RISK MANAGEMENT

UNIT 2

INSURANCE
Definition

Insurance is a contract, represented by a policy, in which an individual or entity receives

History

Rome

Rome used the bottomry contract to issue out loan to merchants with the provision that if the
shipment was lost at sea the loan did not have to be repaid. The interest on the loan covered
the insurance risk.

Ancient Roman law recognized the bottomry contract in which an article of agreement was
drawn up and funds were deposited with a money changer. Marine insurance became highly
developed in the 15th century.

England

Fire insurance started in England after the great fire of London in 1666. A number of insurance
companies were started in England after 1711, during the bubble era. Many of them were
fraudulent, get-rich-quick schemes concerned mainly with selling their securities to the public.
Nevertheless, two important and successful English insurance companies were formed during
this period—the London Assurance Corporation and the Royal Exchange Assurance
Corporation. Their operation marked the beginning of modern property and liability insurance.

No discussion of the early development of insurance in Europe would be complete without

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becoming recognized as the most likely place to find underwriters for marine insurance. Edward
Lloyd supplied his customers with shipping information gathered from the docks and other
sources; this eventually grew into the publication Lloyd’s List, still in existence. Lloyd’s was
reorganized in 1769 as a formal group of underwriters accepting marine risks. (The word
underwriter is said to have derived from the practice of having each risk taker write his name
under the total amount of risk that he was willing to accept at a specified premium.) With the
growth of British sea power, Lloyd’s became the dominant insurer of marine risks, to which
were later added fire and other property risks. Today Lloyd’s is a major reinsurer as well as
primary insurer, but it does not itself transact insurance business; this is done by the member
underwriters, who accept insurance on their own account and bear the full risk in competition
with each other.

United States

The first American insurance company was organized by Benjamin Franklin in 1752 as the
Philadelphia Contributionship. The first life insurance company in the American colonies was
the Presbyterian Ministers’ Fund, organized in 1759. By 1820 there were 17 stock life insurance
companies in the state of New York alone. Many of the early property insurance companies
failed from speculative investments, poor management, and inadequate distribution systems.
Others failed after the Great Chicago Fire in 1871 and the San Francisco earthquake and fire of
1906. There was little effective regulation, and rate making was difficult in the absence of
cooperative development of sound statistics. Many problems also beset the life insurance
business. In the era following the U.S. Civil War, bad practices developed: dividends were
declared that had not been earned, reserves were inadequate, advertising claims were
exaggerated, and office buildings were erected that sometimes cost more than the total assets
of the companies. Thirty-three life insurance companies failed between 1870 and 1872, and
another 48 between 1873 and 1877.

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Russia

Insurance in Russia was nationalized after the Russian Revolution of 1917. Domestic insurance
in the Soviet Union was offered by a single agency, Gosstrakh, and insurance on foreign risks by
a companion company, Ingosstrakh. Ingosstrakh continues to insure foreign-owned property in
Russia and Russian-owned property abroad. It accepts reinsurance from foreign insurers.
However, following the movement toward a free market economy (perestroika) after 1985 and
the breakup of the Soviet Union in 1991, some 230 new private insurers were established.

Gosstrakh offers both property and personal insurance. The former coverage is mandatory for
government-owned property and for certain property of collective farms. Voluntary property
insurance is available for privately owned property. Personal coverages such as life and
accident insurance and annuities also are sold.

Before 1991, insurance against tort liability was not permitted, on the ground that such
coverage would allow negligent persons to escape from the financial consequences of their
behaviour. However, with the advent of a free market system, it seems likely that liability
insurance will become available in Russia.

Eastern Europe

After the breakup of the Soviet Union, countries in eastern Europe developed insurance
systems of considerable variety, ranging from highly centralized and state-controlled systems to
Western-style ones. Because of recent political and economic upheavals in these countries, it
seems likely that the trend will be toward decentralized, Western-style systems.

A few generalizations about insurance in eastern European countries may be made. Although
state insurance monopolies are common, they are losing some business to private insurers.
Insurance of state-owned property, which was considered unnecessary in socialist states, has
been established in several countries.

