basic insurance.pdf

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Learn Insurance

INSURANCE BASICS

© 2004 Insurance Australia Group Limited ABN 60 090 739 927


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Learn Insurance

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Introduction: Insurance – helping you through life. 3

Part 1 - Insurance basics 4What is insurance? 4

History of insurance 5

Important parts of insurance 7What is risk? 7

What is an insurance premium? 7

How do insurance companies calculate the insurance premium they charge? 8

What is a claim? 12

Types of insurance claims 13

What can be insured? 13

What do insurance companies do? 14

How much of the premiums customers pay goes back into paying claims? 16

How to reduce risk 18

Part 1 Revision 22

Part 2 - Insurance industry overview 23

Part 3 - Premiums, profits and losses 27

Part 4 - Risk 32

Part 5 - Business and Community Sustainability 33

Part 6 - Glossary 37

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Contents

DISCLAIMER

The information contained within this document is of a general nature.

It is for educational purposes only and is not intended to be comprehensive, complete or advice.

While all due care has been taken in the preparation of this document, we take no responsibility and expressly disclaimall liability incurred by any person in connection with the document or its contents to the extent permitted by law.

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Learn Insurance

Introduction

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Insurance – helping you through life

Insurance plays an important part in people’s lives by taking out the worry and helping the

whole community.

Insurance is all about ‘pooling’.

A large number of people pay a small amount of money into a ‘pool’.

For example if their property is damaged, stolen or destroyed or if someone suffers an injury,the ‘pool’ is there to help pay for repairs, replacement or compensation for injury.

This means those who put money into the ‘pool’ may not have to pay some or all of the

repair, replacement or in case of injury, the medical and associated costs.

Insurance gives peace of mind, letting people get on with their lives.

While this basic ‘pooling’ principle of insurance is simple, the workings behind insurance are

fairly complex.

This document is designed to provide a better understanding of insurance, including car,home and contents insurance.

This document has information about:

• the history of insurance and how it has developed over the centuries;

• how insurance works, including how the price of insurance is set and the differences

between the various types of insurance available;

• how an insurance company runs;

• the insurance industry in general;

• why and how insurance companies try to reduce risk to make communities safer – on the

road, in the home and in workplaces.

This document has been developed by Insurance Australia Group Limited (IAGL), and has

been reviewed by National Curriculum Services, a group that professionally design and

produce curriculum materials and address the professional development of schoolteachers

nationally.

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Part 1 - Insurance Basics

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1Learn Insurance Contents

The idea of ‘pooling’.

People pay an insurance premium to an insurance company,

but not all those people will make a claim.

What is insurance?

In broad terms, insurance is about a person putting a small amount of money into a ‘pool’ with other

people to cover, for example some or all of the cost of repairing or replacing their valuables if they are

lost, damaged or stolen, or to help pay compensation to a person if they are injured.

Insurance is all about a group of people or a community sharing risk. In this sense insurance is a

community product. Through an insurance company, people in the community, pool their premiums to

pay the claims of those insured with that insurance company.

When a person needs to make a claim, insurance companies must ensure that there is enough money

in the ‘pool’ to meet the cost of that claim. Insurance involves a large number of people paying a small

amount of money to make sure the few who need to make a claim are covered.

Most people own something valuable, such as a car, house, furniture, boat or a business.

They also have other valuable things, such as their health and the ability to work.

It is important to protect what is valuable.

One of the ways people protect what is valuable is by taking out insurance.

The advantage of having insurance is that it allows the community to pool risks. This takes away theneed for people to pay the full cost of loss or damage on their own, which in some cases, could, if it

occurred, leave people in great financial difficulty.

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History of insuranceInsurance has been around for a long time.

Since the time of Chinese traders 7,000 years ago, insurance has been used to reduce the risk of thetraders getting into financial trouble and going broke.

Over the centuries, people have joined together and cooperated to reduce risks, such as accidents ortheft. This included living in groups to reduce the risk of attacks from wild animals or other people,and to increase the amount of food they could gather or hunt.

Similarly today, people buy insurance by paying some money into a pool to replace or repair damagedor stolen cars or belongings, to rebuild houses or help them recover from an accident.

Insurance is ‘pooling’ the money of many to support those, who have put money into the ‘pool’, thatare unfortunate enough to have an accident or be affected by a disaster or suffer a loss.

History of insurance - Ancient China

In about 5,000 BC, instead of putting all their property in just one boat, Chinese traders spread theirgoods over several boats.

If one boat sank, no individual trader went broke.

If two traders spread their goods over two boats and one boat sank, each would lose only a half oftheir goods rather than everything they owned.

Each of these traders had to sell their goods far from home. The only way they could get their goodsto the buyers was by boat. Many risks were involved in sailing the boats from port to port, throughrough seas, chance of shipwreck, getting lost or being raided by pirates.

These traders could do business in two ways. The ‘high risk’ way was to go alone and have all theirgoods in just one boat and do nothing about reducing their risk. The ‘low risk’ way involved thetraders ‘pooling’ their risk by placing their goods on several boats.

Sharing the risk of losing goods was an early form of insurance. In the high-risk situation, the boat mightnot make it and the one trader could lose everything and go broke. In a low risk situation, even if a boatdid sink in rough seas, each trader would only lose a portion of their goods and none would go broke.

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History of insurance – Great Fire of LondonIn 17th century London, insurance companies did more than take a small amount of money from

many people to compensate them if their home burnt down. Some insurance companies directly paid

for some of Londons’ city fire brigades.

People who paid insurance companies to insure their home were given a ‘fire plate’ showing the

insurance company’s logo. This fire plate was fixed near the front door of their house.

If a house caught fire, the fire brigade would check if the house had a fire plate. If the house did not

have a fire plate, or had the fire plate of another insurance company, the fire brigade would let the

house burn down.

People who wanted the fire brigade to help them if their home caught fire, would each put in a little

money to help pay for the fire brigade to protect their house.

The idea was simple. If people pooled their money there would be enough to pay the fire brigade to

put out fires. The pool of money would also provide enough to help the house owner rebuild their

home if it was damaged or destroyed by fire.



