INSURANCE

Important of Insurance

Every individual business faces risks. It could be the risk of loss and damage to property, vehicles and stock due to fire, burglary, flood, accident and even theft by its own employees. It could be the risk of being sued for claims by members of the public, its customers and even by its own employees due to damages and losses suffered by these people as a result of its negligence. It could also be the risk of financial loss due to bad business decisions or unanticipated changes in demand for the business' goods. In return for a small premium, insurance underwriters are willing to offer a wide variety of insurance cover (see Types of Insurance) to the ordinary business to protect it against some of these eventualities. Should the insured risk occur, the business will be indemnified and protected?

It must be realized, however, that not all risks faced by the business is insurable. Some, such as loss due to bad business decisions and unanticipated changes in demand, are non-insurable.  The insurance premiums collected by the various insurance companies in the country forms a very important pool of liquid funds in the country. Apart from setting a certain proportion aside to meet the claims of those who do eventually suffer loss as a result of the insured risk occurring, the rest of the funds provide an important source of finance for the development of the national economy which are shown on the figure on the next page:

(a) Invested in shares in industry and commerce, at home or abroad;

(b) Lent out to businesses and families for example to purchase property;

(c) Lent out to central governments and local councils.

Insurance is of particular importance to the UK. Sale of general and life insurance policies of British Insurance companies abroad via overseas branches forms a very important part of her (UK) invisible exports. The repatriation of interest, dividends and profits from these overseas branches back to the UK also helps in her Balance of Payments.

Insurance is a pooling of risks to enable people to share risks. In life, everyone including businessmen, faces risks, resulting in losses. Any loss due to the insurer's risk materializing will be compensated for out of the common pool. The amount of compensation will be just enough to indemnify or restore the insured to the position he was in immediately before the loss. The indemnity will not exceed the amount originally insured for. The insurance company will have to study the risk involved for each insurance proposal. It will consider all factors that may make the insured risk more likely to happen. The basic principle is: The higher the risk, the higher the premium charged. The premium finally payable by the insured can be calculated based on:

(a) The insured value of the property;

(b) The tariff rate or the rate of premium quoted by the insurance company.

Illustration

After studying the risks involved for a certain proposal for fire insurance, the insurance company quoted a rate of 20 cents per $100. Suppose the value of property was $100,000, the total amount of insurance premium payable would be:

Rate quoted to insure property against fire 20 cents per $100

Insured value of property $100,000

Amount of premium payable  0.20 x 100,000 = $200

                                                    100

The premium payable ($200 per year) is so small compared to the amount of possible compensation payable, i.e. $100,000. 'This is because the total number of people who face the risk of loss due to fire is very great. It incorporates all owners of properties in the country. Therefore, the number of those who are willing to contribute to the central pool is very great. Consequently, the central pool is very big even though each insured pay a small premium. But only a small percentage of the total population who buys fire insurance will eventually suffer a loss. So, it is possible to pay the few unfortunate from the central pool. It is a case of the fortunate many (who did not suffer any loss due to fire) who help the unfortunate few (who did suffer a loss due to fire). This is the whole principle of 'pooling of risks'.

How Insurance Company Make Profit?

Insurance underwriters are in business providing an essential service to the public. In return, they hope to make a profit for their shareholders. Insurance underwriters sell insurance cover to their clients in return for insurance premiums. In order to reduce competition amongst themselves and to introduce stability into the business, they have introduced uniform practices such as adopting standard tariffs or rates of premium and standard forms of policy, especially in fire insurance. The proper management of funds will ensure that while there is sufficient liquid funds out of which claims can be promptly paid, the rest of the funds will be skillfully invested to earn an income in excess of their expenses so that the insurance company will make a profit.

Insurable and Non-Insurable Risks

Insurers (i.e. insurance companies and insurance underwriters) will only undertake to cover anyone against insurable risks. Insurable risks are those whose chances of occurring can be mathematically calculated by statisticians and actuaries from available statistical records. The calculated risk is then used as a basis for computing the premium to be charged. This must be high enough to ensure that the insurance company will not run at a loss in the long run, in order to meet the various claims from the central pool. The insurer is able to cover such a risk because:

a)    A large number of people who are subjected to the risk, are willing to pool their risks, by contributing premiums to a central fund;

b)    Only a small number actually suffers loss;

c)     Claims in the long run are less than the funds available to meet them.

Examples of insurable risks are perils at sea, fire, burglary, personal liability, motor accident and flood. Some risks are non-insurable because it is not possible to calculate the chances of their occurring as no statistical records of their occurrence are available. Hence, no insurer can calculate the premium. Examples of non-insurable risks are war and trade risks like business losses due to bad management, failure of demand, rise in costs, changes in fashion and bad debt.

