Insurance, legal and regulatory 2019 Study textContents : Risk and insurance ‘A The concept of risk V2 B Risk management WZ] C Categories of risk v6 D Insurable risks ve E Components of ri vio F The need for insurance ns Pooling of risks ws H Benefits of insurance vis T Risk sharing vs J Dual insurance ws K Self-insurance Wi L Classes of insurance war 2: The insurance market A Structure of the insurance market 2/8 B Ineurere 2/5 © Loye’s 2/8 D The London Market 2/10 E Intermediaries 2m F Distribution channels 2/5 G Comparison websites 28 H Reinsurance 278 1 Professionals in insurance 2/21 J Market organisations 2/24 K Motor Insurers’ Bureau (MIB) 2/29 3: Contract and agency ‘A Contract law 3/2 B Offer and acceptance ys C Consideration 3/5 D Cancellation of insurance contracts 3/5 E Agency 3/8 F Terms of business agreements (TOBAs) 7a 4: Insurable interest ‘A Definition of insurable interest 4/2 B Timing of insurable interest 4/3 Creation of insurable interest 4/5 D Application of insurable interest 4/6 vIFVOctober 2018 Insurance, legal and regulatery 5: Good faith A Principle of utmost good faith 5/2 B Duty of disclosure 5/3 C Material facts 5/10 D Facts that do not need to be disclosed s/n E Consequences of non-disclosure s/s F Misrepresentation s/4 G Breach of the duty of fair presentation 5/16 H Compulsory Insurances 5/18 6: Proximate cause A Meaning of proximate cause 6/2 B Application to simple claims 6/s € Modification by policy wordings 6/6 Appendix 6.1: Standard fire policy (material damage) 6 7: Indemnity A Definition of indemnity 7/2 B Application of indemnity 7/5 € Measuring indemnity v6 D Modifying indemnity 7/9 E Limiting factors: 70 8: Contribution and subrogation ‘A Contribution 8/2 B Applying the contribution principle 8/4 ‘€ Subrogation 8/7 ‘D Insurers’ subrogation rights 8/8 E Insurers’ rights arising from the subject-matter 8/9 F Market agreements 8/10 G Precluded subrogation rights sfContents 9: Compulsory insurance and statutory regulation A Compulsory insurances 9/3 B Consumer Rights Act 2015. 9/6 € Legislation concerning third parties 9/8 D EU Gender Directive 9/9 E Enterprise Act 2016 9/9 F Insurance premium tax 9/10 G UK regulatory framework 9 H Prudential Regulation Authority (PRA) 9/13 | Financial Conduct Authority (FCA) 9/5 J PRA Rulebook and FCA Handbook 9/18 K Discipline and enforcement 9/25 L Authorisation and regulation of insurers 9/26 M Authorisation and regulation of intermediaries 9/30 N Insurance: Conduct of Business Sourcebook (ICOBS) 9/32 (© Insurance Distribution Directive (IDD) 9736 P Money laundering 9/38 10: Consumer protection and dispute resolution ‘A Data protection 10/2 B Ethical standards 10/6 C Training and competence 10/10 D Complaints procedures al E Financial Ombudsman Service (FOS) 10/13 F Financial Services Compensation Scheme (FSCS) 10/4 ‘Appendix 10.1: Cll Code of Ethics a) ‘Self-test answers o Glossary x Cases w Legislation vil Index xixRisk and insurance Contents Syllabus learning ‘outcomes Learning objectives Introduction Key terms A The concept of risk WA, 2.1, 3.2 B Risk management 1.2, 2.1 C Categories of risk 13,21 D Insurable risks 1.4,2.1 E Components of risk. 1.5, 1.6, 1.7, 2.1 F The need for insurance 3.4,3.2 G Pooling of risks 32 H Benefits of insurance 33 T Risk shai 34 J Dual insurance 35 K Self-insurance 35 Classes of insurance 36 Key points ‘Question answers Self-test questions Learning objectives After studying this chaptor, you should be able to: + list the main components of risk: + describe how risk is perceived; ‘+ state the function of risk management; + describe the process of risk management; + demonstrate how insurance relates to risk; + identify the categories into which risks are divided; + compare insurable and uninsurable risks; + describe the relationship between frequency, severity, risk and insurance; + distinguish the torms peril and hazard as they relate to insurance; + describe how insurance operates asa risk transfer mechanism; describe how the common peal operates: describe how insurance benefits policyholders and saciety: describe what is meant by co-insurance, dual insurance and self-insurance; and + describe the main classes of insurance. Porc e)root ve seeesomant of ik IFVOctober 2018 Insurance, legal and regulatory Introduction In this chapter, we will look at how the concept of risk and how it is perceived, as well as the different categories of risk. We will go on to explain how insurance acts as a risk transfer mechanism and how the common pool works. This chapter will also introduce the main classes of insurance. Key terms This chapter features explanations of the following terms and concepts: ‘Co-insurance Dual insurance Financial sk Frequency and severity Fundamental risk Hazard Homogeneous insurable interest exposure Law oflarge numbers _ [Non-financial risk Particular risk Perl Pooling of risk Premium reserve Pure risk Retention Risk Risk-averse ‘SelFinsurance Speculative isk A The concept of risk The word tisk is used in a number of different ways in the insurance market place and we need to look at each of these in turn. Examining the term in ts everyday sense soon reveals ‘ur first problem: there is ne universally recognised definition for the term, Al_ Risk perception Ityou were to ask anyone what the term Tisk’ means to them you are likely to receive a wide variaty of ancwars - avarything from a hiinas< owner haing cancarned ahout the posciility of recession to parents’ worries about the dangers faced by their children. Yet others may identify the risks inherent in running a business, perhaps the demand for their products or ‘obsolescence issues. The list of risks that we face is almost endless. Ina personal sense we all take decisions based upon an assessment of risk. Most of this is carried out informally. We assess the likethood of rain occurring and decide whether to take {an umbrella with us when we leave our home in the morning. There may be some data involved (a weather forecast from a reliable source) or we may have merely looked out of the window to make a judgment about the likelihood of rain. This informality may be acceptable in ‘low risk’ situations where the ultimate calamity is something like wet clothing, but in many contexts we need better measurement tools, especially where the potential for loss is significant Risk measurement and the means of attempting to deal with the risks we face are collectively termed risk management. In a commercial context this is often a well-defined and scientific process, attempting to answor questions such as ‘How much will it cost if things go wrong?’ and ‘What are the chances of the risk becoming a reality?’ We will deal with these issuos in groator detail later in FI Ina personal sense most individuals make less precise calculations, often preferring instead to simply protect against those things that seem capable of inflicting some kind of financial disaster, such as fire or theft. We begin by considering just what is meant by the term ‘risk A2__ Definition of risk Consider the following statomonts, each giving a differont slant to tho torm ‘isk’ + The possibility of an unfortunate occurrence. + Doubt concerning the outcome of a situation. + UnpredictabilityChapter? Riskand insurance *+ The possibility of loss. + The chance of gain (such as hoped-for benefit from a gamble or investment strategy) Whichever definition we chooso, wo nead to recognise the elements of uncertainty and unpredictability or, in some of our definitions, danger. The term often implies something that we do not want to happen. As we shall see later, not every type of riskis insurable. Just think for the moment about owning a car. There are many risks associated with this, including: ‘the risk that the car will be stolen in the future; + the risk of a car accident with or without injury to the driv. + the risk of injuring others as a rasult of a car accident; and + tho risk of damage to the car caused by another driver. Each of these represents a risk so far as the owner is concerned. In each case itis possible to insure (transfer) the risk. This is done by the owner paying a known promium to an insurer in return for the insurer accepting the future unknown cost of the insured risk. The insurer does, this by promising to pay for loss, damage or liability as dofined by the policy torms (seo figure 11). Insurance therefore is a means of transferring the risk. ‘The accepting of an unknown future potential risk by an insurer for an agreed premium is a ‘way of defining Insurance as a risk transfer mechanism. It brings peace of mind to tho insured because they have replaced the uncertainty of possible future loss with the certainty of the agreed premium, We consider this aspect later in the chapter. igure 1.1: Risk of causing injury while driving a car | Risk transferred 1 Driver ——— Insurer Pays premium A3 Other meanings of the term ‘risk’ Although this section is devoted to risk in its generic sense, there are three other ways in which the term is used in the market place: + The first refers to the peril or contingency that is insured - the fire risk, the theft risk and + The second use of the term relates to the thing (or liability) actually insured. In this context the ‘isk’ could be a factory or manufacturer's liability to the public, + When an underwriter quotes for ‘a risk’ an even wider definition is implied. The underwriter will mean both the thing insured, such as the property itself, and the range of. contingencies or scope of cover required. A4 Attitude to risk Each person's attitude to risk is different, therefore we all respond to risk in a different way. ‘Some people are willing to carry certain risks themselves and are termed risk-seeking, while others lean more towards being risk-averse, fecling happier minimising the risk to which they are exposed (perhaps by transferring the risk, as in insurance). Very few individuals are ina position to evaluate, with any accuracy, the risks to which they are exposed. However, as ‘we shall now see, many companies attempt to achieve this as part of their risk management process. Elements of tins the studs Petite)Coron va tewards takin isk management Ise sorsicontly ‘Soren coneapt forinsivicua| management isthe Snes IF/October 2018 Insurance, legal and regulatory B_ Risk management ‘There is a continuing trend towards taking control and developing a formal strategy for managing the various risks that affect businesses. The appointment of risk managers in industry and commerce is now commonplace. Many are members of the Association of Insurance and Risk Managers in Industry and Commerce (Airmic). This organisation has ‘been influential in setting standards in areas of risk management and, with other ‘organisations, has published a Risk Management Standard that has been widely adopted. Risk managemont is important for a number of roasons: + Itreduces the potential for loss by identifying and managing hazards. + Itgives sharcholdors a greater dogree of confidence in a company's ability to manage its risks. For companies quoted on the stack market there is a legal requirement to identify all significant risks to which the business is exposed and to explain in the annual report how these are being managed. + Itprovides a disciplined approach to quantifying risks. ‘The decision to transfer risks (for example, by insurance) is an important final stage in the risk management process. ‘When it comes to general insurance, risk management is a significantly different concept for individuals than itis for businesses, Many individuals, when they consider their own financial planning, personal protection and wealth management issues, tend to adopt a formalised approach, often facilitated by a financial adviser. This will invoive the completion of a dotailed “fact find’ and an oqually detailed consideration of the income, savings, assots, health and future aspirations of an indivicual. However, the issue of personal general insurance does not very often follow this detailed pattern. Often it is not bought as the result of a carefully made decision that insurance is the best solution to a particular financial problem. Instead it is bought because certain elements of cover may be compulsory, such as third-party motor insurance, which the law requires everyone to have. Alternatively, Itmay hha that another party has financial interact in tha item ta he insured, for example ifn. individual buys a house, there is usually a mortgagee who will insist upon insurance being effected. Of course there are aroas whore there is real choice about whether to insure or manage the risk in some other way. However, even here itis highly