Tài liệu Bảo hiểm và sản phẩm bảo hiểm Insurance document

Increased cost of working...582.2.2.3 Motor Vehicle Insurance...59 - Insurable risks...61 Commonly, insurable risks in the construction and erection insurances include:...61 Many exclusi

Academy of Finance

INSURANCE

FUNDAMENTALS

In English

Co- compiled by Dr Hoang Manh Cu

MA Vo Thi Pha

HA NOI, 2009

Table of Contents

Table of Contents 2

PREFACE 7

CHAPTER 1 8

OVERVIEW OF INSURANCE 8

1.1 Risks and insurance 8

1.1.1 Concept of risk 8

1.1.2 Concept of Risk Management 12

1.1.3 Concept of Insurance 16

1.1.4 Insurance Contracts 19

1.2 Principles of insurance 22

1.2.1 Insurable interest 23

1.2.2 Utmost Good Faith .25

1.2.3 Principle of Indemnity 26

1.2.4 Subrogation 28

1.2.5 Contribution / Double insurance 30

1.2.6 Proximate cause 31

Foreseeability: It determines if the harm resulting from an action was reasonably able to be predicted 32

Direct Causation: The main thrust of direct causation is that there are no intervening causes between an act and the resulting harm An intervening cause has several requirements - it must: 32

○ be independent of the original act, 32

○ be a voluntary human act or an abnormal natural event, and 32

○ occur at some time between the original act and the harm 32

1.3 Insurance market 33

1.3.1 The buyers of insurance 34

1.3.2 The intermediaries 34

1.3.3 The sellers 38

1.3.4 Other insurance related professions and bodies 43

Actuaries are essential to the insurance and reinsurance industry, either as staff employees or as consultants Insurance actuaries can be defined as qualified professionals concerned with the application of probability and statistical theory to problems of insurance, investment, financial management and demography 43

CHAPTER 2 45

GENERAL INSURANCE 45

2.1 Overview of general insurance 45

2.2 Commercial general insurance 46

2.2.1 Marine Insurance and Oil & Gas Insurance 46

2.2.2 Non - marine General Insurance 54

Reduction in turnover 58

Increased cost of working 58

2.2.2.3 Motor Vehicle Insurance 59

- Insurable risks 61

Commonly, insurable risks in the construction and erection insurances include: 61

Many exclusions exist under the construction/ erection insurance policies, commonly such as: 62

- Overview 64

- Types of liability insurance 65

As we have seen, the concept of liability insurance concerns a wide range of various types of liability However, in this section we focus on the types of policies that not yet discussed 65

Professional liability insurance protects professionals such as architectural corporation and medical practice against potential negligence claims made by their patients/clients Professional liability insurance may take on different names depending on the profession For instance, professional liability insurance in reference to the medical profession may be called malpractice insurance Notaries public may take out errors and omissions insurance (E&O) Other potential E&O policyholders include, for example, real estate brokers, Insurance agents, home inspectors, appraisers, lawyers and website developers 66

▪ Public liability insurance 66

▪ Product liability insurance 66

- Hull "All Risks" 67

- Spares insurance 67

- Hull War Risks 68

- Hull Total Loss Only Cover 69

This is similar to Hull All Risks cover given above but will respond only to total losses of aircraft, whether actual, constructive or arranged This is particularly given for old aircraft since the old aircraft are heavily depreciated and insured for low sums and premium on such low sums would result in low premium, which would be inadequate for the partial losses The ratio of partial losses to total losses in such old aircraft is distorted 69

- Liability Insurance 69

2.3 Personal general insurance 69

2.3.1 Personal accident insurance 70

2.3.2 Medical and health insurance 71

2.3.3 Worker compensation insurance 72

2.3.4 Consumer credit insurance 73

CHAPTER 3 75

LIFE INSURANCE 75

3.1 Overview 75

3.2 Term/Temporary Term Insurance 76

3.2.1 Concept 76

3.2.2 Annual renewable term 77

3.2.3 Level Term Life Insurance 78

3.3 Permanent life insurance 79

3.3.1 Concept 79

3.3.2 Whole life insurance 79

- Participating policy 81

- Indeterminate Premium 82

- Economic 82

3.3.2 Universal life insurance 83

Types of universal life insurance: 84

- Single Premium 84

- Flexible Premium 84

3.3.4 Variable universal life insurance 84

- Characteristics of variable life insurance 86

Premium Flexibility 86

Investment choices/ Investment options 87

- Risks of Variable Universal Life 87

3.4 Endowment Insurance and Pure endowment 88

3.4.1 Endowment Insurance 88

- Traditional With Profits Endowments 89

- Unit-linked endowment 89

- Full endowments 90

- Low cost endowment 90

- Traded endowments 90

3.4.2 Pure endowment 91

3.5 Income stream products 91

Annuities can be clarified also into follows: 92

Fixed and variable annuities 92

Guaranteed annuities 92

Joint annuities 93

Impaired life annuities 93

3.6 Group life insurance policies 94

Beside the basic covers that are listed above, life insurance companies always offer many Riders or Optional Benefits or Supplementary benefits to insurance buyers These are modifications to the insurance policy and change the basic policy to provide features desired by the policy owner Depending on the types of life insurance, the riders/optional/ supplementary benefits are diverse The following brings out the main point of some these benefits: 95

CHAPTER 4 96

REINSURANCE 96

4.1 Overview 96

4.1.1 The Concept 96

4.1.2 Functions of Reinsurance 97

- Risk transfer 97

- Income smoothing 97

- Reinsurer expertise 97

- Creating a manageable and profitable portfolio of insured risks 98

- Surplus relief and Managing cost of capital for an insurance company 99

4.2 Methods of reinsurance 100

4.2.1 Facultative Reinsurance 101

4.2.2 Treaty Reinsurance 102

4.2.3 Facultative/ Obligatory Treaty 104

4.3 Types of Reinsurance 105

4.3.1 Proportional Reinsurance 105

4.3.2 Non – Proportional Reinsurance 109

4.3.2.1 Excess of Loss reinsurance 109

Risk-attaching Basis 112

Loss-occurring Basis 112

Claims-made Basis 112

▪ Paid Basis, such as: 15/12: Incurred in 15 month period / paid in 12 month contract period For example, Policy Period: 1/1/07 - 12/31/07; Incurred Dates: 10/1/06 to 12/31/07 -> Paid Dates: 1/1/07 to 12/31/07 .113

