

    • Money/Cash In Transit Insurance: Covers loss of money and cash belonging to the business

  • Commercial Motor Insurances: provide cover for the risks faced by businesses arising from the ownership or use of motor vehicles, including legal liability arising from the use of such vehicles and damage to the vehicles:

    • Commercial Motor Insurance: Insures the risks associated with the corporate ownership of motor vehicles and commercial vehicles, such as buses, coaches, lorries, taxis, tractors, trucks and vans.

    • Motor Trade Insurance: Insures the risks of businesses that deal primarily with motor vehicles, such as car dealers and car repairers.

  • Liability Insurances: provide cover for the legal liability to pay damages, compensation, legal expenses and costs awarded against the insured in favour of another party in respect of death, bodily injury, or loss of or damage to property:

    • Work Injury Compensation Insurance: Insures the employer’s obligations to their eligible employees under the Work Injury Compensation Act 2019 against certain occupational diseases or accidents arising out of and in the course of employment.

    • Public Liability Insurance: Insures a business’ legal liability to third parties for injury or property damage.

    • Products Liability Insurance: Insures against liability arising from defective products.

    • Carriers and Bailees Liability Insurance: Insures the insured’s liability for loss of or damage to property held in their custody and control.

    • Commercial General Liability Insurance: Covers a wide range of legal liability under common law and contract.

    • Innkeeper’s Liability Insurance: Insures the legal liability of innkeepers arising from loss of guests’ property.

  • Marine Insurance: covers the loss and damage of ships, cargo and goods in transit.

  • Aviation Insurance: covers damage to the aircraft and liability arising from the use of the aircraft:

    • Marine Cargo Insurance: Insures cargo during transit.

    • Marine Hull Insurance: Insures the physical loss or damage to a vessel or ship.

    • Aviation Insurance: Insures the physical damage of aircraft and the insured’s legal liability arising from the use of such aircraft.

  • Green Insurance: Increasingly, insurers are developing green insurance products in response to the need to protect the environment and battle climate change. Green insurance products are those that cover the design, production and use of sustainable products and where certain features promote sustainable or green behaviour.

Individual and Group Insurance

General Difference

• General Insurance products can be sold on an individual or group basis.

• Group Insurance provides coverage on each of the individual member of the group, while only the individual who applies for the coverage is covered under Individual Insurance.

Group Insurance

• Provides coverage to many people under one master policy.

• Members must belong to a group formed for purposes other than obtaining insurance.

• Examples: Companies, membership clubs, professional associations, trade unions.

Characteristics of Group Insurance

• Master Contract: Issued under a single "master contract" (group policy).

• The plan itself will still carry on, because it belongs to the holder of the master contract

• Minimal Underwriting Requirements: Simpler medical underwriting, especially for large groups; may involve a health declaration form or the pre-existing condition exclusion clause.

• Experience Rating: Underwritten based on the past claims experiences of the group to be insured.

• Cost-Effective: Low-cost protection due to savings in administrative costs and a greater pooling effect of risks.

• Plan Continuation: Renewable by the employer on a yearly basis.

• Eligibility Requirements: May have specified classes or full-time employment requirements specified in the group insurance.

• Actively At Work Clause: Employees must be actively at work for coverage to take effect.

Group Insurance Fact-Finding (GIFF) Form

• Must be completed when seeking a quotation for a Group Insurance Plan

• Does not apply to a Group Travel Insurance proposal

Compulsory & Voluntary Plans

Compulsory (Non-Contributory) Plan

• All eligible employees must be covered

• Premiums are paid by the employer.

• Advantages: Ease of administration, lower cost, greater employer control.

Voluntary (Contributory) Plan

• Does not require full participation from the employees who are expected to pay part of the premiums.

• Employer generates interest and appreciation from the participating employees in the plan and participating employees can obtain coverage at a lower premium rate than buying it individually.