Hailey college of banking and finance

Assignement : Fundamentals And Terminology

Of Insurance

Date : October 25 ,2010

Presented by : Emad ul Islam

Roll no : Mi10BBA032

Presented to : Sir Khursheed Ahmed

Q: The term insurance can be defined in both legal and financial terms .How do these definitions differ?

Legal definition of insurance:It is more fully defined to be a contract by which one of the parties, called the insurer, binds himself to the other, called the insured, to pay him a sum of money, or otherwise indemnify him in case of the happening of a fortuitous event, provided for in a general or special manner in the contract, in consideration of a premium which the latter pays, or binds himself to pay him. 

Financial definition of insurance:A contract between a client and a provider whereby the client makes monthly payments, called premiums, in exchange for the promise that the provider will pay for certain expenses. For example, if one purchases health insurance, the provider will pay for (some of) the client's medical bills, if any. Likewise in life insurance, the provider will give the client's family a certain amount of money when the client dies. The insurance company spreads the risk of any one expense by pooling the premiums from many clients

In the eyes of law insurance is an agreement between two parties where one party agrees to compensate the other one in case of loss to property or any thing mentioned in the agreement, where as in the eyes of finance it is a contract between two parties where one party pays an amount called

premium annually or monthly against the security of risk ,the party which provide compensation is called insurer , and the one getting compensation is called insured

Q: Describe the difference between direct and indirect losses, Give example of each.

Direct loss:

“Property loss in which the insured peril is the proximate cause (an unbroken chain of events) of the damage or destruction. Most basic property insurance policies (such as the standard fire policy) insure against only direct loss and not indirect loss or consequential loss.

Indirect loss:

“Loss that is not a direct result of a peril. For example, damage to property of a business firm would be a direct loss, but the loss of business earnings because of a fire on its premises would be an indirect loss.

Indirect losses also called CONSEQUENTIAL LOSSES or loss of use are a secondary result of an peril.

There must be direct loss before there can be an indirect loss.

Examples:

Direct loss:

If a house is damaged by fire caused by electric shock or gas, this loss is called direct loss

Indirect loss:

Living expenses caused while living when the damaged house was under construction is indirect loss

Q: What is the difference between a hazard and a peril? Give examples of each.

Peril:“A peril is something that can cause a loss. Examples include falling, crashing your car, fire, wind, hail, lightning, water, volcanic eruptions, choking, or falling objects. “

Hazard:“A hazard is any condition or situation that makes it more likely that a peril will occur.”

Hazards include:  Physical hazard: like ice on the sidewalks, smoking, or skydiving;

Moral hazards:(most of which are avoidable), like dishonesty (such as burning down the warehouse when your company goes bankrupt to collect insurance money or buying insurance on someone with yourself as beneficiary and then killing them); and

Morale hazard: like a careless attitude since "insurance will pay for it."

Examples:

Peril,

Peril include earthquake, storms, heavy rain , fire, tornadoes, heart attack and criminal acts.

Insurance companies compensate the loss caused by perils.

Hazard,

Storing 55 gallons of oil in oil drum increase the severity of frequency of loss, using cheap building material while constructing house, using cheap quality brake oil while using a car, not wearing seat belt while driving a car and eating high cholesterol food are the hazards which may increase the chance of peril to occur.

We can also say that,

Peril refers to “the causes of loss” Peril is caused by hazards. Hazard is something which exacerbates the precarious situation.

Q: What is the difference between insurable losses and depreciation expense?

Insurable losses:

Insurable losses are those losses,

Those have large number of exposures. Those are accidental. Those are definite and measureable. Those are not catastrophic. Those are economically feasible to insure.

Large number of exposure means that the loss is in common, e.g. many people are suffering from that loss, in this way insurance companies can accumulate huge funds,large number of exposures to loss also help to predict the loss through law of large numbers.

In order to have an exposure insurable the losses need to be accidental from the stand point of insured,if an exposure is certain to result in loss or damage then insurance companies are sure to pay the claim.

To be insurable a loss should have a definite time and place of occurrence and the amount of loss must be measureable in pecuniary terms.

Effective pooling of exposure means that the exposure units are independent, independence means that a loss suffered by one insured does not affect other insured or group of insureds. If exposures are not independent then loss to one

insured can cause losses to sizable proportions of insured’s at the same time.