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Japan

Insurance in Japan is mainly in the hands of private enterprise, although government insurance
agencies write crop, livestock, forest fire, fishery, export credit, accident and health, and
installment sales credit insurance as well as social security. Private insurance companies are
regulated under various statutes. Major classes of property insurance written include
automobile and workers’ compensation (which are compulsory), fire, and marine. Rates are
controlled by voluntary rating bureaus under government supervision, and Japanese law
requires rates to be “reasonable and nondiscriminatory.” Policy forms generally resemble those
of Western nations. Personal insurance lines are also well developed in Japan and include
ordinary life, group life, and group pensions. Health insurance, however, is incorporated into
Japanese social security.

Worldwide operations

Because of the great expansion in world trade and the extent to which business firms make
investments outside their home countries, the market for insurance on a worldwide scale
expanded rapidly in the 20th century. This development required a worldwide network of
offices to provide brokerage services, underwriting assistance and claims services. The majority
of the world’s insurance businesses are concentrated in Europe and North America. These
companies must service a large part of the insurance needs of the rest of the world. The legal
and regulatory hurdles that must be overcome in order to do so are formidable.

Insurance companies

An insurance company is a business that provides coverage, in the form of compensation

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Types of insurance company in Sierra Leone

Principle of Insurance

There are seven basic principles that create an insurance contract between the insured and the
insurer, these principles are;

 Indemnity

The principle of indemnity ensures that an insurance contract protects you from and
compensates you for any damage, loss, or injury. The purpose of an insurance contract is to
make you "whole" in the event of a loss, not to allow you to make a profit. Thus, the amount of
your compensation for a loss is directly related to the amount of loss that you actually suffered.

 Contribution

Contribution is a similar principle to indemnity, and it applies to situations where you have
more than one insurance policy for the same asset or entity. For example, imagine that you
own a truck that is insured by both Company A and Company B. If another driver hits your truck

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and it will cost you $5,000 to fix it, you can submit your claim to Company A, Company B, or to
both companies. If Company A compensates you fully, then it can claim a proportionate
contribution from Company B. However, if both companies compensate you fully, you can't
keep the full amount and turn a profit, because this would amount to an unfair windfall.

 Insurable Interest

The insurable interest principle requires that the owner of a particular insurance policy have an
ownership interest in the particular subject matter of the insurance policy. For example, the
owner of a hot dog cart has an insurable interest in the cart because he owns it and is earning
money from it. However, if he sells the hot dog cart, this means he will no longer have an
insurable interest in it. Creditors also have an insurable interest in debt. The absence of an
insurable interest can make the insurance policy in question null and void.

 Subrogation

Subrogation means that one party stands in for another. In the insurance context, subrogation
will arise if you are injured by a negligent third party, and your insurance company reimburses
you for your damages. Under the principle of subrogation, your insurance company can stand in
your shoes and recover the pay-out from the negligent party. The goal of this principle is to
encourage responsibility and accountability by holding negligent parties responsible for injuries
they cause.

 Loss Minimization

As the owner of an insurance policy, you have an obligation to take necessary steps to minimize
the loss of your insured property. The law doesn't allow you to be negligent or irresponsible just
because you know you're insured. For example, if a fire breaks out in your kitchen, you have an
obligation to take reasonable steps to put it out, like using a fire extinguisher or calling the fire
department. You can't just stand back and allow the fire to burn down your house because you
know that insurance will pay for it.

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  Proximate Cause

The principle of proximate cause, or nearest cause, comes into play when more than one event
or bad actor causes an accident or injury. An example would be if two separate landowners
carelessly burn piles of leaves, and the fires eventually join together and burn down your
house. The insurance principle of proximate cause dictates that nearest or closest cause should
be taken into consideration to decide the liability.

 Utmost Good Faith

Insurance contracts also require that both parties act with the utmost good faith. This means
that both parties must accurately and fully disclose all material information. This not only
ensures fairness, but also helps insurance companies accurately price premiums for insurance
applicants. Insurance policies can be declared null and void if an applicant made a
misrepresentation of material fact that was relied on by the insurance company.