unlikely that a scientific approach will bbe takan to assessing risk. The most dominant factor is likely to be an individual's risk appetite of an inability to afford insurance protection. Individuals with very substantial physical assets may adopt a more formalised approach selecting individual elements of cover with variable sums insureds and excesses. These types of policyholders are often termed ‘high net worth individuals’ (HNW/s) and certain insurance products have been developed specifically for them. B1_ Function of risk management Risk management is the identification, analysis and economic control of those risks which. can threaten the assets or earning capacity of an enterprise. The focus of good risk management is the identification and treatment of defined risks, Risk management should be a continuous and developing process embedded in the firm's strategy. It should address methodically all the risks surrounding the firm's current, past and future activities. This definition identifies the three steps involved in managing the risk: Risk identification > Ask analysis > Rsk controlChapter? Riskand insurance us BIA Risk identification Risk identification involves discovering the threats to a company that may already exist, and the potential threats that may exist in the future. Not all of these risks will be insurable but inroationtorick they must all be managed. For the retail shop, petty theft and shoplifting may be real risks Se"! and will need to be managed in some way or funding set aside to cover their casts. For many conventional risks, an insurer may become involved in helping to identify existing and potential risks through carrying out a physical examination or survey. Insurers also play @ role in relation to risk control when they provide reports following the survey. BIB Risk analysis Risk managers will examine past data to evaluate of analyse the risk. For example. they can look at the past loss patterns of, say, motor accidents involving drivers under the age of 25, land so predict what is likely to happen in the future for drivers who fall into this catogory. Equally, patterns of reported accidents in the accident register may be analysed for future trends. Insurers will look at many of the same elements when considering the rating of a risk BIC Risk control If the risk is seen to have the potential for adverse consequences, some course of action should be put in place to control, reduce or even eliminate the risk. Elimination is the most effective, but may be costly or impractical. For example, if a manufacturer carries out some paint spraying activity that is highly hazardous, it may be possible to outsource that part of ‘the process and in so doing eliminate that cloment of the risk. The elimination of risk, or even its reduction, will always be subject to the test of whether the cast of doing so is reasonable ‘compared to the cost of the feared event happening. ‘Thore aro a number of different aspects to the controlling of risk: a Physical control Tror example, putting specific locks on the doors of afactorytoreducethe {ga ‘measures theft risk, Financial control ‘Such as transferring the risk by either taking out insurance or by contract ‘measures (eg. arranging fora security fir to accept responsibility for cash whilst in its contro). Developing a good risk | Key to improving isk awareness and managing risk. This can be achieved by culture: ‘educating employees or clients on how to avoid or reduce risks Depending on what they were designed for, internal controls are usually categorised as detective, corrective or preventative. + Detective controls are designed to detect errors or irregularities that may have occurred. *+ Corrective controls are designed to correct errors or irragularities that have been, detected. + Preventative controls, on the other hand, are designed to keep errors or irregularities from occurring in the first place. Insurers assist in the area of loss prevention and control. They do so by imposing iareiaian requirements and making recommendations designed to improve the risk, following the {re aree of owe ‘completion of a survey. Those are important parts cf the surveyor's report and will either be Prevention and aimed at improving the risk to an acceptable standard from the insurer's point of view, or will offer promium reduction as an incentive for worthwhile risk improvements. Insurers may also offer risk management training, guidance or other literature to help their policyholders avoid ‘or manage risk. Inourerspiayarote PeoriteyCora vs Froud nae rk tomansge and rniiaate Notevery woe ot fskoreventity capabieoF IFVOctober 2018 Insurance, egal and regulatory Ina wider context, insurers are involved in researching areas of loss prevention and control Much of the work is carried out on their bahaif by the Fire Protection Association (FPA), The kind of work this body undertakes includes: + researching new materials and methocs of construction and seeing how they behave in a fire: + providing rules that sat standards of construction; + reporting on new industrial processes and machinery; and + providing rules for the construction, installation and operation of fire extinguishing appliances, e.g. sprinkler systems, Motor insurers also rely on Thatcham Research Centre for testing vehicle safety and security systems, and for testing seats for whiplash protection. Fraud is a key risk that insurers also need to manage and mitigate, The Motor Insurance Anti-Fraud and Theft Register (MIAFTR) was formed through the participation of Association of British Insurers (ABI) member companies to combat the increasing number of fraudulent claims. The register records all details of vehicles and motorcycles that become total losses arising from any cause, including fire and theft. Third party and insured losses are also recorded, and the information is available to all companies as well as Lloyd's. Insurers that place information onto the register relating to a now claim will bo advised if tho vehicle, claimant or the claimant’s address matches existing data that is already present on. the register. Even if fraud is not discovered, previous claims may be disclosed that had not been advised by policyholders when they took out their policy. ‘The Loss Prevention Research Council's isk-basod rosearch and other initiatives