financial services lecture 4 1 chara charalambous cda college

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FINANCIAL SERVICES

LECTURE 4

Chara Charalambous CDA COLLEGE


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Outcomes

Types of business: what risks are insurance and what is the purpose of insurance? What is pure risk and what is speculative risk?Conditions that must be met in order to arrange insurance.Contracts of insurancePrinciple of ‘utmost good faith’What is the insurable interest?The UK insurance marketBancassurance


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Definitions

Insurer or underwriter A person or company that insures: offering insurance

policies in return for premiums (fees). It contracts to cover another in the event of loss or damage. Also named the underwriter.

Policyholder or insured A person or organization covered by insurance. Insurance Cover against events which might occur e.g. fire, theft

e.t.cAssurance Cover against events which are certain to occur e.g.

death


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Definitions

Industrial life insurance

Refers to an insurance which provides insurance coverage to industrial workers or people who are unable to afford insurance for bigger amounts. Here a fixed amount is given in case of accident or death. They are also known as burial policies, small death benefits and street insurance. It is paid weekly or monthly and the amount is small. The roots of this insurance are in the industrial revolution.

Ordinary life insurance

insurance on the life of the insured for a fixed amount, at a specific premium that is paid each year in the same amount during the entire lifetime of the insured. The amounts of cover and the premiums paid are considerably higher for ordinary life than for industrial life.


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Insurance BusinessTypes of Business

It is possible to arrange insurance for virtually any eventuality (possible event). The more normal types of insurance business are many and varied and include life and annuity (income), accident, sickness, fire, damage to property, motor vehicle, aviation, general liability and legal expenses.

The purpose of insurance is to spread the risk or losses that threaten everyone but which will actually happen to a few of the potential sufferers. Because the costs are shared by many, each individual has to pay less than would otherwise have been the case. A premium will be paid by the person or body that wishes to arrange insurance at a level which is usually far less than that of the potential loss that might be incurred. The insurance company which is providing the cover and has accepted the risk, will have done so on the basis of statistical evidence which suggests that only a proportion of those insured will make a claim.


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example

As an example an insurance company may provide one hundred car-owners with £5000 insurance cover for damage to the vehicles. Each of these car owners pays an annual premium of £100. if ten of the car-owners during the year each makes a claim for £500 then both the car owners and the insurance company will have found that insurance was a sensible financial move. In this very simplified example the car-owners who have made a claim will have been relieved of considerable expense, those car-owners who have not made a claim will have had the benefit of insurance protection and the insurance company will have made a profit. In real life the targeted profit margin would not be so high.


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Insurance companies generally are only interested in insuring pure risk – that is a situation in which, if the even which is insured against happens, then loss or damage of one sort or another occurs. This is the case when a car is stolen or stock destroyed.

Speculative risk refers to the fact that there is a chance of gain as well as of loss. This risk is uninsurable. For example in setting up a new business profits might occur if the business is successful but losses might occur if it is not.

Only pure risks are insurable because they involve only the chance of loss. They are pure in the sense that they do not mix both profits and losses. Insurance is concerned with the economic problems created by pure risks. Speculative risks are not insurable. Both speculative risk and pure risk involve the possibility of loss. However the speculative risk also involves the possibility of gain as well even of there is no loss. In order to understand the difference between the two:

Investing in the stock market is an example of the speculative risk. One can only speculate on whether the investment will produce a profit or loss. Insuring an automobile is an example of pure risk. If the insured auto is involved in an auto accident, there is most definitely going to be some sort of damage (loss). On the other hand if no accident occurs there is no possibility of gain. And that’s the difference.


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Speculative risks involves the possibility of loss and gain.

Pure risks involve the possibility of loss only.


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In order for a risk to be insurable a number of conditions need to be met. These are:

I. That the insurer (insurance company) must be able to calculate the probability and the severity of the loss

II. That the loss must be measurable in monetary terms

III. That the risk is not speculative riskIV. That the possible loss must be

sufficiently large to justify the cost of arranging the insurance.


