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NATURE OF INSURANCE
How Insurance Works
Introduction 3.1 Definition 3.2 How Does Insurance Work? 3.3 Concept of Common Pool 3.4 Law of Large Numbers 3.5 Insurance Premium 3.5.1 Breakdown of the Premium 3.6 Characteristics of Insurable Risks 3.6.1 Financial Value 3.6.2 Large number of similar risks 3.6.3 Pure risk only 3.6.4 No catastrophic loss 3.6.5 Fortuitous loss 3.6.6 Insurable interest 3.6.7 Legal and not against public policy 3.6.8 Reasonable premium 3.7 Function of Insurance 3.7.1 Primary function 3.7.2 Secondary function 3.7.3 Indirect functions
Characteristics of Insurable Risk
Function of Insurance
Insurance is an agreement whereby a group of individuals facing similar risks can share the fortuitous losses of the unlucky few by the transfer of such risks to the insurer who agrees to compensate the losses.
not all of whom will suffer losses in any one year. These premiums are then pooled together.HOW DOES INSURANCE WORK? Insurance works because the insurer can collect premiums from a group of people in similar circumstances. . and used by the insurer to pay losses. Losses are thus shared out among all the policyholders rather than borne solely by the unlucky few.
the closer the actual losses experienced by the .CONCEPT OF COMMON POOL Insurance uses a common pool concept. In a nutshell it involves contributions from many insured pooled together to pay for losses suffered by a few. The common pool mechanism involves the following: An insurance company sets itself up to operate the pool It takes contributions. in the form of insurance premiums from many insured's and pay for the losses of a few Law of large numbers – the larger the group of similar risks.
In fixing the premium.LAW OF LARGE NUMBERS The application of the law allows the insurer to fix premium/contribution to the pool in advance. The effect of this is that the person insuring knows he will not have to pay any premium at the end of the period of insurance. In addition. insurer has to consider the other operating costs and the profit of the insurer in fixing the premium. the insurer has to assess the risk and fix a premium which reflects the hazard and value of the risk which an insured brings to the pool. .
INSURANCE PREMIUM Contribution from many insured RM100 Common Pool RM600 Contribution from many insured The calculation of premium for insurance of nearly every kind is based upon the application of the principles of probability to past experiences The principle of probability is that chance may be represented by a fraction. the numerator of which express the number of time the event may posibly happen .
the premium rate actually charged for insurance is the gross premium rate Gross premiums or commonly known as office premium have 4 main components: Pure Premium Rate Expense loading Contingency loading Profit loading Page 41 & 42 .A BREAK DOWN OF THE PREMIUM ( GROSS PREMIUM) An insurance company has to incur expenses. pay out commissions. provide for variation in losses and earn a small profit in the course of assuming the risks.
RISK PREMIUM RATE Risk premium: Portion of the office premium that insurance must recover from each policyholder in order to cover the expected claim costs in the period of insurans. Risk premium= Risk premium rate X Value at risk Risk premium rate: Average total claims X 100 = $ % Average total value insured .
. Why? To enable the insurer to predict loss based on the law of large numbers If there are a few exposures the principle of losses of a few to be borne by many will not apply.CHARACTERISTIC OF INSURABLE RISKS Financial value: an insurable risk should involve a loss that is capable financial measure Large number of similar risks: there must be large number of similar risks before any one of the risks is capable of being insured.
CHARACTERISTIC OF INSURABLE RISKS Pure risk: Only pure risk can be insurable but not speculative risk. . A pure risk exist when there is a chance of loss but no chance of gain Speculative risk are less predictable and therefore generally uninsurable No catastrophic loss: a catastrophic loss arise when a large number of exposures incur losses at the same time.
Insurable interest: A person cannot insure a risk in which he does not have any insurable interest or legally recognized financial interest in the subject matter of insurance.CHARACTERISTIC OF INSURABLE RISKS Fortuitous loss(accidental): The happening of the event must be entirely accidental. since it involve no uncertainty of loss and therefore no transfer of risk would be taking place. It is not possible to insure against an event which will definitely occur. .
CHARACTERISTIC OF INSURABLE RISKS Legal and not against public policy: Common principle of law stated that contracts must not be contrary to what society would consider to be the right and moral thing to do.s claim handling expenses. the insurance premium required to cover a risk worth a few cents may be quite unreasonable in relation to the potential loss in view of the insurer. On the hand. . It is not acceptable to insure against the risk of criminal venture. Reasonable premium: A risk that has a very high probability of loss or near certainty would involve a premium that may be unreasonable from the prospective insured’s point of view.
provides the stimulus to business activity It also means that jobs may not be lost and goods or services can still be sold .THE BENEFITS OF INSURANCE Peace of mind: The knowledge that insurance exist to meet the financial consequences of certain risks provides a form of peace of mind Loss control Insurers do have an interest in reducing the frequency and severity of losses not only to enchance their own profitability but also to contribute to a general reduction in the economics waste that follows from losses Social benefits The fact that the owner of a business has the funds available to recover form a loss.
THE BENEFITS OF INSURANCE Investment of funds Insurers invest in a wide range of different forms investment (securities.shares etc) By having spread of investments. It helps the domestic economy to achieve a surplus in the balance of trade . the insurance industry helps national and international governments in their borrowing Invisible earnings Insurance is a source of invisible earning to Malaysia.