Insurance companies seek to cover only those exposures which are economically feasible to insureBecause of this constraint loss exposures involving small losses and as well as those involving high probability of loss are generally considered uninsurable losses

Depreciation expense:

“That portion of a tangible capital asset which is deemed to have been consumed or expired, and has thus become an expense.” OR“Depreciation Expense is the expense we claim from Accumulated Depreciation and though it is an expense it does not affect our Cash. We do not actually "pay" this expense. Depreciation is the decline in usefulness of a Fixed Asset. “

Q: How does moral hazard differ from morale hazard? Give examples of each.

Moral hazard:

“If an insured advertently causes loss or damage to his property- which is insured –in order to collect his insurance proceeds, this is insurance fraud and the loss results from the moral hazard.”

OR

“Moral hazards are those that result from insured are dishonesty.”

Examples:

1. If someone burns down a building to collect the insurance, the fire causes the damage but the moral hazard is responsible for this loss.

2. If a thief steals Rs, 5000 but the insured claim that 2000 has stolen , in order to get 1500 more ,this is insurance fraud caused by moral hazard.

Morale hazard:

“It refers to an attitude of carelessness or indifference to loss created by the purchase of an insurance contract.”

Insurance can be regarded as a morale hazard because it increases the possibility of a loss that results from the insured worrying less about losses. Therefore, they take fewer precautions and may engage in riskier activities—because they have insurance

Examples:

1. The attitude “why should I care I am insured is the example of morale hazard.

2. If a person remains unnecessarily in hospital to collect insurance benefits rather than returning to work is an example of morale hazard.

3. If a person does not lock the locker – in which gold is placed – just because that gold is insured. Is also an example of morale hazard.

Q: Explain the term “proximate cause”.

Proximate cause:

“Active direct and efficient cause of loss in insurance that sets in motion an

unbroken chain of events which bring about damage, destruction, or injury without the intervention of a new and independent force. Also called direct cause.”

OR

“ An event  which, in a natural and continuous sequence, unbroken by any efficient intervening cause, produces an injury, and without which the injury would not have occurred.”

OR

“In this segment of business insurance, this is the first event in a series that results in a claim. It is not always the one that is nearest in time to the event.”

Explanation with example: if lightning cause a fire in a house ,which in turn causes fire truck to be sent to the fire, and if in responding to the call the truck collides with a car, one might assert that the proximate cause of the collision between the fire truck and the car was the lightening that struck 5 miles from the collision. The question of proximity or nearness to the loss becomes hazy if stretched thin enough .if the fire truck siren give a heart attack to a neighbor ,is the lightening the cause of this attack? If while giving treatment to the patient, the neighbor is given a wrong medicine negligently and suffers injury is the lightning still the proximate cause?

Sometimes it takes a court trial to determine whether the breaking point occurs and what the proximate cause of the loss is.

Q: Explain the difference between speculative and pure risk.

Pure risk:

In pure risk there are two positions, “loss” or “no loss” no loss point is also called break even point.

OR

A category of risk in which loss is the only possible outcome; there is no beneficial result. Pure risk is related to events that are beyond the risk-taker's control and, therefore, a person cannot consciously take on pure risk. 

Explanation of pure risk by example:

if a car driver is driving his car there are two possibilities , he may struck his car with another vehicle or injure a person and second possibility is he came back home without any loss , there was no situation of benefit or gain so this situation is called pure risk.

Speculative risk:

“In this situation of risk there are three positions one is loss , second is no loss or breakeven and the third one is gain”

OR

“A category of risk that, when undertaken, results in an uncertain degree of gain or loss. All speculative risks are made as conscious choices and are not just a result of uncontrollable circumstances.” 

speculative risk refers to those exposures to price change that may result in gain or loss

Explanation of speculative risk by example:

If a person buy share of a company at Rs. 10 ,each and after an year there may be three positions , the share may reach at value of Rs.20 or

remain Rs.10 or may decline at Rs.5.this type of situation of risk is called speculative risk

Q: what is cash flow underwriting?

Cash flow underwriting:

“Pricing of the insurance product below the necessary premium rate to reflect the costs of expected losses. The thesis of this pricing strategy is to obtain large sums of money to invest and earning a greater return on the investment than the costs associated with the under pricing of the insurance product.”