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Important parts of insuranceInsurance is about people each ‘pooling’ a small amount of their money to reduce the risk of them

being financially impacted if, for example something valuable to them is damaged, destroyed

or stolen.

It can also include pooling money to reduce the risk of someone being financially impacted if they are

injured at work or in a car accident.

To help explain insurance, terms such as risk, premium and claims need to be explained.

In the following pages, we will describe insurance as it relates to motor, home and injury or disability

to people.

What is risk?

Risk is a word that is used often by insurance companies.

In insurance, risk means the chance of something unpleasant or unwelcome happening.

Risk is the chance that something valuable to a person might be lost, stolen, damaged or destroyed. It

can also mean the chance of a person being injured.

One of the things insurance companies do is to work out the cost of insurance premiums by assessing

and pricing risk. In other words, putting a financial value on the risk.

Assessing and pricing risk involves working out the chance of whatever is insured becoming accidentally

injured, lost, damaged or stolen, and how much it will cost to repair or replace what is insured.

Working out how much it costs to pay claims and how often people are likely to be injured or have

their property lost or damaged is a very important part of an insurance company’s work. This is called

pricing risk.

By pricing risk, insurance companies know how much money they need in the ‘pool’ to pay claims.

The better insurance companies are at pricing risk, the better they know how much money needs to

be in the ‘pool’ to pay their customers when they make a claim.

What is an insurance premium?An insurance premium is an amount of money a person pays to an insurance company for an

insurance policy. This payment could be regarded as transferring some or all of the risk (or cost) of

loss or damage. For example replacing, repairing or rebuilding a particular valuable if it is lost stolen,

damaged or destroyed.

This is also the same for insurance against accidents at work or on the road that may hurt and

injure people.

The cost of an insurance premium needs to take into account the:

Expected number of claims multiplied by the expected average claim size.



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How do insurance companies calculate the insurance premium theycharge?

No one knows for sure if or when what is valuable to someone will be accidentally lost, stolen,

damaged or destroyed or when someone could be injured on the road or at work.

Because of this, insurance is based on what may or may not happen in the future. Insurance

companies spend a lot of time trying to work out the chances of their customers having to make a

claim and the potential cost of that claim.

Generally the higher the risk of loss, theft, damage, destruction or injury, the higher the insurance

premium.

Not everyone’s risk is equal. So the amount people pay for their insurance cover or premium, may

differ depending on their own circumstances.

Insurance companies should try to make sure that every individual who has insurance pays a premium

that reflects their risk.

Insurance premiums are made up of different parts, including the cost of estimating, collecting and

managing the premiums, the cost of paying the claims, taxes, levies, duties, reinsurance costs, the

profit margin and the cost of the insurance company administering the insurance cover, and the cost

of insuring the particular valuable.

How premiums are set – Car insuranceInsurance companies typically set premiums depending on the amount of risk the insured valuable has

of being damaged, lost, stolen or injured.

For instance, with car insurance, premiums may be based on:

• the age and sex of the main driver and their driving experience and accident or traffic conviction

record;

• who else may be driving the vehicle;

• where the vehicle is used or kept;

• what the vehicle is used for, for instance if the vehicle is used for business purposes, as this may

mean it will be driven more and is more likely to be involved in an accident;

• the vehicle’s value, if the car is an exotic import with expensive and hard-to-get parts; and

• previous claims record.

Family cars with moderate repair costs may be cheaper to insure than large or powerful cars, which

may be more expensive to repair.

Some people may pay more for their insurance than others because their risk of an accident or theft is

higher. Others, for example, older drivers, may pay less, because they are statistically less likely to have

a car accident.

Insurance claims are typically more frequent in urban areas so motorists in cities may pay more for

their insurance than those who live in the country.



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Speeding Convictions - Insurers believe that there is a likely connection between the number ofspeeding convictions a person may have and their likelihood of making an insurance claim. Sometimes

people with speeding convictions may pay higher premiums until their driving record improves.

Drink Driving Convictions - Drink driving convictions are taken very seriously by insurers. Convicted

drivers returning to the roads may face difficulty in obtaining insurance and may have to pay far higher

premiums than before their conviction. The level of cover available may be reduced - for example from

comprehensive down to third party fire and theft. These higher premiums and cover restrictions may

apply for a number of years.

People should look after their car - Insurance policies may require that the car is in a roadworthy

condition. If the car is not roadworthy, it may affect the insurance cover.When buying or renewing motor insurance, the insurer’s questions need to be answered truthfully. For

instance the insurer needs to be informed about the details, or any changes to details such as address,

occupation, type of car and motoring convictions.

Some insurance companies provide information on their websites about the ratings on factors

such as how safe the car is, how likely the car is of being stolen, and how expensive the car is to

repair and run.

For example see; http://www.sgic.com.au/carresearch


http://www.sgic.com.au/carresearchhttp://www.sgic.com.au/carresearch


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How premiums are set – Home and house contents insuranceIn setting premiums for homes and house contents, insurers may start with the postcode of the

property to be insured. Postcodes enable insurers to identify a geographical area, thereby allowing

premiums to better reflect the claims experience in that locality.

Insurance companies may take into account a number of factors when setting premiums for home and

house contents insurance.

Some of these factors may include: the policyholder’s previous claims history, the houses’ postcode,

the sum(s) insured and the nature of the items insured, the size and style of the house, whether the

house is rented, or is occupied by the owner, if the house has a monitored security alarm and the

houses’ location; for example, whether it is in a bushfire or storm prone area.

For example, a person may discover they are paying more for their home insurance than their

neighbour is, even though they have the same kind of policy from the same insurance company.

There may be a logical explanation for this difference.

Perhaps one person’s house has a monitored security alarm, while their neighbour does not; maybe

their house is larger in square footage than their neighbour’s; or they have some valuable jewellery

listed on their insurance policy that their neighbour does not.

Some of these factors outlined above may be why a large country mansion may cost more to insure

than a smaller suburban unit.There are certain risks that some insurers will not agree to cover, because the odds are too great that a

loss will occur; for example, a home that is near a river that floods a lot.