4.4 Non - Traditional Reinsurance 113

4.4.1 The Concept 113

4.4.2 Types of Financial Reinsurance Contract 116

CHAPTER 5 120

FINANCE AND ACCOUNTING IN INSURANCE 120

5.1 Implementing the IASs/IFRS in the insurance industry 120

5.1.1 Overview 120

5.1.2 Financial statements of insurance companies in accordance with IAS/IFRS 129

5.1.2.2 Financial statements in accordance with the IAS / IFRS 133

▪ Objective of financial statements 133

▪ Underlying assumptions 133

▪ Qualitative characteristics of financial statements 133

▪ Elements of financial statements 133

▪ Recognition of elements of financial statements 134

▪ Measurement of the Elements of Financial Statements 134

▪ Concepts of Capital and Capital Maintenance 135

▪ Content of financial statements 135

5.2 Assessing Financial Strength of insurance companies 136

5.2.1 Financial strength ratings methodologies of rating agencies 136

5.2.2 Capital adequacy and solvency of insurance companies 141

5.2.3 Ratios used in assessing insurance company’s financial condition 144

5.2.4 Roles of Actuaries, independent Auditors, internal audit and internal control in the financial management 148

CHAPTER 6 152

LEGAL ASPECTS OF INSURANCE 152

6.1 Overview 152

6.2 Legal aspects of insurance contract 153

6.2.1 Concept of insurance contract 153

Generally, in comparison with others contracts, the insurance contracts

have following characteristics : 154

6.2.2 Essentials of a Valid Insurance Contract 154

6.2.3 Content of an insurance contract 156

Generally, an insurance contract consists of: 156

6.2.4 Entering into contracts of insurance 157

Industry association rules and “best practice” codes 157

Law - Either common law, statutory law, or both 157

- Insurer’s legal obligations 157

An insurer will normally have obligations to provide the applicant with a copy of the proposed contract terms as well as a document which includes the following information if relevant: 158

Depending on local law and custom, an insurer may have additional obligations as follows: 159

Provide required disclosures and notices 159

Avoid misleading or deceptive conduct 159

Express documentation in plain language 159

Ensure that products sold are suitable for the applicant’s circumstances 159

Post-inception obligation 159

An insurer will normally have obligations to: 159

Interpret its contract terms with utmost good faith 159

Comply with the terms of its own contract 159

6.2.5 Cancellation of insurance contract 162

6.3 Insurance Regulation and supervision 164

6.3.1 Objectives of Insurance Regulation and supervision 164

It is important to recognise that any participant in the insurance market has taken the necessary actions to meet regulatory requirements 165

6.2.2 Prudent supervision of insurance company solvency 167

6.3.3 Globalisation of the regulatory framework 175

Appendix 1 184

Appendix 2 186

Appendix 3 194

“Insurance Fundamentals” is a module of the training program for students

of the Insurance Department of the Academy of Finance prepared to provide afundamental knowledge of the insurance in English This textbook is alecturer training framework designed to provide students with fundamentalinsurance and risk management knowledge The content of the textbookfocuses on issues closely related and greatly impacted by internationalintegration in the insurance markets, issues which have achieved basicunification and become international standards in insurance business

The module aims:

- to improve knowledge of insurance and risk management;

- to provide knowledge of international insurance issues;

- to provide the basic knowledge needed in practice of internationalinsurance business

The Academy endeavors to provide the most accurate and useful informationpossible Every attempt has been made to ensure that the information

contained in the textbook is current at the time of printing of the text.

However, the information of this publication may be affected by changes inlaw or industry practice

We would like to thank Mr Michael Abadie, Director of Risk ManagementServices, ADI Joint Stock Company, for sharing his experience and advice tocomplete this textbook

This textbook is provided for training program of the AOF The writer andAOF are not engaged in other uses such as professional advice

Written by Dr Hoang Manh Cu and Ma Vo Thi Pha; Published by Academy of Finance, Hanoi, 2009

CHAPTER 1 OVERVIEW OF INSURANCE

1.1 Risks and insurance

1.1.1 Concept of risk

- Definition of risk

In general, risk is defined as:

“The probability of something happening that will have an adverse impact upon people, plant, equipment, financials, property or the environment and the severity of the impact.”

Basically, the concept of risk has three elements:

- The perception that something could happen

- The likelihood of something happening

- The consequences if it happens

Risk implies some form of uncertainty about an outcome in a given situationand the outcome is not favorable

In the insurance area, as a basic insurance term, risk may be definned as “the

chance of something happening that may have an unfavorable financial impact upon subject matter of insurance” However, the term “Risk” is also

used in various senses, notably:

- The subject matter of insurance;

- Uncertainty as to the outcome of an event;

- Probability of loss;

- The peril insured against;

- A particular unfavorable outcome such as fire damage or a brokenarm

The term “risk” can be used as a noun as in the above examples or as a verb inwhich the usual meaning is to “take a chance” on something For example amountain climber risks a broken arm and even risks death if he were to fall

- Types of risks

Risk takes many forms, normally being classified into two main types being:

▪ Speculative (or Dynamic) Risk and Pure (or Static) Risk

Speculative (dynamic) risk is a situation in which either gain or loss ispossible Examples of speculative risks are betting on a horse race, investing

in stocks/, bonds and real estate In these situations, both gains and losses arepossible In the daily conduct of its affairs, every business establishmentfaces decisions that entail elements of risk The decision to venture into anew market, borrow additional capital, etc., carry risks inherent to thebusiness The outcome of such speculative risk is either beneficial(profitable) or loss

In contrast to speculative risk, a pure risks involves possibility of loss only or

at best a “no gain” situation The only outcome of pure risks are adverse (in aloss situation) or neutral (with no loss), never beneficial A pure risk does notinclude the possibility of gain