also help insurers to develop crime- and loss-control solutions. C_ Categories of risk It does not follow that, having identified ¢ risk, it will automatically be incurable. Not every type of risk or eventuality is insurable. It will help our understanding if we look at (and contrast) different types of risk to identify those that are insurable and those that are not. particular and is [pureand speculative C1 Financial and non-financial risks ‘Some of the risks that we face are not capable of financial measurement. They may have a financial aspect to them, but itis incidental. The real risk arises from decisions and actions ‘motivated by other considerations. Take for example the choice of a marriage partner or our enjoyment of a holiday. We cannot measure these in financial terms. In the same way, the value we might place on an heirloom that has been in the family for years may be far beyond its intrinsic or market value. Insurance is rot appropriate for such risks. The heirloom could indeed be insured but only for its intrinsic value, not for the sentimental value we place onit. Fora risk to be insurable the outcome of adverse events must be capable of measurement in financial terms. Most general insurances are compensatory in nature, as we shall see later. ‘This means that the value placed on the loss is not determined in advance. Important ‘exceptions to this general rule are personal accident and sickness policies. This is because there is no way of valuing precisely the loss ofa life or the loss of sight so these policies are: takon out in order to provide pro-agreed amounts in the evant of an accidont or sicknoss. They are known as benefit policies. Similar considerations apply to life insurance policies or twins insurance where for a one-off payment you can chose a lump sum which is only paid in the event that twins are born.Chapter? Riskand insurance uw Lot us look at some examples of financial risks to help us understand this concept: + Accidental damage to a motor car: tho financial valuo of the risk is the cost of ropsiring or replacing the vehicle. + Theft of property: the financial value of the risk of theft of an item of jewellery is its current market value. This is measurable in financial terms. It would not include: sentimental value because, as we have seen, this is not precisely measurable in financial terms. + Loss of business profits following a fire: this riskis measurable since comparisons can be made to similar trading periods to devise a fair estimate of the loss to be paid by the insurer as compensation. + Legal liability to pay compensation for personal injury to others: the courts measure the value of damages applicable for the loss of a leg, for example against compensation payments made previously in similar situations. Usually a standard formula is applied to calculate damages that will take account of financial circumstances as wall as the injury itselt. 2 ‘Pure and speculative risks There are many situations in life when we speculate with a view to making some kind of gain. ‘Obvious examples are the National Lottery or other forms of gambling. There are also situations such as investing in the stock market or starting up a new business that fall into this catagory, as well as pricing dacisions and other aspects of marketing, Each of these aims tomake a gain, but carries the possibility of break-even or failure. Consequently, though there are some aspects of business activity that can be insured, this does not include things such as misreading the market or a business failing because of local competition. insurance doos not apply to speculative risks. Pure risks, on the other hand, are those where there is the possibility ofa loss but not of gain, Kamans ‘and whore tho bost that wo can achiove is a break-even situation. Travolling home in a car is rare thre isthe '8 good example. The best tnat we can nope for Isa safe arrival. The possibility exists pone oflee however, that thore might be an accident and tho car damaged or someone injured. It is these types of risk that are generally insurable Consider this... Think of two pure risks to which a company might be exposed. ‘You may have already thought of these, but here are some examples of pure risks: + The risk of fire: it could damage or destroy property or cause an interruption to the running of the business, both are measurable in financial terms. + The risk of machinery breakdown: this could lead to actual damage or business interruption. + The tisk of injury to employees at work: if such injury is caused by the nesligence of the company, a court may award damages and costs. These are measurable in financial terms. 3 Particular and fundamental risks There are some risks that occur on such a vast scale that they are uninsurable. These are a aaaw called fundamental risks. Take for example the risk of earthquake ina region known tobe aise seca prone to such risks, or famine, economic rocession or a moro general isk - that of war. econamie oii However unlikely the rk of war may seem, its effects bring a catastrophe potential that snare insurers are not willing to carry. We can, therefore, define fundamental risks as those that eroead nth arise from social, economic, political or natural causes and aro widespread in their offect. As ‘we have seen, non-financial or speculative risks are uninsurable as a matter of principle. In contrast, the problem with fundamental risks is that its often a lack of willingness or capacity on the part of insurers that causes such risks to be uninsurable. PeoriteyCora ve Not ever kis Inawabe Contacte mast not IFVOctober 2018 Insurance, legal and regulatory It is not an easily defined category and there seem to be, on the face of it, many exceptions to the general rule. Just think of the terrorism cover provided on the World Trade Center, or the fact that marine insurers will often grant war risks cover for vessels and cargo, or even the fact it is possible to be insured for earthquake cover in California. Nevertheless, the fact ‘remains that those risks that tend to affect whole countries, regions or communities are classified as fundamental and thorofore, generally, oxcluded from cover. ‘Two risks automatically categorised in thss way for non-marine policies are war risks and. nuclear risks. Consider this... Think about some