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PB502 - INSURANCE AND TAKAFUL : PRINCIPLE AND PRACTICE -CHAPTER 1 INTRODUCTION TO INSURANCE

Having seen the role of insurance and how it works in very general terms, it is now appropriateto put down in precise terms what insurance is all about. Insurance, as an organizational, seeks to

provide protection against financial loss caused by fortuitous[1]events.

Insurance can therefore defined as: An economic institution based on the principle ofmutuality, performed for the purpose of establishing a common fund, the need for which arises

from chance occurrences[2]of nature, whose probability can be fairly estimated. The insurance service, therefore involves payment of contracted benefits of compensation

to the insured or a third party against unforeseen losses.

ESSENTIAL FEATURES OF INSURANCE:The essential features of insurance therefore are:

It is an economic institutions It is based on the principle of mutuality or cooperation

Its objective is to accumulate funds to pay for claims that arise as a result of the operation ofspecific risks.

Only certain risks can be insured against, namely those whose occurrence with a certain degreeof accuracy.

HISTORY OF INSURANCE

The earliest evidence of insurance contracts dates back to the period around 2,800 B.C. wherethe Babylonian legal code showed regulations on insurance. Basically the concept of insurance wasdeveloped to deal with perils faced by merchants and traders at sea. This varied from protection of thecargo and goods carried by ships to the protection against the loss of lives of sailors and officers

There is evidence showing that such practices were also prevalent among the Chinese, Greeks

and Europeans. The first case of life insurance dates back to 1583 in England where a term contractwas issued on the life of a certain William Gybbon. A significant development in the life insuranceindustry was the development of the mortality table by Edmund Halley in 1693. However, it was abouta century later that any degree of accuracy was achieved in predicting mortality rates.

The Government subsequently intervened and the Insurance Act, 1963 was introduced.Under the Act, the general conduct and supervision of the insurance industry was vested in theDirector-General of Insurance under the Ministry of Finance.

THE IMPORTANCE OF INSURANCE

While approaching to the consumer throughout the world, and to the market of insurance as a scope, itcan be concluded it is important to both individual and business. Some of the importance is:

a) The need for income :-Every moment, individuals, families and business are exposed to losses arising from their property,occupations, activities and responsibilities. Who will bear these financial losses and where will thefunds be obtained from to offset such losses? Usually, in the absence of legal remedies, contractarrangements or cooperative efforts, losses will fall on the individual or business unit concerned. To

DEFINITION OF INSURANCE

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solve this problem, an arrangement is introduced for coping with some of the risks and possible lossesfaced by individuals and business enterprises.

This arrangement works on the law of large numbers, i.e. by spreading the risk of loss faced by aspecific person or enterprise to all parties who pool their resources to pay for individual losses. Thisloss sharing arrangement is called insurance

The insurer is the intermediary who manages this risk pool. The insurer holds and invests the premiumsin trust for policyowners, and pays them in the event that these losses, for which insurance protectionis taken, occur.

b) Source of incomeA person may create his source of income by either setting up his own business or working for otherpeople where, upon completion for the jobs done, he will receive payment in the form of a salary,wages, allowances or commissions.

The other means is though investment income by way of dividends bonuses or interest on the capitalinvested.

However, both sources are always at the risk of being affected by circumstances over which theindividual has no control.

c) Unfortunate Event or Risks

Earning capacity may be ended abruptly[3]due to death, old age, sickness or accident that may resultin disability (permanent or temporary)

Likewise, the investment may suddenly depreciate in value or the goods in which capital is investedmay be destroyed by fire

In any of these contingencies, the individual or the dependents have to bear the consequences of thefinancial or emotional losses. Those affected have no other sources to which they can look for relief forsharing part of all the loss.

The painful experience as a consequence of losses is obvious to anyone.

HOW INSURANCE CONDUCTED / HOW INSURANCE WORKS

Let us next understand how insurance works to compensate for the financial losses consequent to theoccurrence of a risk or perils.

Rather than providing a more formal definition of the risk and peril now (see chapter 2),we shall look at some instances where we can say that a risk or peril has occurred.

Some forms of risk

Shipwreck[4]at sea

An outbreak of fire resulting in material damage;

Loss of income due to disability or premature death.

Pooling of risksIt is not possible for an individual to predict or prevent such occurrences but through insurance,

arrangements can be made to provide against their financial effects, i.e. loss of property and/orearning.

Insurance in its various forms aims at safeguarding the interest of the individuals who are insured. Thisis achieved by having losses experienced by the unfortunate few compensated by the contributions,i.e. the premium, of the many that are exposed to the same risk.