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How premiums are set – Injury / Disability insuranceIn a similar way to how motor and home insurance premiums are set, some types of injury / disability

insurance premiums may be set depending on risk factors, including:

• person’s age;

• whether the person smokes;

• person’s medical history;

• person’s occupation, for example some occupations may be considered more risky and dangerous;

and

• person’s hobby, (they may like to indulge in what is considered a risky hobby, like skydiving).

Also with some types of injury / disability insurance, if the person has what is called a “pre-existing

condition” – an existing or previous illness that the insurer believes is likely to worsen or recur - there

may be some insurers that will not cover this risk.

An insurance premium is not like paying for a typical service or product because:

• Insurance companies are selling the customer a promise to cover what is insured by the insurance

policy. For example if the customer’s insured property is accidentally lost, stolen or damaged and

the customer makes a claim.

• The cost of paying a claim is not certain at the time the insurance policy (coverage) is sold.

• Insurance companies do not know what misfortune any of their customers may encounter.

Therefore, insurance companies may not know exactly how often a customer may make a claim.

• Insurance companies usually offer insurance cover for 12 months at a time and insurance premiums

usually need to be paid and renewed every 12 months.



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What is a claim?A claim occurs when a person contacts their insurance company seeking what they are entitled to

under a policy of insurance because, for example, the property they have insured with that insurance

company is lost, stolen, damaged or destroyed. For instance, a person damages their car in an

accident. They have an insurance policy that covers the damage caused by the accident. They contact

the insurance company to request it repair the vehicle or pay for the repairs.

A person, who has paid a premium to an insurance company, to cover a loss, can go to the insurance

company and make a claim. If their claim falls within the insurance cover offered by the insurance

policy, the insurance company can use the money from the ‘pool’ to pay the claim.

Paying the claim is the moment of truth for the insurance company.

When an insurance company pays a claim, it is keeping its promise to pay the claims of those who

have suffered a loss from the ‘pool’ created by many.

Paying claims is what insurance companies do. Making sure enough money is in the ‘pool’ to pay

claims should be a main task of an insurance company.

Making a claim

An insurance claim can only be made if a premium has been paid for an up-to-date insurance policy

that covers risk. This means that a person has to contribute to the ‘pool’ before they are eligible to

make a claim.

Some general steps that may be relevant in making a claim include:

• Contacting the police, for instance, if the claim involves theft, a serious car accident or any crime;

• Trying to prevent further damage or loss if it can be done safely;

• Contacting the insurance company as soon as possible. Some insurance companies allow certain

claims to be made over the telephone, meaning there may not be a need to fill out a claim form. It

also means that the insurance company can begin processing the claim immediately. However if a

claim form needs to be filled out the insurance company should be able to send a claim form when

they are contacted or there may be downloadable claim forms on the insurance company’s website;and

• Keeping a written record of what happened, as it is easy to forget about some small details that

might prove to be important later on. Also any supporting evidence, such as receipts should be kept.

The insurance policy needs to be read. Insurance policy holders would have received one when they

paid their insurance premium. Of course, its in everyones’ best interests if people check what is

covered in their insurance policy when they first buy, or renew their insurance. The insurance company

may send out a loss or claims assessor to look at and check the claim for the loss or damage. The

Insurance Council of Australia has a General Insurance Code of Practice, which sets out rules that

insurance companies, that are members of the Insurance Council of Australia, must follow. The

General Insurance Code of Practice outlines principles and standards about the insurance claims

handling process.

The Insurance Code of Practice can be found at: http://www.ica.com.au/codepractice/ .


http://www.ica.com.au/codepractice/http://www.ica.com.au/codepractice/


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Types of insurance claimsInsurance companies sometimes categorise claims into two groups, known in the insurance industry as

short tail and long tail. The “tail” refers to the time it takes for the claim to be settled.

In broad terms short tail claims are generally:

• claims usually known and settled within a short period of time, usually within 12 months;

• not hard to manage;

• easy to work out the exact amount to be paid out; and

• are often based around property.

In broad terms long tail claims generally:

• often relate to personal injuries;

• are sometimes not even reported within 12 months, (like the effects of an injury);

• are claims that can take three to four years and sometimes as long as 20 years to settle;

• are harder to work out the final amount to be paid out; and

• are sometimes based around medical and legal outcomes.

What can be insured?

Almost anything that is valuable can be insured, including a person’s health.

However, not all insurance companies provide insurance for everything.

Below is a list of some of the things that insurance companies may cover.

PERSONAL LINES COMMERCIAL

SHORT TAIL

• Private Motor

• Home, Contents

• Personal Effects

• Boat

• Caravan / Trailer

• Health

• Travel

• Transport Accident

• Consumer Credit

• Fleet Motor

• Fire, Explosion

• Burglary, Theft

• Goods in Transit

• Construction

• Personal Accident / Travel

• Credit

• Political Risks

• Kidnap & Ransom

LONG TAIL

• Compulsory Third Party (statutory)

• Home Liability

• Workers Compensation (statutory)

• Public & Products Liability

• Product Recall• Professional Liability

• Defamation

• Environmental



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Small and frequent lossesHome contents insurance against burglary is an example where the risk is of small and frequent loss. It

does not usually cost too much to replace what is stolen from a house, but burglary is not uncommon.

FOR EXAMPLESay every year 100 in every 1,000

houses suffers a burglary (1:10 loss),at a cost of $900 per burglary.

If a householder has no insurance,they risk having to pay the full $900 ifthey experience the 1:10 loss, due to

their house being burgled.

However if the householder has home

contents insurance and if the homecontents insurance costs, say, $90 perhouseholder per year, then a group of1,000 householders pooling together

pays $90 each to pay for the costsof goods stolen. Over 10 years the

individual householder has paid $900.

What are insurance companies expected to do?

Although most people may not see it as such, insurance could be regarded as the ultimate

community product.

Customers and the community should expect insurance companies to:

Affordable

Pay Claims

Insurance companies need to make sure they have enough

money to pay claims, otherwise they are not living upto their promise to the community.

