Insurance revision

Would the government make a better job of catastrophe protection?

1) Governments can intervene in the catastrophe insurance markets in a number of ways: Social insurance. In this case, governments pay compensation to victims via a social insurance or welfare scheme. The distinguishing feature is that compensation is driven by need while 'premium' payments are determined by ability to pay rather than risk. Most social insurance schemes are 'pay as you go' rather than funded. Note that 'contributions' to such a social insurance fund will be built up by the government tax-free. 2)State-owned 'direct' insurance company: State-owned insurance companies are a method of providing catastrophe protection directly to individuals and businesses via a funded insurance company. In many cases, the purchase of insurance from the company is doubly compulsory (via purchase, and choice of company). Such companies often reinsure their risks in the worldwide reinsurance market. 3) State-operated mutual pools. In some countries, the State has organised a mutual pool (e.g. flood protection in the USA) whereby people pay premium contributions into the pool (often at a subsidised rate and possibly not risk-related). This is very similar to the previous point, except that the pool is usually locally or regionally based and only covers specific types of risk. 4) State-backed reinsurance. Increasingly, the State has intervened in catastrophe insurance by providing capital in the form of reinsurance to the direct insurance market (i.e. becoming a 'reinsurer of last resort'). The usual arrangement is for the State to establish a proper reinsurance company, which then provides excess of loss reinsurance to licensed direct insurers at 'reasonable' rates. The State guarantees to 'bail out' this reinsurance company in the event of losses which exceed its capital base. 5)Compulsory insurance programmes. The infrequent nature of catastrophes means that people are often unwilling to insure against them (regarding them as having zero probability). The experience of the US National Flood Insurance Programme (adopted in 1968) shows that people may not even buy catastrophe insurance at heavily subsidised rates. The solution is to make catastrophe insurance compulsory - but the problem is that consumers will regard this either as a form of taxation or as a subsidy for the insurance industry. There are clear problems in charging risk-based premiums (since the rates may be unaffordable to some sectors of the community), but the alternative may involve politically unacceptable cross-subsidisation.

Regulation against fraud in insurance?

Every life insurer had to deposit £20,000 with the Accountant-General of the Court of Chancery. Companies had to separate their life insurance business into a separate fund, which meant that, for a composite company, a loss on the company's general insurance business should not deplete the amount available to life insurance policyholders. Note that the equivalent requirement for banks (that retail and investment banking businesses should be separate) is only now being introduced. Accounts had to be prepared on a common basis, and a periodical valuation of the assets and liabilities of a company had to be made by an actuary, with regular returns of statistical and financial information being sent to the regulator (the Board of Trade). The amalgamation of life insurance companies was to be subject to approval by the Court

Market Practices in the London Insurance Market

The customer (which might be an individual, company or other Lloyd's syndicate) approaches an insurance broker with the details of a risk to be insured. Virtually all the business placed in the LIM is via accredited insurance brokers (although Lloyd's has recently removed this as a requirement). The broker therefore takes responsibility for collecting and presenting the information (the 'material facts') that the underwriters will use to decide the terms and conditions of the contract. The broker approaches one or more specialist underwriters (a lead underwriter) to discuss the price (premium rate), and the terms and conditions. If the underwriter is interested, a premium rate will be suggested and proposal made to accept a percentage of the total risk. At the current time, this process is largely paper-based with a heavy emphasis on face to face contact between the parties engaged in the transaction. The reasons for this are the immediacy of and access to decision making it enables, the highly customised nature of the business, and the interpersonal relationships involved. The broker feeds back information to customers to enable them to place an order. The broker prepares a 'slip' with the details of the insurance, which is signed by the lead underwriter. The broker then approaches the other (following) underwriters to also take a share of the business- with a view to obtaining written lines of insurance which total 100% or more of the risk. A number of underwriters may accept portions of the risk - almost always on the same price as established by the lead2. This is known as the subscription system. Recently attempts have been made to introduce some uniformity in the way that such contracts are constructed. A separate organisation (Xchanging Ins-sure Services, XIS), processes the slip and the broker adjusts or 'signs down' the lines if they have exceeded 100% of the risk. The premium is paid by the insured (policyholder) to the broker, who deducts any agreed brokerage fee and submits the net amount to Lloyd's Central Accounting (LCA) as part of a regular bulk settlement process. LCA allocates the premium to the insurers.

What are the 3 key issues for insurers?