Examples of pure risks are premature death, occupational disability,catastrophic medical expenses, damage to property and the loss ability togenerate revenue from the asset which has been lost or damaged

It is important to distinguish between pure and speculative risks for threereasons:

- First, through the use of general insurance policies, insurance

companies generally insure only pure risks Speculative risks are notconsidered insurable, with some exceptions

risks than to speculative risks The law of large numbers is important ininsurance because it enables insurers to predict loss figures in advance

- Finally, society as a whole benefits from speculative risk even though

a losses sometimes occurs, but is only harmed by pure risk This is to say,society would not benefit when pure risks such as earthquakes occur butbenefits from speculative risks taken by entrepreneurs since jobs and wealthare created by them in the process

▪ Particular risk and Fundamental risk

Particular risks are risks that affect only a single or relatively few individuals,not the entire communnity Examples of particular risks are burglary, theft,auto accident and dwelling fires In contrast to particular risks, fundamentalrisks affect the entire economy or large numbers of people or groups withinthe community Examples of fundamental risks are high inflation,unemployment, war and natural disasters such as earthquakes, hurricanes andfloods, etc

The distinction between a fundamental and a particular risk is important, sincegovernment assistance may be necessary in order to insure fundamental risks.Social insurance, government insurance programs, and governmentguarantees and subsidies are used to meet certain fundamental risks which arenot insurable by private insurance companies

▪ Financial risk and Non - financial risk

A financial risk is the situation in which the outcome must be capable ofmeasurement in monetary terms Example of financial risk: damage to the

hull and machinery of a vessel The financial value of the risk is the cost ofrepairing or replacing the different portions of the vessel

In contrast to financial risk, non - financial risk is the situation in which theoutcome is not measurable in monetary terms Examples of non financialrisks are choosing a spouse or deciding whether to leave one’s hometown tolive Each of the above situations will involve a degree of uncertainty or riskand the result may be satisfactory or disappointing

It is important to distinguish between a financial risk and a non - financialrisk For a risk to be insurable, the outcome must be capable of measurement

in monetary terms Non financial risks are not insurable

▪ Insurable and Non-Insurable Risks

For a risk to be insurable it must meets certain conditions as follows:

- There must be an insurable interest in the object or person beinginsured

- There must be a large number of similar risks being insured

- Any losses occurring must be accidental

- It must be possible to calculate the risk of a loss occurring

Further, for an efficient insurance system to exist, an insurable risk mustmeets the ideal criteria as follows:

- The insurer must be able to charge a premium high enough to cover notonly claims expenses, but also to cover the insurer's expenses

- The nature of the loss must be definite and financially measurable That

is, there should not be room for argument as to whether or not payment is due,nor as to what amount the payment should be

- The loss should be random in nature

Also, risks that are not measurable, can not be rated properly The insurer willneed to charge a conservatively high premium in order to mitigate the risk of

paying too large a claim The premium will thus be higher than ideal, andinefficient.

1.1.2 Concept of Risk Management

Risk Management involves the understanding and identification of a broadspectrum of risks faced by individuals and businesses together with the ability

to make decisions with respect to methods to avoid, reduce and control risk tothe extent possible and to then make decisions with respect to determining themost efficient way to treat the remaining risk which includes firstly todetermine the amount of risk that the organization has the ability to absorbfinancially and then to plan for either insurance or other contractual transfer

of the remaining risk “Risk” includes the full range of unfavorable outcomesthat may result from a chain of events involving hazards and perils all leading

to any one of the many possible unfavorable outcomes Individual risks can

be studied and analyzed with the purpose to reduce its probability and itseffect With respect to all individual risks there are chains of events that canlead to the risk occurrence It is important to understand these “chains” so thatrisk can be most appropriately understood and managed

All risk chains include hazards and perils It is important to understand thedistinction among “hazard”, “peril” and “risk” as many people are confused

by these terms but in fact the succinct meaning of each is very different

“Hazards” are states or conditions that increase the possibility of a “peril”from happening A “peril” is an risk event possibility that may lead to anyparticular unfavorable final outcome If a peril is incurred the risk of aparticular negative outcome is increased For example a wet floor is a

“hazard” that may lead to the peril of a “fall” which may lead to the ultimaterisk of a “broken arm” A wet floor does not always lead to a fall and a falldoes not always lead to a broken arm however where hazards exist then perils

are more likely to occur and where perils occur then particular ultimate risk (atype of loss event) such as the risk of a broken arm in this case is increased.Thus by understanding this “chain” it is possible to manage or control thehazard and to make perils that occur less likely to occur which in turn willdecrease the chance of suffering the ultimate particular risk (in this case is abroken arm) Poor housekeeping is an example of a hazard that may lead tothe peril of fire Fire may lead to complete destruction of a building.However by ensuring good housekeeping the peril of fire is reduced But ifthe peril of fire is incurred then if there is a proper loss reduction system inplace such as a sprinkler system then the severity of the loss by fire will likely

be made by a risk assessor who can look at housekeeping, maintenance logs,physical condition of equipment especially boilers etc Lastly review of theoperations process should be made to identify where any specific problemscould occur in the event of an interruption Once risk is adequately identifiedthe process of determining appropriate treatment begins

People, organizations and society usually try to avoid risk but where notavoidable, then best to manage it There are 5 major methods of handling risk:avoidance, loss control, retention, noninsurance transfers, and insurance

- Avoidance

Avoidance involves not participating in certain activities that involve risk Forexamples, the risk of a loss of investing in the stock market can be avoided by

not buying but the fact remains that not all risks can be avoided, and evenwhere they can be avoided, it is often not desirable Avoiding risk may beavoiding certain pleasures of life, or the potential profits that result fromtaking risks Those who minimize risks by avoiding activities are usuallybored with their life and don't make much money Where avoidance is notpossible or desirable, loss control is the next best thing.

