Posted: June 16th, 2015

Insurance

 

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:

• Increased potential for growth due to wider scope and broader customer base than mutuals.
• The ability to raise share capital as well as loan capital, which provides greater flexibility in how the business is capitilised, which as Thoyt points out is increasingly important in times of regulatory change which will be discussed later in this module.
• Less vulnerable to downturns in specific lines of insurance or markets due to the spread of business.
• Greater distance between the policyholder and the business which means that underwriting is less likely to be affected by policyholder opinion

Insurance companies (both proprietary and composite) can be further classified as:

• Composite insurers – insurers which offer both life and general insurance
• Life or general insurers – those which write either life or general business
• Specialist insurers – those which offer a single class of insurance e.g. a specialist motor insurer.
Worldwide there are around 13,000 independent insurance companies actively trading. Around 70% of these concentrate on non-life, 25% on life and 5% are composites. Markets tend to be very concentrated and a few large companies handle a large proportion of the business.

Lloyds Syndicates

Lloyds is one of the most famous names in insurance and it is completely unique. It is not an insurance company but can be best described as an insurance marketplace that facilitates and provides administration and a regulatory structure for the transaction of insurance. Most importantly it provides a clear and very distinct brand under which its members can operate.

Chapter 6 of the Thoyt textbook considers the operations and history of Lloyds in some detail and you should read this chapter to familiarise yourself with the nature of the Lloyds market in more detail.

The origins of Lloyds can be traced back to 1688 and in many respects since that time its operations have fundamentally remained the same. There still exists a Lloyds building, insurance is transacted in the ‘room’ which houses all the Lloyds syndicate underwriters and the market continues to operate on the basis of lead underwriters and following underwriters, operating from a ‘box’. It although modern communications are used for routine business it still remains very much a face-to-face business operation as it did when it originated.

Lloyds underwriters will only transact business with authorised Lloyds brokers, who introduce the risks to the underwriters. Brokers who are not authorised will go via an authorised broker to gain access the Lloyds market. The broker prepares a ‘slip’ which is the document containing details of the risk.

The broker then enters the market and looks to find a lead underwriter for the risk, who will set the premium and terms. The lead underwriter may take all the risk, if not then the broker will then approach other underwriters to look for the remainder of the cover, on the basis of the lead underwriters premium and conditions. They will do this until 100% of the risk is covered.

A feature of Lloyds is that underwriters have developed specialist expertise in specific areas and the role of the broker is to have sufficient knowledge of this to know who they can approach to place risks.

Financing of Lloyds

Aside from the unusual way in which Lloyds operates what distinguishes it further from other insurance markets is the way in which it is financed. The capital needed to underwrite business was found by way of investment by Lloyds ‘names’ who formed ‘syndicates’. These syndicates could potentially involve hundreds or even thousands of names however more recently, with the introduction of corporate capital, limited companies can be names and the number forming a syndicate in these cases is lower.

Individual names provided capital to transact insurance business on an unlimited liability basis; they were fully liable for the payment of claims. However following a period of large losses and significant claims made (among other issues discussed in more detail in Chapter 6) between 1988 and 1992 Lloyds names faced bankruptcy and the decision was made to accept corporate members, who had limited liability. Many names then also took the option to protect themselves from personal liability by forming limited liability companies or partnerships.
Take a look at the Lloyd’s web site for an introduction to how Lloyd’s operates and the issues that are of current concern to Lloyd’s investors, underwriters, and administrators. http://www.lloyds.com/
Captives

Large corporations, in the interests of tax efficiency may set up in-house insurance companies to cover their own risks. It is essentially a method of retaining risk. By setting up a captive insurance companies organisations separate funds within a wholly owned subsidiary which contributions called ‘premiums’. A true captive would be defined by the following characteristics:

• It is a wholly owned subsidiary
• Its parent company is not primarily engaged in insurance
• Its primary function is to cover the risks of it parent company – though some may be prepared to accept risks from other captive companies,

The main reasons for forming a captive are, firstly it allow premium contributions to the captive company by group companies to be tax deductible. Secondly it allows the captive to purchase reinsurance directly at ‘wholesale’ prices i.e. not incurring commission normally charged. Some captives will retain a significant amount of risk; others reinsure most of it. There are several thousand captives in existence, which are mostly located in favourable tax environments – Bermuda, Guernsey etc.
Reinsurers

Primary insurers will often transfer some of the risk to reinsurers, the reinsurers accepts risk from another insurer (or ceding company). This allows them to spread the risk and also them to take on business they may otherwise have been unable to do so due to limitations in capital. The reinsurer has no contact with the customer and the primary insurer is fully liable for payment of valid claims, even in the event the reinsurer defaulted in payment to the primary insurer. Insurance companies and Lloyds syndicates will undertake reinsurance for other insurers however the market is generally dominated by specialist companies such as Swiss Re and Munich Re. Reinsurance will be considered in more detail in topic 3.

Insurance Service Providers

These are non-risk bearing companies working within the insurance market, depending on the role they play they may be paid by the customer or the insurer. This type of company can include:

–Risk assessors/surveyors/inspectors
–Loss adjusters
–Loss assessors
–Damage/loss control services/salvors
–Assistance services, e.g. medical repatriation from overseas

Market representation and market management organisations

Most markets have their own market organisations to maintain market stability and generally represent the industry. Within the UK the most influential and important associations are as follows:
• The Association of British Insurers (ABI) are the trade association representing insurers licensed to operate within the UK.
• BIBA – British Insurance Brokers Association
• AIRMIC – Association of Insurance and Risk Managers in Industry and Commerce

Please take a look at the ABI web site – it contains a lot of useful material. If you are interested, you can use it to order from their range of current publications, some of which are free. http://www.abi.org.uk/
Rating Agencies

The rating agencies are:
• Standard & Poors
• AM Best
• Moodys
• Fitch

Their role is to give ratings assessing the financial strength of insurers. Similar to the way they rate corporate debt (credit ratings). The ratings can influence the way that insurance business is carried out, e.g. brokers or corporate customers may only choose to deal with insurers of a certain rating level. Primary insurers may also choose only do business with reinsurers of a certain rating level. The highest category AAA+ is very attractive from trading perspective however from a shareholder perspective may give rise to the suggestion that insurers are holding too much capital and therefore limiting dividends.
Standard and Poor’s Rating

S & P consider factors such as:
• State of the business environment
• Profile of the insurers business
• Quality of the management
• Corporate strategy
• Performance ratios
• Investment portfolio
• Capital adequacy now and in the future
• Liquidity

The insurer is then placed in one of the following categories:
• AAA extremely strong
• AA very strong
• A strong
• BBB good
• BB marginal
• B weak
• CCC very weak
• CC extremely weak
(Atkins and Bates, 2008, pp 56)

This lecture has considered in brief some of the key players in the in insurance market place, we have focussed primarily on the UK market however the types of organisations (with the exception of Lloyds) discussed here can be found in most insurance markets.

Self-assessment Questions

1. Mutual insurance companies have diminished in recent years, what are the main reasons for this?

2. Most large organisations rely on a broker to advise them on insurance cover, what are the benefits of doing this?

3. Lloyds is considered to be unique in terms of insurance, briefly outline the way that Lloyds operates and the key players in the Lloyds market place.

4. Lloyds has faced numerous issues over financing, provide an explanation of these and an outline of the current situation regarding capital provision at Lloyds.

End of Topic 3
Topic 4: Forms and Types of Insurance

This lecture will examine the different types of insurance cover available with a focus on those products most commonly used by business insurance customers. The use of reinsurance will be discussed with an overview of some of the key approaches taken to this.

• Outline the main types of non-life insurance products
• Critically analyse the purpose of reinsurance
• Discuss the main methods of reinsurance available and evaluate the advantages and disadvantages of each.
Reading:

Thoyt, chapter 7 and appendix I and II
Skipper and Kwon, chapter 23 (in reader)

We have already mentioned insurance customers in topic 2, primarily made up of individuals and businesses with different insurance needs.

Individuals commonly need:
• Home insurance for house and contents
• Motor Insurance
• Travel Insurance

Small businesses commonly need:
• Combined Insurance Policy – a package with specified limits/sums insured
• Commercial vehicle insurance

Larger organisations may need cover for:
• Commercial property
• Business interruption
• Theft
• Engineering insurance for machinery breakdown
• Motor fleet
• Employer’s liability, public liability and product liability
• Goods in transit inland
• Marine cargo for exports
• Fidelity guarantee for dishonesty of employees

Insurance products are built around specific perils, the subject matter or by type of customer:

ElementExamplesPerilFire, earthquake, theft, liability, sickness, accidental damage
Subject matterPremises, person, inventory, ship, motor vehicle, business jewellery
Customer typeCommercial, personal
Customer segmentHomeowner, tenant, shopkeeper, building contractor

(Atkins & Bates, 2008, pp.41)
They may be written around a single peril e.g. standard fire policy or third party motor insurance policy but are normally sold as packages or comprehensive policies which cover a range of perils suitable for certain customer types or industry sectors. We will discuss some of the more commonly seen insurance products in this topic.

Property Insurances

Property insurance developed from the standard fire policy which was designed to cover a building, plant, machinery, other contents and stock against fire, lightening and certain types of explosion. Additional perils have later become available as a response to customer needs. These are broadly categorised as ‘wet’ perils (involving water) and ‘dry’ perils. They are also divided by their nature:

• Chemical perils
• Social perils
• Perils of nature
• Impact perils

A full explanation of these can be found on pp 312 and 313 of the Thoyt textbook.
Commercial All Risks Insurance

A widely used approach, particularly for insuring larger risks, is commercial all risks insurance. This covers all risks for loss or damage to property with certain exceptions:

• Wear and tear
• Inventory shortages
• Machinery breakdown
• Dishonesty
• Money shortage

Theft Insurance

Usually included within part of a package although often as a separate section. Single theft policies are still written for more high risk business such as jewellers. Commercial policies usually restrict to theft involving forcible entry or exit to or from the premises. The intention being to exclude pilferage or shoplifting by staff or customers, which is much harder to control. Personal lines policies usually offer wider cover i.e. regardless of thief’s method of entry/exit.

Business Interruption Insurance

Sometimes also called loss of profits or consequential loss insurance this cover indemnifies the business for loss of expected future profits following a disruption caused by fire or special perils, machinery breakdown, or any other insured peril. The purpose is to allow the business time to recover from any physical damage that may have occurred. Cover includes: loss of gross profit, wages, additional costs of working. The policy would also specify an indemnity period for which cover was operable, usually 12, 24 or 48 months.

Contractors All Risks insurance

This type of insurance was developed in response to the requirements of the standard contracts used for large scale building/civil engineering works which specify that the contractor must take out insurance for the building site in joint names of employer and contractor.

The property part is covered by a contract works policy and the policy is usually issued on an all risks basis indemnifing the policyholde against the cost of restoring the works to their pre-loss condition. Will indemnity the policyholder against loss or damage from any cause with a few exceptions:

• War, civil commotion
• Consequential loss
• Cessation of work
• Defective design
• Defective material or workmanship
• Breakdown of plant
• Lack of maintenance

(Atkins and Bates, 2008, pp 43)

Engineering Insurance

Deals with insurance of plant and machinery as is focused on loss or damage within the plant itself i.e. explosion, breakdown, collapse, although it may be extended to cover business interruption arising out of a loss. Most insurers also offer an inspection service with or without insurance cover. In some countries regular inspection of plant is statutory and the insurer may be authorised to carry these out.

Liability Insurance

These policies are designed to indemnify the insured for compensatory awards made against the insured’s company with any associated legal costs. Companies, organisations or individuals may become liable for bodily injury or damage to property caused by their acts or omissions. The liability may arise out of negligence, statute or contract. Potential for claims to arise often relates to local culture, custom or predisposition of the legal system to support such actions e.g. the USA has cultivated a ‘compensation culture’ due to the likelihood of initiating a successful claim and the large awards given if successful.

Public Liability
Public liability covers the general liability of an insured to the public as a result of its operation e.g. pollution, injury to a visitor, damage to third party goods in the custody of the insured. Pollution claims however are limited to sudden and accidental pollution, not that caused by long-term emissions.

The policy will be subject to a maximum limit of indemnity which should be sufficient to cover both compensation and third party legal costs arising from a claim. The policyholder’s legal costs will be met in addition to the limit of indemnity. The limits offered by insurers are normally £1 million, £2 million and £5 million. If a limit of Indemnity is required which is higher than that which the Insurer can provide an excess layer can be arranged in order to provide the level of indemnity required by the policyholder. A claim which is in excess of the limit under the base policy will be met by the additional policy.

Product Liability
Product liability covers liability arising out of goods sold, supplied, repaired or serviced by the insured. This cover needs to be underwritten with care, especially for high-risk areas such as pharmaceuticals, vehicle components and goods exported to the USA.

Claims for damages usually fall into four categories:
• Defective Design: means that an item is inherently dangerous because of inadequate design.
• Defective Manufacture: generally occurs because of a quality control failure ensuring that the item does not achieve the required specification.
• Defective Warnings: do not accurately reflect the dangers associated with the item or adequate warnings may have been minimised by the salesman.
• Negligent Surveillance: occurs when a manufacturer does not properly warn consumers about an items subsequently discovered lack of safety.

Efficacy Insurance is designed to cover the failure of an item to perform its intended function and is often purchased as an extension to Products or Public Liability Insurance. Efficacy insurance is commonly required by business involved in the manufacture, supply or installation of performance critical products such as fire alarms, emergency lightening, brake systems, temperature controls etc. Most standard public or product liability policies will exclude efficacy cover.

Professional Indemnity
Professional indemnity insurance provides cover for negligent acts carried out and advice given as part of a professional service. This cover is usually taken out by lawyers, accountants, brokers etc. It can be particularly expensive for doctors.

Employers Liability
Employers liability insurance provides cover for liability to employers for injury or sickness. It is compulsory in many countries including the UK
Also called workers compensation cover in some countries including the US and New Zealand.

The UK Employers’ Liability (Compulsory Insurance) Regulations 1998 specified that the limit of indemnity per occurrence must be £5 million
In practice most policies issued in the United Kingdom are issued with a £10 million indemnity limit. Where a need for a higher limit has been identified then additional cover may be purchased in the form of Excess Layer or Excess of Loss Insurance.

When working out the right level of cover an organisation should consider:
• What are the main risks faced?
• How much the most serious claim faced could cost (not forgetting legal fees)
• Whether they have any contracts which stipulate that a certain level of cover

Employers are strongly advised to keep, as far as is possible, a complete record of their employers’ liability insurance. Some diseases can appear decades after exposure to their cause and former or current employees may decide to make a claim against their employer for the period they were exposed to the cause of their illness. Employers that fail to hold the necessary insurance details risk having to meet the costs of such claims themselves.

Directors and officers (D&O) cover:
D&O insurance covers the personal liability of directors for the way in which they run their companies. This is a growing area as a result of various corporate scandals in the last decade. Directors of all companies are now held, at an unprecedented level, to be personally responsible for any actions and decisions they make on behalf of the company – putting their personal assets at risk if those decisions are tested in the courts.

Example D&O claim:

In October 1997 a driver fell asleep whilst driving for the family-run haulage company for which he was employed. Two motorists were killed. The court held that the operations manager should have ensured that his driver adhered to the relevant driving regulations. He had also failed to keep in close touch on these matters with his co-director. Both directors incurred substantial defence costs before being convicted of corporate manslaughter.

Motor

Motor insurance covers liability in respect of road accidents, and damage to the vehicle itself.

Private car insurance
The minimum statutory insurance for the UK is for third party liability but this is usually combined with cover against loss by fire or theft. A comprehensive policy will also include accidental damage and windscreen cover. Personal motor insurance can be extended to cover personal accident, personal possessions, legal expenses, etc.

Commercial vehicle insurance
This is usually called motor fleet insurance for commercial policies that include all types of vehicle designed for road use. Specialist non-road vehicles would be covered under the engineering policy not the motor fleet.

A motor trade policy is a specialist package policy for garages. This also covers the building, showroom and vehicles. Motor trade policies may also cover vehicles under the care of the garage’s custody and control.

Marine & Aviation Insurance

These are highly specialised classes of insurance. Marine is the oldest type of insurance and uses different terminology to property and casualty insurance. Aviation has much in common with marine in terms of wording etc.

Marine
• Provides cover against the perils of the sea e.g. sinking, heavy weather damage, fire, collision, piracy.
• Cover may include: the hull, the cargo or the freight (payment for the carriage of cargo)
• Cover can apply during the construction of the vessel or during voyages
• Cargo usually insurance on a warehouse-to-warehouse basis covering all risks

Aviation
• Covers hull, passenger liability and third-party liability, usually on all risks basis.
• May be used by airlines, individuals & flying clubs

Goods in transit
Goods in transit insurance covers the owner or the carrier of goods for damage or loss incurred during inland transit. This is an area where insurers are vulnerable to acts of dishonesty and much attention is given to the quality of the carrier.

Terrorism
Most UK property insurers participate in the Pool Re scheme and have agreed to offer terrorism cover to clients or prospective clients. This covers any losses resulting from damage to property as a result of any act of terrorism. In the event losses were ever so large as to exhaust their funds Pool Re would then draw funds from the Government to cover its obligations. Pool Re in turn would pay a premium to the Government for this cover and would be required to repay any funds drawn in this way from future income. Terrorism pools operate in USA, UK, Germany, France, Netherlands, Australia, Namibia and South Africa.