of the widespread natural disasters, wars and economic recessions of the past 15 years. What might the claims impact have been on the insurance industry? In contrast to fundamental risks, particular risks aro localised or oven personal in their cause and effect. Sometimes the cause may be more widespread (a storm over a whole region), bbut the effect is localised or even related to an individual. Not all properties in the ragion will have been damaged. Again, to help us understand lat us look at some examples of particular risks: + A factory fire: this would cause localised damage to the factory and possibly to its ‘surroundings, but would not affect the whole community. + Acar collision: damage to the vehicles and any third-party liability are localised events affecting relatively few individuals. + Theft of personal possessions from a home: an event that only affects an individual or family. We have established that only certain classifications of risk are insurable: those that are financial, pure and particular. There are certain other things that need to be in place for a risk to be insurable. In section L we will look zt what these are. D_Insurable risks It is important that you understand that not every risk is insurable. For a risk to be insurable, in addition to being financial, pure and, generally speaking, particular, the following features must also apply: + The event insured against must be fortuitous or unforesoon. + There must be insurable interest. + Insuring the risk must not be against public policy. D1 A fortuitous event To be insurable, the happening of the event must be fortuitous. In other words, it must be accidental or unexpected and not inevitable, so far as the insured is concerned. It must certainly not be deliberate on the part of the insured. An example of a non-fortuitous loss is. {an insured who deliberately damages their car. Not all clements of loss or damage may be fortuitous; for example: a theft may have required careful planning by the thieves, but still be unexpected so far as the insured is concerned. D2 Insurable interest Insurable interest is the legally recognised financial relationship between the insured and the object or liability that is being insured. For example, you can insure against the theft of your ‘own car because you suffer financial lossif it is stolen. Other financial interests are also recognised as we shall see in a later chapter. D3 Public policy Itis commonly recognised in law that contracts must not be against public policy or go against what socioty considers to be the right or moral thing to do. Insurers should not, therefore, cover risks that are against public policy.Chapter? Riskand insurance ve For example, it would be against public policy to insure the risk of incurring a fine for a criminal offence. The risk may appear to have all the features of an insurable risk, as the ‘event may be considered fortuitous (accidental) and the insured has an insurable interest, since they suffer financial loss as a result of the fine. However, itis clearly unacceptable to be able to insure against paying a fine, because the fine's purpose is to punish the individual. Providing insurance for it may encourage people to break the law. Question 1.1 @ Think of another risk which would be against public policy. What would be the effect on an insurer's professional reputation if it were to insure such risks? ‘Thera is one other aspect of a risk that insurors will examine when deciding whether it will consider a risk insurable: the question of homogeneous exposures. D4 Homogeneous exposures sufficient number of exposures to similar risks, historical patterns and trends willenable an [osccnamow insurer to forecast the expected extent of future losses. We could call such risks objective sifu to risks. In the absence ofa large number of homogeneous exposures (ie. similar risks) the task *e"™n= is harder, as a pattern is more difficult to determine. In extreme cases where there is no. historical data, the risk becomes a subjective one from an insurer's point of view. Whereas fortuitous loss, insurable interest and not being against public interest are absolute roquiroments, the concept of homogonoous exposures is an ideal. There aro occasions when ‘an insurer will need to use less than fully reliable historical data when fixing premiums, The UK insurance market is, in fact, renowned for its ability to insure almost any risk. There are examples of unique risks, such as the fingers of a famous pianist, being insured in the UK markt. Similarly, insurance is available for eatollito launchor, ovon though instancor of such launches are fairly infrequent and any failure catastrophic. However, wherever possible, an insurer looks for homogeneous exposures in order to utiliso as fully as possiblo tho law of Fge numbers. The greater the number of similar risks to insure, the closer the actual ‘outcome will be to what was expected in terms of losses, DS Summary of insurable and uninsurable risks From what we have seen in the preceding sections we can summarise risks that are generally insurable and those that are not as follows: insurable risks Uninsurable risks Financial Nonsfinancial Pure Speculative Particular Fundamental (generally) Fortitous event Deliterate act insurable interest No insurable interest Not against public policy ‘Against the public interest Homogeneous exposures Oneotts (generally) Perce)Cora vio Uncertainty eat the verycore of Different evs of IF/October 2018 Insurance, legal and regulatory E Components of risk In order to gain a deeper understanding of the meaning of risk, we must now take a closer look at the various components of risk. These include: + uncertainty; + level of risk; and + peril and hazard. El ‘Uncertainty ‘The concept of uncertainty implies doubt about the future, as a result of our incomplete knowledge. Uncertainty is at the very core of the concept of risk for, if we know what is going to happen, there is no element of risk involved. If you know that your house will burn ‘down at 4.00pm tomorrow, or that on the way home you will have an accident in the car, there is no risk of the event happening, as the event would become a certainty. As we do not have this prior knowledge, we can say that we live in an uncertain or risky environment and that risk exists separately from