Price Risk Fairly

Some people will pay higher premiums into the pool becausetheir risk is higher. If insurance companies price risk fairly, they

will stay in business and can continue to pay claims.

If insurance companies underprice, they may notsurvive as they will pay out more in claims than they

are taking in premiums.

If insurance companies overprice, people may not beable to insure their valuables at all.

Minimise Cost

There are costs involved in running an insurance company.If insurance companies minimise costs, they will be

able to do business with less costs. This will help keep

insurance affordable.

Help Reduce Risk

Helping reduce risk is an integral part of what insurancecompanies should do.

If insurance companies work with customers and thecommunity to make homes, workplaces and roads

safer, fewer people will have to make a claim, insurancecompanies can keep the costs of insurance down. This is a

benefit to the community.

Accessible



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How much of the premiums customers pay goes back into paying claims?As an example the graph below shows that about 54% of all the money paid into the ‘pool’ from

Insurance Australia Group’s customers goes back into paying claims.

CONTRIBUTIONS TO THE COST OF RUNNINGTHE INSURANCE AUSTRALIA GROUP’S BUSINESS (2004)

Source: IAG SUSTAINABILITY REPORT 2004 (Page 28 on the full PDF REPORT):www.iag.com.au/sustyreport04

Disclaimer: This graph is indicative only and constructed for educational purposes.

What is the difference between insurance companies and other financial businessessuch as banks?

Insurance, unlike banking, is not a ‘guaranteed’ investment. Money will only be taken out of the ‘pool’

if there is a claim that is covered by the insurance policy. Also there is the possibility that a particular

person, who has put money in the ‘pool’ may never make a claim.

If everyone made a claim every year, there may not be enough money in the ‘pool’ and insurance

companies may not be able to operate.

With a bank, customers pay money into their bank savings account.

That money, plus interest, will be available to them whenever they decide to withdraw that money.

When people pay an insurance premium to an insurance company, they are getting a promise from

the company that they will pay if the customer makes a claim that falls within what is covered in their

insurance policy.

Insurance is often referred to as buying “peace of mind” in case of an accident, loss or disaster.

Commissions

6%Reinsurance Expenses

5%

Underwriting &Administration

12% Claims Expenses54%

Government Levies& Taxes

18%

Underwriting Profit

5%


http://www.iag.com.au/sustyreport04http://www.iag.com.au/sustyreport04


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An insurance company’s workAn insurance company needs to do many things to fulfil its promise to its customers and return profits

to its shareholders or members.

These tasks include:

• Pricing risk (working out the right price of insurance premiums);

generally if the cost of premiums is too high, fewer people will pay for the insurance and the pool

may not have enough money in it to pay claims;

generally if the cost of premiums is too low, there may not be enough money in the pool to pay for

claims.

• Paying claims that fall within what is covered in the insurance policy;

if the insurance company does not pay fair and honest claims, covered by the policy, it will lose

customers, and be held accountable by the Government Regulators and industry associations.

• Administration of insurance policies;

insurance companies must be efficient and not use too much of the ‘pooled’ money to pay the

costs of running the company.

• Investing pooled funds (premiums);

if the insurance company is good at investing some of the ‘pooled’ money waiting to pay claims,

then the interest from that money can help ensure there is enough money in case many people

make a claim at the same time, or can be used as profit.

• Managing capital;

insurance companies need money set aside to ensure that there is always enough money in the‘pool’ even if there are many claims all at the same time. This may happen if a large natural disaster

like a bushfire or big storm or cyclone occurs. The money that is set aside by insurance companies is

called capital.



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How to reduce riskInsurance is one way of managing risk.

The best way to reduce the risk of loss or damage to things that are valuable is to take precautions

against mishaps, accidents or theft happening at all.

An example of some of the things that can be done to reduce risk and improve security in the home or

car are outlined at:

http://www.nrma.com.au/crimesafebooklet

Some insurers are also helping to reduce the risk of injuries in the workplace, an example is at:

http://www.nrma.com.au/pub/nrma/about_us/media_releases/20040826a.shtml

How do insurance companies work out the risk?

This is called underwriting

Not all risks are the same. Insurance companies need to consider many things when they are pricingthe risk of a person who wants insurance for something valuable to them.

Below are some of the things insurance companies may look at when they are working out how tomatch up the amount of premium customers pay to the risk that these customers have:

Specific Socio Demographic Economic Catastrophic

Individual Risk• Driver ability• Driver age• Gender

Asset Risk• Type of car

• Type of finance

• Area • Inflation• Exchange rates• Cost of parts• Fuel prices

• Hail• Earthquake• Bushfires• Cyclone


http://www.nrma.com.au/crimesafebooklethttp://www.nrma.com.au/pub/nrma/about_us/media_releases/20040826a.shtmlhttp://www.nrma.com.au/pub/nrma/about_us/media_releases/20040826a.shtmlhttp://www.nrma.com.au/crimesafebooklet


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What is underinsurance? How could underinsurance affect you?Underinsurance is when a customer pays an insurance company an insurance premium for an insurancepolicy that does not cover the full cost of the customer’s loss. For instance if the insurance cover does notmatch the cost of replacing a house, contents or a car.

For example; a house owner may have an insurance policy that will pay $100,000 if their home isdestroyed in a fire and another $25,000 to replace or repair the contents of the house.

If the house burns down, and it costs $150,000 to rebuild and $50,000 to replace the contents, thecustomer will have to make up the shortfall. In this case, the true cost is $200,000, but the customerwas only covered for $125,000. This means they will need to find $75,000 of their own money torebuild their homes and replace their contents.

People should review their insurance regularly, at least once a year to make sure they have the rightamount of insurance.

Some useful web-based interactive home and contents calculators are available.

For example see: http://www.nrma.com.au/homecalculators

What is overinsurance?

Overinsurance is also an issue. If it costs $90,000 to rebuild a house and $20,000 to replace thecontents, but it is insured for $100,000 to rebuild and $50,000 to replace the contents, then theremay be overinsurance.

