Chapter 1: Insurance products - background Flashcards
Requirements for a risk to be insurable
For a risk to be insurable:
- the policyholder must have an interest in the risk being insured, to distinguish between insurance and gambling
- a risk must be of a financial and reasonable quantifiable nature
- the amount payable by the insurance policy in the event of a claim must bear some relationship to the financial loss incurred
Ideally risk events should meet following criteria to be insurable:
- Individual risk events should be independent of each other / low correlation (reinsurance is available where risks are not independent
- The probability of the event should be relatively small (or premium would have to be exorbitantly high)
- Large numbers of similar risks should be pooled to reduce the variance of the average claim size and hence achieve more certainty (the law of large numbers reduces the variance of the average claim size, hence the insurer will benefit from more predictable claims experience than each of the policyholders would individually.
- There should be an overall limit on the liability undertaken by the insurer (will help meet criteria that it must be of reasonably quantifiable nature)
- Moral hazard should be eliminated as far as possible (because they are difficult to quantify, result in selection against the insurer and lead to unfairness in treatment between policyholders)
- There should be sufficient existing statistical data / information to enable the insurer to estimate the extent of the risk and its likelihood of occurrence
Moral hazard
The risk that an insured may behave in a less risk averse manner when they are insured
Uberrima fides
- “Utmost good faith”
- This honestly principle is assumed to be observed by the parties to an insurance, or reinsurance, contract.
This principle of honesty underlies all insurance business.
Example misrepresentation or non-disclosure of any material proposal can make the policy void
Nil claim (or zero claim)
A claim that results in no payment by the insurer. because, for example
- the claim is found not to be valid
- the amount of the loss turns out to be no greater than the excess
- the policyholder has reported a claim in order to comply with the conditions of the policy, but has elected to meet the cost in order to preserve any entitlement to no-claim discount
Nil claims still invariably result in administrative expenses for the insurer
Underinsurance
Insuring for a sum insured lower than the actual value (such as for the value of your belongings for a home contents policy)
Average (Non-marine insurance)
- In order to prevent underinsurance, some property insurance policies where premium rates are based on sum insured contain an average clause.
This provides that, if the sum insured is less than the full value of the property at the time of a loss, the insurance payment will only be a proportion of the value of the loss – the same proportion as the sum insured bears to the full value.
- This is known as the principle of average.
Average (Marine insurance)
A general average loss is a loss resulting from a sacrifice or expenditure made by an individual for the benefit of others at a time of peril
eg throwing cargo overboard from a boat to stop it sinking, thereby saving the remaining cargo and the vessel
General average loss
A general average loss is a loss resulting from a sacrifice or expenditure made by an individual for the benefit of others at a time of peril
eg throwing cargo overboard from a boat to stop it sinking, thereby saving the remaining cargo and the vessel
First loss
A form of insurance cover for which the chosen sum insured is restricted, with the insurer’s agreement, to a figure less than the full reinstatement-as-new-value of the property
The insured therefore has to bear any loss in excess of the sum insured
If the cover is specified as first loss then the principle of average does not come into play
Subrogation
Subrogation is the substitution of one party for another as creditor, with a transfer of rights and responsibilities
It applies within insurance when an insurer accepts a claim by an insured, thus assuming the responsibilities or recoveries relating to the claim
For example, the insurer will be responsible for defending legal disputes and will be entitled to the proceeds from the sale of damaged or recovered property
Example: If you receive a payment from an insurer for replacement of your boat, following serious damage or loss, then the original boat becomes the insurer’s property. insurer may then be able to recover a salvage value, for its own benefit.
Discovery period
Discovery period is a time limit, usually defined in the policy wording or through legislative precedent, placed on the period with which claims must be reported.
Generally applies to classes of business where several years may elapse between the occurrence of the event or the awareness of the condition that may give rise to a claim and the reporting of the claim to the insurer; for example employers liability or professional indemnity
In principle it allows insurance companies to write of IBNR liabilities from a contract once the discovery period has elapsed, although courts have sometimes overridden this in the past
-Specified in the sunset clause
Sunset clause
Clause defining the time limit within which a claim must be notified, if it is to be valid.
Underwriting
- Underwriting is the process of consideration of insurance risk on individual policies
- This includes assessing whether the risk is acceptable and, if so, the appropriate premium, together with terms and conditions of the cover.
- In addition to deciding on premium rates to charge, underwriters will specify excesses or exclusions to cover or possibly required improvements to the risk before cover is provided.
- The more individual the risk (for example most commercial lines), the more detailed the consideration.
- For small and standard homogeneous risks, insurers will often provide insurance automatically, without referring the individual risks to the underwriters.
Policy document
- Legal contract setting out the terms and conditions under which an insurer is liable to pay insurance claims in specific circumstances
- Must be carefully worded to cover all circumstances for payment and non-payment of claims
- Policy forms are normally standard for all personal lines business and small commercial policies, including a common section and personalised schedule for any variations
- Common items in the persionalised schedule include: details of item/risk insured, excess, limits, exclusions, time limits, optional add-ons, premium