the individual. Even in the contoxt of life insurance, there is uncertainty. We know that we will all dio at ‘some time; the uncertainty relates to the timing of our death. E2 Level of risk ‘The second aspect of risk relates to the different levels of risk that exist. We know that there isa greater likelihood of some things happening than others and this is what we mean by the level of risk involved. Risk is usually assessed in terms of frequency (how often it will happen) and severity chow serious it will be ifit does happen). These are the measurement criteria used in the risk management process. E2A Frequency Imagine a house situated on the side of ariver which is known to be prone to overflowing its ‘banks. This situation involves risk: there is some doubt as to the future outcome because it is uncertain whether the river will ever overfiow and ifit does, when this will happen. The fact that the river is prone to overflowing increases the chance that damage will occur. Imagine a second house which is 100 metres away from the river bank and ona slight hill This house will be less at risk from flooding because of its position, E2B Severity (Our judgment as to the level of risk posed may change if we consider the potential amount of loss, damage or destruction. For example, ifthe first house close to the river is valued at £150,000 and tho second houso, further away, is valued at £350,000, we might modify our view as to which house represents the higher risk, in view of the higher potential severity of oss. Therefore, factors relating to both frequency and severity must be taken into account in our assessment of risk. The relationship between frequency and severity varies from one risk to another. High frequency and low severity Ina large number of different risk situations, thare is a high frequency and low severity of oss where there are a large number of small losses and relatively few large losses. This is illustrated in figuro 12. This could rolato to comprehensive private car policias, where there are many losses for damage to the insured’s own vehicle at a fairly modest level, but relatively few very costly third-party personal injury claims.Chapter? Risk and insurance Figure 1.2: High frequency and low severity losses Frequency Severity Question 1.2 Consider water damage caused by a leaking washing machine in relation to the loss profile shown in figure 12. What do you imagine is the relationship between frequoncy and soverity for this type of claim? Draw a graph to illustrate your conclusions. Think of two other insurable risks for property which would fit this same profile. ‘This relationship between high frequency and low severity losses is not limited to property damage. Research has becn carried out in the area of motor accidents (by Frank E Bird i 1969) using the statistics from two million accidents and near misses. Critically from an insurer's perspective, the relationship between serious and minor incidents is an important ‘one, as we shall see. Typically insurers have their own in-house modelling tools and/or use external models to look at past experience and determine future outcomes for the classes of business which they underwrite. Low frequency and high severity In some cases there is a low frequency and high severity of loss, illustrated in figure 13. The total number of such events will not be as high as tho events that wo illustrated in figure 12. In this case, a small number of events would result in very high costs. Accidents involving aircraft are good examples of this type of risk profile because, when a loss occurs, the cost could be substantial. Howover, tachnological advances halp to reduce the froquency of accidents, Figure 1.3: Low frequency and high severity losses Frequency Severity E2C Significance of frequency and severity ‘The different frequency and severity profiles are imoortant to insurers. This is because they wish their businesses to be, as far as possible, free from great peaks and troughs of claim. payments mado from one year to the next. Smooth trends in trading patterns tend to ‘encourage investors to support an insurer. vn Per ctp)Cora va Aninswrerbaees| Seczionson rover physial or moral eons IF/October 2018 Insurance, legal and regulatory An insurer will often base its decisions on how much of a risk it can prudently accept on factors relating to frequency and severity. Insurers have various ways of dealing with a risk thats offered to them where the amount involved exceeds their normal acceptance limits. ‘We will examine these later in this course. E3 Peril and hazard The concepts of peril and hazard together form the final aspect of risk. This aspect relates to the causes of losses: + Aperilcan be defined as that which aives rise to a loss, + Ahazard can be defined as that which influences the operation or effect of the peril. At first, the distinction between the two may not be that obvious. However, the following ‘example should help, Example 1.1 Consider a thatched cottage insured against fire. Fire is the prime cause giving rise to a loss, but the thatched roof provides the potential for the fire to spread more quickly and ‘do more damage, if one does occur. Fires, therefore, the peril and the thatched roofis the hazard. Here are some other examples of peril: + The overflow of water tanks: this is the ovont insured against, which may give rise to loss. itning: when it occurs, this natural peril can result in damage. And some other examples of hazard: + High value sports cars: the hazards in this motor insurance example are the potential for high speed, which in turn incroases the risk af accidents, and the high value and attractiveness that increases the risk of theft. + A safari holiday: the climato, the oxistence of local diseases and the likolihood of injury all increase the possible extent of loss and are, therefore, hazards in travel insurance. Hazard breaks down into two further parts: it can be physical or moral. Physical hazard ‘relates to the physical characteristics of the risk and includes any ‘measurable dimension ofthe risk. Here are some examples: + Security protection at a shop: the greater the security protection, the better the physical hazard level asit may even prevent a loss altogether. + The construction of the property: the higher the standard of bulding