Losses can be prevented by identifying the factors that increase the likelihood

of a loss, then either eliminating the factor or minimizing its effect Mostbusinesses actively control risk because it is a cost-effective way to preventlosses from accidents and damage to property, and generally becomes moreeffective the longer the business has been operating

- Retention

▪ Active retention (Risk assumption)

Risk retention, as active retention or risk assumption, is handling theunavoidable or unavoided risk internally, either because insurance cannot bepurchased for the risk, because it costs too much, or because it is much morecost-effective Usually, retained risks occur with greater frequency, but have alow severity An insurance deductible is a common example of risk retention

to save money, since a deductible is a limited risk that can save money oninsurance premiums for larger risks

▪ Passive risk retention

Passive risk retention is retaining risk where the risk is unknown orimproperly understood.

- Transfer

▪ Non-insurance transfers of risk

Risk can also be managed by noninsurance transfers of risk The 3 majorforms of noninsurance risk transfer is by contract, hedging, and, for businessrisks, by incorporating A common way to transfer risk by contract is bypurchasing the warranty extension that many retailers sell for the items thatthey sell The warranty itself transfers the risk of manufacturing defects fromthe buyer to the manufacturer Transfers of risk through contract is oftenaccomplished or prevented by a hold-harmless clause and other forms ofindemnity agreements which may limit liability for the party to which theclause applies

Hedging is a method of reducing portfolio risk and some business risksinvolving future transactions A Stockholders can reduce his risks by buying

“put options” A business can hedge a foreign exchange transaction bypurchasing a forward contract that guarantees the exchange rate for a futuredate Airlines will typically hedge fuel prices by buying “forward contracts”also known as “futures” to guaranty a maximum price for up to a certainfuture period

Investors can reduce their liability risk in a business by forming a corporation

or a limited liability company This prevents the extension of the company'sliabilities to its investors

▪ Insurance

Insurance is one major method that most people, businesses, and otherorganizations can use to transfer certain risks By using the law of largenumbers, an insurance company can estimate fairly reliably the amount of

loss for a given number of customers within a specific time An insurancecompany can pay for losses because it pools and invests the premiums ofmany subscribers (customers) to pay the few who will have significant losses.

1.1.3 Concept of Insurance

Generally, insurance is the means whereby the losses of a few are transferred

to many Insurance works on the basic principle of risk-sharing Whilecommunity grain pools have probably existed for thousands of years, modernorganized risk sharing began in the coffee houses of London a few hundredyears ago where ship owners would meet and agree to share losses with eachother A great advantage of insurance is that it spreads the risk of a few peopleover a large group of people exposed to risk of similar type

Insurance provides financial protection against a loss arising out of happening

of an uncertain event A person can avail this protection by paying a feeknown as premium (or contribution) to an insurance company A pool iscreated through contributions (premiums) made by persons seeking to protectthemselves from common risk Premium is collected by insurance companieswhich also act as trustee to the pool Any loss to the insured in case ofhappening of an uncertain event is paid out of this pool

In a legal respect, insurance is defined as: “a contract between two parties

whereby one party (insurer) agrees to undertake the risk of another (insured)

in exchange for “consideration” known as premium and promises to pay a fixed sum of money to the other party on the happening of an uncertain event

or after the expiry of a certain period in case of life insurance or to indemnify other parties on the happening of an uncertain event in case of general insurance”.

- Benefits of insurance

Insurance brings many benefits to individuals and to society as a whole

▪ Provides financial stability

With insurance, even when losses occur, peoples have the assurance that theirassets can be restored after suffering losses So, however unfortunate eventssuch as these may be, their finances will not be drained, and they and theirfamily’s financial stability will not be undermined They will be able to keeptheir present lifestyle and their future plans With respect to commercialbusiness operations insurance allows for normal operations of the business tocontinue to function normally after losses have occurred

▪ Provides peace of mind and Stimulates business enterprise

By knowing that insurance exists to meet the financial consequences ofcertain risks provides peace of mind for an individual Anxiety is also reducedwhen insured persons knows that insurance is available to indemnify themwhen loss occurs

The indemnity function of insurance also relieves businesses from the worry

of anxiety they may have about how they would meet the cost of risk In thecase of businesses, this is a positive stimulus to their activities and allowsthem to get on with their own business in the knowledge that they arefinancially protected against many forms of risk

Business people will be more inclined to risk their money by building

factories, making goods, sailing ships, flying planes, etc, with the knowledgethat they will not lose everything should they fall victim to risk This is anextremely important benefit which insurance brings – not only to theindividual insuring but to the whole country – as stimulating businessesmakes for a healthy economy and allows for additional employment

The need for businesses to retain large sums of money to pay for potential

losses largely disappears This helps the business cash flow and financial

planning as money does not need to be kept in reserve for losses which may

occur Instead, there is known cost – the premium The availability ofinsurance, therefore stimulates enterprises as it makes it easier for existingbusinesses to invest and expand

▪ Encourages loss control

Insurance also can help in actually reducing losses Insurers have an

interest in reducing the frequency and severity of losses, and insurancecompanies have a great deal of experience in risks of all kinds and, over manyyears, they have found ways in which certain risks can be reduced Theyemploy surveyors who go out and look at premises which people may want toinsure They can, from that experience, often suggest ways in which thelikelihood of some risk occurring may be reduced They might see somehazard which could injure employees, or a host of other problems The adviceand the recommendations they make on behalf of insurance companiesreduces the likelihood of many of the losses from ever occurring An examplewould be for a surveyor to point out that flammable liquids must be stored inproper containers and only in proper locations You would expect that the lastplace that a flammable storage container should be stored is in a stairwell.Correct? Remember this the next time you see motorcycles being stored in thestairwell of a residential building! In fact there is a flammable liquids storagecontainer in every motorcycle and so keeping motorcycles at the bottom of astairwell is extremely dangerous not only because it blocks exit from thebuilding but that because in a fire situation the gasoline containers in themotorcycles will explode creating heat and smoke in the stairwell Insurancecompanies will help the insured facilities identify these risks and makerecommendations to reduce or even eliminate certain aspects of risk