Reinsurance

Reinsurance is a further means of spreading risk and has been in existence since insurance itself began to emerge. Insurance companies are bound by their underwriting capacity in terms of what risks they can write. Underwriting capacity can be affected by numerous internal and external constraints including capital, underwriting expertise, type of business, regulation etc. In order to increase capacity an insurer will turn to reinsurance, reinsurers therefore insure primary insurers.

There are several reasons why a primary insurer will reinsure:

• Capacity – as mentioned already one of the reasons an insurer will look to reinsure is to increase their capacity. Insurers are required to provide a guarantee of solvency in the event of large or multiple losses occurring and this means their underwriting capacity can be restricted by their financial reserves. Reinsurance allows insurers to take on single risks which they otherwise would be unable to do due to capacity.
• Catastrophe Protection – the basic principles of insurance also applies to insurers who must also protect themselves from financial catastrophe. Accumulations of loss e.g. the impact of a large number of claims from small value policies can accumulate to the point where they result in what would be considered a catastrophic loss. In addition to reinsuring single risks cover can be taken to insure specific events such as storms or floods that can result in an accumulative effect.
• Loss-spreading and stabilisation – by purchasing reinsurance (at a known and affordable cost) insurers can reduce the level of uncertainty they face, thereby encouraging investment and satisfying shareholder demands. Reinsurance also helps stabilise the insurance market as a whole, allowing risks to be spread on a global basis rather than just in the domestic market. This is particularly important for insurers who only operate in a country that is prone to natural disaster.
• Confidence – Reinsurance can allow insurers to enter a new market with some level of confidence. Insurers base their underwriting decisions on claims data generated over years of experience and for new markets accurate data will be less readily available. By heavily reinsuring at the early stages of entering a new market they can do so with less risk while they gain the necessary experience of the market. Insurers can also make use of the expertise of reinsurers and gauge their own underwriting pricing structure on the cost of reinsurance.
• Regulatory compliance – this will be discussed in the next topic however regulation dictates that insurers must hold certain levels of capital and guarantee a certain level of solvency. Reinsurance allows insurers to expand and take on risks whilst still meeting any minimum regulatory requirements.

Further explanation of the drivers for reinsurance can be found in Chapter 23 of Kwon and Skipper (in the reader) which you should read through in your own time.

Reinsurance Terminology

• Ceding office – insurer placing part or all of a risk
• Cession – The unit of insurance passed (or ceded) to a pro-rata reinsurer by a primary company or cedent which issued a policy to the original insured. A cession may be the whole or a portion of single risks, defined policies, or defined divisions of business, all as agreed in the reinsurance contract.
• Retrocession – whereby a reinsurer passes on some of the risk to another reinsurer

Reinsurance Distribution

Reinsurance is sold both by brokers and directly by reinsurance companies. Reinsurers selling directly to primary insurers are called direct writing reinsurers. They use their employees to solicit business and help clients design reinsurance programs. However the majority of reinsurers get their business through brokers, who will deal with the complexities of reinsurance. Reinsurance brokers also monitor financial and operational soundness of reinsurers with whom they place business
Small and new insurers will depend heavily on the judgment of brokers in selecting reinsurers.
• Contract is made between primary insurer and customer.
• Contract of reinsurance is made between the insurer and the reinsurer
• Some exceptions to this – cut through provision (see below)
• Defined as traditional and non-traditional reinsurance.
Methods of Reinsurance

There are two major types of reinsurance, treaty and commission:

Treaty
Agreed in advance of the years underwriting by the insurer and reinsurance. The insurer agrees to cede and the reinsurer accept any business that falls within the scope of the treaty. It is therefore an automatic arrangement with pricing and conditions set beforehand. This method has several advantages:

• Cheap to administer – admin costs and underwriting costs for reinsurer are low.
• Gives insurer automatic increase in capacity and often technical assistance from the reinsurer.
• Long term relationship is built between the insurer and the reinsurer.
The main disadvantage for the insurer is that they must cede all risks within the agreement. So they may reinsurer smaller risks (and forward premiums) for risks they could have kept.

Facultative Reinsurance
Risks that will fall out with the scope of a treaty can still be reinsured through facultative reinsurance. The insurer in this type of arrangement is free to decide what risks will be ceded and the amount that will be ceded. The reinsurer can also select which risks they wish to take on and at what terms. Whilst this method has obvious advantages for both parties the cost of underwriting and administration is much higher as each risk is negotiated on a case-by-case basis. As a result it is only used for high risk policies with a substantial premium relative to the underwriting cost. Facultative reinsurance would usually occur when an insurer has no treaty agreement in place for a line of business or a particular territory, when a certain risk is excluded from an existing treaty or the existing treaty’s capacity has been exhausted.
1. You are a risk manager for a large manufacturing firm, what key insurance covers would your company require and why?

2. Explain the purpose of reinsurance.

3. What factors can affect an insurers decision to reinsure?

4. What is the difference between facultative reinsurance and treaty reinsurance?

5. Chapter 23 of Skipper and Kwon discusses different forms of reinsurance, explain the following:

a. Proportional reinsurance
b. Quota share treaties
c. Surplus treaties
d. Excess of loss treaties

End of Topic 4
Topic 5: Law and Regulation of Insurance

This topic will examine the regulatory context in which insurance is conducted. Particular attention will be given to the Financial Services Authority and the role they play in regulating insurance in the UK and also Solvency II regulation which will be introduced across EU member states by 2013.

Learning Objectives

• Discuss the regulatory, fiscal, legal and accounting frameworks within which non-life insurance is conducted.
• Evaluate the role of the FSA in regulating both the insurance companies and intermediaries
• Discuss the role of the Financial Ombudsman Service.
• Critically discuss the purpose of Solvency II regulation and the impact this is likely to have on the EU insurance market.

Reading

Thoyt – Chapter 5, pp 106 – 135
Introduction

As with all other organisations Insurance companies operate in an environment where they are subject to various legislative and regulatory requirements. Examples of regulation affecting a non-life insurer:

• Employment law
• H&S law
• Generally accepted accounting principles (GAAP)
• Company Law
• Corporate governance regulations
• Taxation regulations
• Data protection
• Competition law

However, all of the above affect ALL corporate entities, not just insurers.

In addition there exists various legislation and regulation specific to insurers:

• Financial Services & Markets Act (2000)
• The Financial Services Handbook (resulting from above act)
• Various Insurance Companies Acts
• Insurance-specific taxation rules

It is also impacted by the requirements for statutory insurance, which will differ in different countries, however for the UK is: third party motor cover, employer’s liability and professional indemnity for certain professions

Some laws and regulations may also affect insurance covers:

• Terrorism cover was excluded from standard commercial covers in the UK which led to the establishment of Pool Re – a market-wide pool for this type cover.

• Case law – can often affect the extent and nature of covers and the monetary value of liability. Precedents can be set for the payment of claims and extent of cover.
Other influences

The industry will also come under pressure from government, regulators or consumer groups to act in certain ways, that may not necessarily be in their interest, for example:

• Availability & pricing of flood cover
• Availability & pricing of motor/property covers in high-crime areas
• Availability and pricing of liability cover post-Enron environment

Taxation

In addition to normal tax rules for employee salaries, corporate earnings and VAT insurers have two other areas of focus:

• Insurance Premium Tax (IPT) – different rules to VAT, collected in a different way, 5% in the UK.
• Insurers must make judgments regarding claims reserves, for known claims, claims not reported and for large events that occur occasionally but have a significant impact. There are tax rules depending on the amount an insurer keeps in reserve and what is considered taxable income.

Interests of government

For an effective and efficient insurance market to exist, government must create a situation whereby:

• Customers can buy appropriate products at an affordable price
• Customers are protected from malpractice by or the mismanagement of insurance companies
• There is confidence that the insurer will pay a claim
• Insurers are allowed to generate sufficient returns on the capital invested to make it worthwhile continuing to participate in the market
• The market is seen to operate in an environment of openness, confidence and trust

Governments can facilitate this kind of market through legislation and regulation and usually a regulatory body is formed to oversee the industry.

The Role of Insurance Market Regulation

Regulators have a varied role that can include all or most of the following:

• Authorisation of companies so that they may participate in the market
• Regular financial and statistical monitoring of the market
• Establishes operational rules for companies, including risk management, conducting business, reporting systems etc.
• Process of inspection/review of authorised companies
• To ensure the solvency of participants – to protect society from the insolvency of any insurance company
• To ensure market confidence and an efficient market.
• To protect consumers by ensuring that retail consumers are able to buy the most appropriate products for their needs, at an affordable price, and have recourse if insurers act improperly.

Insurance Regulation in the UK

In the UK the Financial Services Authority (FSA) decided to introduce its own regime based on Basel II pending implementation of Solvency II in 2012. The FSA capital resources requirements are much higher than EU requirements and it expects firms to have approx twice the MCR.
Its capital resource requirement is the higher of an enhanced capital requirement (ECR) and the MCR. The ECR is usually higher in practice at about twice the MCR.

The FSA is the UK’s single regulator for the financial services industry. It is an independent body set up under the Financial Services and Markets Act 2000 and it replaced various other bodies which had regulated the FS sector up to this point.

The FSA’s has set its aims out under three broad headings:
• Promoting efficient orderly and fair markets;
• Helping retail consumers achieve a fair deal;
• Improving their business capability and effectiveness

As stated the approach is risk-based, with the following principles of good regulation:
• Maintaining the UK’s international competitive position
• Seeking to ensure the most efficient and economic use of resources
• Encouraging competition
• Facilitating innovation
• Emphasising the responsibility of firms own management
• Being proportionate (in how it deals with issues)

The FSA Handbook

Rules and guidance are set down in the FSA handbook, which is an amalgamation of nearly 40 books and manuals relating to regulation in the FS industry, 26 of which apply to insurance.

Not surprisingly it is lengthy and difficult to read for the non-specialist audience. Which is the downside of trying to deal with a varied industry using one regulator.

FSA Requirements

All regulated firms must comply with the following principles:
• Integrity
• Skill care and diligence
• Management and control
• Financial prudence
• Market conduct
• Customer interests
• Communications with clients
• Conflicts of interests
• Clients assets
• Relations with regulators

A firm must maintain appropriate apportionment of responsibilities among its directors and senior managers so that business affairs can be adequately monitored and controlled. It must be supported by effective risk management structures, systems and controls. This reinforces the Combined Code on Corporate Governance. Organisations are to provide rules on how to assess risks which affect it meeting its liabilities, how it will deal with the risks and the nature of the financial resources that the firm considers necessary. They are also expected to carry out stress tests and scenario analysis.

Complaints Procedures

FSA specifies requirements for handling complaints:
• Internal complaints handling procedures that a regulated firm must have, and;
• The Financial Ombudsman Service – established under the FS and Markets Act 2000 to help resolve disputes between FS firms and customers, fairly, quickly, reasonably and informally.
• Free and completely independent – for small businesses with a turnover of less than £1m and individuals.

Solvency II

Solvency II is to replace Solvency I with a more risk-based approach. A solvency capital requirement has the following purposes:
• To reduce the risk that an insurer would be unable to meet claims
• To reduce the losses suffered by policyholders in the event that a firm is unable to meet all claims fully
• To provide supervisors early warning so that they can intervene promptly if capital falls below the required level
• To promote confidence in the financial stability of the insurance sector

Solvency II is a unified, prudential reserving and regulatory framework for European Union insurers and reinsurers. It has a much wider scope than Solvency I and proposes a Basel II three-pillar structure which has been adapted for the insurance sector. This new system is intended to offer insurance companies incentives to measure and manage their risk situation and includes both quantitative and qualitative aspects of risk.
On the FSA website you will find extensive information on Solvency II, in addition you will find many other consulting and financial advisory firms who have written reports on Solvency II. As a minimum please read the following links:
http://www.fsa.gov.uk/Pages/About/What/International/solvency/background/index.shtml

http://www.fsa.gov.uk/Pages/About/What/International/solvency/governance/index.shtml

http://www.fsa.gov.uk/Pages/About/What/International/solvency/reporting/index.shtml

http://www.ey.com/Publication/vwLUAssets/EY_Solvency_II_Pillar_III_and_IFRS_4/$FILE/EY_Solvency_II_Pillar_III_and_IFRS_4.pdf

Self-Assessment Questions

1. Why is government involvement in the insurance industry required?

2. Outline the role that regulation plays in the insurance market and the key powers a regulator should have.

3. Explain the remit of Solvency II and the purpose of introducing such a framework.

4. Outline the key objectives of Solvency II

5. Outline each of the three pillars of Solvency II.

6. What is the purpose of the ORSA?

7. What do you think the main challenges for Solvency II implementation are likely to be?

Topic 6: Underwriting and pricing of general and life insurance

Preview

If an insurance company’s business is to be sustainable in the medium to long term, the policies that they issue need to be correctly underwritten and priced. The history of insurance is littered with companies who have failed financially and, very often, this failure can be attributed to the inadequacy of their underwriting and pricing strategy. This topic looks at the basic principles that insurers should follow and some of the factors that will impact on these principles. Following on from a general overview of underwriting and pricing, the topic looks separately at the main issues surrounding general and life insurances.
Learning outcomes

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

• Analyse the means by which insurance companies assess levels of risk
• Discuss the operation of the reinsurance market and evaluate its impact on general insurance underwriting and pricing
• Discuss the principles of general insurance pricing
• Critically evaluate the impact of the ‘underwriting cycle’
• Outline the mathematical basis of life assurance
• Analyse the key similarities and differences between life assurance and general insurance
• Discuss the major classes of life business
• Discuss the main forms of pensions business
• Critically analyse the causes of life and pension related controversies and problems and their effects on the insurance industry

Indicative reading:

Thoyt (2010), Chapters 3, 4, 10 & 11
Atkins & Bates (2008), Chapter 13 (supplied in the Module Reader)

Stein, W. (2007), Chapter 2 (CIOBS text on GCU Learn)
Principles and practice of underwriting

The term ‘underwriting’ can be traced back to the early marine insurance policies issued by Lloyds of London. Those who were prepared to provide financial backing for these marine insurance contracts signed their name under the details of the risk. As insurance grew in sophistication, the term ‘underwriting’ developed to encompass a more complex set of tasks than simply signing your name.

In Topic 2 we looked at the concepts of:

• the common pool
• equitable premiums
• adverse selection
The role of the underwriter is to use a range of techniques to manage these three concepts. Fundamentally, these techniques will revolve around:

• evaluating the risk that a proposer brings to the pool
• coming to a decision on whether to accept that risk and, if so, whether partially or in full
• deciding on the cover, terms and conditions of the insurance
• calculating a suitable and equitable premium

The precise underwriting practice and techniques vary from one type of insurance to another, but we will cover the general principles which any insurer, offering any type of insurance would need to consider. Underpinning these general principles is a very strong mathematical basis of pricing, which will fundamentally revolve around:
• relative frequency
• the Law of Large Numbers
• Stochastic modelling

The detailed mathematics behind these three concepts is beyond the scope of this course, but it is important to anyone interested in insurance pricing to be broadly familiar with their nature and function.

The general underwriting principles will operate at two main levels within the organisation; the management / strategic level and the operational / front-line level.

Underwriting at the management / strategic level is, generally, an insurance ‘Head Office’ function. At this level, the senior underwriter (and there may be a number of these to reflect the different forms of insurance offered) will decide on the overall underwriting policy to be pursued. This will contain such elements as:

• what products do we want to offer
• what type of risks are we hoping to attract
• what are the broad criteria which operation underwriters must follow
• what should our reinsurance arrangements be
• how will we ensure operational underwriting competence

Depending on the insurer’s overall structure and philosophy, senior underwriters will delegate more or less authority to operational underwriters. These underwriters will be expected to follow the company’s general strategy, but may have a degree of discretion in how that strategy is implemented.
General Insurance

Firstly, we will look at the question of hazard assessment.
In insurance terms, ‘hazard’ relates to something that may impact on the frequency and/or severity of the insured event. In general, underwriters will consider two main forms of hazard – physical and moral.

Physical hazard is something which is related to the physical, tangible characteristics of the insured risk. For example, this could be:

TYPE OF INSURANCEPHYSICAL HAZARDFireConstruction of the buildingMotorMake and model of the vehicleMarineNature of the cargo
If we take fire as a specific example, a building that is constructed of wood is clearly more ‘hazardous’ than one which is constructed of stone. A fire starting in a wooden building is likely to be much more severe, therefore, the physical hazard is much greater than the stone building and, consequently, the fire underwriter will charge a much higher premium or give much more restricted cover.

In many respects, the underwriting of physical hazards is more straightforward in that, assuming there is full disclosure, the hazards are capable of more objective assessment.