Over-Insurance

A man insures his property which is worth only $10,000 for $12,000. It is NOT to his advantage to do this because:

(a)   He has to pay a higher premium than otherwise necessary.

(b)  He can NEVER get $12,000 even if his property is totally destroyed. The maximum compensation is only $10,000 since insurance is a contract of indemnity.

(c)    He should not knowingly over-inflate the value of his property since insurance is a contract of utmost good faith.

Under-Insurance

A man insures his property which is worth $10,000 for $8,000. He hopes to save on the insurance premium since he will be paying a lower premium. However, under-insurance is also not advantageous to him because:

(a)   His property is not fully covered. If it is totally destroyed, the maximum he could get is only $8,000, since premium is only paid for $8,000. If half of the property is destroyed, the amount he would receive as compensation would be half of the amount covered (i.e. ½ of $8,000), i.e. $4,000 even though the replacement value of the property destroyed is 5,000. This is because insurance is a contract of indemnity.

(b)  He should not knowingly deflate the value of his property since insurance is a contract of utmost good faith.

Principles and Doctrines of Insurance

These fundamental principles ensure that the whole basis of insurance — the pooling of risks — runs properly. The insured would not be able to defraud the insurer who will in turn be able to fulfill their obligations as contained in the insurance contract.

1. Insurable Interest: This applies to all contracts of insurance. We may only insure those things in which we have insurable interest. To have insurable interest in something is to be in danger of suffering loss or incurring some personal liability should the thing be destroyed or damaged in any way or to be able to derive benefits from its preservation. Examples:

(i)    I cannot insure my neighbor's house and property since I have no insurable interest in them.

(ii)   I can insure my own –V property, house, life, even my spouse's life or the life of the man who manages my business as I have insurable interest in these things.

(iii) I can insure my stock stored in a rented premises against fire although I cannot insure the premises (building) itself.

(iv)  A creditor may insure the life of his debtor up to the value of the amount owed.

2. Utmost Good Faith: This applies to all contracts of insurance. The insured must disclose fully all material facts known in answering all questions in the proposal form and in all dealings with the insurance company. The insurance company must be informed of factors that are likely to increase the chances of the insured risk occurring because it will base the computation of the premium on the truth of the information supplied. Failure to disclose the whole truth will make the policy void and the insurance company will refuse to pay compensation should a loss occur. Example: When 1 apply to insure my premises against fire, it is my duty to inform the insurance company if my premises contains goods which are inflammable.

3. Indemnity: This Applies to all contracts of insurance except life assurance and personal accident insurance. To indemnify' means to restore a person to the position that he was in immediately before the event concerned took place. Thus, all compensation to the insured who had suffered a loss would be to indemnify him, and NOT to allow him to make a profit out of his misfortune. Life assurance and personal accident policies are not contracts of indemnity because it is not possible to restore the dead to life, or to restore an amputated leg for instance, to one who has met with an accident. Instead, a lump sum called the 'benefit' is paid to the beneficiary. Examples:

(i)    A new motor car was insured for $100,000. After 6 months, it was totally wrecked in a motor accident.

(ii)   The owner would be paid compensation in the form of a sum of money which will enable him to buy a 6 month-old car of the same make, that is, depreciation on the car would be considered. If the current market value of such a car is $85,000, then the owner would get a compensation of $85,000. This is sufficient to indemnify him.

(iii) Mr X insured his stock against fire for $3,000. One-third of it was destroyed. Even if the replacement value of the stock destroyed was $1,100, Mr X, would only receive a proportionate compensation of $1,000 (1/3 of $3,000) as he had paid premium based on $3,000. If the replacement cost of the stock destroyed is $900, then Mr X would be reimbursed $900 even though he had paid a premium based on the higher figure. If Mr X's stock 5 p was totally destroyed, the maximum compensation he could get would be only $3,000 even though the replacement value might be $3,300.

• The First Corollary of Indemnity — Contribution: This applies to all contracts of insurance except life risks. Contribution' applies where a person has insured identical risks on the same property with a number of companies, or when policies overlap. The amount of the loss is shared proportionately between the insurance companies. Examples:

Ø Suppose Mr A insures his goods worth $1,000 against fire for $1,000 each with 3 insurance companies. In the event of a loss due to fire, Mr A would receive a maximum of $1,000; each of the insurance companies paying $333V3. He cannot receive $1,000 from each insurance company, or he would be making a profit.