- Designing products that meet customer needs - Pricing products appropriately: need to cope with moral hazard and adverse selection - Have the resources to pay claims

Advantages of government catastrophe insurance

- State solutions to the catastrophe problem have the advantage of removing the bankruptcy risk to insurers (assuming that the State's credit is better than the insurance industry's) and therefore allow the spreading of catastrophe risk over time. - State-backed reinsurance prevents an insurance cycle, because direct private insurers do not have to raise prices to an extraordinary degree in order to replenish capital. However the State guarantee may induce moral hazard on behalf of the direct insurers (which may charge premiums which do not reflect the risk, or operate with too little capital).

The insurance contract specifies in great detail what risks are included, and what risks the insurer will not cover. What characteristics of the risk are usually required?

- There must be an element of randomness (certainties cannot be insured) - The loss must be fortuitous or accidental (in other words, the insured must have preferred the loss NOT to happen) - The loss must be capable of financial compensation - The contract must be legal (i.e. legally enforceable and not against public policy) - Problems information asymmetry (adverse selection and moral hazard) must be controllable

Why do individuals buy insurance?

- To protect themselves against risk, because of the individual's dislike of risk. - To comply with contract conditions. For example, the purchase of insurance is often a condition of a loan or mortgage contract, in order to ensure that the loan can be repaid if the borrower dies, loses her job, or falls ill etc. - To comply with statutory requirements. For example, the owner and/or operator of a motor vehicle must have a valid contract of third party motor insurance.

The insurance market has initiated a number of new initiatives in response to the challenges posed by catastrophes in developed and developing countries. What are they?

1) New insurance and capital market products: Considerable interest has emerged in solutions to the catastrophe risk which do not involve conventional insurance (or reinsurance). In most cases, the capital is provided directly from the capital market and new capital market (sometimes known as alternative risk transfer). products are structured to mirror existing capital market products (e.g. as corporate bonds or derivatives). The attractiveness of such products lies in the fact that catastrophes (natural and some man-made) are not usually correlated with capital market indexes. The products can only be offered if it is possible to find some way of making them marketable and liquid (i.e. so that they can be securitised or traded). 2) Correct Demand-Side Anomalies Individuals often underestimate the impact of rare events and therefore do not buy enough insurance cover against the risk of catastrophes. It has been argued that catastrophe insurance should effectively be made compulsory by 'packaging' it with standard householders' comprehensive property cover (as in the UK): but note that this may have to be imposed on insurers and customers, otherwise cherry-picking behaviour would ensue. 3) Correct Supply-Side Anomalies It is often argued that the taxation of insurance companies, specifically the limitation on their ability to set aside reserves (provisions) out of pre-tax income, discourage insurers from building up reserves to cover catastrophes. One solution is to relax the taxation of general insurance companies to allow the build-up of tax-free catastrophe reserves. Some countries do allow this facility, but it is often perceived as a tax-avoidance mechanism for insurers.

What are the key properties of property insurance? There are 7

1. Although the subject matter of the insurance is always related to property, the insurance may also cover financial losses associated with the property loss (e.g. architects' fees). Many contents policies also cover cash. 2. It is not the property per se which is covered by the insurance policy, but the policyholder's insurable interest in it. Owners obviously have an insurable interest in their own possessions, but non-owners may also have an interest in the property of others. 3. Property insurance contracts only cover losses which are accidental or fortuitous in origin (from the perspective of the policyholder). Suppose, for example, that your house is flooded because of a leak in an old water tank. Your property insurance will probably cover the loss of your things (contents insurance) and the repair of the water damage (buildings policy) but would not cover the repair of the tank. 4. Domestic building and contents insurance usually cover losses from any cause (except the usual exclusions of war). In contrast, commercial insurance only covers losses from very specific causes: obviously fire (which has a legal definition) and the losses directly resulting from that fire and causes such as lightening strike. Other causes such as weather, flood etc can be included with a specific extension to the policy to include additional perils (but may be at an extra premium). 5. In general, the loss or damage to property is compensated by the insurer with a cash payment based on the principle of indemnity1 (as in the example below). However the insurer will sometimes include a term in the contract giving it the option to reinstate the damaged or lost property (by repairing, rebuilding or replacing it) - this is particularly common in domestic buildings cover. 6. Some contracts (e.g. domestic contents) use a 'new for old' measure, where the compensations is based on the new value of item without any deduction for the improvement (or 'betterment') - hence departing from the principle of indemnity. 7. Property is often acquired using finance from a bank. In such cases, the bank may insist on the purchase of insurance as a condition of the loan.