Moral hazards can be much more difficult to assess with any degree of objectivity. These relate to the personal attitudes or characteristics of the person who is seeking insurance. These attitudes may reveal themselves in a connection with a physical hazard, e.g. a lack of care (a moral hazard) may manifest itself in a failure to ensure that dangerous machinery is correctly used (a physical hazard). However, many of the moral hazards such as dishonesty or recklessness may only become evident after the insurer has accepted the business and the claims start to roll in.
The underwriting process
Although the fundamental principles apply to all forms of insurance, the degree of complexity in the underwriting process will vary considerably depending on the:

• type of insurance
• insurer’s experience of, and attitude towards, that insurance
• reinsurance market attitude

For example, if we consider personal lines insurance, such as house insurance, most insurers who offer this will underwrite a large amount of it. In effect, it will be considered to be ‘volume’ business with very little individual underwriting for the vast majority of policies. The insurer’s experience will be such that the personal lines portfolio of business will be commoditised. Reinsurers will take a close interest in potential aggregate losses on the portfolio, but will be less intrusive than they will be with more complex and high risk insurance. An example of this complex and high risk insurance would be the property and liability covers of a multi-national manufacturing company. Here the underwriting will be much more individualised and will involve the insurer in a range of assessment methods, including those that are desk-based and those that will involve such measures as risk surveys.
To give you an indication of the relative complexity that will be involved in underwriting home insurance as compared to commercial insurance, please look at the text available on GCU Learn:

Stein, W. (2007) Introduction to Insurance, Edinburgh, Chartered Institute of Bankers in Scotland (CIOBS)
Home insurance starts on page 73 and commercial insurance starts on page 137

Pricing
In most developed markets, insurance companies are commercial, private sector organisations, therefore their fundamental purpose is to make profits. As we will see when we look at the underwriting cycle they do not always to this successfully, although in the long run most insurers will be profitable. Central to this expected profitability is the need to have an effective pricing system. In some insurance markets, pricing will be influenced by government regulation or by the existence of ‘tariffs’ (an agreement by all insurers in that market to charge the same rate). These clearly have an impact on the insurer’s freedom and discretion regarding pricing. Our discussion will revolve around those markets where insurers can set their own pricing structure.

Central to the question of pricing is the notion of the equitable (or fair) premium. This was introduced in Topic 2. An equitable premium for an individual insured should be set at such a level that it will cover:

• the expected claims costs
• the insurer’s administrative and other costs
• an amount for investment by the insurer
• a profit loading
• various external factors, such as interest rates and inflation

For the vast majority of insurers, and forms of insurance, the expected claims cost represents the largest component of the equitable premium. As previously indicated, insurers will use the Law of Large Numbers as a method for calculating the likely losses across the common pool of risks. Even within the common pool, however, the individual risks will not be entirely homogenous, therefore it will not be equitable to charge every insured the same premium. Consider the following example:

A motor insurer’s target market is female drivers aged between 30 and 60. In statistical terms, this is a common pool of drivers that have a lower than average claims frequency and severity. However, even within this safer than average pool of risks there will be some who:
• have a poor accident record
• have a history of driving convictions
• drive very powerful and/or expensive cars.
Those who have one or more of these adverse characteristics cannot, realistically, expect to pay the same premium as those who do not have any of the characteristics. Quite simply, the ‘riskier’ segment of the common pool will have higher than the average claims costs. If the insurer is prepared to accept them, which will depend on their underwriting criteria, their equitable premium will be higher than the average for the common pool.
In effect, the insurer will be looking at two basic aspects of expected claims costs:
1. the total premiums charged will be adequate to deal with the total claims costs of the pool
2. individual premiums reflect the level of risk that each insured brings to the pool
Insurers will always be working with imperfect knowledge, therefore, as will be discussed in Topic 7, the expected claims costs for any common pool are a combination of the known and the unknown.

Reinsurance
Reinsurance is covered in more detail in Topic 4, but it would be useful here to recap on the role that it plays in underwriting. Ultimately, reinsurance (in whatever form it takes) is the insurance that insurance companies buy. They will buy this for four main reasons:

1. financial security
2. financial stability
3. underwriting capacity
4. protection against catastrophes

The reinsurers, who are often much larger and have a much more global spread of business than the insurance companies, will exercise their own underwriting criteria on business that is proposed to them by the insurers. Given that reinsurers only tend to get involved in losses, either individual or cumulative, that are substantial, their underwriting criteria are often rigorous. Given these criteria, it is unsurprising that the influence of reinsurers on the underwriting and pricing strategy and practice of insurers is significant. For example, in recent years reinsurers have been behind significant changes in insurers’ attitudes towards such covers as terrorism, environmental and employers’ liability.
The underwriting cycle
The well-understood phenomenon of the ‘underwriting cycle’ is a key factor in the underwriting and pricing practices of both the insurance market as a whole (excluding the life insurance market) and also individual insurers. The drivers of the cycle have been neatly summarised as follows:
Underwriting results follow a cyclic pattern caused by external factors affecting capacity – such as catastrophic events and investment performance. In addition, internal factors – such as insurers striving for market share during times of robust investment results – contribute to the cycle. The cycles average about six years in length and are synchronised across countries and to some extent across lines of business.

Swiss Re, Sigma No. 5, 2001

Within the underwriting cycle there are two separate components:

• a underwriting profit cycle
• a pricing cycle
Underwriting profit cycle
We could start at any point on the cycle, but it is easier to understand the concept of the underwriting cycle as a whole if we start at the top of the profit cycle. At this point insurance is highly profitable. As with many profitable businesses, there may be an increase in supply as more providers seek a share of the market. The demand is, however, limited, so more supply and static demand leads to intense competition. To attract, or retain business, insurers (who may have become complacent due to their underwriting profit) will start to reduce underwriting standards and prices. This is known as the soft market. Insurance is, relatively, easy and cheap to purchase.
The inevitable consequence of these actions will be a swing from underwriting profit to underwriting loss. Supply will reduce, although demand remains, roughly, the same. This static demand and reduced supply allows insurers to return to stricter underwriting and pricing practices. We are now in the hard market.

Pricing cycle
The pricing cycle lags behind the profit cycle by approximate two years. This is due to the fact that it takes that period of time for changes in pricing to translate into results, either profit or loss. If we start at the bottom of the profit cycle (the hard market), insurers will now be charging much higher premiums than they were before. They are, however, still facing the consequences of the soft market, i.e. increased claims and decreased income. In addition, they may have exhausted much of their capital. It will take a period of time, therefore, for the effects of increased premiums and stricter underwriting to feed-through to the profit and loss account.
As indicated by Swiss Re, the underwriting cycle is a factor of external and internal factors. The external factors are substantially beyond the control of the insurance market, but the internal ones are fully within their control. Why, therefore, given the well-understood nature of the underwriting cycle, do insurers not seem to learn from the mistakes of the past? There is no consensus view on why this is the case and no real evidence that the underwriting cycle is likely to disappear in the foreseeable future. This not a desirable situation for either insurers or insureds. In particular, large scale buyers of insurance are discomforted by the vagaries of the cycle. If an organisation has a large insurance portfolio and an insurance budget running into millions of pounds, it prefers a high degree of certainty and consistency. The risk / insurance manager of that organisation does not relish the prospect of covers that were widely available at reasonable cost in one insurance year, becoming highly problematic and expensive in another insurance year. This problem has been widely cited as one of the reasons why many large scale buyers of insurance have increasingly utilised other forms of risk financing.
Life insurance and Pensions

Although the basic principles of insurance apply to all forms of business, many of the practical issues surrounding general (often referred to as ‘short term’) insurance and life and pensions (‘long term’) assurance differ. In theory, and in many practical respects, life and pensions business should be a much more predictable and less volatile sector. However, as we will discuss, in recent years it is a sector that has faced a number of controversies and difficulties.
Terminology
In the English-speaking world, some of the terminology surrounding long-term and short-term business frequently differs. In particular, life business is frequently referred to as ‘assurance’ rather than ‘insurance’. This dates back to a time when the range of life business was narrower than it is today and was, substantially, restricted to policies that would pay out on the death of the policyholder, whenever that occurred. Given that death is inevitable (or assured), the word ‘assurance’ passed into common usage. The words assurance and insurance have, increasingly, became interchangeable for long term business, and we will stick with the generic terms of ‘insurance’ and ‘insured’.
Life Insurance
The common pool principle is as relevant for life Insurance as it is for general insurance. Indeed, the common pool is more reliable and predictable for pricing of life Insurance than it is for most other forms of insurance. This is primarily due to the very strong mathematical basis of life Insurance, in particular the use of mortality tables. These have their origins in the work of Edmund Halley (1656-1742) and James Dodson (1705-1757), and they work on the following basis:

Mortality tables are grids of numbers which show that for each age, within a population, what the probability of death is within one year, e.g. a standard mortality table might show that a 21 year old female has a 0.000243 chance and a 54 year old male has a 0.006612 chance of death before their next birthday.

Using the Law of Large Numbers, mortality tables are mathematically sound for groups, although they clearly do not give a reliable prediction for the time of death for individuals. The basic probabilities are calculated on age and gender, given that women tend to live longer than men, and are then modified for additional risk factors, e.g. smoking, family history and occupation. It is not the case, therefore, that the mortality table is the only instrument for pricing. Life Insurance will use risk-based underwriting in the same way that general insurance does – risk factors that make the risk worse than the average will attract additional premium charges. Dodson’s mathematical work in particular, led to the ‘level premium concept’ which is one of the fundamental differences between the pricing of Insurance and insurance.
Level premiums
If we accept that in life Insurance that the ‘risk’ is the individual Insured, then intuitively the risk becomes worse with each passing year. In simple terms, as we get old we become more likely to die. That being the case, should it not be the case that our premiums increase with each passing year? If we look at fire insurance, if the fire risk associated with the building increased from one year to another, it is reasonable to assume that the insurers would increase the cost of the insurance. In reality, however, life Insurance premiums do not increase as you get older, sicker and more likely to die as they are grounded in the level premium concept. Level premiums are based on the total premium needed between the time of the inception of the policy and the year of the expected death of the Insured. The latter is based on use of mortality tables. The total premium is then divided into annual / monthly amounts.
The rationale behind this is entirely sensible – if premiums increased year on year, the Insurance would become unaffordable in the years when it was most needed. Using level premiums, the Insured is over-paying in the early years, will reach an equilibrium level and under-pays when that level is exceeded.
Given the long-term nature of life Insurance, provided the Insured continues to pay the premiums, the assurer cannot cancel or amend the policy after the initial terms and conditions are agreed, irrespective of how bad the ‘risk’ may become.
Types of life Insurance policies
Fundamentally, there are four main forms of policy;
1. Whole life
2. Endowment
3. Term
4. Group life
Whole life and endowment policies may be with or without profits, or as they are generally called, ‘bonuses’. These operate on the following basis

• Premiums are invested by the insurer in a range of assets which will, hopefully, generate profits
• The policyholder shares in the this profit
• ‘Smoothing’ is used to even-out bonus payments, i.e. a proportion of the profits earned during good years is held back to top-up bonuses paid during bad years
• Two main types:
1. Regular (or ‘Reversionary) bonus – allocated yearly and guaranteed
2. Terminal bonus – allocated at maturity or death and is not guaranteed
The policies themselves operate as follows:

Whole life
• Level premiums are paid from inception to death, although the policy may be ‘paid-up’ at a given age. A ‘paid-up’ policy is one where the premiums cease at a pre-determined age, although the policy remains in force and will pay-out when the Insured dies.
• As payment is assured, the policy has a monetary value and can either be surrendered prior to the death of the Insured or it may be sold to a third party. The surrender value will vary over time, but in the early years of a policy it will be very low. As insurable interest need only exist at inception, it is valid to sell the policy to a third party, who then takes over payment of premiums and is assigned the benefit of the policy
• These were once the most common form of life Insurance, but their popularity has declined in recent years

Term Insurance
• The policy is for a set period of time, e.g. a term of 25 years.
• Premiums are paid during that period and if the Insured dies then payment is made by the insurer. If the Insured survives, no payment will be made by the insurer. In that respect, the ‘Insurance’ only exists during the pre-determined term.
• These policies, which in the UK are the most common form of life cover, have no surrender or market value
Endowment Insurance
• Originally an endowment was not an Insurance policy, but was a form of investment plan. However, in the 1980s the product developed whereby endowment Insurance combined term Insurance and an endowment. This endowment was for a pre-determined period and at the end of that period, assuming the Insured has survived, the endowment would mature and its value paid. Death during the period of the policy triggers the term policy.
• For reasons that will be discussed, these policies have developed a bad reputation.
Group life
• These are policies that are, generally, purchased by employers for the benefit of their employees. The employee may be required to make a contribution to the premium, but often they are funded in their entirety by the employer.
• The cover only exists during the period of the worker’s employment with the company, so in that regard they share characteristics of term Insurance. Hence their common name – ‘death in service policies’.
• Given the economies of scale involved in purchasing cover for, perhaps, many thousands of employees, the unit cost per employee will be less than if the individuals purchased their own cover.

Pensions business
Pensions business handled by the insurance industry is, to a very large extent, determined by a country’s attitude to state provision of pensions and other welfare benefits and the provision of pensions by employers. In that respect, there is no universal system that will apply to all times in all countries. This section will, therefore, look at some general principles and concepts.

In many countries, pensions provision will be a combination of:

• State
• Occupational
• Personal

The state will not normally use the insurance industry and will fund its pensions’ liabilities to citizens through a combination of specific contributions, e.g. National Insurance in the UK, and general tax revenue. The state will also be a very large-scale employer and will also, therefore, be a provider of occupational pensions. Again, these will not normally be funded through the commercial insurance market.

On the other hand, private sector employers will use a variety of methods to fund their occupational pension schemes. Many large employers will manage the fund themselves, but some large and most small-medium sized employers will use the services of an insurance company.

Insurance-related occupational schemes
The pension contributions made into these schemes are analogous to the premiums paid in other insurance contracts. These contributions may be funded in a number of ways:

• Solely by the employer
• A combination of employer and employee (currently the most common method in many countries)
• Solely by the employee
Although there may be individual variations, when the employee reaches the normal pensionable age the benefits due under the scheme will be paid. Again the main methods of payment will vary from country to country, but in many countries they will based around what are known in the UK as:

1. Defined benefit, or final salary, schemes, or
2. Defined contribution, or money purchase, schemes.

In almost all cases, the first category is the most attractive to the employee as the payment (a product of final salary x years of service) is guaranteed. Any shortfall in the fund, i.e. due to unfavourable investment conditions, needs to be made-up by the employer. Due to a combination of increasing longevity and uncertain investment conditions, these schemes have become increasingly uncommon.

Consequently, the second category has grown in prominence. In these schemes the fund builds up over time, and on reaching pensionable age it is used to but an annuity. An annuity is similar to a single premium – it is paid to the annuity provider who then provides a yearly or monthly income from it. In this case the investment risk rests with the employee and is two-fold. Firstly, the fund will have been subject to investment risk over the period of the contributions. If the returns have been weak, the amount available to purchase the annuity might be lower than would have been expected. Secondly, when the annuity is purchased, the payments made to the annuitant will be influenced by what the insurance company predicts will be the investment return on the fund. Pessimistic expectations will lead, again, to lower payments.
Insurance-related personal schemes
These are purchased by individuals and are funded by their own contributions. Apart from that, they are very similar in nature to the money purchase schemes referred to above. On retirement, the contributions will purchase an annuity.
It is worth noting that, in many countries, governments offer financial incentives for individuals to contribute to either (or both) their occupational scheme or a personal scheme. These incentives normally revolve around tax relief on some, or all, of the contributions. This relief will have an upper limit and will have conditions relating to the payment of benefits etc when the pension is eventually drawn.

Problems and controversies in the life and pensions markets
Like any other form of insurance, life and pensions business is affected by both national and international factors. Economic problems, medical and scientific advances, regulation and competition are seldom delineated by national borders. Many of the problems and controversies that have impacted on these sectors are, therefore, beyond the control of insurers in individual countries, although, as will be discussed, there are some that are a factor of specific country-related difficulties.

One of the key global issues that many small – medium sized life assurers face is that of competition. Competition may come from international financial services groups, e.g. banks, who see the financial stability of the life Insurance market as one that they should aggressively enter, or it may come from the ‘mega’ assurers who have been formed in recent years following mergers and acquisitions. In many ways, this competition is a function of the wider globalisation agenda.

In addition to this global competition, specific countries, e.g. the UK, have seen a rise in the ‘direct’ insurers. These companies, Direct Line being an example, have maximised the use of technology to create a direct link between them and the customer. They have identified niche markets, kept their operating expenses well below the levels of conventional insurers and, consequently, have offered very competitive premium levels. Their success thus far has mainly been in general personal lines business such as motor insurance, but there is no reason to suspect that they could not transfer their business model to the life market.

A highly problematic product area, which generally falls within the category of life business, is that of health insurance. However, this category of business is much more problematic in countries such as the USA where it is the pre-eminent method of funding health care. Medical advances, longevity, the rising cost of treatment and political divisions have made health Insurance a highly contentious issue in the USA. If we compare that with the UK, which has the largest life Insurance market in Europe, health insurance is not such a problematic area. In relative terms, the UK private health insurance market is quite small and does not feature in the insurance-buying strategy of the vast majority of the population who rely on the tax-payer funded National Health Service.

A relatively new scientific development which has the potential to significantly refine the underwriting of life Insurance is genetic testing. These tests could give assurers a predictive tool that has a very high level of accuracy. However, the reality for the life companies is that their ability to underwrite on the basis of genetic tests has been severely curtailed, and in some cases eliminated, by governments. In both Europe and the USA, legislation has been passed, or voluntary agreements reached, whereby assurers will either eschew the use of genetic testing, or severely restrict its use, in respect of life underwriting. There may very well be sound risk-based advantages and disadvantages associated with genetic testing, but the political reality for the life market is that its use is unlikely to be permissible in the foreseeable future.