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Contracts of insurance

An insurance contract is setting out the terms of the insurance and the premium payable and is undertaken by two parties: the underwriter or insurer and the policyholder or insured.

Some policies provide for a ‘cooling off’ period – this is a set number of days during which the policyholder can cancel the policy.


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Once the contract is in force , both parties have specified rights and obligations:

I. The policyholder must pay premiums in accordance with the terms of the contract. In addition he must also be obliged to disclose any material events – an example is driving assurance and alterations to a vehicle.

II. The insurance company in turn is obliged to make future payments to the policyholder on the occurrence of specified risks.


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In arranging insurance the principle of utmost good faith applies: minimum standard that requires both the buyer and seller in a transaction to act honestly toward each other and to not mislead or withhold critical information from one another. The principle of utmost good faith applies to many common financial transactions. .

In the insurance market, the principle of utmost good faith requires that the party seeking insurance discloses all relevant personal information. For example, if you are applying for life insurance, you are required to disclose any previous health problems you may have had. Likewise, the insurance agent selling you the coverage must disclose the critical information you need to know about your contract and its terms.

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Insurable Interest

A right, benefit, or advantage arising out of property that is of such nature that it may properly be compensate.

In the law of insurance, the insured must have an interest in the subject matter (property which is valuable and thus insured and protected) of his/ her policy or otherwise such policy will be void and unenforceable since it will be regarded as a form of gambling. An individual normally has an insurable interest when he or she will obtain some type of financial benefit or other kind of benefit from the continuous existence of the insured object - subject matter (or in the situation of living persons, their continued survival) or will sustain economic loss from its damage or harm when the risk insured against occurs.Chara Charalambous CDA COLLEGE

Insurable interest is not dependent upon who pays the premiums of the policy. In addition, different people can have separate insurable interests in the same subject matter, thing or property.

For example, when a ship is mortgaged, and the mortgage has become absolute, the owner of the legal estate has an insurable interest, and the mortgagor, on account of his equity, has also an insurable interest.

Typically, insurable interest is established by ownership, possession, or direct relationship. For example, people have insurable interests in their own homes and vehicles, but not in their neighbours' homes and vehicles, and certainly not those of strangers.

In certain fields, the innocent purchaser of a stolen car, who has a right of possession superior to all with the exception of the true owner, has an insurable interest in the automobile. This is not the case, however, where an individual knowingly purchases a stolen automobile.


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During 1700s people took out life assurance policies on the lives of famous people such as the king or Queen, politicians and others. On the death of these people the policyholders, who had not suffer any financial loss, were able to collect from the underwriters the insured sum.

The development of the concept of insurable interest as a prerequisite for the purchase of insurance distanced the insurance business from gambling, thereby enhancing the industry's reputation and leading to greater acceptance of the insurance industry. The United Kingdom was a leader in that trend by passing legislation that prohibited insurance contracts if no insurable interest could be proven, notably the Life Assurance Act 1774 which makes such contracts illegal, and the Marine Insurance Act 1906, which make such contracts void.

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Finally in respect of liabilities it is possible to insure one’s liability to others. Examples of this are motorists being required by law to insure their liability for injury to third parties and dentists who insure their liability for injury caused to patients from their actions.


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The UK insurance market

The British insurance market is big business. Not only do insurance companies arrange insurance in the UK but they also account for a significant amount of world business and earn substantial sums by exporting services.

The segments of the Insurance Market

INSURERS INTERMEDIARIES

INSUREDS

Proprietary Companies

Brokers Personal

Mutuals Consultants Commercial

Lloyd’s Agents


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The previous table shows the segments into which the insurance market can be divided and the components of each of those segments.

Lloyd’s is UK insurance company providing services in over 200 countries and territories

What is mutual insurance?