construction, the better the physical hazard for fe and similar risks, as the bullding will be more resistant to damage ‘+ The age ot a proposer and type of car for motor insurance. Thoso are factual, measurable factors. Moral hazard ‘arises from the attitude and behaviour of people. In insurance, thisis usually the conduct of the person insured. However, the conduct of the Insured's employees and that of society asa whole are also aspects of ‘moral hazard. Examples include the following: + Carelessness: a driver's lack of care can increase the chance of an accident happening and its severity ‘+ Dishonesty: a person who has previously made fraudulent or ‘exaggerated claims represents a poorer moral hazard than one who has not, + Social attitudes which, for example, do not regard cheating insurers Itis sometimes difficult to distinguish botwoen physical and moral hazard. This is because, quite often, poor moral hazard will be accompanied by some kind of poor physical aspect. Take the example of careless or lax management in a factory. This is clearly something relating to attitude and behaviour, but it may be evident because of unguarded machinery or lack of control of smoking by employees, for example.Chapter? Riskand insurance We must guard against the tendency to jump to the conclusion that there is an adverse ‘moral aspect to a risk merely because the risk is an obviously heavy one. For example, a fireworks factory represents a very heavy fire risk, but it does not follow that there is a poor ‘moral aspect to the risk. Equally, a young driver who is driving a high performance car certainly represents a poor physical hazard. Statistics show that a disproportionately high. numbar of accidonts are caused by young drivers. The car itself will bo in a high rating group because of its value and performance. These two aspects are physical because thay are ‘measurable, Its, of course, possible that some other factor may point towards poor moral hazard - perhaps a poor claims history or serious motoring convictions. Question 1.3 ‘Which types of hazard are likely to cause insurers groatest difficulty when deciding on the terms for a new risk - physical or moral? F The need for insurance Do we really need insurance? This is a question that's frequently asked, particularly when an insurance renewal notice drops through the letterbox. Whether an individual wants some form of insurance depends on their attitude to a potential risk, what price they are prepared to pay for the peace of mind which insurance gives, and the extent to which they feel they have a choice about insuring the risk. Insurance has been around for a very long time. It has its origins in the different kinds of situation where financial protection is required against the possibility of suffering some misfortune or loss. ‘We shall now look at how peace of mind is achieved. The primary function of insurance is to act as a risk transfer mechanism; that is, to transfer a risk from one person, the insured, to another, the insurer. Transferring the risk te an insurer ‘does not in itself prevent losses from occurring, but it provides a form of financial security and peace of mind for the insured. The large unknown financial risk that an individual faces of their home burning down, for example, is transferred to the insurer and replaced by the ‘much smaller and certain cost of the premium, In tho noxt few sections we will move on to look at some othor key concepts that underline the way insurance works, G_ Pooling of risks ‘The basic concept of insurance is that the losses of the few who suffer misfortune are met by the contributions of the many who are exposed to similar potential loss. An insurance company gathers together relatively small sums of money from people who want to be protected financially from similar kinds of porils. The insuror sots itsolf up to oparate a pool. In fact, as we shall see, insurers operate a number of separate pools for each different class of insurance. Contributions, in the form of premiums from many insureds, go into this pool From the pool, payments are made to compensate the losses of the fow. ‘These contributions, or premiums, must be large enough in total to meet the losses in any ‘one year. In addition, they must cover the costs of cperating the pool and provide an ‘element of profit for the insurer. The insurer endeavours to make sure that the premium, which each insured pays is proportionate to the risk which they introduce to the pool, G1 Lawof large numbers In operating the pool, insurers benefit from the law of large numbers. This states that where thare are a large number of similar situations, the actual number of events occurring tends towards the expected number. The law of large numbers can be illustrated by considering the flip of a coin, which can result in a head or a tail. Flipping @ coin 20 times may result in any combination of heads and tails; there may be twelve heads and eight tails or any other ‘combination. On the simple mathematics of the situation, you would expect to get the same number of heads and tails, because the chance of getting either is 50%. vis Theormary Sear trator ‘mechanism Lote oF ha row ‘Gemany erie)Cora ff rickbrouahe into ‘eos! @ ‘many benefits to polyheders ana IFVOctober 2018 Insurance, legal and regulatory However, flipping the coin just 20 times may not give us the 50/50 split we would expect. Flipping the coin 10,000 times, we would almost certainly see a result of approximately 5,000 heads and 5,000 tails. The law of large numbers, therefore, operates to give a result whichis in keeping with the underlying probability (likelihood of something happening) of, in this example, 50% heads and 50% tails. Applying the principle of large numbers to insurance enables the insurer to pradict fairly confidently the final cost of claims in any one year. This is because insurers provide cover ‘against a large number of similar risks, and the final numbor of actual loss events tends to be very close to the expected number, provided the conditions under which the original data were gathered remain constant. This enables the insurer to calculate likely losses and so confidently charge a fixed premium, meaning that the insured knows what their costs will be for the year, irrespective of the number or size of their own particular losses