▪ Encourages investment

One further benefit derived from the transaction of insurance is the use to

which the insurance company puts the money it holds in the common pool.Insurers have, at their disposal, large sums of money This arises from the factthat there is the gap between the receipt of a premium and the payment of aclaims The insurer can invest this money in a wide range of investmentswhich all go towards aiding government, industry, commerce andconsequently the whole of society

▪ Enhance provision of credit facilities

Bankers and other financial institutions require the security of insurance infinancing properties and overseas trade In this case, insurance enhancesborrower’s credit because it helps to guaranty the value of the borrower’scollateral, or gives greater assurance that the loan will be repaid

We could go on with the benefits of insurance, but those listed above areenough to show that the insurance industry has a major importance to thesociety In the act of creating the common pool, security and peace of mindare provided, the likelihood or severity of losses may even be reduced, vastfunds of money are invested for the prosperity of the economy, the country isrelieved from what it may look upon as a financial burden to compensate thevictims of loss and, finally, society gains large amounts of money from thepayment of premiums from overseas Insurance companies contribute to theefficiency of the economy

1.1.4 Insurance Contracts

This section is intended to provide an overview of the structure of theinsurance contract But first it is noted that Insurance contracts are normallygoverned by the common law of contracts namely that any contract whetherthe subject of insurance or any other matter require certain elements tobecome enforceable Section 6 will provide additional detail however simply

said, the law of contracts require that there be a “meeting of the minds”between “competent parties” with respect to legal subject matter which is tosay that the parties entering the contractual agreement be sufficientlycompetent to understand the terms of the contract, that there must be

“consideration”, that the subject of the contract be of a “legal nature” natureetc With respect to “competent” parties, each side must normally be of a legalage to enter contracts and be sane of mind to become enforceable Thus acontract entered into by an adult and a child or between a sane person and onewho is insane is not enforceable except in certain rare circumstances Eachside must agree to exchange something of value as “consideration” A simpleunilateral promise to give someone money or anything else is not enforceable

in the absence of the agreement of the other person to provide something ofvalue in return Regarding the legality of the subject matter a contract to buyand sell illegal drugs would not be enforceable Insurance contracts are againjust like any another contract however as previously noted there is a specialduty to make each side aware of material information so that there is indeed aproper understanding or “meeting of the minds” before the contract isundertaken

Insurance contracts have three main sections being the “declarations page”,the main body of the policy, and a set of extensions The following describesthese sections of the insurance contract in a bit more detail

- The declarations page

The declarations page which can also be known as a “cover schedule”includes basic summary information including the type of insurance, nameand addresses of the insurer and the insured, the subject matter and thelocation of the risk, the jurisdiction of the risk, the effective period of theinsurance, and a policy number

- Policy wording

The policy wording is the full set of contractual wordings which normallyinclude a printed set of common wordings used by the insurer on all risks of asimilar nature together with the wordings of any particular extensions or othermodifications to the main wordings The wordings are normally prepared bythe insurer or broker with the insurer’s final agreement This distinction isimportant since the courts normally provide that any vagaries in the contractwill be viewed in favor of the party which did not prepare the wording

▪ The “Insuring Agreement”, general wording, conditions and exclusions

The main wording normally starts with a short sentence called the insuranceagreement This provides for the main essence of the insurance contract.Nearly everything else in the contract is modifying the main insuranceagreement For example the insuring agreement found in an Industrial AllRisk property policy will typically state something like, “In consideration ofthe payment of premium this policy covers all risks of loss or damage” Allthe remaining wording provides the framework of the risk by explaining thatwhich is required to effect the coverage, that which is required to keep thecoverage in place etc The policy will then specify certain conditions whichmust be met such as proper maintenance of equipment, the perils which areexcluded, the type of property which is excluded etc

▪ Extensions and Modifications

Some of the perils or types of property that are excluded under the basicpolicy may be covered or “bought back” by way of an “extension” Theremay be other modifications to the original wording which restrict thecoverage being provided under the basic form For example the main policyform may exclude losses occurring as a result of the risk of “faulty design”.This particular exclusion is commonly “bought back” which is to say for

some additional premium the insurer will agree to cancel the exclusion Othermodifications may be made on an individual basis For example the insurermay be aware that a fire sprinkler system is inoperable The insurer may putsome restrictions to the coverage amount while the sprinkler system isinoperable

A proper review of any insurance contact begins with a review of the insuringagreement, then a review of the assets items subject to insurance to be surethat they are covered by the policy, then a review of the perils covered or notcovered, then lastly and assuming the property is found to be the subject ofthe policy and that the peril causing the loss is also covered or not excludedthen a review of the policy conditions is made to ensure that all conditionshave been met If there is a loss for example there is a sequence of items toreview in order to determine whether the loss is covered or not The sequenceshown above would be typical of that done by loss adjusters to determinewhether the coverage is applicable Once there is a determination thatcoverage is applicable then the adjuster will determine the quantum of the lossand settle the claim

1.2.1 Insurable interest

- Concept

Insurable interest is a fundamental principle of insurance It means that theperson wishing to take out insurance must be legally entitled to insure thearticle, or the event, or the life In other words, the happening of the eventinsured against, or the death of the life insured must cause thepolicyholder/insured financial loss The policyholder/insured must stand tolose financially if a loss occurs

An insurable interest in the life of another requires that the continued life ofthe insured be of real interest to the insuring party The connection may befinancial (as when a creditor insures the life of his debtor ), or it may consist

of familial or other ties of affection

The principle of insurable interest demonstrates the difference betweeninsurance and a wager or bet

- Purpose of the insurable interest requirement is

- To be able to measure the amount of loss

- Existence of insurable interest

▪ Non - life insurance

Insurable interest varies according to the type of insurance policy Theserelationships give rise to insurable interest:

- owner of the property;

- vendor and vendee;

- bailee and bailor;

- life estates;

- mortgagee and mortgagor;

- creditor of an insured has an insurable interest in property pledged assecurity.

- Creditor-debtor relationships give rise to an insurable interest

- Business relationships give rise to an insurable interest

- When must insurable interest exist?