A constant concern relating to life and pensions business is that of giving bad advice. Buyers, who will generally lack knowledge of the technical complexity of insurance, rely on the companies to give them sound advice on long-term products such as life Insurance and pensions. No insurance based product is entirely risk-free, but there is a clear distinction between the buyer voluntarily accepting a risk that is clearly explained to him and being exposed to a risk that was either poorly explained or concealed from him. A situation that has prevailed in the UK in recent years is an unambiguous example of this. The two main products which proved to be problematic were with profit endowment policies and personal pension plans.

With profit endowments
For many years these were seen as ‘safe’ products and were a widely accepted form of combining investment with life cover. In the 1980s the Conservative Government had a clearly stated policy of encouraging home ownership. A by-product of this was, for the first time, an opportunity for social housing tenants to buy their homes, often at substantial discounts. This wider policy of ‘a property owning democracy’ and a general relaxation on the rules surrounding granting mortgages, led to a huge increase in demand for financial products. Assurers, keen to tap into this demand, actively encouraged their sales forces to promote endowment-backed mortgages. These worked, in theory, as follows:

1. You borrow £100,000 to buy your house, repayable in 25 years
2. You pay the interest on that capital sum over 25 years
3. You buy a 25 year with profits endowment, which at the end of the period will pay-off the £100,000
The main problem arose due to the fact that, using our example, very few buyers purchased a £100,000 endowment. On the advice of the salesperson, they bought a, say, £50,000 endowment and were given bland Insurances that by the end of the 25 year period the accumulated bonuses on the policy would more than make-up the £50,000 difference. Many companies used wildly optimistic bonus predictions, which were never likely to materialise. The outcome was that, again using our example:

1. You borrow £100,000 to buy your house, repayable in 25 years
2. You pay the interest on that capital sum over 25 years
3. You buy a 25 year with profits endowment, with a sum assured of £50,000. You are informed that the accumulated bonuses will, by the end of 25 years, pay-off the £100,000 (and may even have some left over for yourself)
4. The bonus predictions have been wrong – your policy is only worth £80,000 at the end of 25 years
5. The mortgage lender wants their £100,000, therefore the borrower is left with a £20,000 shortfall which they must raise from some other source
6. Much government, regulator and consumer concern followedIn the UK, between 2001 and 2008, the number of endowment-backed mortgages fell from @11 million to @5 million. Their use continues to decline and insurers are now severely restricted on the predicted growth rates that they can use.
Personal pension plans
Although the nature of these products is fundamentally different from that of with profit endowments, the causes and the effects of the main problems are surprisingly similar.

Again, a key driver was central government policy, i.e. to reduce state pension liabilities by encouraging people to buy a personal pension. This created a huge new market for the insurance companies, which, unsurprisingly, was highly competitive. Sales forces were encouraged to persuade people to abandon occupational pension schemes, many of which were, for all practical purposes, risk free. The probability of a personal pension, with its exposure to market risk, providing a better pension than most of these occupational schemes was negligible. In addition, there was a huge sales drive to encourage people to leave that part of the state pension scheme which they could opt-out of. Again, the returns under personal pension schemes for many pensioners were unlikely to better, or even match, the state scheme.

Pensions providers were under a legal obligation to give ‘best advice’ and it soon became patently obvious that many of them had failed in that duty.

The main outcomes of both of these crises have been:
• The industry has been faced with a massive compensation bill
• Public confidence in the sector has been reduced
• The industry has seen increased regulation
Clearly the endowment and personal pensions ‘mis-selling’ scandals are UK based, however, there are wider, global lessons for the industry. Firstly, if the main driver is ‘sales at all cost’ the potential arises for the sales force to lose sight of the need to give good advice on complex, and potentially risky, products. Secondly, in a more consumerist age, buyers of substandard products have far more protection and far more vocal advocacy than they may have had in the past. Thirdly, the industry needs to recognise now only the direct financial consequences of such scandals, but also the long-term, indirect reputational damage. Finally, governments’ response to these problems tends to be ever-greater regulation, which can constrain companies both financially and operationally.
Self-assessment questions

1. Proposal forms, completed by the proposer, were the traditional basis on which insurance business was underwritten. For some types of business, many insurers have moved away from these. Do you see any inherent dangers in that and, if so, what are they?
2. How would you explain the operation of the law of large numbers, in the context of insurance, to a non-insurance audience?
3. Explain why expected claims costs in liability business are more problematic than in life business.
4. Assume that you are an underwriter for an insurer who has decided that they will no longer follow the underwriting cycle. What would be the main elements of your underwriting and pricing strategy that would allow you to move away from this cyclical behaviour?
5. How would you explain to a lay person why life Insurance pricing differs from that of general insurance?
6. Under what circumstances would you recommend a Term Insurance policy to someone who was looking to buy life cover?
7. Briefly discuss the following statement:
The only way to ensure that best advice is given to customers is to have greater regulation of life Insurance and Insurance-based personal pension plans
Topic 7: The claims process
Preview

Many people would take the view that an insurance company is in business to pay claims. When a claim arises, that is a point when insurers are tested against all the promises about the security provided by the policy and about the level of service to be given. Yet it is well established that many policyholders attempt to defraud insurers either by fabricating claims or by inflating the amount claimed on an otherwise legitimate loss. Claims officials thus have to strike a delicate balance between a) swift settlement of claims and b) a rigorous and time-consuming investigation of the legitimacy of any claim. In addition, they have a key role in providing timely data to underwriting management to allow underwriting strategy to be modified as and when necessary.
Learning outcomes

• Analyse the different aspects of strategic and operational claims management
• Explain what is meant by the insurance loss ratio
• Evaluate the nature and importance of claims reserving
• Critically analyse the anti-fraud initiatives that insurers use
Indicative reading:

Thoyt (2010), Chapter 9
Atkins & Bates (2008), Chapter 14 (supplied in the Module reader)
Establishing basic facts regarding the claim

Every person employed by an insurance company is an ‘expense’ that must be met out of premium income. The time of claims officials must, therefore, be used as efficiently as possible. Some policyholders will submit claims that are, unfortunately, not covered. It is best for all concerned that such cases are disclosed quickly by establishing a system of routine checks to be applied to every new claim notification.

These basic tests (is the peril insured? Is it within the period of insurance? etc) are outlined in the indicative reading. Note the additional test applied whenever we identify that a policy carries a ‘Warranty’. This special form of condition must be strictly and literally complied with. Even if an identified breach of warranty is found not to have been material to the occurrence of the actual loss, the insurers still have the right to reject the claim.

It is worth noting that there needs to be a relationship between underwriters and claims handlers and that:
a) underwriters may need to be consulted about the intention of a particular policy wording and
b) that underwriters certainly need to be kept informed about important losses.

Notification of claims and completion of claims forms

In the past, insurers used much more formal, written, systems for claims notification and the completion of a ‘claims form’ was standard practice. However, filling in a complicated form is probably the last thing that a policyholder likes to do following a loss, although it is an extremely efficient way of capturing (in a single document) the basic points of information that, at least theoretically, will be sufficient to allow the issue of a settlement cheque to be authorised.

Note, however, that claim forms are not now always used for commercial claims, particularly the larger ones. There is also a trend in personal lines business to eliminate or at least reduce the length of forms wherever possible.

Note also that where fraud is suspected on the part of the policyholder, it is most helpful to have them sign a claim form as evidence that they are claiming on the policy. This means that they can no longer claim that they were simply enquiring about policy cover.
Procedures for handling claims

Modern practice in insurance claims management and handling has focused on distinguishing claims by likely value and adopting different procedures based on that likely value. As an example, an insurer may categorise claims on the following scale:

1. Small claims, i.e. those worth less than £500
2. Medium range claims, i.e. those worth between £500 and £50,000
3. Large claim, i.e. those over £50,000

For those in the small claims category, insurers need to carefully weigh-up the costs of investigation against the likely savings that will be yielded from that investigation. There is a trade-off between the need to ensure that the claim is valid and the need to keep administration costs low. In practice, many insurers have a policy of not investigating many claims at this level. They will make a judgement on claim validity and indemnity based on either a claim form, information provided over the telephone or an electronic means of claim submission. However, even at this level, insurers will wish to satisfy themselves that they have some quality control procedures in place and will, therefore, conduct sample audits of claims and also pay close attention to fraud indicators.

For the larger claims, it is axiomatic that these will be more complicated. Consequently, the management and handling of these claims is much more individualised. The insurer’s most experienced claims staff will be involved along with external specialists such as; loss adjusters, forensic, legal and medical experts and engineers.

The medium range claims will, by volume, make up the largest number of claims in any one year. These claims will be investigated, although generally not to the same extent as the >£50,000 claims. In addition, insurers may use quite different management and investigative techniques depending on the type of insurance involved, e.g. a fire claim at £40,000 will be handled in a quite different way from a liability claim of the same value.

This section of the text outlines the work of claims handling that is often outsourced to specialist claims handlers called Loss Adjusters. Loss adjusting is a well established business. Many who work in that business gained their claims handling experience with an insurance company.

It is important to note that there is no reason why an insurer could not have all the claims handling experience it needs ‘in-house’. This is especially the case for the largest of insurance companies because they could expect to have enough claims of each type to maintain a level of expertise in their staff and to keep them fully occupied. However, smaller insurers will not expect (nor do they desire) to have a sizeable number of claims under all of the categories of business they write. It is much easier for them to hire a claims settling expert (i.e. a Loss Adjuster) as and when they need one.

Even when we get down to very routine claims such as personal motor or home insurance, we may find that insurers turn to outsourcing and that Loss Adjusters are used to handle claims of quite modest size. In effect, these insurers have convinced themselves that the loss adjusters can do it more cheaply and more efficiently.

Measuring Indemnity

We have already touched on this in Topic 1. If we take a contract of property insurance as an example, this is a contract of indemnity. This means that the insurers undertake, as much as possible, to place the insured after an incident in the same financial position as he was in immediately before the incident.
Calculation of value: There are three aspects to this.

1. First we have some ground rules set down about the situation which applies if a contract is one of indemnity (i.e. it will use words like “We shall indemnify you” etc.). The value of the subject matter of the insurance is its value at the time of the loss and the place of the loss. Neither sentimental value nor consequential losses are included.
2. Second, we have a number of interpretations that have been made in situations where it has proved hard to apply the basic principles. Sometimes these are as a result of the deliberations and pronouncements of a Court of Law in a claims dispute. Sometimes they are they result of discussion amongst insurers resulting in a market agreement. An example would be the issue of ‘betterment’.
3. Third, we have situations where the insurer and the insured have knowingly departed from the principles of indemnity by means of some form of agreed policy wording. An example is the Reinstatement Clause where insurers agree to bear the full cost of reinstatement without any deduction for wear and tear. But note that insurers are not prepared to cover stock on this basis – just buildings and all other contents. So there are limits to what an insurer will agree.

Insurers have the right to reinstate if they wish and that this is one way of providing an indemnity. Insurers prefer to make cash settlements so it would be unusual for them to take such a course of action. Nonetheless, they have this possibility open to them and could use it to thwart a claimant who was intent on destroying their property to raise cash.

The application of Average in complex commercial insurances is a specialist subject, especially where several different insurance policies overlap in relation to, say, the same fire loss, and the principle of contribution is also dragged in to the calculation. It is beyond the scope of this Module.

When serious fire damage affects a business, urgent decisions have to be made in order for the Insured to have their business fully recovered as quickly as possible and also to minimise the loss for the Insurers and for the Insured. This requires close liaison between all parties concerned: Insured, Insurer, Loss Adjuster and Insurance Broker. In considering measures to reinstate physical damage to buildings and machinery, the implications for the ongoing business interruption must be paramount. Indeed, in most situations, the business interruption claim should drive the material damage claim.

Settlement of claims in the event of a dispute

In the event of a serious dispute over liability, insurer and insured may well resort to a Court of Law for a settlement. However, this is hugely expensive and is not undertaken lightly. The issues surrounding whether a policy covers a loss are not always black and white.

Often the argument is not about the actual policy wording but about information that may or may not have been discussed between insurer and insured in the run up to taking out the insurance. Realistically, commercial factors come into the negotiations. A policyholder with a substantial block of premium income to place may well receive more sympathetic interpretation of a problem case.

In many cases, the insurer accepts that the cover is in force and all the argument with the policyholder centres on the level of the claim to be paid. These are referred to as disputes about ‘quantum’. There are four main approaches that are available in the UK:

• Arbitration

• Insurance Ombudsman

• Personal Insurance Arbitration Service

• Alternative Dispute Resolution

Loss ratios and claims reserving

The loss ratio is a significant contributor to whether an insurance portfolio is profitable or otherwise. The loss ratio is calculated by dividing the losses paid and estimated in any one accounting year by the premiums earned in that year. This is then expressed as a percentage. For example:
• Paid and estimated claims for Year X – £6.5 million
• Earned premium for Year X – £10 million
• Loss ratio for Year X – 65%

The loss ratio is then combined with the insurer’s expense ratio and this combined figure gives a broad indication of underwriting profitability.

Insurers use the loss ratio to give them a broad indication of the effectiveness of their underwriting and claims quality, e.g. a consistent loss ratio of >80% will suggest that something is fundamentally wrong. In the medium to long run, high loss ratios will affect the viability of insurers, e.g. as happened with the Municipal Mutual Insurance in 1992. On the other hand, if loss ratios are consistently low, e.g. <50%, this could suggest to buyers and intermediaries (assuming that they can access this information), that premiums are higher than the market average.

It would be wrong, however, to assume that the calculation of the loss ratio is a simple arithmetical task. It is fairly straightforward for the insurer to calculate on the basis of claims that have been settled, but what about those that have not been? How are they factored into the calculations?

A major concern for insurers is the adequacy of their reserves for claims that have not been settled. Again, a distinction can be made and this is between reserving for outstanding claims that have been notified to the insurer (a relatively straightforward process) and those claims where the incident has occurred, but the claim has not been notified (a not-at-all straightforward process). Donald Rumsfeld, who was the American Secretary of Defence, made a famous, and much criticised, speech in 2002 where he said the following:

“We know there are known knowns: there are things we know we know. We also know there are known unknowns: that is to say we know there are things we know we don’t know. But there are also unknown unknowns — the ones we don’t know we don’t know.”

The language used by Mr Rumsfeld may be fairly impenetrable, but the logic of what he says, certainly in the context of insurance reserving, is sound. For insurers the ‘known knowns’ are the claims that have been reported and settled. The ‘known unknowns’ are those that have been reported, but the settlement figure has not been finalised. The ‘unknown unknowns’ are the most difficult of all; those claims where the incident has occurred, but the insurers have not been informed. In insurance terms, these are ‘incurred but not reported (IBNR)’ events. These are more problematic in some classes of business than others. For example, commercial fire claims are generally notified very quickly, so cause fewer IBNR problems. On the other hand, in some types of complex liability claims it can take a long time for various parties to be identified, therefore it may be a number of years before an insurer is notified. Insurers will calculate an IBNR figure for various classes of business based on factors such as; their portfolio, historical data, current claims trends and changes in law and regulation. This will involve complex accounting and actuarial calculations.
Fraud

You will see from the indicative reading that claims fraud is a major, and apparently, growing problem for insurers.
It is suggested that you look at the Association of British Insurers (ABI) website (www.abi.org.uk) where you will find a large amount of information on insurance fraud. In addition, there are links to other relevant sites.

Another useful site is that of the Coalition Against Insurance Fraud in the USA (www.insurancefraud.org)
Self-assessment questions

1. Do you see any dangers for insurers in only investigating a small percentage of claims below a certain figure? If so, how could these dangers be minimised?

2. Outline the role of loss adjusters and the extent to which they can be considered to be independent.

3. Why are IBNR reserves likely to be challenging for an insurer with a large employers’ liability portfolio?

4. In your view is insurance fraud a growing problem, or are insurers simply becoming better at detecting a problem that always existed?

End of Topic 7

Topic 8: The international insurance market and contemporary issues

This topic will consider a selection of important international insurance market, some that are well developed and others that are considered to still be growing but are of significance to the global market place and particularly the economies of the countries in which they operate.

• Discuss the differences between insurance regulation internationally
• Compare, contrast and analyse differences in the insurance markets of the Americas, Europe, Asia Pacific region and Africa.

Reading:

Thoyt textbook – Chapter 13
Skipper and Kwon – Chapter 22 (module reader)
Overview of Insurance Worldwide
Insurance markets vary enormously in terms of size and structure. This will usually depends on the size of a country’s economy. A few state-owned monopolies remain the sole suppliers for some countries. Some developing countries deny foreign controlled insurers market access. OECD countries have a blend of domestic and foreign companies. Most large insurers despite operating internationally will write the majority of business within their domestic markets however reinsurers will write business internationally.

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:

•    Increased potential for growth due to wider scope and broader customer base than mutuals.
•    The ability to raise share capital as well as loan capital, which provides greater flexibility in how the business is capitilised, which as Thoyt points out is increasingly important in times of regulatory change which will be discussed later in this module.
•    Less vulnerable to downturns in specific lines of insurance or markets due to the spread of business.
•    Greater distance between the policyholder and the business which means that underwriting is less likely to be affected by policyholder opinion

Insurance companies (both proprietary and composite) can be further classified as:

•    Composite insurers – insurers which offer both life and general insurance
•    Life or general insurers – those which write either life or general business
•    Specialist insurers – those which offer a single class of insurance e.g. a specialist motor insurer.