THE FUNCTIONS OF INSURANCE Risk transfer mechanism Insurance provide some form of financial security It will not prevent any of the risks from occuring The owner can transfer the financial consequences of the risk to the insurer in return for paying a premium .
the closer the actual losses experienced by the group will approach the expected losses The greater the number of similar risks.THE FUNCTIONS OF INSURANCE Creation of the common pool An insurance company sets itself up to operate a pool It takes contributions. in the form of insurance premiums form many insured and pays losses of a few Based on the Law of Large Numbers (the larger the group of similar risk. the more accurate the insurer can be in predicting future .
THE FUNCTIONS OF INSURANCE Equitable premiums Individual pool are organized for different types of risk. Even when risks of a similar type are brought together in common pool. they do not represent the same degree of risk to the pool itself This is differing magnitude of risk or hazard and this will be reflected in the contributions which each will make to the pool No subsidization of risk and each person must be prepared to make an equitable contribution to the pool they represent .
Stimulate business enterprise The risk transfer mechanism provided by insurance has made possible and has helped to maintain the present day large scale industrial and commercial organizations. .SECONDARY FUNCTION Releasing funds otherwise tied up in reserves Through the purchase of insurance. business enterprises and others are able to avoid the necessity of freezing capital to provide financial protection against losses. The fund released would be available for investment.
SECONDARY FUNCTIONS Insurance also stimulates business in other ways: It facilitates financing of property by banks and other financial institutions: and It facilitates overseas trade Remove fear and worry Insurance helps to remove fear and worry for losses of individuals and business executives. The removal of fear and worry of such losses helps to establish confidence and improve personal efficiency of business executives. .
.SECONDARY FUNCTIONS Reduction of losses Insurers help to reduce losses both in frequency and severity through their actions and recommendation in rating. inspection and salvage activities. insurance provides a climate in which savings are encouraged. survey. Life insurance (endowment assurance)is often used as a means of savings. Savings By protecting the individual against unforeseen events.
SECONDARY FUNCTIONS Social benefits Insurance benefits the society indirectly through: compensation paid by insurers to insurers which reduced the cost of social services. . and workers of a factory destroyed by fire might have to face unemployment had the factory been uninsured.
whilst Britain is a net exporter of insurance. Malaysia is a net importer of insurance. Invisible exports Insurance can contribute considerably to a country’s balance of payments as an invisible exports.INDIRECT FUNCTIONS Investment of funds Insurers accumulate large funds which they hold as custodians and out of which claims are met. These funds are usually invested (to earn interest/income) in the public and the private sector. . For example.
. Classes of insurance Insurance business is broadly classified into (1) Life Assurance and (2) General Insurance.INDIRECT FUNCTIONS Source of employment The insurance industry in Malaysia has generated numerous employment opportunities.
INDIRECT FUNCTIONS Risk Covered By Life Assurance Premature death Continuous stream of income during retirement (i.e. old age) Sickness or Disability Risk Covered By General Insurance General Insurance contracts can be arranged to provide cover against the following forms of risk to insured and third parties for damages arising in respect of: Motor vehicles Marine and aviation Products or goods sold .
General insurance subjected to the principle of indemnity. In general insurance. Most form of general insurance the contract is for a term of one year and is cancelable. . cannot canceled by the company and therefore usually a long term contract which include a savings or investment features In life insurance principle of indemnity is not applicable. by either party. a house insured under a fire policy may or not be lost.DIFFERENCE BETWEEN LIFE AND OTHER FORM OF INSURANCE Life assurance General Insurance The event that is contemplated in life assurance is a certain event The contract may be terminated by the insured. before the term has expired.
In other word. Insurer will take a reasonable step to overcome such case by applying average when loss occurred. the value insured is inadequate or insufficient to cover for a particular loss or damage. Under-insurance: a situation which the subject matter of insurance is under insured. Example: any property or subject matter which the insured value is less than the actual value Sum insured<cmv .
Over-insurance: a situation which the subject matter of insurance is over insured. normally insurer will pay claim in full when such claim arises. Sum insured>CMV . Example: any property or subject matter which the insured value is more than the actual value. In other word. the value insured is excessive to compare with the actual value of such subject matter. Regardless the excess condition.
fire occurred and his bungalow is partially damaged. At the time of loss the value of the house is RM650. After investigation carried by loss adjuster. (3 marks) .000. the loss suffered is worth RM125.000.000. Razlan insured his bungalow under a standard fire insurance policy with sum insured of RM525. Eight months later. Calculate the claim amount payable (4 marks) Explain why Razlan would not get the full amount of loss.
000 Loss : RM 125. Calculate the claim amount payable and explain why Razlan would not get the full amount of loss. Claim amount payable: Sum Insured : RM 525. 000 Value of house : RM 650. 000 . 000 Current MV at time of loss: RM 550.
will not receive the full amount because under insurance exist. in settling a claim.000 x (525. especially fire insurance. Claim Payable : loss X (Sum insured / value of house) RM 125. Basically.962 Razlan . average is applied in settling the claim because the insured will not be placed greater than what he enjoyed immediately before the loss occurred. In this case.000 / 650. . insurer will take into consideration the market value of the subject matter rather than sum insured.000) = 100.
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