OR

“A pricing tool used by insurance companies. Cash flow underwriting occurs when a given insurance product is priced below the rate of premium required to take into account the cost of expected losses that will be incurred. The purpose of this strategy is to generate substantial investment capital from the increased business that will come from the lower pricing.”

Brief explanation:

The investment capital that is presumably generated by the sales from the lower-priced product can be used to invest in vehicles that will pay higher rates of return. If a smaller amount were invested, then a less advantageous investment may have to be used instead. Ultimately, the higher investment returns make up for the difference in pricing for the insurer.

Q: Define “law of large numbers” and what is the implication of this law in insurance system?

Law of large number:

“The theory of probability on which the business of insurance is based. Simply put, this mathematical premise says that the larger the group of units insured, such as sport-utility vehicles, the more accurate the predictions of loss will be”

Explanation:

An insurance system can operate successfully only when it can predict losses accurately. Predicting losses reduce risk. Insurance pools reduce risk by applying this law, which states that the greater the number of observations of an event based on chance, the more likely the actual result will approximate the expected result.

Example: (implication)

Suppose an insurance pool expected 1 percent of its members to experience a loss, based on historical records of losses. The law of large numbers states that the greater the number of exposures in the pool , the more is the 1 percent loss figure to be realized. By applying the law the insurance company can predict accurately the dollar amount of losses it will experience in a given period.

Q: what are the two definitions of risk discussed in this chapter? Are they really differ from one another?

Two definitions of risk discussed in this chapter are :

1. “risk is to be defined as a variation in possible outcomes of an event based on chance”

2. “Risk is stated as an uncertainity concerning a possible loss.”

The first definition of risk as variability in possible out comes focuses attention on the degree of risk in given situations. The degree of risk is a measure of the accuracy with which the outcome of an event based on chance can be predicted .

The second definition of risk as uncertainty concerning loss is useful because it helps to explain why people purchase insurance . if Mr.X does not buy insurance, he may be uncertain about whether he will have to pay for fire losses to his home . He is uncertain because he does not know in advance if his house will burn or if a fire occurred, how severe it would be . once he has purchased fire insurance ,it becomes certain he should have to pay for no fire losses to his home.

Q: how does insurance redistribute the cost of losses?

Redistribution of cost of losses:

Insurance involves the transfer of potential losses to an insurance pool. the pool combines all the potential losses to an insurance pool . The pool combines all the potential losses and hen transfers the cost of predicted losses back to those exposed. Thus, insurance involves the transfer of loss exposures to an insurance pool and the redistribution of losses among the members of pool .certainty of financial payment from a pool with adequate resources and accurate predictability of losses are the hall marks of the insurance transaction.

Q: list the four building blocks of insurance premium, why investment earnings are included in calculations?

1) Cost of paying for losses.

2) Cost of operating and maintaining insurance pool

3) Reserve for unexpected losses

4) Investment earnings

Investment earnings are included in calculations because it reduces the premium charged to insured.

Q: In what ways does operating insurance system benefit the society?

The benefits to the society of insurance systems:

1)Stability in families:2)Aids the planning process in business3)Facilitates credit transactions4) Investment in national economy

Stability in families:

Insurance prevents the families from experiencing the great hardships caused by unexpected losses of property or the premature death of the family income provider.

Aids the planning process in business:

Insurance aids the planning process because the planner knows a property loss will not mean financial ruin and the future of business cannot be destroyed

Facilitates the credit transactions:

Insurance facilitates credit transactions because creditors are more willing to lend money if the debtor’s death does not make collection of the loan difficult.

Investment in national economy:

Insurance companies do not leave the accumulated money with no use instead they invest it in many businesses and other financial corporations and in stock exchange bringing prosperity to economic condition of the country.

Q: why is that the chance of loss, and not the loss itself, that creates the need for insurance?

Answer:

Insurance companies make agreement of providing compensation before the loss took place not after the loss.

People purchase insurance because of risk and risk is the chance of uncertainty which is before expected loss.

From above two points it is obvious that the loss by itself is not the reason of purchasing policy but it is the chance of loss in other words risk which is actually the need for insurance.

Q: what are the major costs of operating insurance systems?

Answer:

The major costs may include:

Administrative expenses Acquisition expenses Managerial expenses Accounting expenses Unexpected loss expenses Investigation expenses Court expenses