Subscription system; what are the important features?

1. Efficient coinsurance or risk-sharing with two or more insurers The subscription system is an efficient way of sharing the risk between two or more coinsurers, which share the premium and any claims payments in an agreed proportion. The coinsurers may be either syndicates at Lloyd's, or LIM companies, or both. Without this system, the broker would have to enter into simultaneous negotiations with a number of (co)insurers and/or reinsurers. 2. Encourages risk-taking by underwriters The fact that the lead underwriter takes less than 100% share of the risk means that it is more likely to accept the risk (and charge a lower price) than it would do if required to take the whole. However a lead underwriter which doesn't back its own judgment by taking a sufficiently large share is unlikely to be followed. 3. Common price, terms and conditions The subscription system ensures that all subscribing insurers agree to common terms and conditions (usually as established by the lead underwriter). The fact that the key decisions are taken by the lead underwriter (and the followers then decide primarily whether to follow or not) avoids horribly complex deals where coinsurers require different prices, terms and conditions for their share of the risk. Clearly the expertise of the lead underwriter is crucial here: without at least one expert underwriter to establish a lead, the business could not be placed. 4. Avoids the 'hold-up' problem with reinsurance In many other markets, risk would be shared via reinsurance, where the primary insurer P agrees to cover the risk (say 100% of it) and then looks to lay-off a share to one or more other insurers (R - the reinsurer). The fact that P is committed to the contract gives R additional bargaining power, because P now has too much risk - which may mean that R can charge a disproportionally high price. Obviously the potential hold-up problem would mean that very few large risks (which needed to be shared with several insurers) could be insured. 5. Provides a 'reality check' on ambiguous risks Much of the business placed in the LIM is specialist and complex - which are hard to price, large or otherwise difficult to quantify and understand. In cases where the details of the risk (e.g. the probability distributions of the loss frequency and severity) cannot be known with precision, the risk is often described as ambiguous. If the lead underwriter sets a price or terms and conditions which the followers think are inadequate (and might therefore produce negative profits), the slip is unlikely to be completed in full - and the broker will probably start again. Thus the subscription system enables the following market to provide a vote of confidence on the terms set by the lead - providing that the followers also have a degree of expertise. 6. The market for expertise The subscription market illustrates the role and importance of underwriting expertise in the LIM. In order to underwrite any given risk, there only needs to be one expert underwriter, and the risk can then be shared with other insurers which do not have the same degree of expertise. The role of the broker is not only to provide details of the risk, but also to know which underwriter has the expertise to lead. 7. Economies of scale in administration The subscription system provides a common insurance contract for all insurers (rather than a separate one for each) and central administration of the documents and money. 8. Limiting the market power of brokers The system ensures that all the insurers pay the broker the same commission rate. This means that the broker cannot exercise its bargaining power over smaller insurers.

What requirements need to be met for a contract to be legally enforcable?

1. Offer and acceptance: A contract exists only after an offer has been made by one party and accepted by the other. This offer does not have to be in writing - a verbal agreement would be sufficient. 2. Consideration: For a contract to be enforceable in a court of law, there has to be something of value (a "consideration") exchanged by both parties. Consequently, a gift is not a legally enforceable agreement. The consideration made by an insurer is the promise to pay in the event of a loss; the consideration made by the insured is the premium paid. 3. Public interest: The contract is not legally enforceable if it is against the public interest: that is, it is not possible to enter into a legally enforceable contract to commit a crime.

What are the typical reasons for why private markets may not find it possible to deliver insurance profitably?

1. Probability of claim close to one: e.g. chronic illness; individuals who have a chronic long term health condition (perhaps from birth) will have a known requirement for medical treatment/care 2. Non-quantifiable risks: e.g. long-term care; the uncertainties about the future delivery of long-term care provision means that it is difficult to estimate future claims costs 3. Information asymmetry: e.g. health care, income protection; both moral hazard and adverse selection problems can emerge when individuals have better information than insurers about their own health status.

A typical insurance contract will provide six main services. What are they?