In this case, the house and contents are insured for $150,000 (which is called the sum insured).However the true cost of rebuilding and replacing the contents is $110,000. This means the houseand contents is overinsured by $40,000. In this example, if the house did burn down, the insurance

company may only cover the true costs of rebuilding the house and replacing the contents, (in thisexample $110,000), and not the sum insured.


http://www.nrma.com.au/homecalculatorshttp://www.nrma.com.au/homecalculators


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Reinsurance

What is reinsurance?

Reinsurance is ‘insurance for insurers’.

It is a way of moving the risk that one insurance company takes on from its customers into a pool thatother insurance companies also share.

Reinsurance is just the same as insurance for people; each insurance company puts some money into apool that is then shared by all the other insurance companies that have put money in.

Reinsurance helps to make sure that an insurance company has enough money to pay claims if manyof its customers make claims at the same time.

Each insurance company puts some money into a pool. This way, just like individuals, insurancecompanies can spread some of the risk.

Below are some examples of how reinsurance works:

1. A man pays an insurance company an insurance premium to have his large cargo ship insured for$20 million in case it sinks. The insurance company believes this is too great a risk, so it pays areinsurance premium to a reinsurance company to cover $18 million of this risk. If the ship doessink, the insurance company will pay the customer $20 million but will get back $18 million fromthe reinsurance company.

2. An insurance company may insure a number of homes and cars in your suburb or town. If thereis a large storm, many of the houses and cars may be damaged. The insurance company will pay

the claims from the home and car owners, then the insurance company, if they are reinsured forthis loss, will claim some of this money from the reinsurance company. This reinsurance coverscatastrophes. Catastrophes are natural disasters such as large hailstorms, earthquakes andbushfires.



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What rules do insurance companies have to follow?Insurance companies must obey the law.

Laws that are relevant to insurance companies include:

• financial services legislation;

• privacy laws;

• trade practice; and

• insurance contracts law.

Regulators that oversee the conduct of insurance companies include:• Australian Prudential Regulatory Authority (APRA) http://www.apra.gov.au

• Australian Securities and Investments Commission (ASIC) http://www.asic.gov.au

Note:

Australian Securities and Investments Commission (ASIC) have an informative Financial Tips and Safety

Checks (FIDO) website http://www.fido.asic.gov.au.

ASIC’s FIDO website includes good information about insurance and other consumer education

information.

In Australia there is legislation regulating insurance companies. Some of thislegislation and some areas covered by that legislation is outlined below.

CORPORATIONSACT 2001

• Financial Services Law

INSURANCE ACT 1973 • Regulation of general insurance companies, including regulatingcapital adequacy of those insurance companies

INSURANCE CONTRACTSACT 1984

• Regulation of information provided to consumers

• Defines duty of disclosure for consumers

• Limits areas in which a claim may be denied or policy cancelled

AUSTRALIAN SECURITIESAND INVESTMENTSCOMMISSIONS ACT 2001

• Misleading and deceptive conduct

• Unconscionable conduct.

PRIVACY ACT 1988 • Regulating the collection, use and disclosure of personalinformation.


http://www.apra.gov.au/http://www.asic.gov.au/http://www.fido.asic.gov.au/http://www.fido.asic.gov.au/http://www.asic.gov.au/http://www.apra.gov.au/


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22


Part 1 Revision

What is insurance?

Insurance is about a person putting a small amount of money into a pool with other people to cover

the cost of claims. For example when a person’s property is lost, stolen, damaged or destroyed, or if

they are injured, that person can draw from the ‘pool’ of money to replace or fix their property or fund

their recovery.

People who have put money in the pool should not have to pay the full amount to cover their loss

or accident.

What is a premium?

A premium is the amount of money a customer pays an insurance company for the insurance policy.

For example to cover the customer’s property if it is lost, stolen, damaged or destroyed or help them

recover from an accident.

The premium is the amount of money the person puts into the ‘pool’ of money. Once this premium is

paid the customer receives an insurance policy from the insurance company.

An insurance policy is an agreement setting out what is covered, under what circumstances, for how

much and for how long.

What is a claim?

A claim occurs when a person contacts their insurance company seeking what they are entitled to

under a policy of insurance because, for example, the property they have insured with that insurance

company is lost, stolen, damaged or destroyed. For instance, a person damages their car in an

accident. They have an insurance policy that covers the damage caused by the accident. They contact

the insurance company to request it repair the vehicle or pay for the repairs.

If the person has an insurance policy that covers the particular valuable being claimed, they should

expect the insurance company to honour the agreement, (policy) and repair or replace the lost or

damaged item, or pay the customer the amount of money set out in the insurance policy.

What is an insurer and what should an insurer do?

An insurer accepts a premium from a person or a business to cover, for instance, property if it is lost,

stolen, damaged or destroyed or for compensation for a person if they are injured.

The insurer/insurance company manages a ‘pool’ of money.

The insurer/insurance company pays claims covered by the insurance policy, and prices risk (the premium).

An insurer should help the community manage and reduce risk (accidents, crimes, disasters)

through education.



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Part 2 - Insurance Industry Overview

23


Insurance Industry Overview – The World

How much is spent on insurance a year?

Total Insurance Market Size in 2002 – US$ Billions

Source: Swiss Re, Economic Research and Consulting,

Sigma No 8/2003 Refer to www.swissre.com Research & Publications

Although all the information used in this study was taken from reliable sources, Swiss Reinsurance Company does not accept anyresponsibility for the accuracy or comprehensiveness of the details given. The information provided is for informational purposesonly and in no way constitutes Swiss Re’s position. In no event shall Swiss Re be liable for any loss or damage arising in connectionwith the use of this information.

Top 5 General Insurance Markets compared with Australia (US $Billions)

Source: Swiss Re, Economic Research and Consulting,

Sigma No 8/2003 Refer to www.swissre.com Research & Publications


General Insurance$1,53658%

Life Insurance$1,091

42%

UK

$77AUSTRALIA

$14

USA

$520

JAPAN

$91

GERMANY

$75

FRANCE$75


http://www.swissre.com/http://www.swissre.com/http://www.swissre.com/http://www.swissre.com/


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24


Insurance Industry Overview – Australia

Geographical Spread of Premiums

Source; Selected Statistics on the General Insurance Industry’, June 2002, produced by the Australian Prudential Regulation Authority.