▪ Non - life insurance

Insurable interest has to exist both at the inception of the contract and at thetime of a loss For instance, an insured can purchase a homeowners policybecause of insurable interest in a home Upon selling it, the insured no longerhas an insurable interest because there is no expectation of a monetary lossshould the home burn down

Note that in certain types of insurances such as marine cargo insurance, theinsured’s relationship with a thing that supports issuance may exist at the time

of loss only, not necessarily at the inception of the contract

▪ Life insurance

Insurable interest must exist at the inception of the contract, notnecessarily at the time of loss For example, because a woman has aninsurable interest in the life of her fiancé, she purchases an insurance policy

on his life Even if the relationship is terminated, as long as she continues topay the premiums she will be able to collect the death benefit under thepolicy

1.2.2 Utmost Good Faith

- Concept

One of the important basic principles of insurance is known as 'utmost goodfaith' The duty of utmost good faith is central to the buying and selling ofinsurance - both the insured and the insurer are expected to disclose anyinformation, important to the contract This means that the insurer and theinsured have a duty to deal honestly and openly with each other in thenegotiations which lead up to the formation of the contract This dutycontinues whilst the contract is in force If one party is in breach of this duty,the other party usually has the right to avoid the contract entirely

- Duty of Disclosure

▪ Insured’s Duty of Disclosure

The insured is legally obliged to disclose all information that would influence

the insurer's decision to accept the risk Very often, the insurer has to rely only

on the description and details filled in the proposal form In the absence of aformal verification through third party surveyors, the Insurer has no way ofverifying these details After an insured peril has operated, the subject matter

of the insurance may very well have gone up in smoke or washed away It istherefore an implied condition or principle of insurance that the insured berequired to make a full disclosure of all material particulars within hisknowledge about his risk After taking out an insurance policy, if there areany alterations or changes to the business or risk which increases the risk, theinsured must inform the insurer

Normally, a breach of the principle of utmost good faith arises when insured,whether deliberately or accidentally, fails to divulge these important facts.There are two kinds of non-disclosure:

- Innocent non-disclosure or misrepresentation;

- Deliberate non-disclosure - providing incorrect material informationintentionally

In the case of an innocent breach that is irrelevant to the risk, the insurer maydecide to ignore the breach as if it had never occurred but if the insurerconsiders the breach as innocent but significant to the risk, it may choose tocollect additional premiums to reflect that which would have been charged ifthe risk was properly known in the first place In certain cases ofmisrepresentation, where the effect may only have been increased premium, it

is possible that the insurer may partly pay the a claim on a proportional basis

to the premium originally paid vs the correct premium on the true risk

In the case of a deliberate material breach, the insurer would be entitled toavoid any payment of claims or monies under the Policy

▪ Insurer’s Duty of Disclosure

The insurer also has a duty of disclosure to the insured In order to fulfill thisduty, the insurer must also exercise utmost good faith, notably by :

- notifying an insured of a possible entitlement to a premium discountresulting from a good previous insurance history;

- only taking on risks which the insurer is registered to accept, i.e.avoid unenforceable contracts;

- ensuring that statements made are true since misleading an insuredabout policy cover is a breach of utmost good faith

In respect of utmost good faith, besides duty of disclosure there are manyothers duties imposing on the parties of a insurance contract These issues will

be dealt with in the Chapter 6

1.2.3 Principle of Indemnity

- Concept

Indemnity is arguably the most fundamental principle of insurance The term

‘indemnity’ means the protection of or security against damarge or loss.Therefore, when an insurance policy is said to be a contract of indemnity, it isintended to provide financial compensation for loss which the insured hassuffered and put the insured back in the same position that the insured hadenjoyed immediately before the loss

One of the basic tenets of insurance is that the insured should not profit from

a loss or damage but should be returned (as near as possible) to the samefinancial position that existed before the loss or damage occurred In otherwords, the insured cannot recover more than his or her actual loss from theinsurer

- Purpose

- To prevent the insured from profiting from a loss

- To reduce the “moral hazard” of an insured intentionally creating aloss in order to take advantage of the insurance

written There are also some exceptions in the case of property insurancewhere the subject of the insurance is a unique property such as a painting orother artwork In these cases the insurance will be based on an agreed amount

in advance

The aim of the indemnity provision is to provide a claim amount that will helpthe claimant regain the lost financial position In some indemnity contracts,the amount payable by the insurance company is subject to the amount ofactual loss Some indemnity contracts also have a provision for the claim to

be paid only if the actual loss exceeds a certain amount

In property insurance, indemnification is based on the actual cash value of theproperty at the date and place of loss There are three main methods todetermine actual cash value:

- Replacement cost less depreciation

- Fair market value is the price a willing buyer would pay a willingseller in a free market

- Broad evidence rule means that the determination of actual cash valueshould include all relevant factors an expert would use to determine the value

of the property

In liability insurance, the indemnity under a liability insurance policy is theamount of damages awarded by the court In actual practice, mosst liabilityclaims do not go to court They are usually settled by negotiation between theinsurers and the third - party on the basis of what a court would award if thathe case had come before it

1.2.4 Subrogation

- Concept

Subrogation is a legal principle under which an insured party surrenders itsrights against a third party to the insurer after claiming and receiving acompensation for an insured loss.

The principle of subrogation enables the insured to claim the amount from thethird party responsible for the loss It allows the insurer to pursue legalmethods to recover the amount of loss, which the company has paid theinsured via the insurance claim

- Purpose

- To prevent the insured from collecting twice for the same loss

- To hold the negligent person responsible for the loss

- To hold down insurance rates by allowing the insurer to recover the loss from the responsible party

in respect of the loss may themselves bring an action against the third – partywho is legally responsible for it

There are four notable aspects of the principle of subrogation:

- The insurer is entitled only to the amount it has paid under thepolicy

- The insured cannot impair the insurer’s subrogation rights

- Subrogation does not apply to life insurance and to mostindividual health insurance contracts

- The insurer cannot subrogate against its own insureds

Further, note that there are some legal requirements of application ofsubrogation, for example: the insurer shall not be entitled to exercise rights ofsubrogation against a member of the household of the policyholder or insured,

a person being in an equivalent social relationship to the policyholder orinsured, or an employee of the policyholder or insured, except when it provesthat the loss was caused by such a person intentionally or recklessly and withknowledge that the loss would probably result