1. risk transfer or shifting (the insurer takes on the risk of loss) - prime purpose 2. risk sharing or pooling (the insurer arranges that the losses of the few are paid by the many) 3. risk financing (a supply of cash at the time of loss) 4. other administration (insurers offer economies of specialisation in the performance of administrative services) 5. investment (since premiums are usually paid in advance of claims - particularly for long term insurance) 6. advice (on risk management issues)

What is a risk premium?

= represents the amount they are prepared to give up in return for certainty. The more risk averse they are, the greater the risk premium {Note this is different to an insurance premium}. Typically risk aversion declines with a person's income or wealth and increases with their age. Women are usually more risk averse than men.

What were the issues with employer liability insurance?

A problem for insurance companies was that, as this was a new type of insurance, they had no data on past claims that they could use to estimate future claims and hence help them work out what premium to charge. The premium rates charged could only be experimental at first, and there were therefore some significant changes in premium rates as insurers gained experience about the level of claims. There was concern that most accidents at work did not give rise to compensation because it could not be proved that the employer was negligent. After the Workmen's Compensation Act of 1897 introduced the principle of automatic compensation for all accidents in various hazardous occupations, negligence did not have to be proved: a further Act of 1906 extended the principle to all workers. In 1972 it became compulsory for employers to insure these liabilities. Employers also have to display certificates of insurance at places of work

What is property insurance?

A property insurance contract provides insurance cover against accidental loss in the value of the policyholder's insurable interest in a physical object (the subject matter of the insurance). There are a variety of types of property insurance, but the most common are 'commercial insurance' (for the buildings and contents of business premises) and 'home insurance' or 'household insurance' or 'consumer insurance' (covering the domestic buildings and contents for private households). ***Most contracts last for a term of one year and must then be renewed.*** The property insurance protects two stakeholders in the house: the householder and the bank. The bank usually makes insurance compulsory as a condition of the mortgage, because the householder may not have a strong enough incentive to buy it. This removes the householder's bankruptcy option (that is, the choice to go bust and avoid paying-off the debt) and the bank gets the loan repaid.

What are the issues of the bundle system?

A real difficultly with the bundle system is that it removes the incentives on existing high-risk customers to reduce risk, and indeed subsidises and encourages the creation of new high-risk properties. This has always been a feature of the bundle system, but is now a growing source of friction as the number of new households (and therefore new properties) has been rising rapidly in the UK. In other words, the bundle system solves one type of information asymmetry problem (adverse selection) but creates another (moral hazard).

What requirements need to be met for an insurance contract to be legally enforcable?

A separate body of contract law applies to insurance contracts, reflecting the distinctive nature of these transactions. The most important of these are: 1. Insurable interest: For an insurance contract to be enforceable, it is necessary that the occurrence of the insured event leads to an identifiable loss for the insured party. Examples of such an identifiable loss would be the value of your house, or the value of your own or your spouse's life. 2. "Utmost Good Faith": each party is required to provide the other with all of the information which might be considered relevant to them in deciding whether or not to agree to the contract. If the insurer asks for information, the policyholder must answer truthfully, otherwise he is guilty of "misrepresentation". If there is relevant ("material") information not asked for by the insurer, the policyholder is still required to bring it to the insurer's attention, otherwise he is guilty of "non-disclosure". Information is "material" if it affects the insurer's decision to sell or price the policy (even if it is not causally connected with the event leading to a claim). The traditional justification for this rule is to ensure that any potential information differences ("information asymmetries") are removed, and therefore that the possibility of the insurer suffering from an adverse selection problem is minimised. -> TODAY: Duty to Take Reasonable Care has replaced 'upmost good faith'; much better for the consumer. 3. The indemnity principle: Most property and liability insurance contracts are "contracts of indemnity": that is, the insurer promises to put right the loss incurred by the insured. The legal principle of indemnity states that the insured must be put back in the same financial position after a loss as he/she would have been if the loss had not occurred. In practice it is not always easy to achieve this.

What was the first clear birth of insurance?

A ship may be lost at sea, together with its cargo, and this represented a potentially significant loss for the ship owner. It would be worthwhile for ship owners to receive a payment from someone in the event of the ship not reaching its destination: it was the birth of 'marine insurance'. Marine insurance became established in Continental Europe, and standard wordings were designed that could apply to policies. In the early stages, the risk was accepted not by insurance companies but by merchants. Lloyd's of London became a centre for arranging marine insurance from around 1688. In 1720, two corporations were established by Act of Parliament, to write marine insurance: Royal Exchange Assurance and London Assurance. These were (jointly) given a legal monopoly for writing marine insurance, in the sense that it was not permitted to establish another company in competition with them, although the writing of contracts by Lloyd's of London and by ad hoc groups of underwriters did provide some competition. Although marine insurance has a long history, it was only in the 19th century that ship owners began to feel the need to insure liabilities to third parties. Injured crew members began to seek compensation from their employers, and there were also claims by passengers

What is the accumulation stage?