Insurer business Model

Insurance companies base their business models around assuming and diversifying risk. The
essential insurance model involves pooling risk from individual payers and redistributing it
across a larger portfolio. Most insurance companies generate revenue in two ways: Charging
premiums in exchange for insurance coverage, then reinvesting those premiums into other
interest-generating assets. Like all private businesses, insurance companies try to market
effectively and minimize administrative costs. Below are the different model used by insurance
companies;

 Pricing and Assuming Risk

Revenue model specifics vary among health insurance companies, property insurance
companies, and financial guarantors. The first task of any insurer is to price risk and charge a
premium for assuming it. Suppose the insurance company is offering a policy with a $100,000
conditional payout. It needs to assess how likely a prospective buyer is to trigger the conditional
payment and extend that risk based on the length of the policy.

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This is where insurance underwriting is critical. Without good underwriting, the insurance
company would charge some customers too much and others too little for assuming risk. This
could price out the least risky customers, eventually causing rates to increase even further. If a
company prices its risk effectively, it should bring in more revenue in premiums than it spends
on conditional payouts.

 Interest Earnings and Revenue

Suppose the insurance company receives $1 million in premiums for its policies. It could hold
onto the money in cash or place it into a savings account, but that is not very efficient: At the
very least, those savings are going to be exposed to inflation risk. Instead, the company can find
safe, short-term assets to invest its funds. This generates additional interest revenue for the
company while it waits for possible payouts. Common instruments of this type include Treasury
bonds, high-grade corporate bonds, and interest-bearing cash equivalents.

 Reinsurance

Some companies engage in reinsurance to reduce risk. Reinsurance is insurance that insurance
companies buy to protect themselves from excessive losses due to high exposure. Reinsurance
is an integral component of insurance companies' efforts to keep themselves solvent and to
avoid default due to payouts, and regulators mandate it for companies of a certain size and
type.

For example, an insurance company may write too much hurricane insurance, based on models
that show low chances of a hurricane inflicting a geographic area. If the inconceivable did
happen with a hurricane hitting that region, considerable losses for the insurance company
could ensue. Without reinsurance taking some of the risks off the table, insurance companies
could go out of business whenever a natural disaster hits.

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Regulators mandate that an insurance company must only issue a policy with a cap of 10% of its
value unless it is reinsured. Thus, reinsurance allows insurance companies to be more
aggressive in winning market share, as they can transfer risks. Additionally, reinsurance reduces
the natural fluctuations of insurance companies, which can see significant deviations in profits
and losses.

For many insurance companies, it is like arbitrage. They charge a higher rate for insurance to
individual consumers, and then they get cheaper rates reinsuring these policies on a bulk scale.

 Evaluating Insurers

By reducing the fluctuations of the business, reinsurance makes the entire insurance sector
more appropriate for investors.

Insurance sector companies, like any other non-financial service, are evaluated based on their
profitability, expected growth, payout, and risk. But there are also issues specific to the sector.
Since insurance companies do not make investments on fixed assets, there is little depreciation
and very small capital expenditures. Also, calculating the insurer's working capital is a
challenging exercise since there are no typical working capital accounts. Analysts do not use
metrics involving firm and enterprise values; instead, they focus on equity metrics, such as
price-to-earnings (P/E) and price-to-book (P/B) ratios. Analysts perform ratio analysis by
calculating insurance-specific ratios to evaluate the companies.

The P/E ratio tends to be higher for insurance companies that exhibit high expected growth,
high payout, and low risk. Similarly, P/B is higher for insurance companies with high expected
earnings growth, low-risk profile, high payout, and high return on equity. Holding everything
constant, return on equity has the largest effect on the P/B ratio.

When comparing P/E and P/B ratios across the insurance sector, analysts have to deal with
additional complicating factors. Insurance companies make estimated provisions for their
future claims expenses. If the insurer is too conservative or too aggressive in estimating such
provisions, the P/E and P/B ratios may be too high or too low.

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The degree of diversification also hampers comparability across the insurance sector. It is
common for insurers to be involved in one or more distinct insurance businesses, such as life,
property, and casualty insurance. Depending on the degree of diversification, insurance
companies face different risks and returns, making their P/E and P/B ratios different across the
sector.

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