A mutual insurer is an insurance undertaking which is collectively owned by its members who are at the same time its clients (policyholders). Traditionally, all clients (policyholders) of a mutual insurer are members. In some fields, however, mutual insurers also have policyholders who are not members. Typically, every member of the mutual has an equal vote in members’ meetings .

mutual insurance continue…. Since mutuals are not established through the provision of capital by their

members and do not have any shareholders, they do not have to reward equity investors by paying dividends. Proprietary companies have shareholders. Generally therefore, mutuals:

are able to construct their products in a very competitive way; are able to retain profits in the company to build up reserves for good risk

provision and future growth; have the possibility to re-distribute profits to membership, e.g. via refunds

and rebates; have the possibility to establish particular bonds with their employees, e.g.

by including them in result-related remuneration schemes; have no need to keep their eyes fixed on shareholder value, on maximising

returns to capital investors or on the development of the price of their own shares;

are protected to takeover bids – this, together with other characteristics, fosters long-term strategic planning and means the undertaking does not have to be managed in line with short-term interests;

engage strongly with their local communities. Instead of focusing on short-term profitability, the management of a

mutual can look at broader aspects, such as ethics, democratic governance, and a wider social responsibility, and can enter into intense interaction with member-policyholders about their needs and expectations.


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Acting in the best interest of its members Enhanced information to member-policyholders,

competitiveness and long-term vision allow mutual insurance companies to offer member-policyholders high-quality services at a low price. .

The basic characteristics of a mutual make it possible to avoid certain conflicts of interest that can emerge institutionally in other corporate structures and that usually require time and energy to identify and address.

National farmers Union and Standard Life are mutual companies. The Guardian Royal Exchange and Sun Alliance are examples of proprietary companies.


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Proprietary companies

Of the insurers the proprietary companies are the most important sector , comprising some 800 or so registered insurance companies licensed to trade in the UK. All are public companies. Some are small specialist firms offering particulars types of insurance only. At the other end are combined companies, so called because they transact most classes of insurance business including fire, theft, motor, liability, life and personal accident.

As Britain is the leading insurance market, many overseas-based insurance companies have set up operations there. Names such as Australian Mutual Life or Zurich life indicate the country of origin.


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A recent trend has been for large firms to form their own insurance companies as part of a diversification plan. One example is the Black horse insurance company which was formed by Lloyds Bank initially for the transaction of household insurance arranged for the bank’s customers. In 1985 the Royal Bank of Scotland set up its own insurance company for the writing of motor insurance . Later in 1991 the Abbey National, Halifax, Leeds and Woolwich have all formed their own insurance companies.

Various Building societies have set up their own life companies: for example Britannia Life for the Britannia Building Society.


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The term bancassurance is beginning to take hold. The concept refers to banking and insurance products being provided by the same organization. (integration-lecture 1)

The advantages of bancassurance include:

I. Increase in sales and the resulting income and profits

II. Enabling an independent arm as well as a tied life assurance company to operate within the same group.

III. The ability to use the existing customer base for possible sales

IV. Greater opportunities to use branches for ‘one-stop’ financial services shopping

V. Life companies generally having long term profitability


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The disadvantages include:I. The capital needed to set up the

companyII. Understanding the different sales

process involved in life salesIII. Having the structure to cope with the

sales processIV. Changing the culture of the

organization away from a deposit-based business.

Lloyd’s of London is unique. It consists of underwriters who are technically in the position of being sole traders. The underwriters are organized into teams or syndicates which tend to specialize in particular areas of insurance.

A syndicate may have just a few members or up to several hundred. To become a member it is necessary to have significant disposable income that is not tied up in a property. Syndicates operate as separate firms but all share common facilities for the transaction of business in the Lloyd's building where business is accepted from brokers.

Intermediaries are those who introduce insurers to policyholders . They may be individuals, partnerships, small companies or large financial institutions. Insurance brokers are the most important sector of the intermediaries market.

A client using a broker should obtain a number of benefits by doing so. Firstly brokers deal with a wide range of insurers from the company markets and Lloyd’s. Secondly the broker will shop around to find the best deal for the client , thereby saving the client time and effort. Thirdly brokers have access to computers which enable quotations from several companies to be obtained and compared very quickly.


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Commission: is the reward which insurance companies pay to those who find the policyholders. It can be paid as percentage of premium at each renewal date or paid up front when the client signs the direct debit to commence payments or a combination of the two.

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financial services lecture 4 1 chara charalambous cda college

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