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The concept of Insurance explainedThe concept of insurance is illustrated in figure 1.1 in relation to a house owner or a term life

insurance portfolio. For the purpose of illustration, it is assumed that the portfolio consists of 1000houses of identical value, say RM100,000 each or 100 life assured with identical capital sum, andpremium of RM200 is charged for each of life assured per year.

The fund has to meet:

The contribution from the 1000 house owners or life assured results in the creation of an insurancefund on RM200, 000. The insurer uses this amount of money to pay for claims, management expensesand other outgoes such as commission, taxes, etc. The balance, if any, constitutes the insurers profit.

The fund can become deficitThus, in the situation illustrated earlier, the fund created is just sufficient to pay for a maximum oftwo claims and this leaves the expenses and other outgoes of the insured uncovered. If more than two

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claims were arise, the insurance fund would be in deficit and clearly, the insurer would experience aloss on his portfolio.

Premiums have to be adequate in a competitive business environmentIt becomes clear from the above that for the insurer to operate profitably in a competitiveenvironment, premiums have to be fixed at adequate levels, and management and other expensescontrolled.

The law of large numbersInsurance as a device for spreading the loss of a few among many can only work when insurers are ableto underwrite a large number of similar risks. When insurers are able to write a large number of similarrisks the law of large numbers operates.

The law of large numbers states that as the number of loss exposures increases, the predicted loss tendto approach the actual loss. Although the law of large numbers is a simple concept, it can only operateefficiently in the following requirements are fulfilled:

There are a large number of similar loss exposures

The loss exposures must be independent

There is a random or chance occurrence of loss.The operation of the law of large numbers will ensure will better prediction of future losses. This isimportant to insurer because they must charge a premium (based on predicted future losses) that willbe adequate for paying losses for the period of insurance.

FUNCTION OF INSURANCE

The function of insurance can be look closely in two perspective, (primaryand secondary)

Functions of insurancePrimary Function The primary function of insurance is the equitable distribution of the financial losses of the

few who are insured among the many insured.The secondary functions

Stabilization of costs Through purchase of insurance, business enterprise avoids the necessity of having protectionagainst losses. This provides a means of stabilizing the costs involved in managing risks.

Stimulation of

Business EnterpriseThe risks transfer mechanism provided by insurance has made possible the present-day

large-scale commercial and industrial enterprises. These large-scale enterprises would not

have started if the owner were not able to transfer their risks through insurance. Provision of

Security for

Insurance helps to remove the fears and worries of losses of individuals and business

executives. This removal of fear and worries helps to establish confidence and enables the

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Expansion of

Businessforward-planning of economic activities.

Reduction of Losses

-Insurer helps to reduce losses (both in frequency and security) through their action and

recommendations in rating, survey, inspection service and salvage[5].

Provision of a means

of savingInsurance function as a means of saving, primarily through the use of

endowment[6]insurance. Endowment insurance is a combination of protection plus savings.

The investment part of the contract is a savings accumulation. By combining the twofeatures in a single plan, endowment assurance provides both protection and savings to the

insured.Provision of Sources

of Capital for

Investment

- Insurers accumulate large funds which they hold as custodians and out of which claims and

losses are met. These funds are usually invested (to earn interest) in the public and private

sectors. Such investment helps considerably in the overall development of the economy.Provision of

Employment for

many

The insurance industry in Malaysia has created various categories of employment

opportunities. Following are the statistics for 2007;Market Structure No. of personnel

employedInsurers 20,600Insurance brokers 1162Adjusters 1844

Registered life agents 78,587Registered general

agents39,165

While the nature of jobs for brokers and adjusters are independents and more of specialized

roles, the various job function in an insurance company such as underwriting, claims

handling, accounts, audit/compliance, human resource/administration, electronic data

processing, marketing and servicing, investment and other support functions are inter-

independentCLASSES OF INSURANCE

Life Insurance General InsuranceLife insurance can be defined as a contract which pays

an agreed sum of money on the happening of a

contingency (event), or of a variety of contingencies,

dependent on a human life.As we progress through the book, you may note that the

above definition is not precise in relation to with profit

policies, for there is no agreed sum of money at the

outset

General insurancebusiness can be taken to be all other forms of insurance

business (including the reinsurance of liabilities under a

policy in respect thereof) which is not life insurance

business as defined in the insurance Act 1996.

Risk CoveredPremature deathLoss of a continuous stream of income during

retirement (i.e. during old age)Sickness or disability

Loss or damage to property, e.g. to motor vehicles,

ships, buildings, stock-in-trade;Legal liability caused by products or goods sold, or the

process carried out;Death or injury to a person by an accident

[1]Synonyms = accidental

[2]Synonyms = incident

[3]Synonym= Shortly

[4]Synonym = Ruin

[5]Synonym=Recover

[6]Synonym=Gift

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