Worldwide there are around 13,000 independent insurance companies actively trading.  Around 70% of these concentrate on non-life, 25% on life and 5% are composites.  Markets tend to be very concentrated and a few large companies handle a large proportion of the business.

Lloyds Syndicates

Lloyds is one of the most famous names in insurance and it is completely unique.  It is not an insurance company but can be best described as an insurance marketplace that facilitates and provides administration and a regulatory structure for the transaction of insurance.  Most importantly it provides a clear and very distinct brand under which its members can operate.

Chapter 6 of the Thoyt textbook considers the operations and history of Lloyds in some detail and you should read this chapter to familiarise yourself with the nature of the Lloyds market in more detail.

The origins of Lloyds can be traced back to 1688 and in many respects since that time its operations have fundamentally remained the same.  There still exists a Lloyds building, insurance is transacted in the ‘room’ which houses all the Lloyds syndicate underwriters and the market continues to operate on the basis of lead underwriters and following underwriters, operating from a ‘box’.  It although modern communications are used for routine business it still remains very much a face-to-face business operation as it did when it originated.

Lloyds underwriters will only transact business with authorised Lloyds brokers, who introduce the risks to the underwriters.  Brokers who are not authorised will go via an authorised broker to gain access the Lloyds market.  The broker prepares a ‘slip’ which is the document containing details of the risk.

The broker then enters the market and looks to find a lead underwriter for the risk, who will set the premium and terms.  The lead underwriter may take all the risk, if not then the broker will then approach other underwriters to look for the remainder of the cover, on the basis of the lead underwriters premium and conditions.  They will do this until 100% of the risk is covered.

A feature of Lloyds is that underwriters have developed specialist expertise in specific areas and the role of the broker is to have sufficient knowledge of this to know who they can approach to place risks.

Financing of Lloyds

Aside from the unusual way in which Lloyds operates what distinguishes it further from other insurance markets is the way in which it is financed.  The capital needed to underwrite business was found by way of investment by Lloyds ‘names’ who formed ‘syndicates’.  These syndicates could potentially involve hundreds or even thousands of names however more recently, with the introduction of corporate capital, limited companies can be names and the number forming a syndicate in these cases is lower.

Individual names provided capital to transact insurance business on an unlimited liability basis; they were fully liable for the payment of claims.  However following a period of large losses and significant claims made (among other issues discussed in more detail in Chapter 6) between 1988 and 1992 Lloyds names faced bankruptcy and the decision was made to accept corporate members, who had limited liability.  Many names then also took the option to protect themselves from personal liability by forming limited liability companies or partnerships.

Take a look at the Lloyd’s web site for an introduction to how Lloyd’s operates and the issues that are of current concern to Lloyd’s investors, underwriters, and administrators.  http://www.lloyds.com/

Captives

Large corporations, in the interests of tax efficiency may set up in-house insurance companies to cover their own risks.  It is essentially a method of retaining risk.  By setting up a captive insurance companies organisations separate funds within a wholly owned subsidiary which contributions called ‘premiums’.  A true captive would be defined by the following characteristics:

•    It is a wholly owned subsidiary
•    Its parent company is not primarily engaged in insurance
•    Its primary function is to cover the risks of it parent company – though some may be prepared to accept risks from other captive companies,

The main reasons for forming a captive are, firstly it allow premium contributions to the captive company by group companies to be tax deductible. Secondly it allows the captive to purchase reinsurance directly at ‘wholesale’ prices i.e. not incurring commission normally charged.  Some captives will retain a significant amount of risk; others reinsure most of it. There are several thousand captives in existence, which are mostly located in favourable tax environments – Bermuda, Guernsey etc.

Reinsurers

Primary insurers will often transfer some of the risk to reinsurers,  the reinsurers accepts risk from another insurer (or ceding company).  This allows them to spread the risk and also them to take on business they may otherwise have been unable to do so due to limitations in capital.  The reinsurer has no contact with the customer and the primary insurer is fully liable for payment of valid claims, even in the event the reinsurer defaulted in payment to the primary insurer.  Insurance companies and Lloyds syndicates will undertake reinsurance for other insurers however the market is generally dominated by specialist companies such as Swiss Re and Munich Re.  Reinsurance will be considered in more detail in topic 3.

Insurance Service Providers

These are non-risk bearing companies working within the insurance market, depending on the role they play they may be paid by the customer or the insurer.  This type of company can include:

–Risk assessors/surveyors/inspectors
–Loss adjusters
–Loss assessors
–Damage/loss control services/salvors
–Assistance services, e.g. medical repatriation from overseas

Market representation and market management organisations

Most markets have their own market organisations to maintain market stability and generally represent the industry. Within the UK the most influential and important associations are as follows:
•    The Association of British Insurers (ABI) are the trade association representing insurers licensed to operate within the UK.
•    BIBA – British Insurance Brokers Association
•    AIRMIC – Association of Insurance and Risk Managers in Industry and Commerce

Please take a look at the ABI web site – it contains a lot of useful material.  If you are interested, you can use it to order from their range of current publications, some of which are free.  http://www.abi.org.uk/

Rating Agencies

The rating agencies are:
•    Standard & Poors
•    AM Best
•    Moodys
•    Fitch

Their role is to give ratings assessing the financial strength of insurers.  Similar to the way they rate corporate debt (credit ratings).  The ratings can influence the way that insurance business is carried out, e.g. brokers or corporate customers may only choose to deal with insurers of a certain rating level.  Primary insurers may also choose only do business with reinsurers of a certain rating level.  The highest category AAA+ is very attractive from trading perspective however from a shareholder perspective may give rise to the suggestion that insurers are holding too much capital and therefore limiting dividends.

Standard and Poor’s Rating

S & P consider factors such as:
•    State of the business environment
•    Profile of the insurers business
•    Quality of the management
•    Corporate strategy
•    Performance ratios
•    Investment portfolio
•    Capital adequacy now and in the future
•    Liquidity

The insurer is then placed in one of the following categories:
•    AAA  extremely strong
•    AA    very strong
•    A      strong
•    BBB   good
•    BB    marginal
•    B      weak
•    CCC  very weak
•    CC    extremely weak
(Atkins and Bates, 2008, pp 56)

This lecture has considered in brief some of the key players in the in insurance market place, we have focussed primarily on the UK market however the types of organisations (with the exception of Lloyds) discussed here can be found in most insurance markets.

Self-assessment Questions

1.  Mutual insurance companies have diminished in recent years, what are the main reasons for this?

2. Most large organisations rely on a broker to advise them on insurance cover, what are the benefits of doing this?

3. Lloyds is considered to be unique in terms of insurance, briefly outline the way that Lloyds operates and the key players in the Lloyds market place.

4. Lloyds has faced numerous issues over financing, provide an explanation of these and an outline of the current situation regarding capital provision at Lloyds.

End of Topic 3

Topic 4: Forms and Types of Insurance

This lecture will examine the different types of insurance cover available with a focus on those products most commonly used by business insurance customers.  The use of reinsurance will be discussed with an overview of some of the key approaches taken to this.

•    Outline the main types of non-life insurance products
•    Critically analyse the purpose of reinsurance
•    Discuss the main methods of reinsurance available and evaluate the advantages and disadvantages of each.

Reading:

Thoyt, chapter 7 and appendix I and II
Skipper and Kwon, chapter 23 (in reader)

We have already mentioned insurance customers in topic 2, primarily made up of individuals and businesses with different insurance needs.

Individuals commonly need:
•    Home insurance for house and contents
•    Motor Insurance
•    Travel Insurance

Small businesses commonly need:
•    Combined Insurance Policy – a package with specified limits/sums insured
•    Commercial vehicle insurance

Larger organisations may need cover for:
•    Commercial property
•    Business interruption
•    Theft
•    Engineering insurance for machinery breakdown
•    Motor fleet
•    Employer’s liability, public liability and product liability
•    Goods in transit inland
•    Marine cargo for exports
•    Fidelity guarantee for dishonesty of employees

Insurance products are built around specific perils, the subject matter or by type of customer:

ElementExamplesPerilFire, earthquake, theft, liability, sickness, accidental damage
Subject matterPremises, person, inventory, ship, motor vehicle, business jewellery
Customer typeCommercial, personal
Customer segmentHomeowner, tenant, shopkeeper, building contractor

(Atkins & Bates, 2008, pp.41)

They may be written around a single peril e.g. standard fire policy or third party motor insurance policy but are normally sold as packages or comprehensive policies which cover a range of perils suitable for certain customer types or industry sectors.  We will discuss some of the more commonly seen insurance products in this topic.

Property Insurances

Property insurance developed from the standard fire policy which was designed to cover a building, plant, machinery, other contents and stock against fire, lightening and certain types of explosion.  Additional perils have later become available as a response to customer needs.  These are broadly categorised as ‘wet’ perils (involving water) and ‘dry’ perils.  They are also divided by their nature:

•    Chemical perils
•    Social perils
•    Perils of nature
•    Impact perils

A full explanation of these can be found on pp 312 and 313 of the Thoyt textbook.

Commercial All Risks Insurance

A widely used approach, particularly for insuring larger risks, is commercial all risks insurance.  This covers all risks for loss or damage to property with certain exceptions:

•    Wear and tear
•    Inventory shortages
•    Machinery breakdown
•    Dishonesty
•    Money shortage

Theft Insurance

Usually included within part of a package although often as a separate section.  Single theft policies are still written for more high risk business such as jewellers.  Commercial policies usually restrict to theft involving forcible entry or exit to or from the premises.  The intention being to exclude pilferage or shoplifting by staff or customers, which is much harder to control.  Personal lines policies usually offer wider cover i.e. regardless of thief’s method of entry/exit.

Business Interruption Insurance

Sometimes also called loss of profits or consequential loss insurance this cover indemnifies the business for loss of expected future profits following a disruption caused by fire or special perils, machinery breakdown, or any other insured peril.  The purpose is to allow the business time to recover from any physical damage that may have occurred.  Cover includes: loss of gross profit, wages, additional costs of working.  The policy would also specify an indemnity period for which cover was operable, usually 12, 24 or 48 months.

Contractors All Risks insurance

This type of insurance was developed in response to the requirements of the standard contracts used for large scale building/civil engineering works which specify that the contractor must take out insurance for the building site in joint names of employer and contractor.

The property part is covered by a contract works policy and the policy is usually issued on an all risks basis indemnifing the policyholde against the cost of restoring the works to their pre-loss condition.  Will indemnity the policyholder against loss or damage from any cause with a few exceptions:

•    War, civil commotion
•    Consequential loss
•    Cessation of work
•    Defective design
•    Defective material or workmanship
•    Breakdown of plant
•    Lack of maintenance

(Atkins and Bates, 2008, pp 43)

Engineering Insurance

Deals with insurance of plant and machinery as is focused on loss or damage within the plant itself i.e. explosion, breakdown, collapse, although it may be extended to cover business interruption arising out of a loss.  Most insurers also offer an inspection service with or without insurance cover. In some countries regular inspection of plant is statutory and the insurer may be authorised to carry these out.

Liability Insurance

These policies are designed to indemnify the insured for compensatory awards made against the insured’s company with any associated legal costs.  Companies, organisations or individuals may become liable for bodily injury or damage to property caused by their acts or omissions. The liability may arise out of negligence, statute or contract. Potential for claims to arise often relates to local culture, custom or predisposition of the legal system to support such actions e.g. the USA has cultivated a ‘compensation culture’ due to the likelihood of initiating a successful claim and the large awards given if successful.

Public Liability
Public liability covers the general liability of an insured to the public as a result of its operation e.g. pollution, injury to a visitor, damage to third party goods in the custody of the insured.   Pollution claims however are limited to sudden and accidental pollution, not that caused by long-term emissions.

The policy will be subject to a maximum limit of indemnity which should be sufficient to cover both compensation and third party legal costs arising from a claim.  The policyholder’s legal costs will be met in addition to the limit of indemnity. The limits offered by insurers are normally £1 million, £2 million and £5 million.  If a limit of Indemnity is required which is higher than that which the Insurer can provide an excess layer can be arranged in order to provide the level of indemnity required by the policyholder. A claim which is in excess of the limit under the base policy will be met by the additional policy.

Product Liability
Product liability covers liability arising out of goods sold, supplied, repaired or serviced by the insured.  This cover needs to be underwritten with care, especially for high-risk areas such as pharmaceuticals, vehicle components and goods exported to the USA.

Claims for damages usually fall into four categories:
•    Defective Design: means that an item is inherently dangerous because of inadequate design.
•    Defective Manufacture: generally occurs because of a quality control failure ensuring that the item does not achieve the required specification.
•    Defective Warnings: do not accurately reflect the dangers associated with the item or adequate warnings may have been minimised by the salesman.
•    Negligent Surveillance: occurs when a manufacturer does not properly warn consumers about an items subsequently discovered lack of safety.

Efficacy Insurance is designed to cover the failure of an item to perform its intended function and is often purchased as an extension to Products or Public Liability Insurance. Efficacy insurance is commonly required by business involved in the manufacture, supply or installation of performance critical products such as fire alarms, emergency lightening, brake systems, temperature controls etc.  Most standard public or product liability policies will exclude efficacy cover.

Professional Indemnity
Professional indemnity insurance provides cover for negligent acts carried out and advice given as part of a professional service.  This cover is usually taken out by lawyers, accountants, brokers etc. It can be particularly expensive for doctors.

Employers Liability
Employers liability insurance provides cover for liability to employers for injury or sickness. It is compulsory in many countries including the UK
Also called workers compensation cover in some countries including the US and New Zealand.

The UK Employers’ Liability (Compulsory Insurance) Regulations 1998 specified that the limit of indemnity per occurrence must be £5 million
In practice most policies issued in the United Kingdom are issued with a £10 million indemnity limit. Where a need for a higher limit has been identified then additional cover may be purchased in the form of Excess Layer or Excess of Loss Insurance.

When working out the right level of cover an organisation should consider:
•    What are the main risks faced?
•    How much the most serious claim faced could cost (not forgetting legal fees)
•    Whether they have any contracts which stipulate that a certain level of cover

Employers are strongly advised to keep, as far as is possible, a complete record of their employers’ liability insurance.  Some diseases can appear decades after exposure to their cause and former or current employees may decide to make a claim against their employer for the period they were exposed to the cause of their illness.  Employers that fail to hold the necessary insurance details risk having to meet the costs of such claims themselves.

Directors and officers (D&O) cover:
D&O insurance covers the personal liability of directors for the way in which they run their companies.  This is a growing area as a result of various corporate scandals in the last decade.  Directors of all companies are now held, at an unprecedented level, to be personally responsible for any actions and decisions they make on behalf of the company – putting their personal assets at risk if those decisions are tested in the courts.

Example D&O claim:

In October 1997 a driver fell asleep whilst driving for the family-run haulage company for which he was employed. Two motorists were killed. The court held that the operations manager should have ensured that his driver adhered to the relevant driving regulations. He had also failed to keep in close touch on these matters with his co-director. Both directors incurred substantial defence costs before being convicted of corporate manslaughter.

Motor

Motor insurance covers liability in respect of road accidents, and damage to the vehicle itself.

Private car insurance
The minimum statutory insurance for the UK is for third party liability but this is usually combined with cover against loss by fire or theft.  A comprehensive policy will also include accidental damage and windscreen cover.  Personal motor insurance can be extended to cover personal accident, personal possessions, legal expenses, etc.

Commercial vehicle insurance
This is usually called motor fleet insurance for commercial policies that include all types of vehicle designed for road use. Specialist non-road vehicles would be covered under the engineering policy not the motor fleet.

A motor trade policy is a specialist package policy for garages.  This also covers the building, showroom and vehicles.  Motor trade policies may also cover vehicles under the care of the garage’s custody and control.

Marine & Aviation Insurance

These are highly specialised classes of insurance.  Marine is the oldest type of insurance and uses different terminology to property and casualty insurance.  Aviation has much in common with marine in terms of wording etc.

Marine
•    Provides cover against the perils of the sea e.g. sinking, heavy weather damage, fire, collision, piracy.
•    Cover may include: the hull, the cargo or the freight (payment for the carriage of cargo)
•    Cover can apply during the construction of the vessel or during voyages
•    Cargo usually insurance on a warehouse-to-warehouse basis covering all risks

Aviation
•    Covers hull, passenger liability and third-party liability, usually on all risks basis.
•    May be used by airlines, individuals & flying clubs

Goods in transit
Goods in transit insurance covers the owner or the carrier of goods for damage or loss incurred during inland transit.  This is an area where insurers are vulnerable to acts of dishonesty and much attention is given to the quality of the carrier.

Terrorism
Most UK property insurers participate in the Pool Re scheme and have agreed to offer terrorism cover to clients or prospective clients.  This covers any losses resulting from damage to property as a result of any act of terrorism.  In the event losses were ever so large as to exhaust their funds Pool Re would then draw funds from the Government to cover its obligations.  Pool Re in turn would pay a premium to the Government for this cover and would be required to repay any funds drawn in this way from future income.  Terrorism pools operate in USA, UK, Germany, France, Netherlands, Australia, Namibia and South Africa.