© Australian Prudential Regulation Authority (‘APRA’) 2005.The copyright in this material belongs to APRA.Reproduction in unaltered form for your personal, non-commercial use is permitted.Other than for any use permitted under the Copyright Act 1968, all other rights are reserved.

Classes of Insurance (% of total $18 billion premiums)

Source; Selected Statistics on the General Insurance Industry’, June 2002, produced by the Australian Prudential Regulation Authority.


WA

8%TAS

2%

NSW

51%

VIC

19%

ACT

2%NT0.5%

QLD

13%

SA

5%

Workers

5%Other

7%

Home

14%

Motor(Domestic & Commercial)

26%

Liability

6%

Professional Indemnity

3%

Fire

9%

Compulsory Third Party

11%

Inward Treaty

14%

Accident

5%



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25


Insurance Industry Overview

Is the general insurance pool growing?

Yes. Historically the market has grown 11% each year despite thecollapse of HIH Insurance in 2001, the industry has recovered quickly.

Australian general insurance industry growth by line of business

Other

Employers Liability

Public & Product Liability

Professional Indemnity

Domestic Motor Vehicle

Commercial Motor Vehicle

CTP

Householders

Fire and Industrial Special Risk

G r o s s W r i t t e n P r e m i u m i n $ B i l l i o n s

OtherEmployers LiabilityPublic & Product Liability

Professional IndemnityDomestic Motor VehicleCommercial Motor Vehicle

CTP - Compulsory Third Party InsuranceHouseholdersFire and Industrial Special Risk

1992

25

20

15

10

5

01995 1996 1997 1998 1999 2000 2001 2002

Source; Selected Statistics on the General Insurance Industry’, June 2002, produced by the Australian Prudential Regulation Authority.*HIH not included in 2002.


Insurance industry overview – trends

Price Increases - The Insurance Market Cycle

Source: JP MORGAN 2002

Underwriting Profits Peak

Capacity Increases

Competition Increases /Rates Deteriorate

Loss Ratio Begins to Rise /Rates Continue to Fall

Major Underwriting Losses

Capacity Leaves

Underwriting Profits Peak

Rates Rise

Loss Ratio Improves



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26


Insurance industry overview – trendsThe impact of September 11, 2001:

• Reinsurers increased pricing and reduced capacity worldwide.

• Increased financial instability of reinsurers as a direct result of September 11, 2001 losses.

Largest insurance losses internationally – trends $ billions (as at 2003)

Source: PWC Insurance facts and figures 2003.

Converted to Australian dollar from Swiss Re Sigma no.2/2003


2001

1999

1994

1992

1991

1990

0 10 20 30 40

September 11, New York, USA 30+

15.8

30.3

36.6

13.3

Storms - Lother & Martin, Western Europe

Northridge Earthquake, California, USA

Hurricane Andrew, Miami, USA

Typhoon Mireille, Japan

Storm Daria, UK 11.3



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Part 3 - Premiums, profits and losses

27


How insurance companies operate

The different financial parts of an insurance premium

Premiums =

Gross Written Premium (GWP)

Is the total amount the insurance company receives from customers who

pay their insurance policies.

Net Earned Premium (NEP)

The net premium is the gross premium received by the insurance company

less reinsurance costs.

How insurance companies work out their underwriting profit/loss

Net EarnedPremium

Is the total amount

the insurance

company receives

after making

adjustments for

‘reinsurance’ costs.

–

Claims & ClaimsExpenses

This is the amount

paid out during

the year, as well

as an estimate of

how much the

insurance company

needs to meet

future claims.

–

UnderwritingExpenses

These include

the cost of

research and

pricing premiums,

as well as the

cost of running

the insurance

company.

=

UnderwritingProfit/Loss

This is the profit/

loss the insurance

company makes

from its insurance

business before

it adds any other

money it makes

from investments.



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28


How insurance companies operate

How insurance companies work out their insurance profit/loss

Underwriting Profit/Loss

This is the profit/loss an

insurance company makes

from its insurance business

before it adds any moneyit makes from other

investments.

(Net Earned Premium

minus the claims and

underwriting expenses - as

shown on previous page)

+

Investment Income from

Technical Reserves

Technical reserves are the

funds held by an insurance

company. They representthe money customers

have paid through their

premiums that has not yet

been paid out to customers

who may one day make a

claim. Insurance companies

make money on these

investments.

=

Insurance Profit

The insurance company

profit is worked out by

adding the Underwriting

Profit/Loss to theInvestments Income the

insurance company make

from their technical reserves.

How insurance companies work out their net profit/loss

Insurance Profit

The insurance

company profit

is worked out

by adding the

Underwriting

Profit/Loss to

the Investments

Income the

insurance

company make

from their

technical reserves.

+

Investment

Income from

Shareholders

Fund

This is the income

received from the

capital supporting

the business.–

Tax

This is the income

tax expense on the

company’s profit.

=

Net Profit/Loss

This is the final

amount after

allowing for

income taxes and

the share of profit

owing to minority

shareholders/unit

holders within the

company.

• A working example of this can be seen on the Insurance Australia Group Annual Report 2004 (page 12).

Refer: http://www.iag.com.au/annualreport


http://www.iag.com.au/annualreporthttp://www.iag.com.au/annualreport


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29


How much does it cost an insurance company to run its business?Insurance companies try and keep the costs of running their business low. This means that less of the

premiums they charge customers is eaten up in administration costs. Lower administration costs can

mean lower insurance premiums.

The cost of running an insurance company – of selling and collecting premiums, paying claims and

administration costs is sometimes called an insurer’s combined operating ratio or COR.

IAG’s Combined Operating Ratio (COR)

The sum of all claims, administration and underwriting costs as a percentage of Net Earned Premium.

85%

80%

90%

95%

100%

105%

110%

115%

120%

1998 1999 2000 2001 2002 2003 2004

Short Tail Long Tail

Data is for Insurance Australia Group (IAG) only as at the year end 30 June 2004



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30


Insurance companies’ requirement for capital

What is capital?