Accumulation products taken out by people on their own account (i.e. not as part of an employer's pension scheme) are usually known as personal pensions. The policy may specify that premiums are paid on a regular basis such as monthly or annually; or that only a single premium is paid at the outset; or may permit flexibility. Premiums cease at the specified retirement age or upon death if that takes place earlier. The payment under the policy is a lump sum at retirement age - which must then be used (mainly) to purchase a decumulation product such as an annuity6. If the insured dies before retirement age, the policy specifies the benefit then payable, typically a return of premiums with some investment return. So these personal pensions look rather like an endowment life insurance policy (paying a lumps sum at a set age or on earlier death) - but a different terminology and structure is used because of differences in tax treatment.

What are the types/products of health insurance?

Also differ between men and women. 1) Critical illness ('dread disease'): you pay monthly premiums; policy pays say £50,000 if you suffer a specified illness, e.g. heart attack, cancer, stroke. Pays on the diagnosis of the critical illness. The key things about these contracts is the wording of the exact diseases on which payments will be made. It's like life insurance, but paid out before you are dead. 2) Income protection: you pay monthly premiums; policy pays say £1000 per month if you are sick & unable to work; starts say 13 weeks after falling ill and up to age 65, say. This protects you if you are ill and cannot work, but still need a salary. Note that medical expenses insurance (MEI) is offered by general insurers rather than life insurers. An MEI policy is a one-year policy where the insurable event is where expenses are payable to a provider of health services such as a private hospital.

What are the basics of an insurance contract?

An insurance contract (the policy) is an agreement between the buyer (the insured) and provider of insurance (the insurer). Under the terms of the contract, the insurer promises to pay the insured a sum of money (the claim) on the occurrence of an event covered by the policy (the insured event). However, no claims money will be paid unless an insured event occurs: insurance contracts are therefore contingent ones. In return for this promise, the buyer pays the insurer a premium - either as a one-off lump sum payment or in instalments

Are flood risks really insurable?

As before insurability can be a problem if one or more of the following conditions arise: - Losses cannot be pooled - this is clearly a potential problem for weather and flood risks, because the same adverse conditions affect a large number of customers. - Losses are large in relation to the capital available in the insurance market (causing bankruptcy problems). This has been a very real problem in hurricane- and earthquake- prone areas of the USA, and would be an issue in relation to, say, the flooding of London - which could cost an estimated £30 billion. - Information asymmetries are severe. Moral hazard is a problem since as the individual customer has little incentive to reduce the flood risk if insurance is available. Given that the flood damage will be paid by insurers, individual residents have no incentive to pressurise the government and environmental agencies to reduce the flood risk. Adverse selection might have been an issue in the past (since the customer would know more about the flood risk in their particular location), but insurers have been investing heavily in Geographical Information Systems. In the UK, concerns about possible adverse selection have caused a number of major insurers to invest substantial sums of money in better risk assessment. - Public Goods: Perhaps the greatest problem with the flood insurance market is that flood defences are a public good, since they meet the three classical characteristics for such goods: non-rivalness (my consumption of flood defences doesn't reduce their availability to you), non-excludability (people who haven't paid for defences can still enjoy them - so why pay?), and non-rejectability (once defences are in place, people living on high ground cannot opt out). So flood insurance markets have to operate in a context where control of the major risk factor lies with the government and not with the insured - hence removing or diluting any incentive effects on the customer to reduce risk. - Even in the UK, the Governance recognises that Flood Re is not designed to cover catastrophic flooding, and the ABI notes that in such unlikely circumstances the Government would have primary responsibility for the response.

Discuss the International expansion of insurace

British insurers were among the first to see insurance as a potential export industry, and much like insurers today, they expanded overseas - accompanying British companies abroad with the development of international trade. From the 1700s British fire insurers began expanding into foreign markets. By the early 1800s companies based in London and rapidly growing cities like Liverpool and Manchester were insuring risks across the British Empire, as well as expanding into the US and Europe. Their experience and their techniques and products developed for the rapidly changing UK domestic market could be applied to foreign markets, enabling UK insurance companies to gain market-leading positions in many countries in the 18th century. With the help of reinsurance contracts, British insurers created a safety net that spanned Europe, the US and much of the Empire. Their economic success and technical superiority led to their risk management methods being replicated worldwide.