Reinsurance

Reinsurance is a further means of spreading risk and has been in existence since insurance itself began to emerge.  Insurance companies are bound by their underwriting capacity in terms of what risks they can write.  Underwriting capacity can be affected by numerous internal and external constraints including capital, underwriting expertise, type of business, regulation etc.  In order to increase capacity an insurer will turn to reinsurance, reinsurers therefore insure primary insurers.

There are several reasons why a primary insurer will reinsure:

•    Capacity – as mentioned already one of the reasons an insurer will look to reinsure is to increase their capacity.  Insurers are required to provide a guarantee of solvency in the event of large or multiple losses occurring and this means their underwriting capacity can be restricted by their financial reserves.   Reinsurance allows insurers to take on single risks which they otherwise would be unable to do due to capacity.
•    Catastrophe Protection – the basic principles of insurance also applies to insurers who must also protect themselves from financial catastrophe.  Accumulations of loss e.g. the impact of a large number of claims from small value policies can accumulate to the point where they result in what would be considered a catastrophic loss.  In addition to reinsuring single risks cover can be taken to insure specific events such as storms or floods that can result in an accumulative effect.
•    Loss-spreading and stabilisation – by purchasing reinsurance (at a known and affordable cost) insurers can reduce the level of uncertainty they face, thereby encouraging investment and satisfying shareholder demands.   Reinsurance also helps stabilise the insurance market as a whole, allowing risks to be spread on a global basis rather than just in the domestic market.   This is particularly important for insurers who only operate in a country that is prone to natural disaster.
•    Confidence – Reinsurance can allow insurers to enter a new market with some level of confidence.  Insurers base their underwriting decisions on claims data generated over years of experience and for new markets accurate data will be less readily available.  By heavily reinsuring at the early stages of entering a new market they can do so with less risk while they gain the necessary experience of the market.  Insurers can also make use of the expertise of reinsurers and gauge their own underwriting pricing structure on the cost of reinsurance.
•    Regulatory compliance – this will be discussed in the next topic however regulation dictates that insurers must hold certain levels of capital and guarantee a certain level of solvency.  Reinsurance allows insurers to expand and take on risks whilst still meeting any minimum regulatory requirements.

Further explanation of the drivers for reinsurance can be found in Chapter 23 of Kwon and Skipper (in the reader) which you should read through in your own time.

Reinsurance Terminology

•    Ceding office – insurer placing part or all of a risk
•    Cession – The unit of insurance passed (or ceded) to a pro-rata reinsurer by a primary company or cedent which issued a policy to the original insured. A cession may be the whole or a portion of single risks, defined policies, or defined divisions of business, all as agreed in the reinsurance contract.
•    Retrocession – whereby a reinsurer passes on some of the risk to another reinsurer

Reinsurance Distribution

Reinsurance is sold both by brokers and directly by reinsurance companies. Reinsurers selling directly to primary insurers are called direct writing reinsurers.  They use their employees to solicit business and help clients design reinsurance programs.  However the majority of reinsurers get their business through brokers, who will deal with the complexities of reinsurance. Reinsurance brokers also monitor financial and operational soundness of reinsurers with whom they place business
Small and new insurers will depend heavily on the judgment of brokers in selecting reinsurers.

•    Contract is made between primary insurer and customer.
•    Contract of reinsurance is made between the insurer and the reinsurer
•    Some exceptions to this – cut through provision (see below)
•    Defined as traditional and non-traditional reinsurance.

Methods of Reinsurance

There are two major types of reinsurance, treaty and commission:

Treaty
Agreed in advance of the years underwriting by the insurer and reinsurance.  The insurer agrees to cede and the reinsurer accept any business that falls within the scope of the treaty.  It is therefore an automatic arrangement with pricing and conditions set beforehand.  This method has several advantages:

•    Cheap to administer – admin costs and underwriting costs for reinsurer are low.
•    Gives insurer automatic increase in capacity and often technical assistance from the reinsurer.
•    Long term relationship is built between the insurer and the reinsurer.

The main disadvantage for the insurer is that they must cede all risks within the agreement.  So they may reinsurer smaller risks (and forward premiums) for risks they could have kept.

Facultative Reinsurance
Risks that will fall out with the scope of a treaty can still be reinsured through facultative reinsurance.  The insurer in this type of arrangement is free to decide what risks will be ceded and the amount that will be ceded.  The reinsurer can also select which risks they wish to take on and at what terms.  Whilst this method has obvious advantages for both parties the cost of underwriting and administration is much higher as each risk is negotiated on a case-by-case basis.  As a result it is only used for high risk policies with a substantial premium relative to the underwriting cost.  Facultative  reinsurance would usually occur when an insurer has no treaty agreement in place for a line of business or a particular territory, when a certain risk is excluded from an existing treaty or the existing treaty’s capacity has been exhausted.

1.  You are a risk manager for a large manufacturing firm, what key insurance covers would your company require and why?

2. Explain the purpose of reinsurance.

3. What factors can affect an insurers decision to reinsure?

4. What is the difference between facultative reinsurance and treaty reinsurance?

5.    Chapter 23 of Skipper and Kwon discusses different forms of reinsurance, explain the following:

a.    Proportional reinsurance
b.    Quota share treaties
c.    Surplus treaties
d.    Excess of loss treaties

End of Topic 4

Topic 5: Law and Regulation of Insurance

This topic will examine the regulatory context in which insurance is conducted.  Particular attention will be given to the Financial Services Authority and the role they play in regulating insurance in the UK and also Solvency II regulation which will be introduced across EU member states by 2013.

Learning Objectives

•    Discuss the regulatory, fiscal, legal and accounting frameworks within which non-life insurance is conducted.
•    Evaluate the role of the FSA in regulating both the insurance companies and intermediaries
•    Discuss the role of the Financial Ombudsman Service.
•    Critically discuss the purpose of Solvency II regulation and the impact this is likely to have on the EU insurance market.

Reading

Thoyt – Chapter 5, pp 106 – 135

Introduction

As with all other organisations Insurance companies operate in an environment where they are subject to various legislative and regulatory requirements.  Examples of regulation affecting a non-life insurer:

•    Employment law
•    H&S law
•    Generally accepted accounting principles (GAAP)
•    Company Law
•    Corporate governance regulations
•    Taxation regulations
•    Data protection
•    Competition law

However, all of the above affect ALL corporate entities, not just insurers.

In addition there exists various legislation and regulation specific to insurers:

•    Financial Services & Markets Act (2000)
•    The Financial Services Handbook (resulting from above act)
•    Various Insurance Companies Acts
•    Insurance-specific taxation rules

It is also impacted by the requirements for statutory insurance, which will differ in different countries, however for the UK is: third party motor cover, employer’s liability and professional indemnity for certain professions

Some laws and regulations may also affect insurance covers:

•    Terrorism cover was excluded from standard commercial covers in the UK which led to the establishment of Pool Re – a market-wide pool for this type cover.

•    Case law – can often affect the extent and nature of covers and the monetary value of liability.  Precedents can be set for the payment of claims and extent of cover.

Other influences

The industry will also come under pressure from government, regulators or consumer groups to act in certain ways, that may not necessarily be in their interest, for example:

•    Availability & pricing of flood cover
•    Availability & pricing of motor/property covers in high-crime areas
•    Availability and pricing of liability cover post-Enron environment

Taxation

In addition to normal tax rules for employee salaries, corporate earnings and VAT insurers have two other areas of focus:

•    Insurance Premium Tax (IPT) – different rules to VAT, collected in a different way, 5% in the UK.
•    Insurers must make judgments regarding claims reserves, for known claims, claims not reported and for large events that occur occasionally but have a significant impact.  There are tax rules depending on the amount an insurer keeps in reserve and what is considered taxable income.

Interests of government

For an effective and efficient insurance market to exist, government must create a situation whereby:

•    Customers can buy appropriate products at an affordable price
•    Customers are protected from malpractice by or the mismanagement of insurance companies
•    There is confidence that the insurer will pay a claim
•    Insurers are allowed to generate sufficient returns on the capital invested to make it worthwhile continuing to participate in the market
•    The market is seen to operate in an environment of openness, confidence and trust

Governments can facilitate this kind of market through legislation and regulation and usually a regulatory body is formed to oversee the industry.

The Role of Insurance Market Regulation

Regulators have a varied role that can include all or most of the following:

•    Authorisation of companies so that they may participate in the market
•    Regular financial and statistical monitoring of the market
•    Establishes operational rules for companies, including risk management, conducting business, reporting systems etc.
•    Process of inspection/review of authorised companies
•    To ensure the solvency of participants – to protect society from the insolvency of any insurance company
•    To ensure market confidence and an efficient market.
•    To protect consumers by ensuring that retail consumers are able to buy the most appropriate products for their needs, at an affordable price, and have recourse if insurers act improperly.

Insurance Regulation in the UK

In the UK the Financial Services Authority (FSA) decided to introduce its own regime based on Basel II pending implementation of Solvency II in 2012. The FSA capital resources requirements are much higher than EU requirements and it expects firms to have approx twice the MCR.
Its capital resource requirement is the higher of an enhanced capital requirement (ECR) and the MCR.  The ECR is usually higher in practice at about twice the MCR.

The FSA is the UK’s single regulator for the financial services industry.  It is an independent body set up under the Financial Services and Markets Act 2000 and it replaced various other bodies which had regulated the FS sector up to this point.

The FSA’s has set its aims out under three broad headings:
•    Promoting efficient orderly and fair markets;
•    Helping retail consumers achieve a fair deal;
•    Improving their business capability and effectiveness

As stated the approach is risk-based, with the following principles of good regulation:
•    Maintaining the UK’s international competitive position
•    Seeking to ensure the most efficient and economic use of resources
•    Encouraging competition
•    Facilitating innovation
•    Emphasising the responsibility of firms own management
•    Being proportionate (in how it deals with issues)

The FSA Handbook

Rules and guidance are set down in the FSA handbook, which is an amalgamation of nearly 40 books and manuals relating to regulation in the FS industry, 26 of which apply to insurance.

Not surprisingly it is lengthy and difficult to read for the non-specialist audience.  Which is the downside of trying to deal with a varied industry using one regulator.

FSA Requirements

All regulated firms must comply with the following principles:
•    Integrity
•    Skill care and diligence
•    Management and control
•    Financial prudence
•    Market conduct
•    Customer interests
•    Communications with clients
•    Conflicts of interests
•    Clients assets
•    Relations with regulators

A firm must maintain appropriate apportionment of responsibilities among its directors and senior managers so that business affairs can be adequately monitored and controlled. It must be supported by effective risk management structures, systems and controls.  This reinforces the Combined Code on Corporate Governance.  Organisations are to provide rules on how to assess risks which affect it meeting its liabilities, how it will deal with the risks and the nature of the financial resources that the firm considers necessary.  They are also expected to carry out stress tests and scenario analysis.

Complaints Procedures

FSA specifies requirements for handling complaints:
•    Internal complaints handling procedures that a regulated firm must have, and;
•    The Financial Ombudsman Service – established under the FS and Markets Act 2000 to help resolve disputes between FS firms and customers, fairly, quickly, reasonably and informally.
•    Free and completely independent – for small businesses with a turnover of less than £1m and individuals.

Solvency II

Solvency II is to replace Solvency I with a more risk-based approach.  A solvency capital requirement has the following purposes:
•    To reduce the risk that an insurer would be unable to meet claims
•    To reduce the losses suffered by policyholders in the event that a firm is unable to meet all claims fully
•    To provide supervisors early warning so that they can intervene promptly if capital falls below the required level
•    To promote confidence in the financial stability of the insurance sector

Solvency II is a unified, prudential reserving and regulatory framework for European Union insurers and reinsurers.  It has a much wider scope than Solvency I and proposes a Basel II three-pillar structure which has been adapted for the insurance sector.  This new system is intended to offer insurance companies incentives to measure and manage their risk situation and includes both quantitative and qualitative aspects of risk.

On the FSA website you will find extensive information on Solvency II, in addition you will find many other consulting and financial advisory firms who have written reports on Solvency II. As a minimum please read the following links:
http://www.fsa.gov.uk/Pages/About/What/International/solvency/background/index.shtml

http://www.fsa.gov.uk/Pages/About/What/International/solvency/governance/index.shtml

http://www.fsa.gov.uk/Pages/About/What/International/solvency/reporting/index.shtml

http://www.ey.com/Publication/vwLUAssets/EY_Solvency_II_Pillar_III_and_IFRS_4/$FILE/EY_Solvency_II_Pillar_III_and_IFRS_4.pdf

Self-Assessment Questions

1.    Why is government involvement in the insurance industry required?

2.    Outline the role that regulation plays in the insurance market and the key powers a regulator should have.

3.    Explain the remit of Solvency II and the purpose of introducing such a framework.

4. Outline the key objectives of Solvency II

5. Outline each of the three pillars of Solvency II.

6. What is the purpose of the ORSA?

7. What do you think the main challenges for Solvency II implementation are likely to be?

Topic 6:     Underwriting and pricing of general and life insurance

Preview

If an insurance company’s business is to be sustainable in the medium to long term, the policies that they issue need to be correctly underwritten and priced. The history of insurance is littered with companies who have failed financially and, very often, this failure can be attributed to the inadequacy of their underwriting and pricing strategy. This topic looks at the basic principles that insurers should follow and some of the factors that will impact on these principles. Following on from a general overview of underwriting and pricing, the topic looks separately at the main issues surrounding general and life insurances.

Learning outcomes

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

•    Analyse the means by which insurance companies assess levels of risk
•    Discuss the operation of the reinsurance market and evaluate its impact on general insurance underwriting and pricing
•    Discuss the principles of general insurance pricing
•    Critically evaluate the impact of the ‘underwriting cycle’
•    Outline the mathematical basis of life assurance
•    Analyse the key similarities and differences between life assurance and general insurance
•    Discuss the major classes of life business
•    Discuss the main forms of pensions business
•    Critically analyse the causes of life and pension related controversies and problems and their effects on the insurance industry

Indicative reading:

Thoyt (2010), Chapters 3, 4, 10 & 11
Atkins & Bates (2008), Chapter 13 (supplied in the Module Reader)

Stein, W. (2007), Chapter 2 (CIOBS text on GCU Learn)

Principles and practice of underwriting

The term ‘underwriting’ can be traced back to the early marine insurance policies issued by Lloyds of London. Those who were prepared to provide financial backing for these marine insurance contracts signed their name under the details of the risk. As insurance grew in sophistication, the term ‘underwriting’ developed to encompass a more complex set of tasks than simply signing your name.

In Topic 2 we looked at the concepts of:

•    the common pool
•    equitable premiums
•    adverse selection

The role of the underwriter is to use a range of techniques to manage these three concepts. Fundamentally, these techniques will revolve around:

•    evaluating the risk that a proposer brings to the pool
•    coming to a decision on whether to accept that risk and, if so, whether partially or in full
•    deciding on the cover, terms and conditions of the insurance
•    calculating a suitable and equitable premium

The precise underwriting practice and techniques vary from one type of insurance to another, but we will cover the general principles which any insurer, offering any type of insurance would need to consider. Underpinning these general principles is a very strong mathematical basis of pricing, which will fundamentally revolve around:
•    relative frequency
•    the Law of Large Numbers
•    Stochastic modelling

The detailed mathematics behind these three concepts is beyond the scope of this course, but it is important to anyone interested in insurance pricing to be broadly familiar with their nature and function.

The general underwriting principles will operate at two main levels within the organisation; the management / strategic level and the operational / front-line level.

Underwriting at the management / strategic level is, generally, an insurance ‘Head Office’ function. At this level, the senior underwriter (and there may be a number of these to reflect the different forms of insurance offered) will decide on the overall underwriting policy to be pursued. This will contain such elements as:

•    what products do we want to offer
•    what type of risks are we hoping to attract
•    what are the broad criteria which operation underwriters must follow
•    what should our reinsurance arrangements be
•    how will we ensure operational underwriting competence

Depending on the insurer’s overall structure and philosophy, senior underwriters will delegate more or less authority to operational underwriters. These underwriters will be expected to follow the company’s general strategy, but may have a degree of discretion in how that strategy is implemented.

General Insurance

Firstly, we will look at the question of hazard assessment.
In insurance terms, ‘hazard’ relates to something that may impact on the frequency and/or severity of the insured event. In general, underwriters will consider two main forms of hazard – physical and moral.

Physical hazard is something which is related to the physical, tangible characteristics of the insured risk. For example, this could be:

TYPE OF INSURANCEPHYSICAL HAZARDFireConstruction of the buildingMotorMake and model of the vehicleMarineNature of the cargo
If we take fire as a specific example, a building that is constructed of wood is clearly more ‘hazardous’ than one which is constructed of stone. A fire starting in a wooden building is likely to be much more severe, therefore, the physical hazard is much greater than the stone building and, consequently, the fire underwriter will charge a much higher premium or give much more restricted cover.

In many respects, the underwriting of physical hazards is more straightforward in that, assuming there is full disclosure, the hazards are capable of more objective assessment.

Moral hazards can be much more difficult to assess with any degree of objectivity. These relate to the personal attitudes or characteristics of the person who is seeking insurance. These attitudes may reveal themselves in a connection with a physical hazard, e.g. a lack of care (a moral hazard) may manifest itself in a failure to ensure that dangerous machinery is correctly used (a physical hazard). However, many of the moral hazards such as dishonesty or recklessness may only become evident after the insurer has accepted the business and the claims start to roll in.