Capital is the money any company uses to invest in, to start or expand its business. In an insurance

company, capital is what the company needs to set aside or reserve in addition to the money in the

‘pool‘ collected from customers who have paid their insurance premiums.

Capital gives an insurance company’s customers security that the insurance company should have

enough money to pay claims covered within their insurance policies.

Why do insurance companies have capital?Capital provides a buffer against a large number of claims occurring at the same time. This could

happen after a natural disaster, such as a large storm, earthquake or bushfire.

Capital is also held to fund future growth.

Usually to determine the amount of money needed in the ‘pool’ to pay claims, insurance companies

look at all the different risks of their customers and average them out.

How much capital an insurance company needs is influenced by the type of risks its customers face.

• If the loss or damage is small but happens frequently, such as car insurance claims, then the total

amount required in the ‘pool’ for the claims, is easier to work out; and • If the loss or damage is larger, but happens less often, such as an earthquake or large storm,

then the total amount required in the ‘pool’ for the claims is much harder to work out.

The premiums insurance companies charge customers go into the ‘pool’ and pay for EXPECTED losses

(through customers making a claim) plus the administration expenses of running the insurance company.

EXPECTED losses have about a 50 per cent chance of occurring. This involves half of all customers

making a claim at the same time.

However, insurance companies must also have capital in reserve to pay for UNEXPECTED losses. That is

when the number of claims by customers is more than the expected number of claims.



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How do insurance companies work out how much capital they need?Usually the insurance companies’ profit margins from the premiums they charge customers is enough

to top up the ‘pool’ when UNEXPECTED losses arise from there being many more claims from

customers than expected.

How much capital is enough?

Customers who have paid their premiums and government regulators, such as the Australian Prudential

Regulatory Authority (APRA), have the right to expect insurance companies to have enough capital to

pay claims.

This is because it is important for Australians to know there will always be enough money in the ‘pool’to pay all claims, no matter how many claims are made.

The higher the amount reserved in capital, the greater the chance

there will always be enough money to pay claims.

It is important for insurance companies to be able to calculate and balance how much capital they

should keep.

Too little capital Too much capital

Means the ‘pool’ is too small and the

insurance company runs the risk of not

having enough money in this ‘pool’,

particularly if most of their customers

make a claim at the same time.

Means the ‘pool’ is too big and the

insurance company needs to make more

money, or take away money from its

profits, to fill this bigger pool.



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Part 4 - Risk

32


Why insurance companies should help the community reduce riskHelping reduce risk in the community is an important role for an insurance company.

When insurance companies help customers and the community make homes, workplaces and roads

safer, fewer people should have accidents, mishaps or losses and make fewer insurance claims. If there

are fewer claims, insurance companies should be able to keep the price of insurance premiums lower.

Insurance companies and communities working together to reduce risk may result in:

= the community understanding more about reducing risk

= fewer accidents, injuries and losses

= fewer insurance claims

= cheaper and more accessible insurance.

Insurance companies can educate the community and raise its awareness about reducing risk through:

Programs with police, neighbourhood groups, schools and authorities that:

• reduce the frequency of crime;

• increase awareness of better home and car security; and

• encourage offenders to develop work skills.

Programs with fire services, customers, schools and community groups that:

• help pay for fire-fighting equipment; and

• develop educational material about fire awareness.

Partnerships with young driver education programs and authorities about:

• road and pedestrian safety; and • vehicle modifications and how that may impact the safety and insurance of cars.

Partnerships with community safety groups such as:

• first aid groups that help provide training and equipment to people at work and in the

community; and

• local community groups that encourage people to lead a safer and healthier lifestyle.

Partnerships with schools that:

• increase students’ financial literacy levels; and

• increase understanding of the links between climate change and natural insurable events such

as storms, floods and bushfires.



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Part 5 - Business and Community Sustainability

33


Sustainability and insurance companiesSustainability for insurance companies is about ensuring they are around in the future for the benefit

of their shareholders, customers, employees and the community.

Insurance companies are sustainable when they recognise a clear link between their business and the

social, environmental and economic well being of the communities they serve.

For an insurance company, a healthy and secure community is an essential part of sustainability.

Sustainability in the community

EconomicInsurance in one sense can be regarded as a community product. It makes economic and social sense

to pool effort and resources. This leads to a less risky way of life. If a society has a healthy economy,

then our resources may be used more sustainably and the social and environmental risks are reduced.

Environmental

A balanced healthy environment is very important to the sustainability of the community and to business.

Climate change has a significant impact on the environment, communities and insurance companies.

Climate change continues with increasing amounts of greenhouse gases in the atmosphere.

This global temperature warming is creating more weather related disasters more frequently.

When storms, bushfires and floods occur more frequently, insurance companies face more insurance

claims. This will result in higher premiums to cover the increased amounts of money that is required in

the ‘pool’ to pay these claims.

Social and Safety

Social sustainability is linked to the health and safety of everybody in the community. A safer

community is in everyone’s interest.

The incidence of crime and accidents in the community directly affects how insurance companies

calculate risk and set insurance premiums.

Insurance companies have a responsibility to help create safe communities by helping people

understand and manage the risks they face in their daily lives – at home, at work and on the roads.

What are some insurance companies doing about sustainability?

Insurance companies can play a significant role in helping develop sustainable communities.

It makes good sense for an insurance company to help the community reduce social, environmental

and economic risks.

The following examples show what insurance companies are doing to build sustainability:



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34


Global warming / climate change:

Why is climate change important to insurance companies?

Climate and weather have direct impacts on insurance business.

Insurance is provided to cover damage or loss caused by storms and bushfires. As weather patterns

get less predictable it will be difficult for insurance companies to calculate the correct cost of

insurance premiums.

A major hailstorm in Sydney in 1999 caused enormous damage to cars and homes. Claims totalled

about $1.7 billion.

If storms like this increase in frequency, as predicted by scientific groups like the Intergovernmental

Panel on Climate Change (IPCC), then the cost of premiums will inevitably rise.