What is commercial insurance? What is Business interruption insurance?

Commercial insurance covers the cost of repairing or rebuilding business premises, or replacing contents such as stock or equipment. It covers against risks such as: burst pipes (escape of water), falling trees, fire, flooding, riots, storms, and subsidence theft. Business interruption insurance is closely linked to commercial insurance: it provides cover if the insured cannot do business as normal as a result of an event that causes damage to its premises or equipment. It is usually offered as an extra when the insured buys buildings or contents insurance, and covers any shortfall in pre-tax profits resulting from the event, and any increased costs in running the business as a result of the event, such as extra accountants' fees.

There are two main schools of thought concerning the occurrence of man-made (and to a certain extent natural) catastrophes. What are they?

Disaster theory v Normal accidents - Normal Accident Theory: One view is that such disasters are a natural consequence of the large-scale, highly intensive modern societies: the sociologist Charles Perrow calls these normal accidents. Disasters are therefore inevitable because of the complex nature of modern society, and the tendency to site property in socially-desirable but vulnerable locations. Precautions against such catastrophes become almost impossible to implement. - • Disaster Theory: On the other hand, others argue that crises are a result of an accumulation of process and organisational failures (preconditions or pathogens) set off by a 'triggering' event. In other words, catastrophes are not spontaneous events: they may develop over an 'incubation period' during which a multiplicity of minor causes, misconceptions, misunderstandings and miscommunications accumulate unnoticed until it is too late.

Sometimes, the buyer will elect to pay the first part (say the first £500) of any claim. What is this known as?

Excess or deductible

How does age affect the life insurance contract?

For most types of insurance of the person, the probability of the adverse event (e.g. death, ill health) can be expected to increase with age, and this has important consequences for the design of any insurance contract. If the insurance protection was arranged as a series of one-year contracts (as in general insurance), two inter-related problems would arise: (a) The premium would increase year-on-year as age increased. At older ages, the premium might then be unaffordable. (b) If something happened to the policyholder that increased the risk (for example, ill-health or an accident), this could lead to much higher premiums next year. As a result of such problems, insurance contracts of the person normally have a term running over more than one year, and - if the premiums are paid in instalments - such payments are usually constant for year to year.

What are the issues with pensions?

In many countries, all residents may be entitled to a state pension ('Old Age Pension') provided by the welfare system once they achieve a certain statutory retirement age. In countries like the UK, the state pension is effectively paid by the Government out of taxation revenue - this is known as a pay as you go system. Residents whose earnings are above a minimum level pay a tax contribution (known as 'national insurance') supposedly to cover welfare but in fact not actually linked to the benefits paid out (either in total or individually). State pensions payments made to people over the statutory retirement age are then paid for out of the Government's current tax income (or borrowing). Obviously State pensions are not generous, and are calculated to be just sufficient to keep people alive! In many countries, the provision of a state pension on a pay as you go basis is causing problems - because mortality improvements mean that people are living longer in retirement and more tax is therefore required to meet state pensions. Governments are therefore progressively increasing the age at which the State pension is paid5, and are also keen to incentivise people to make their own provision for their retirement. The state and private pensions arrangements are often reorganised on a regular basis to respond to these challenges. On top of any state pension (if there is one), people can save for their own retirement by using a private pension, and there are two main ways: either on their own account by buying a pension contract from an insurance company or by contributing to a self-administered pension scheme run by their employer/s (a 'employer scheme' or 'workplace pension' or 'occupational pension'). Most people fund it extremely difficult to decide whether or not to save for a private pension and, if so, how much.

Describe providers of insurance

In most countries, insurance can only be provided by licensed private or plc insurance companies. Insurance companies which have issued shares are termed proprietary or stock insurers. The other main form of insurer is a mutual company - which is an insurance company without shares whose ownership is vested in a subset of its policyholders (termed 'members') so that when members buy a policy, they own a part of the company. The majority of the worlds' insurance companies are not listed directly on a stock exchange - they may be subsidiaries, or private companies, or mutuals (that is, they are owned by their customers). Sometimes insurance providers can have slightly different status such as friendly societies (which are essentially mutual insurance companies incorporated under a different Act of Parliament). A major exception in the UK arises because individuals and corporations which are names or members of a syndicate at Lloyd's of London can act as insurers without being licensed insurance companies.