The underwriting process
Although the fundamental principles apply to all forms of insurance, the degree of complexity in the underwriting process will vary considerably depending on the:

•    type of insurance
•    insurer’s experience of, and attitude towards, that insurance
•    reinsurance market attitude

For example, if we consider personal lines insurance, such as house insurance, most insurers who offer this will underwrite a large amount of it. In effect, it will be considered to be ‘volume’ business with very little individual underwriting for the vast majority of policies. The insurer’s experience will be such that the personal lines portfolio of business will be commoditised. Reinsurers will take a close interest in potential aggregate losses on the portfolio, but will be less intrusive than they will be with more complex and high risk insurance. An example of this complex and high risk insurance would be the property and liability covers of a multi-national manufacturing company. Here the underwriting will be much more individualised and will involve the insurer in a range of assessment methods, including those that are desk-based and those that will involve such measures as risk surveys.

To give you an indication of the relative complexity that will be involved in underwriting home insurance as compared to commercial insurance, please look at the text available on GCU Learn:

Stein, W. (2007) Introduction to Insurance, Edinburgh, Chartered Institute of Bankers in Scotland (CIOBS)
Home insurance starts on page 73 and commercial insurance starts on page 137

Pricing
In most developed markets, insurance companies are commercial, private sector organisations, therefore their fundamental purpose is to make profits. As we will see when we look at the underwriting cycle they do not always to this successfully, although in the long run most insurers will be profitable. Central to this expected profitability is the need to have an effective pricing system. In some insurance markets, pricing will be influenced by government regulation or by the existence of ‘tariffs’ (an agreement by all insurers in that market to charge the same rate). These clearly have an impact on the insurer’s freedom and discretion regarding pricing. Our discussion will revolve around those markets where insurers can set their own pricing structure.

Central to the question of pricing is the notion of the equitable (or fair) premium. This was introduced in Topic 2. An equitable premium for an individual insured should be set at such a level that it will cover:

•    the expected claims costs
•    the insurer’s administrative and other costs
•    an amount for investment by the insurer
•    a profit loading
•    various external factors, such as interest rates and inflation

For the vast majority of insurers, and forms of insurance, the expected claims cost represents the largest component of the equitable premium. As previously indicated, insurers will use the Law of Large Numbers as a method for calculating the likely losses across the common pool of risks. Even within the common pool, however, the individual risks will not be entirely homogenous, therefore it will not be equitable to charge every insured the same premium. Consider the following example:

A motor insurer’s target market is female drivers aged between 30 and 60. In statistical terms, this is a common pool of drivers that have a lower than average claims frequency and severity. However, even within this safer than average pool of risks there will be some who:
•    have a poor accident record
•    have a history of driving convictions
•    drive very powerful and/or expensive cars.
Those who have one or more of these adverse characteristics cannot, realistically, expect to pay the same premium as those who do not have any of the characteristics. Quite simply, the ‘riskier’ segment of the common pool will have higher than the average claims costs. If the insurer is prepared to accept them, which will depend on their underwriting criteria, their equitable premium will be higher than the average for the common pool.
In effect, the insurer will be looking at two basic aspects of expected claims costs:
1.    the total premiums charged will be adequate to deal with the total claims costs of the pool
2.    individual premiums reflect the level of risk that each insured brings to the pool

Insurers will always be working with imperfect knowledge, therefore, as will be discussed in Topic 7, the expected claims costs for any common pool are a combination of the known and the unknown.

Reinsurance
Reinsurance is covered in more detail in Topic 4, but it would be useful here to recap on the role that it plays in underwriting. Ultimately, reinsurance (in whatever form it takes) is the insurance that insurance companies buy. They will buy this for four main reasons:

1.    financial security
2.    financial stability
3.    underwriting capacity
4.    protection against catastrophes

The reinsurers, who are often much larger and have a much more global spread of business than the insurance companies, will exercise their own underwriting criteria on business that is proposed to them by the insurers. Given that reinsurers only tend to get involved in losses, either individual or cumulative, that are substantial, their underwriting criteria are often rigorous. Given these criteria, it is unsurprising that the influence of reinsurers on the underwriting and pricing strategy and practice of insurers is significant. For example, in recent years reinsurers have been behind significant changes in insurers’ attitudes towards such covers as terrorism, environmental and employers’ liability.

The underwriting cycle
The well-understood phenomenon of the ‘underwriting cycle’ is a key factor in the underwriting and pricing practices of both the insurance market as a whole (excluding the life insurance market) and also individual insurers. The drivers of the cycle have been neatly summarised as follows:

Underwriting results follow a cyclic pattern caused by external factors affecting capacity – such as catastrophic events and investment performance. In addition, internal factors – such as insurers striving for market share during times of robust investment results – contribute to the cycle. The cycles average about six years in length and are synchronised across countries and to some extent across lines of business.

Swiss Re, Sigma No. 5, 2001

Within the underwriting cycle there are two separate components:

•    a underwriting profit cycle
•    a pricing cycle

Underwriting profit cycle
We could start at any point on the cycle, but it is easier to understand the concept of the underwriting cycle as a whole if we start at the top of the profit cycle. At this point insurance is highly profitable. As with many profitable businesses, there may be an increase in supply as more providers seek a share of the market. The demand is, however, limited, so more supply and static demand leads to intense competition. To attract, or retain business, insurers (who may have become complacent due to their underwriting profit) will start to reduce underwriting standards and prices. This is known as the soft market. Insurance is, relatively, easy and cheap to purchase.
The inevitable consequence of these actions will be a swing from underwriting profit to underwriting loss. Supply will reduce, although demand remains, roughly, the same. This static demand and reduced supply allows insurers to return to stricter underwriting and pricing practices. We are now in the hard market.

Pricing cycle
The pricing cycle lags behind the profit cycle by approximate two years. This is due to the fact that it takes that period of time for changes in pricing to translate into results, either profit or loss. If we start at the bottom of the profit cycle (the hard market), insurers will now be charging much higher premiums than they were before. They are, however, still facing the consequences of the soft market, i.e. increased claims and decreased income. In addition, they may have exhausted much of their capital. It will take a period of time, therefore, for the effects of increased premiums and stricter underwriting to feed-through to the profit and loss account.

As indicated by Swiss Re, the underwriting cycle is a factor of external and internal factors. The external factors are substantially beyond the control of the insurance market, but the internal ones are fully within their control. Why, therefore, given the well-understood nature of the underwriting cycle, do insurers not seem to learn from the mistakes of the past? There is no consensus view on why this is the case and no real evidence that the underwriting cycle is likely to disappear in the foreseeable future. This not a desirable situation for either insurers or insureds. In particular, large scale buyers of insurance are discomforted by the vagaries of the cycle. If an organisation has a large insurance portfolio and an insurance budget running into millions of pounds, it prefers a high degree of certainty and consistency. The risk / insurance manager of that organisation does not relish the prospect of covers that were widely available at reasonable cost in one insurance year, becoming highly problematic and expensive in another insurance year. This problem has been widely cited as one of the reasons why many large scale buyers of insurance have increasingly utilised other forms of risk financing.

Life insurance and Pensions

Although the basic principles of insurance apply to all forms of business, many of the practical issues surrounding general (often referred to as ‘short term’) insurance and life and pensions (‘long term’) assurance differ. In theory, and in many practical respects, life and pensions business should be a much more predictable and less volatile sector. However, as we will discuss, in recent years it is a sector that has faced a number of controversies and difficulties.

Terminology
In the English-speaking world, some of the terminology surrounding long-term and short-term business frequently differs. In particular, life business is frequently referred to as ‘assurance’ rather than ‘insurance’. This dates back to a time when the range of life business was narrower than it is today and was, substantially, restricted to policies that would pay out on the death of the policyholder, whenever that occurred. Given that death is inevitable (or assured), the word ‘assurance’ passed into common usage. The words assurance and insurance have, increasingly, became interchangeable for long term business, and we will stick with the generic terms of ‘insurance’ and ‘insured’.

Life Insurance
The common pool principle is as relevant for life Insurance as it is for general insurance. Indeed, the common pool is more reliable and predictable for pricing of life Insurance than it is for most other forms of insurance. This is primarily due to the very strong mathematical basis of life Insurance, in particular the use of mortality tables. These have their origins in the work of Edmund Halley (1656-1742) and James Dodson (1705-1757), and they work on the following basis:

Mortality tables are grids of numbers which show that for each age, within a population, what the probability of death is within one year, e.g. a standard mortality table might show that a 21 year old female has a 0.000243 chance and a 54 year old male has a 0.006612 chance of death before their next birthday.

Using the Law of Large Numbers, mortality tables are mathematically sound for groups, although they clearly do not give a reliable prediction for the time of death for individuals. The basic probabilities are calculated on age and gender, given that women tend to live longer than men, and are then modified for additional risk factors, e.g. smoking, family history and occupation. It is not the case, therefore, that the mortality table is the only instrument for pricing. Life Insurance will use risk-based underwriting in the same way that general insurance does – risk factors that make the risk worse than the average will attract additional premium charges. Dodson’s mathematical work in particular, led to the ‘level premium concept’ which is one of the fundamental differences between the pricing of Insurance and insurance.

Level premiums
If we accept that in life Insurance that the ‘risk’ is the individual Insured, then intuitively the risk becomes worse with each passing year. In simple terms, as we get old we become more likely to die. That being the case, should it not be the case that our premiums increase with each passing year? If we look at fire insurance, if the fire risk associated with the building increased from one year to another, it is reasonable to assume that the insurers would increase the cost of the insurance. In reality, however, life Insurance premiums do not increase as you get older, sicker and more likely to die as they are grounded in the level premium concept. Level premiums are based on the total premium needed between the time of the inception of the policy and the year of the expected death of the Insured. The latter is based on use of mortality tables. The total premium is then divided into annual / monthly amounts.
The rationale behind this is entirely sensible – if premiums increased year on year, the Insurance would become unaffordable in the years when it was most needed. Using level premiums, the Insured is over-paying in the early years, will reach an equilibrium level and under-pays when that level is exceeded.
Given the long-term nature of life Insurance, provided the Insured continues to pay the premiums, the assurer cannot cancel or amend the policy after the initial terms and conditions are agreed, irrespective of how bad the ‘risk’ may become.

Types of life Insurance policies
Fundamentally, there are four main forms of policy;
1.    Whole life
2.    Endowment
3.    Term
4.    Group life
Whole life and endowment policies may be with or without profits, or as they are generally called, ‘bonuses’. These operate on the following basis

•    Premiums are invested by the insurer in a range of assets which will, hopefully, generate profits
•    The policyholder shares in the this profit
•    ‘Smoothing’ is used to even-out bonus payments, i.e.  a proportion of the profits earned during good years is held back to top-up bonuses paid during bad years
•    Two main types:
1.    Regular (or ‘Reversionary) bonus – allocated yearly and guaranteed
2.    Terminal bonus – allocated at maturity or death and is not guaranteed
The policies themselves operate as follows:

Whole life
•    Level premiums are paid from inception to death, although the policy may be ‘paid-up’ at a given age. A ‘paid-up’ policy is one where the premiums cease at a pre-determined age, although the policy remains in force and will pay-out when the Insured dies.
•    As payment is assured, the policy has a monetary value and can either be surrendered prior to the death of the Insured or it may be sold to a third party. The surrender value will vary over time, but in the early years of a policy it will be very low. As insurable interest need only exist at inception, it is valid to sell the policy to a third party, who then takes over payment of premiums and is assigned the benefit of the policy
•    These were once the most common form of life Insurance, but their popularity has declined in recent years

Term Insurance
•    The policy is for a set period of time, e.g. a term of 25 years.
•    Premiums are paid during that period and if the Insured dies then payment is made by the insurer. If the Insured survives, no payment will be made by the insurer. In that respect, the ‘Insurance’ only exists during the pre-determined term.
•    These policies, which in the UK are the most common form of life cover, have no surrender or market value

Endowment Insurance
•    Originally an endowment was not an Insurance policy, but was a form of investment plan. However, in the 1980s the product developed whereby endowment Insurance combined term Insurance and an endowment. This endowment was for a pre-determined period and at the end of that period, assuming the Insured has survived, the endowment would mature and its value paid. Death during the period of the policy triggers the term policy.
•    For reasons that will be discussed, these policies have developed a bad reputation.

Group life
•    These are policies that are, generally, purchased by employers for the benefit of their employees. The employee may be required to make a contribution to the premium, but often they are funded in their entirety by the employer.
•    The cover only exists during the period of the worker’s employment with the company, so in that regard they share characteristics of term Insurance. Hence their common name – ‘death in service policies’.
•    Given the economies of scale involved in purchasing cover for, perhaps, many thousands of employees, the unit cost per employee will be less than if the individuals purchased their own cover.

Pensions business
Pensions business handled by the insurance industry is, to a very large extent, determined by a country’s attitude to state provision of pensions and other welfare benefits and the provision of pensions by employers. In that respect, there is no universal system that will apply to all times in all countries. This section will, therefore, look at some general principles and concepts.

In many countries, pensions provision will be a combination of:

•    State
•    Occupational
•    Personal

The state will not normally use the insurance industry and will fund its pensions’ liabilities to citizens through a combination of specific contributions, e.g. National Insurance in the UK, and general tax revenue. The state will also be a very large-scale employer and will also, therefore, be a provider of occupational pensions. Again, these will not normally be funded through the commercial insurance market.

On the other hand, private sector employers will use a variety of methods to fund their occupational pension schemes. Many large employers will manage the fund themselves, but some large and most small-medium sized employers will use the services of an insurance company.

Insurance-related occupational schemes
The pension contributions made into these schemes are analogous to the premiums paid in other insurance contracts. These contributions may be funded in a number of ways:

•    Solely by the employer
•    A combination of employer and employee (currently the most common method in many countries)
•    Solely by the employee
Although there may be individual variations, when the employee reaches the normal pensionable age the benefits due under the scheme will be paid. Again the main methods of payment will vary from country to country, but in many countries they will based around what are known in the UK as:

1.    Defined benefit, or final salary, schemes, or
2.    Defined contribution, or money purchase, schemes.

In almost all cases, the first category is the most attractive to the employee as the payment (a product of final salary x years of service) is guaranteed. Any shortfall in the fund, i.e. due to unfavourable investment conditions, needs to be made-up by the employer. Due to a combination of increasing longevity and uncertain investment conditions, these schemes have become increasingly uncommon.

Consequently, the second category has grown in prominence. In these schemes the fund builds up over time, and on reaching pensionable age it is used to but an annuity. An annuity is similar to a single premium – it is paid to the annuity provider who then provides a yearly or monthly income from it. In this case the investment risk rests with the employee and is two-fold. Firstly, the fund will have been subject to investment risk over the period of the contributions. If the returns have been weak, the amount available to purchase the annuity might be lower than would have been expected. Secondly, when the annuity is purchased, the payments made to the annuitant will be influenced by what the insurance company predicts will be the investment return on the fund. Pessimistic expectations will lead, again, to lower payments.

Insurance-related personal schemes
These are purchased by individuals and are funded by their own contributions. Apart from that, they are very similar in nature to the money purchase schemes referred to above. On retirement, the contributions will purchase an annuity.

It is worth noting that, in many countries, governments offer financial incentives for individuals to contribute to either (or both) their occupational scheme or a personal scheme. These incentives normally revolve around tax relief on some, or all, of the contributions. This relief will have an upper limit and will have conditions relating to the payment of benefits etc when the pension is eventually drawn.

Problems and controversies in the life and pensions markets
Like any other form of insurance, life and pensions business is affected by both national and international factors. Economic problems, medical and scientific advances, regulation and competition are seldom delineated by national borders. Many of the problems and controversies that have impacted on these sectors are, therefore, beyond the control of insurers in individual countries, although, as will be discussed, there are some that are a factor of specific country-related difficulties.

One of the key global issues that many small – medium sized life assurers face is that of competition. Competition may come from international financial services groups, e.g. banks, who see the financial stability of the life Insurance market as one that they should aggressively enter, or it may come from the ‘mega’ assurers who have been formed in recent years following mergers and acquisitions. In many ways, this competition is a function of the wider globalisation agenda.

In addition to this global competition, specific countries, e.g. the UK, have seen a rise in the ‘direct’ insurers. These companies, Direct Line being an example, have maximised the use of technology to create a direct link between them and the customer. They have identified niche markets, kept their operating expenses well below the levels of conventional insurers and, consequently, have offered very competitive premium levels. Their success thus far has mainly been in general personal lines business such as motor insurance, but there is no reason to suspect that they could not transfer their business model to the life market.

A highly problematic product area, which generally falls within the category of life business, is that of health insurance. However, this category of business is much more problematic in countries such as the USA where it is the pre-eminent method of funding health care. Medical advances, longevity, the rising cost of treatment and political divisions have made health Insurance a highly contentious issue in the USA. If we compare that with the UK, which has the largest life Insurance market in Europe, health insurance is not such a problematic area. In relative terms, the UK private health insurance market is quite small and does not feature in the insurance-buying strategy of the vast majority of the population who rely on the tax-payer funded National Health Service.