Even small increases in wind strength, such as from 93kms/hour to 111kms/hour, can increase building

damage by over sixfold.*

In the same way, there is a disproportionate increase in damage to motor cars as hail stones increase in size.*

Also, a one-degree rise in the average summer temperature results in a 17-28 per cent increase in

bushfires.*

* These findings are outlined in the Insurance Australia Group - ‘The Impacts of Climate Change on

Insurance Against Catastrophe’ report. This can be found at:http://www.iag.com.au/climatechange


http://www.iag.com.au/climatechangehttp://www.iag.com.au/climatechange


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35


What are insurance companies doing about climate change?Some insurance companies have spent a lot of money and time researching climate change and the

impact it has on insurance.

The findings from this research have encouraged insurance companies to help the community to

reduce risks caused by climate change.

Some insurance companies sponsor community education programs that:

• help people understand where to build and where not to build in flood prone areas;

• help governments prepare enforceable building codes;

• look at reducing customers’ car insurance premiums if they use the train or bus to get to workeveryday rather then their car. This helps reduce pollution and, over time, global warming. It willalso decrease the number of car crashes insurance companies have to pay claims for; and

• support research into climate change and distribute the findings broadly to assist the communityunderstand the impacts of climate change.

Some insurance companies are also reducing the amount of pollution, waste and greenhouse gasesthey produce through their internal operations.

Programs to reduce their environmental impact include using more environmentally friendly cars,recycling paper in the office, installing energy efficient appliances, and minimising water use. All ofthis will reduce negative impacts on our natural environment.

Companies that have recognised the benefits of sustainability know that they need to set an exampleif they expect to help the community reduce the risks of climate change and global warming.

An example of what an insurance company is doing in regards to climate change can be found at:http://www.iag.com.au/sustainability


http://www.iag.com.au/sustainabilityhttp://www.iag.com.au/sustainability


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Energy efficient home goods replacement in the insurance claims process.Some insurance products cover the replacement of home contents such as microwaves, fridges,dishwashers and other whitegoods which may be stolen or damaged in occurrences such as house fires.

This presents an opportunity for insurance companies to recommend products, which are moreenvironmentally friendly either through reduced water usage or reduced energy consumption.

This has long-term benefits for the environment and reduces the amount of coal fired energy neededto produce the electricity to run these products.

This in turn reduces greenhouse gas emissions, which, of course benefits the environment and reducesthe impact on climate change.

Below are links to websites that can provide more information about energy efficient home goods and

appliances:

http://www.helphouse.com.au/whitegoods.html

http://www.sgio.com.au/pub/sgio/home/homehelp/environment/energy/everyday.shtml


http://www.helphouse.com.au/whitegoods.htmlhttp://www.sgio.com.au/pub/sgio/home/homehelp/environment/energy/everyday.shtmlhttp://www.sgio.com.au/pub/sgio/home/homehelp/environment/energy/everyday.shtmlhttp://www.helphouse.com.au/whitegoods.html


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Part 6 - Glossary

37


CompensationCompensation is providing something (for instance money or payment) for a loss or as a result of a

loss. For example in the case of an injury to a person payment for lost wages while the person cannot

work or payment of medical expenses arising from the loss.

Insurance

Insurance is the idea of ‘pooling’. Insurance is when people pay an insurance premium to an insurance

company. This small amount of money goes into a ‘pool’ with payments from other people to cover,

for example the cost of repairing or replacing their valuables if they are lost, damaged, stolen, or

destroyed, or to compensate a person if they are injured. Not everyone will make a claim.

Insured

Is an person or organisation who has paid an insurance premium to an insurance company, and the

insurance company has accepted to cover them by insurance.

Insurer

An insurer is the insurance company. An insurer is the company that offers protection through the sale

of an insurance policy to an insured.

The insurer, (the insurance company) must provide sufficient capital and an efficient fundingmechanism for pooling of individual risks.

The insurer should have core competencies in:

• Underwriting and pricing of risks

• Payment of claims covered by the insurance policy

• Administration of insurance policies

• Investment of ‘pooled’ funds (premiums)

• Claim recoveries

• Capital management

Liability

Liability is when a person or organisation is responsible for something, especially in law.

Liability insurance can be designed to provide coverage for either the exposure on a business or

personal basis.

Mitigation

Mitigation is the action that reduces the chance and the severity, seriousness, or painfulness of an

accident or mishap happening.

Mitigation is also used to describe the action that reduces the effect of the accident after it happens.



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Part 6 - Glossary 6Learn Insurance Contents

PolicyA policy is the contract of insurance. It is a written agreement between an insurance company and the

insured that puts insurance coverage into effect.

Pooling

Pooling is when each member of a ‘pool’ contributes to that ‘pool’. Pooling is when a group of people

share (things) in common, for the benefit of all those involved.

Premium

A premium is the amount to be paid for the contract, (or policy) of insurance.

An insurance premium is an amount of money a person pays to an insurance company for an

insurance policy. This payment could be regarded as transferring some or all of the risk (or cost)

of loss or damage. The insurance company will assume, (or take on, accept, provide a cover for)

the risks of the insured (length of life, state of health, property damage or destruction, or liability

exposure) in exchange for a premium payment.

Premiums are calculated by combining expectation of loss and expense and profit loadings.

Reinsurers

Reinsurers provide “insurance for insurance companies”. This is a means of transferring risk from oneorganisation to another.

Reinsurance enables insurance companies to absorb large losses and remove uncertainty. However,

reinsurance does not enable the insurer to accept a risk it would otherwise not accept.

Reinsurance provides protection against:

• Catastrophic events

• Too much risk in one policy

Reinsurance is a form of insurance that insurance companies buy for their own protection, “a sharing

of insurance”.

Risk

Risk is the uncertainty of financial loss. Risk is any situation that involves the exposure to danger and

the possibility of something unpleasant or unwelcome happening.

Underwriting

Underwriting is when insurance companies manage the ‘pool’ to optimise the result. Because not

all risks are the same, underwriting involves examining, accepting, or rejecting insurance risks, and

l if i th l t d i d t h th i t i f h Th f


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