Ø However, should Mr A insure his life for $100,000 each with three insurance companies, his next-of-kin can receive $300,000 altogether should he pass away. This is because life policies are NOT policies of indemnity

• The Second Corollary of Indemnity — Subrogation: This means that when the insurance company has paid out the claims, it 'subrogates' or steps into the place of the insured and inherits all his rights and remedies against third parties. Example:

Ø Mr A's car was wrecked in an accident. He agreed to accept $4,000 in settlement as indemnity. The wreck is then sold to a junk yard for $50. Mr A loses all rights to this amount because the insurance company, after paying him, is now the owner of the wreck. The $50 therefore goes to the insurance company.

4. The Doctrine of Proximate Cause: This applies to all insurance contacts. The root cause of the event is known as the proximate cause. This means that the insured will only be compensated if his loss was caused directly by the risk he has insured against. If the immediate cause of the loss was due to risks specifically excluded by the insurance policy, then no claim can be made. Examples:

(i) I insure my stock against floods. It is destroyed by flood waters. This is an insured peril. I am therefore entitled to claim compensation form the loss incurred.

(ii)Suppose the policy specifically excludes floods because my warehouse is near a big sluggish river which is very susceptible to over-flooding its banks with every heavy downpour. If flood is clearly the direct cause of the loss, then no claim can be made.

(iii)Similarly, Mr B may take a personal accident policy. One day, while driving, he had an accident. Because of the shock, he died of a heart attack. The insurance company may not pay because the root cause of his death was not due to the accident — but a heart attack.

Effecting an Insurance Policy

The buyer (or proposer) may either approach an insurance company direct, or alternatively may seek the assistance of an insurance agent or an insurance broker. The buyer will have to complete a standard proposal form which contains questions or instructions designed to obtain information regarding the property or the person for which/whom insurance is sought. All material facts known by the buyer must be disclosed otherwise the contract of insurance may be declared null and void. Based on the information given in the proposal form, the insurance company will study the risk involved and then decide on the premium and the proportion of the risk it is prepared to absorb. Bad risks will not be accepted by the company. For life assurance policies, the client may sometimes have to pass a standardized medical examination before the company accepts him. Normally, a risk is absorbed by a large number of underwriters. When the whole risk is covered and the premium collected, a cover note is issued to the client. This is evidence of an insurance contract. For life policies, no cover note is issued. Rather, the binding receipt of premium issued by the insurance company is evidence of the insurance contract. The insurance company then issues the client with an insurance policy which is really the legal contract between the insured and the insurance company.

 Procedure in Making a Claim

For a claim in an insurance policy to be valid, the insured must follow certain procedures. Failure to observe the instructions set down by the insurance company will prejudice the claim. Below is an example of a typical procedure for a marine insurance claim in the event of loss or damage to cargo. The principles involved are essentially the same for other types of policy as well.

1. The insured must inspect the goods before taking delivery if the loss or damage is apparent, or as soon as the loss or damage is discovered.

2.  The insured must then inform the insurer immediately, and request for a survey of the goods by the underwriter's agents or the surveyors named in the policy or insurance certificate. It is important that the condition of the goods and its packing must not be tampered with until the surveyor arrives. However, the insured may take steps to ensure that there is no further damage to the goods. In the case of a claim under other types of policies, say, motor, the insured must inform the insurance company immediately of the event of the loss. He must also make a report to the police within 24 hours after the accident. The police will make an independent report after its investigation as to the probable cause of the event. The vehicle will have to be towed to a workshop approved by the insurance company.

3. The insured must also request ship-owners, other carriers, forwarding agents, Customs, the Port Authority and other bales to be present for a joint survey. It is their responsibility to certify any loss or damage to preserve the insurance companies' rights against third parties. If the latter is found to be guilty of negligence, the insurance company can then sue them for damage or loss incurred.

4. Notice of the loss or damage must be made in writing to the bailees within the time limit prescribed.

5. Together with his claim form, the insured must submit certain documents to substantiate his claim:

  (a)   To prove insurance — original copy of the policy or certificate of insurance

      (b)  To prove ownership

(i)    bill of lading (for cargo)

(ii)   vehicle ownership card (for motor)

(iii) charter party

          (c)   To prove value

(i)    Invoices

(ii)   Packing lists

       (d)  To prove loss/damage

(i)    Survey report

(ii)   Landing/general survey report

(iii) Sales receipt

      (e) To enable the insurance company to make claims on third parties

    (i) The police report

Reference:

Betsy, L., & Tan, K. S. (1999). Insurance., Modern certificate guide: Elements of Commerce (pp.216-223). Singapore: Oxford 
                University Press.