1.2.5 Contribution / Double insurance

- Concept

Contribution is concerned with the sharing of losses between insurers Itcomes ito effect when two or more insurers may be involved on the same risk.This situation arises when the same risk is insured by two overlapping butindependent insurance policies It is lawful to obtain double insurance, andthe insured can make claim to both insurers in the event of a loss because bothare liable under their respective polices The insured, however, cannot profit(recover more than the loss suffered) from this arrangement because theinsurers are law bound only to share the actual loss – the principle ofcontribution has evolved to ensure that all insurers who are involved incovering the risk pay an equitable proportion of claim

- Purpose

- To prevent the insured from profiting from a loss

- To reduce moral hazard

- Application of contribution

Contributions will arise only where the following requirements are satisfied:

- two or more policies of indemnity must exit;

- the policies must cover a common interest;

- the policies must cover a common peril which gives rise to the loss;

- the policies must cover a common subject – matter; and

- each policy must be liable for the loss

Contribution applies only to insurance policies which are contracts ofindemnity

Double insurance causes practical and legal problems and particularly, wherethe sums insured exceed the insurable value in the case of an unvalued policy

or the value fixed by the policy in the case of a valued policy

Note that certain policies have what is known as a non – contribution clause.The effect of this clause is that the policy would not contribute if there wasanother insurance in force However, the courts do not favour such clausesand in situations where a similar clauses applies to both (or all) policies theyare treated as cancelling each other out This means that each insurer wouldcontribute its ratable proportion

1.2.6 Proximate cause

- Concept

Proximate cause concerns the real reason for the loss In the event of a claimthe insurers will want to ascertain if the cause of the loss was an insured peril

Proximate cause is usually defined as “The active efficient cause, which sets

in motion a chain of events which brings about a result without the intervention of any force started and working actively from a new and independent source”

Note two aspects concerning the test of proximate cause

Foreseeability: It determines if the harm resulting from an action was

reasonably able to be predicted.

Direct Causation: The main thrust of direct causation is that there are no

intervening causes between an act and the resulting harm An

intervening cause has several requirements - it must:

○ be independent of the original act,

○ be a voluntary human act or an abnormal natural event, and ○ occur at some time between the original act and the harm

- Application of Proximate Cause

Proximate cause is the active, efficient cause of loss or damage For insurance

to apply, the proximate cause must be an insured peril Establishing that a loss

is covered by insurance is usually straightforward because the event that gaverise to the loss is also usually quite clear However, situations will arise fromtime to time where there is more than one cause of damage, or there is aninitial cause and then a subsequent cause An example of this would beproperty damaged caused during typhoons Typical homeowners insurancewill provide cover for the peril of windstorm but not flood Often homesmost damaged by typhoons lie along coastal regions Damage caused by waveaction is thus typically not covered Many people who lost homes during thefamous hurricane Katrina lost those homes when surge waters moved in Theinsurers denied cover based on the flood peril exclusion People then suedtheir insurers claiming that the homes were first destroyed or damaged bywind and demanded compensation

Once the insurer has established the proximate cause of loss, it must ensuredetermine that the peril which gave rise to the loss is covered by the policy.Perils can be classified as follows:

- Insured perils

- Uninsured or unnamed perils

- Where an uninsured peril is followed by an insured peril, there is aclaim as per the example described above in Hurricane Katrina

- Where an insured peril is followed by an uninsured peril, there is aclaim

- Where an insured peril is followed by an excluded peril, there is aclaim

- Where an excluded peril is followed by an insured peril, there is noclaim

Practically, in many situations, two perils were involved in the widespreadcommunity loss, one usually covered and one usually excluded Determiningthe proximate cause is not always easy Indeed in the case of HurricaneKatrina, it was difficult to determine the amount of windstorm damage thatwould have been present prior to the amount of wave action damage in cases

where the wave action ultimately obliterated the home leaving no trace

1.3 Insurance market

Basically, in respect of market structure, the insurance market comprises:

- Buyers;

- sellers; and

- intermediaries

1.3.1 The buyers of insurance

The buyers of insurance are known as policy-holders or policy-owners, andthey can also be known as insureds For the prospective buyers of insurance,they are known as proposers, prospects and applicants

There are generally three groups of buyers, namely, individuals, commercialenterprises and the government

The insurance types that are purchased by individuals will likely be personalgeneral insurances or life insurances

Commercial general insurances are generally purchased by businessenterprises and the government

1.3.2 The intermediaries

An intermediary is a party who is authorized by a second party, called the

“principal”, to bring that principal into a contractual relationship with another,called a “third-party” The role of an intermediary is to bring buyers andsellers together

Basically, there are two main types of intermediaries in the general insurancesector:

of the agent The agent has the authority to act for a principal (usually the

insurer) with the objective of bringing the principal into legal relationshipswith other persons As agent for the insurer, the agent’s aim is to represent theinsurer in procuring new insurance customers, and therefore new insurancepolicies, thereby increasing the insurer’s customer base and revenue.

In some places only individuals can operate as agents In others, an agent can

be a corporation but the corporation normally has to have individuals who act

- assisting customers with their claims

In the developed insurance mFirstarkets there are many different types ofinsurance agents

- Sole agents (also known as “tied” or “captive” agents): these agentsare tied to one insurance company and must place all of their insurancebusiness with that company

- First option agents: these agents are sole agents who are able to placesome business outside of their principal insurance company

- Multi agents: these agents are able to place insurance business with anumber of insurance companies The services provided by a multi-agent willoften be very similar to the services provided by an insurance broker, giventhat a multi-agent will also represent a number of insurers

- Sub agents: these agents normally work part-time and work with aprincipal full-time agent, sometimes working to find and/or refer potential

clients They can be paid a fee or a portion of the principal agent’scommission.