A relatively new scientific development which has the potential to significantly refine the underwriting of life Insurance is genetic testing. These tests could give assurers a predictive tool that has a very high level of accuracy. However, the reality for the life companies is that their ability to underwrite on the basis of genetic tests has been severely curtailed, and in some cases eliminated, by governments. In both Europe and the USA, legislation has been passed, or voluntary agreements reached, whereby assurers will either eschew the use of genetic testing, or severely restrict its use, in respect of life underwriting. There may very well be sound risk-based advantages and disadvantages associated with genetic testing, but the political reality for the life market is that its use is unlikely to be permissible in the foreseeable future.

A constant concern relating to life and pensions business is that of giving bad advice. Buyers, who will generally lack knowledge of the technical complexity of insurance, rely on the companies to give them sound advice on long-term products such as life Insurance and pensions. No insurance based product is entirely risk-free, but there is a clear distinction between the buyer voluntarily accepting a risk that is clearly explained to him and being exposed to a risk that was either poorly explained or concealed from him. A situation that has prevailed in the UK in recent years is an unambiguous example of this. The two main products which proved to be problematic were with profit endowment policies and personal pension plans.

With profit endowments
For many years these were seen as ‘safe’ products and were a widely accepted form of combining investment with life cover. In the 1980s the Conservative Government had a clearly stated policy of encouraging home ownership. A by-product of this was, for the first time, an opportunity for social housing tenants to buy their homes, often at substantial discounts. This wider policy of ‘a property owning democracy’ and a general relaxation on the rules surrounding granting mortgages, led to a huge increase in demand for financial products. Assurers, keen to tap into this demand, actively encouraged their sales forces to promote endowment-backed mortgages. These worked, in theory, as follows:

1.    You borrow £100,000 to buy your house, repayable in 25 years
2.    You pay the interest on that capital sum over 25 years
3.    You buy a 25 year with profits endowment, which at the end of the period will pay-off the £100,000
The main problem arose due to the fact that, using our example, very few buyers purchased a £100,000 endowment. On the advice of the salesperson, they bought a, say, £50,000 endowment and were given bland Insurances that by the end of the 25 year period the accumulated bonuses on the policy would more than make-up the £50,000 difference. Many companies used wildly optimistic bonus predictions, which were never likely to materialise. The outcome was that, again using our example:

1.    You borrow £100,000 to buy your house, repayable in 25 years
2.    You pay the interest on that capital sum over 25 years
3.    You buy a 25 year with profits endowment, with a sum assured of £50,000. You are informed that the accumulated bonuses will, by the end of 25 years, pay-off the £100,000 (and may even have some left over for yourself)
4.    The bonus predictions have been wrong – your policy is only worth £80,000 at the end of 25 years
5.    The mortgage lender wants their £100,000, therefore the borrower is left with a £20,000 shortfall which they must raise from some other source
6.    Much government, regulator and consumer concern followedIn the UK, between 2001 and 2008, the number of endowment-backed mortgages fell from @11 million to @5 million. Their use continues to decline and insurers are now severely restricted on the predicted growth rates that they can use.

Personal pension plans
Although the nature of these products is fundamentally different from that of with profit endowments, the causes and the effects of the main problems are surprisingly similar.

Again, a key driver was central government policy, i.e. to reduce state pension liabilities by encouraging people to buy a personal pension. This created a huge new market for the insurance companies, which, unsurprisingly, was highly competitive. Sales forces were encouraged to persuade people to abandon occupational pension schemes, many of which were, for all practical purposes, risk free. The probability of a personal pension, with its exposure to market risk, providing a better pension than most of these occupational schemes was negligible. In addition, there was a huge sales drive to encourage people to leave that part of the state pension scheme which they could opt-out of. Again, the returns under personal pension schemes for many pensioners were unlikely to better, or even match, the state scheme.

Pensions providers were under a legal obligation to give ‘best advice’ and it soon became patently obvious that many of them had failed in that duty.

The main outcomes of both of these crises have been:
•    The industry has been faced with a massive compensation bill
•    Public confidence in the sector has been reduced
•    The industry has seen increased regulation
Clearly the endowment and personal pensions ‘mis-selling’ scandals are UK based, however, there are wider, global lessons for the industry. Firstly, if the main driver is ‘sales at all cost’ the potential arises for the sales force to lose sight of the need to give good advice on complex, and potentially risky, products. Secondly, in a more consumerist age, buyers of substandard products have far more protection and far more vocal advocacy than they may have had in the past. Thirdly, the industry needs to recognise now only the direct financial consequences of such scandals, but also the long-term, indirect reputational damage. Finally, governments’ response to these problems tends to be ever-greater regulation, which can constrain companies both financially and operationally.

Self-assessment questions

1.    Proposal forms, completed by the proposer, were the traditional basis on which insurance business was underwritten. For some types of business, many insurers have moved away from these. Do you see any inherent dangers in that and, if so, what are they?
2.    How would you explain the operation of the law of large numbers, in the context of insurance, to a non-insurance audience?
3.    Explain why expected claims costs in liability business are more problematic than in life business.
4.    Assume that you are an underwriter for an insurer who has decided that they will no longer follow the underwriting cycle. What would be the main elements of your underwriting and pricing strategy that would allow you to move away from this cyclical behaviour?
5.    How would you explain to a lay person why life Insurance pricing differs from that of general insurance?
6.    Under what circumstances would you recommend a Term Insurance policy to someone who was looking to buy life cover?
7.    Briefly discuss the following statement:
The only way to ensure that best advice is given to customers is to have greater regulation of life Insurance and Insurance-based personal pension plans

Topic 7: The claims process
Preview

Many people would take the view that an insurance company is in business to pay claims.   When a claim arises, that is a point when insurers are tested against all the promises about the security provided by the policy and about the level of service to be given.   Yet it is well established that many policyholders attempt to defraud insurers either by fabricating claims or by inflating the amount claimed on an otherwise legitimate loss. Claims officials thus have to strike a delicate balance between a) swift settlement of claims and b) a rigorous and time-consuming investigation of the legitimacy of any claim.  In addition, they have a key role in providing timely data to underwriting management to allow underwriting strategy to be modified as and when necessary.

Learning outcomes

•    Analyse the different aspects of strategic and operational claims management
•    Explain what is meant by the insurance loss ratio
•    Evaluate the nature and importance of claims reserving
•    Critically analyse the anti-fraud initiatives that insurers use

Indicative reading:

Thoyt (2010), Chapter 9
Atkins & Bates (2008), Chapter 14 (supplied in the Module reader)

Establishing basic facts regarding the claim

Every person employed by an insurance company is an ‘expense’ that must be met out of premium income.  The time of claims officials must, therefore, be used as efficiently as possible.  Some policyholders will submit claims that are, unfortunately, not covered.  It is best for all concerned that such cases are disclosed quickly by establishing a system of routine checks to be applied to every new claim notification.

These basic tests (is the peril insured? Is it within the period of insurance? etc) are outlined in the indicative reading.  Note the additional test applied whenever we identify that a policy carries a ‘Warranty’.  This special form of condition must be strictly and literally complied with.  Even if an identified breach of warranty is found not to have been material to the occurrence of the actual loss, the insurers still have the right to reject the claim.

It is worth noting that there needs to be a relationship between underwriters and claims handlers and that:
a) underwriters may need to be consulted about the intention of a particular policy wording and
b) that underwriters certainly need to be kept informed about important losses.

Notification of claims and completion of claims forms

In the past, insurers used much more formal, written, systems for claims notification and the completion of a ‘claims form’ was standard practice.  However, filling in a complicated form is probably the last thing that a policyholder likes to do following a loss, although it is an extremely efficient way of capturing (in a single document) the basic points of information that, at least theoretically, will be sufficient to allow the issue of a settlement cheque to be authorised.

Note, however, that claim forms are not now always used for commercial claims, particularly the larger ones.  There is also a trend in personal lines business to eliminate or at least reduce the length of forms wherever possible.

Note also that where fraud is suspected on the part of the policyholder, it is most helpful to have them sign a claim form as evidence that they are claiming on the policy.  This means that they can no longer claim that they were simply enquiring about policy cover.

Procedures for handling claims

Modern practice in insurance claims management and handling has focused on distinguishing claims by likely value and adopting different procedures based on that likely value. As an example, an insurer may categorise claims on the following scale:

1.    Small claims, i.e. those worth less than £500
2.    Medium range claims, i.e. those worth between £500 and £50,000
3.    Large claim, i.e. those over £50,000

For those in the small claims category, insurers need to carefully weigh-up the costs of investigation against the likely savings that will be yielded from that investigation. There is a trade-off between the need to ensure that the claim is valid and the need to keep administration costs low. In practice, many insurers have a policy of not investigating many claims at this level. They will make a judgement on claim validity and indemnity based on either a claim form, information provided over the telephone or an electronic means of claim submission. However, even at this level, insurers will wish to satisfy themselves that they have some quality control procedures in place and will, therefore, conduct sample audits of claims and also pay close attention to fraud indicators.

For the larger claims, it is axiomatic that these will be more complicated. Consequently, the management and handling of these claims is much more individualised. The insurer’s most experienced claims staff will be involved along with external specialists such as; loss adjusters, forensic, legal and medical experts and engineers.

The medium range claims will, by volume, make up the largest number of claims in any one year. These claims will be investigated, although generally not to the same extent as the >£50,000 claims. In addition, insurers may use quite different management and investigative techniques depending on the type of insurance involved, e.g. a fire claim at £40,000 will be handled in a quite different way from a liability claim of the same value.

This section of the text outlines the work of claims handling that is often outsourced to specialist claims handlers called Loss Adjusters.  Loss adjusting is a well established business.  Many who work in that business gained their claims handling experience with an insurance company.

It is important to note that there is no reason why an insurer could not have all the claims handling experience it needs ‘in-house’.  This is especially the case for the largest of insurance companies because they could expect to have enough claims of each type to maintain a level of expertise in their staff and to keep them fully occupied.  However, smaller insurers will not expect (nor do they desire) to have a sizeable number of claims under all of the categories of business they write.  It is much easier for them to hire a claims settling expert (i.e. a Loss Adjuster) as and when they need one.

Even when we get down to very routine claims such as personal motor or home insurance, we may find that insurers turn to outsourcing and that Loss Adjusters are used to handle claims of quite modest size.  In effect, these insurers have convinced themselves that the loss adjusters can do it more cheaply and more efficiently.

Measuring Indemnity

We have already touched on this in Topic 1.  If we take a contract of property insurance as an example, this is a contract of indemnity.  This means that the insurers undertake, as much as possible, to place the insured after an incident in the same financial position as he was in immediately before the incident.

Calculation of value:  There are three aspects to this.

1.    First we have some ground rules set down about the situation which applies if a contract is one of indemnity (i.e. it will use words like “We shall indemnify you” etc.).  The value of the subject matter of the insurance is its value at the time of the loss and the place of the loss. Neither sentimental value nor consequential losses are included.
2.    Second, we have a number of interpretations that have been made in situations where it has proved hard to apply the basic principles.  Sometimes these are as a result of the deliberations and pronouncements of a Court of Law in a claims dispute.  Sometimes they are they result of discussion amongst insurers resulting in a market agreement.  An example would be the issue of ‘betterment’.
3.    Third, we have situations where the insurer and the insured have knowingly departed from the principles of indemnity by means of some form of agreed policy wording.  An example is the Reinstatement Clause where insurers agree to bear the full cost of reinstatement without any deduction for wear and tear.  But note that insurers are not prepared to cover stock on this basis – just buildings and all other contents.  So there are limits to what an insurer will agree.

Insurers have the right to reinstate if they wish and that this is one way of providing an indemnity.  Insurers prefer to make cash settlements so it would be unusual for them to take such a course of action.  Nonetheless, they have this possibility open to them and could use it to thwart a claimant who was intent on destroying their property to raise cash.

The application of Average in complex commercial insurances is a specialist subject, especially where several different insurance policies overlap in relation to, say, the same fire loss, and the principle of contribution is also dragged in to the calculation.  It is beyond the scope of this Module.

When serious fire damage affects a business, urgent decisions have to be made in order for the Insured to have their business fully recovered as quickly as possible and also to minimise the loss for the Insurers and for the Insured.  This requires close liaison between all parties concerned: Insured, Insurer, Loss Adjuster and Insurance Broker.  In considering measures to reinstate physical damage to buildings and machinery, the implications for the ongoing business interruption must be paramount.  Indeed, in most situations, the business interruption claim should drive the material damage claim.

Settlement of claims in the event of a dispute

In the event of a serious dispute over liability, insurer and insured may well resort to a Court of Law for a settlement.  However, this is hugely expensive and is not undertaken lightly.  The issues surrounding whether a policy covers a loss are not always black and white.

Often the argument is not about the actual policy wording but about information that may or may not have been discussed between insurer and insured in the run up to taking out the insurance.  Realistically, commercial factors come into the negotiations.  A policyholder with a substantial block of premium income to place may well receive more sympathetic interpretation of a problem case.

In many cases, the insurer accepts that the cover is in force and all the argument with the policyholder centres on the level of the claim to be paid.  These are referred to as disputes about ‘quantum’.  There are four main approaches that are available in the UK:

•    Arbitration

•    Insurance Ombudsman

•    Personal Insurance Arbitration Service

•    Alternative Dispute Resolution

Loss ratios and claims reserving

The loss ratio is a significant contributor to whether an insurance portfolio is profitable or otherwise. The loss ratio is calculated by dividing the losses paid and estimated in any one accounting year by the premiums earned in that year. This is then expressed as a percentage. For example:

•    Paid and estimated claims for Year X – £6.5 million
•    Earned premium for Year X – £10 million
•    Loss ratio for Year X – 65%

The loss ratio is then combined with the insurer’s expense ratio and this combined figure gives a broad indication of underwriting profitability.

Insurers use the loss ratio to give them a broad indication of the effectiveness of their underwriting and claims quality, e.g. a consistent loss ratio of >80% will suggest that something is fundamentally wrong. In the medium to long run, high loss ratios will affect the viability of insurers, e.g. as happened with the Municipal Mutual Insurance in 1992. On the other hand, if loss ratios are consistently low, e.g. <50%, this could suggest to buyers and intermediaries (assuming that they can access this information), that premiums are higher than the market average.

It would be wrong, however, to assume that the calculation of the loss ratio is a simple arithmetical task. It is fairly straightforward for the insurer to calculate on the basis of claims that have been settled, but what about those that have not been? How are they factored into the calculations?

A major concern for insurers is the adequacy of their reserves for claims that have not been settled. Again, a distinction can be made and this is between reserving for outstanding claims that have been notified to the insurer (a relatively straightforward process) and those claims where the incident  has occurred, but the claim has not been notified (a not-at-all straightforward process). Donald Rumsfeld, who was the American Secretary of Defence, made a famous, and much criticised, speech in 2002 where he said the following:

“We know there are known knowns: there are things we know we know. We also know there are known unknowns: that is to say we know there are things we know we don’t know. But there are also unknown unknowns — the ones we don’t know we don’t know.”

The language used by Mr Rumsfeld may be fairly impenetrable, but the logic of what he says, certainly in the context of insurance reserving, is sound. For insurers the ‘known knowns’ are the claims that have been reported and settled. The ‘known unknowns’ are those that have been reported, but the settlement figure has not been finalised. The ‘unknown unknowns’ are the most difficult of all; those claims where the incident has occurred, but the insurers have not been informed. In insurance terms, these are ‘incurred but not reported (IBNR)’ events. These are more problematic in some classes of business than others. For example, commercial fire claims are generally notified very quickly, so cause fewer IBNR problems. On the other hand, in some types of complex liability claims it can take a long time for various parties to be identified, therefore it may be a number of years before an insurer is notified. Insurers will calculate an IBNR figure for various classes of business based on factors such as; their portfolio, historical data, current claims trends and changes in law and regulation. This will involve complex accounting and actuarial calculations.

Fraud

You will see from the indicative reading that claims fraud is a major, and apparently, growing problem for insurers.

It is suggested that you look at the Association of British Insurers (ABI) website (www.abi.org.uk) where you will find a large amount of information on insurance fraud. In addition, there are links to other relevant sites.

Another useful site is that of the Coalition Against Insurance Fraud in the USA (www.insurancefraud.org)

Self-assessment questions

1.    Do you see any dangers for insurers in only investigating a small percentage of claims below a certain figure? If so, how could these dangers be minimised?

2.    Outline the role of loss adjusters and the extent to which they can be considered to be independent.

3.    Why are IBNR reserves likely to be challenging for an insurer with a large employers’ liability portfolio?

4.    In your view is insurance fraud a growing problem, or are insurers simply becoming better at detecting a problem that always existed?

End of Topic 7

Topic 8: The international insurance market and contemporary issues

This topic will consider a selection of important international insurance market, some that are well developed and others that are considered to still be growing but are of significance to the global market place and particularly the economies of the countries in which they operate.

•    Discuss the differences between insurance regulation internationally
•    Compare, contrast and analyse differences in the insurance markets of the Americas, Europe, Asia Pacific region and Africa.

Reading:

Thoyt textbook – Chapter 13
Skipper and Kwon – Chapter 22 (module reader)

Overview of Insurance Worldwide
Insurance markets vary enormously in terms of size and structure.  This will usually depends on the size of a country’s economy. A few state-owned monopolies remain the sole suppliers for some countries.  Some developing countries deny foreign controlled insurers market access.  OECD countries have a blend of domestic and foreign companies.  Most large insurers despite operating internationally will write the majority of business within their domestic markets however reinsurers will write business internationally.

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