from insured causes. G2 Equitable premiums To operate a pooling system successfully, a number of pools must be set up, one for each ‘main group of risks. For example, an individual poo! for, say, motor insurance and another for household insurance must be set up. Each person wishing to join the pool must be prepared to make an equitable (fair) contribution to that pool. ‘When deciding on an equitable contribution, insurers take into account the different elements of risk brought into the pool by each of the insured. These are often referred to as discrimination factors. Examples include previous medical history for life cover and provious Griving experience for a motor insurance policy. Arriving at a premium is a complex process and the correct assessment of risk is extremely important. The correct assessment will ‘ensure that a fair premium is charged, anda fair profit can be made. This is the task of an underwriter when considering an individual risk. Question 1.4 ‘When pooling risk, insurers use the law of large numbers to make reliable: a. claim payment predictions. b. investment return pradicti © newbusiness predictions. d. premium income predictions. ooo00 H_ Benefits of insurance Insurance brings many benefits to policyholders and to society as a whole. We have already mentioned the peace of mind that it can provide, and how it enables the risk of financial loss to be transferred, There are other benefits in addition + Itreleases capital within companies that can be used in the business. In the absence of insurance large sums would need to be built up and set aside to cater for unforeseen, contingencies, such as fire, flood or liabilities. + Entorprisos aro encouraged to start or expand. In thoir aarly years companios aro particularly vulnerable to loss, and this may inhibit an entrepreneurial approach in, say, ‘opening up a factory or launching a new product. Insurance provides security from which to dovolop such innovations. + Employees aro kopt in work. This is a groat social benefit of insurance. Whenever thero is an insured occurrence at a location there will be physical damage. But often it does not ‘stop there. The insured will loso turnover until their trading position is eventually restorod, Insurance can cover, nat only physical loss or damage, but also wages, salaries and the loss of trading income for the period during which the business is recovering, This in turn ‘ensures that jobs are maintained.Chapter? Riskand insurance + Losses are reduced in size and number. The overall cost to the community of all damage by fire ina year is called ‘fire waste’. Insurers are keen to minimise this. Every fire prevented is a claim that does not need to be paid and a business that can continue trading without disruption. Insurars use the services of surveyors for larger risks. Their role is to assess the risk for the underwriter, estimate the loss potential and make recommendations regarding improvements designed to reduce the incidence of fires or their effect. + The nation benefits from the investments made by insurers. This arises in two main ways: ~ There is a time delay between the receipt of premiums and the occurrence of claims. This creates a premium reserve. = Once claims have occurred there is a further poriod (that can be very extensive for third-party claims involving personal injury or ines) before the claims are actually paid, This element is a claims reserve. At any one time, therefore, insurers will have substantial sums of money in these raserves to invest. They will invest in a wide range of investment types, including property and eauities. ‘+ The nation benefits from so-called invisible exports. Thase are very large sums of money representing the trading activities of insurers that are based in the UK, but are operating in other territories. It also includes tho trading rosults of Lloyd's and other London Markat insurers accepting ‘overseas’ risks directly in the UK. The net earnings that are returned to the UK represent many billions of pounds each year. I Risk sharing Part of an insurer's job is to manage the pool of money from which valid claims are to be paid. Each insuror will thorofore decide upon the maximum limits of accoptance for particular categories of risk. For property Insuranices this will probably be a range of acceptance limits, depending upon the trade being carried an in the premises and usually linked to different construction standards. For example, an insurer will be comfortable accepting a higher sum insured for an office risk than for a plant where plastics are manufactured. ‘So what happens when a risk is offered to an insurer but the amounts at risk are greater than the insurer's retention limits for that category? The insurer has the option of declining to insure the risk. However, they will not wish to do thisif the only reason is one of size and in all ‘other respects the risk is of good quality. The insurer must find a way of sharing the risk with others and the two common ways of doing this are co-insurance and reinsurance. There is also a third way insurers occasionally sharo risk: sometimes thoy come together to form a pool and agree to jointly underwrite particular risks. These are usually designed to cover catastrophic risks, such as terrorism or earthquake. i Co-insurance ‘The term 'eo-insuranee’ is used in two distinct ways by those in the insurance market. The first of these relates to risk sharing betwoen insurers; the second we will consider section IIA, For property insurances in particular, an insurer may choose to share a risk by ‘moans of co-insuranco. This involvos an insurer agreoing with other insurers the rating and terms to be applied and issuing what is known as a collective policy. Each insurer receives a stated proportion of the premium and pays the same proportion of any losses that occur. ‘The leading office is the first namod insuror in tho policy and invariably carries the largost share of the risk. Its the leading office that is responsible for issuing the dacumentation, Each time a change is required the leading office issues closing instructions to each of the \surers advising thom of the proposed change and requesting their agrooment. Thoy provide this by issuing signing slips to indicate confirmation for their share. ws way of shaving fk by meanest Peorctey