- Underwriting agencies: underwriting agencies act on behalf of

insurance companies providing underwriting management and claimsadministration

- Insurance Brokers

Generally speaking a “broker” is a professional negotiator who attempts tobring two parties to accept an agreement by showing the best aspects of anyproposal to the respective parties For example the broker will show the mostpositive aspects of a proposed agreement with respect to party “A” whiledoing his or her best to show the most positive aspects of the same agreementwith respect to party “B” even though the most positive aspects for party “A”may be completely different than for party “B” Thus brokers are oftenthought of as being “smooth talkers” and in many cases this is quite truehowever despite being skilled in “smooth talking” professional brokers bethey stock brokers, insurance brokers or real estate brokers must alwaysremain honest about the way the agreement is portrayed to each party.Insurance brokers find sources for contracts of insurance on behalf of theircustomers Insurance brokers can be individuals or organisations who actprincipally for the client and not the insurance company

A broking operation is a business of one or more brokers that arranges andmanages contracts of insurance for clients Broking operations manage theservices they provide to clients, along with the day-to-day running of theirbusiness

As agent for the insured (the client), the broker’s aim is to save the clienttime, money and worry The broker’s role is to negotiate competitivepremiums and the best insurance coverage They do this through their

knowledge of the various insurance cover benefits and exclusions, as well asthe costs of competing policies in the market Brokers deal with a range ofinsurers and have access to many different policy types

Brokers act in the client’s best interest and provide advice and guidance sothat clients can make informed decisions about their risk exposures andinsurance protection They also ensure their clients receive prompt and fairsettlement of claims

The broker’s first duty is to that of their principal, the client, for whom theyare acting Brokers generally work for insureds but are sometimes hireddirectly by the insurer

Except as is required under duty of disclosure requirements, brokers are notresponsible to the insurer with whom he/she might place the insurance covers

on behalf of its clients but there is an exception to the general rule whichexists where a broker is acting under a binder agreement granted to the broker

by the insurer Brokers may enter into a binding authority with an insurerwhereby the broker is given an authority by the insurer to enter into contracts

of insurance on the insurer’s behalf

In developed insurance markets, the services that can be offered to a broking client have grown to include much more than negotiation services and

include:

- regular meetings with the client for the purpose of updating risk and

or claim information

- collection of information for underwriting purposes

- broking to prospective insurers

- policy placement

- claims management

- providing for mid–term amendments to policies/new policies

- claims recording and analysis

- self insurance management

- handling of losses below deductibles

- risk management advice

- loss control advice

- technical advice (policy coverage/legislation etc)

- advice on the most appropriate manner in which to structure the client’s insurance program,

- access to a broad range of insurance companies and, therefore a

broader range of insurance policies/cover that it markets

- advice on the general financial security of insurers who might be considered as underwriters for the various parts of the client’s insurance program

- access to insurance markets in other countries, particularly for

specialist classes of insurance

- and other services the broker may provide

Although insurance buyers may deal directly with insurers, the vast majority

of commercial insurance business (i.e insurance bought by companies) istransacted through brokers The complexity of many commercial risks and thelarge premiums involved often render a broker’s services invaluable to theinsured

Though agents and brokers handle the majority of business in many insurancemarkets, it is possible to buy insurance directly from an insurance company.Buyers are also buying through banks, the Internet, and other alternativedistribution channels

1.3.3 The sellers

- Direct Insurers

These are insurance companies who exist primarily to provide insuranceprotection to insurance buyers without the use of intermediaries All insurancecompanies are classified according to the main class of insurance businessthey underwrite namely “general” or “life” insurance

In the certain insurance markets, some companies write both general and lifeinsurances and they are called “composite” insurers

- Reinsurers

These are companies who act as insurers to the retail insurance market TheyReinsurers do not deal with the general public; instead, they liaise with thedirect insurers selling into the retail market directly or through reinsuranceintermediaries (these issues will be examined in the chapter 4) Note that Ichange the word from “direct” to “retail” in these two sentences because ofthe text is discussing the concept of “direct” marketing of insurers withoutintermediaries in the previous section The use of the term “direct” here withrespect to reinsurance will confuse the reader

- Protection & Indemnity Clubs (P&I Clubs)

These clubs are mutual insurance associations formed by ship-owners toprovide them with indemnity against certain losses and liabilities which mayarise, and for which cover is not otherwise generally available in the marineinsurance market These include a wide range of Ship Owner’s Liabilitycovers such as Collision Insurance, Crew and Cargo Liabilities and PollutionLiabilities

The Clubs operate on a non-profit making mutual basis It means that thecontributions- "mutual premium" paid by the membership companies inrelation to any one year should be sufficient to meet all the claims,reinsurance and administrative expenses of the Club for that year If there is ashortfall because claims are high, the members may pay a pro rata "additional

call" (additional premium) If there is a surplus, a similar proportional returnmay be made to the membership, or transferred to reserve to meet losses onother years

The present P&I Clubs are the remote descendants of the many small hullinsurance Clubs that were formed by British ship-owners in the 18th century.Similar clubs exist with respect to the marine hull market however after theremoval in 1824 of the company monopoly in favour of the Royal Exchangeand the London Assurance, the hull Clubs became less necessary and wentinto decline A few exist today, but their share of the total hull market is notvery significant However, legal developments during the latter half of the19th Century resulted in a significant increase in ship owners’ liabilities toinjured crew, passengers and others third parties, and the first liabilityinsurance Club was founded in 1855

The Clubs started their activities by insuring the 1/4th liability for collisionsand liability for damage to fixed objects which were excluded from the hullcover This cover was called "protection" insurance The introduction ofstatutory liability for loss of life and injury to passengers gave rise to a newliability which was covered by the establishment of "indemnity" mutuals.Legal developments in the late 19th Century resulted in ship-owners facing anexposure to cargo claims, and in 1874 the Indemnity Clubs started to insureliabilities for loss of or damage to cargo Fusion of the functions of the

"Protection" and "Indemnity" mutual associations gave rise to the Protection

& Indemnity Clubs

While all the original P&I Clubs were based in the United Kingdom, Clubswere subsequently established and today flourish in Scandinavia, in theUnited States and in Japan Most of the major Clubs now belong to theInternational Group for reinsurance and other purposes Moreover, many