How to measure the cost of life insurance?

In order to measure risk, we need to focus on the probability of that event occurring, and since the risk is normally related to the policyholder's age, there will need to be a different probability for each age. Since males and females have different physiologies and lifestyles, it is also standard to distinguish such probabilities by gender too. This means that, in order to represent the risk, it is necessary to use a table of probabilities over a range of relevant ages: the table capturing the risk of death is termed a mortality table while that concerned with ill-health is called a morbidity table. There will normally be separate tables for males and females.

What is a mortality table and how does it work?

In order to measure the risk of death, it is necessary to build a mortality table which shows the probability of death over a range of ages. In practice, there are a variety of different types of mortality table, depending on the people whose mortality is being described and the use to which the table is put. However all mortality tables have some features in common and use the same basic terminology and notation: mx = The central rate of mortality at age x. This is the probability that a person aged x will die before their (x+1) birthday. qx = The mortality rate at age x. This is the probability that a person aged exactly x (i.e. on their xth birthday) will die before their (x+1)th birthday. Although this can't be calculated from raw data, qx can be thought of as the number of people who die at age x (we will call this dx) divided by the number alive on their xth birthday (i.e. exactly aged x - we will call this number lx). Figures for qx are often derived by making a small adjustment to mx. It should be clear that qx is not quite the same as mx and that we would expect mx to be higher than qx because the denominator of mx (the number alive at any age between the xth and (x+1)th birthdays) is smaller than lx. lx = The number of those alive at exact age x (i.e. on their xth birthday) in the mortality table. It is important to realise that these are not real people: what the tables do is start with a fixed number or radix of notional people (whose mortality is to be reflected by the mortality table) and then see how many birthdays it takes for all these people to die. The tables produced by ONS reflect the mortality experience of people in the UK, and therefore start with new-born babies at age 0 where the radix is l0 = 100,000. Some mortality tables used by insurance companies don't need to start at age 0 (e.g. because new-born babies don't buy life insurance or annuities!). dx = The number of people, out of those notional lx people alive at exact age x, who are expected to die before their (x+1)th birthday. It should be obvious that dx = lx times qx. It should also be obvious that lx+1 = lx minus dx ex = The expectation of life at age x. This is the average number of years the typical person aged x in the mortality table is expected to live beyond their xth birthday. One way to think about this is to start with the number alive on their xth birthday lx and then count the total number of years these notional people live (this will be equal lx + lx+1 + lx+2 + .... and so on until they're all dead): we then get the average expectation of life per person as ex = (lx + lx+1 + lx+2 + ....) / lx. Note that the expected age at death = (ex + x)

What is "The insurer's duty to defend"?

In parallel with the insurer's right of subrogation, it is usually the case that liability insurance policies include a clause which obliges the insurer to pursue any reasonable defences on behalf of their policyholder against a third party's allegations of negligence leading to a claim for damages. Liability insurers with "duty to defend" clauses in their policies have the obligation to manage the litigation process from the initiation of the claim. At the same time, insurers with such clauses normally have the right to choose claims managers and lawyers, who are usually, but not always, their in-house staff. If the insurer's in-house lawyers and claims adjusters are used, the costs for those parties generally are not considered part of the defence costs. Therefore, the overall defence costs are greatly reduced for all parties involved. However, the downside is that the insured usually has no control over the lawyers being assigned.

How is the loss valued?

In practice there are a number of alternative ways of measuring what has been lost including: • Replacement/rebuilding cost (but what about betterment and depreciation?) • Repair costs (but what about 'improvement') • (Decline in) book value • (Decline in) market value • Some contracts (e.g. domestic contents) use a 'new for old' or 'as new' measure, where the compensations is based on the new value of item - hence departing from the principle of indemnity. When the value of the property is unknown or hard to measure: Property insurance requires the policyholder to choose a sum insured S at least as great as value V if underinsurance is to be avoided. How can this be done if V is unknown? For example, what if the property is a work of art or an antique? One solution is to use a 'valued policy', where S is paid whenever a loss occurs.

Is indemnity desired?

In some cases the use of a full indemnity policy, even where feasible, is simply not desirable. It may not be desirable for the insurer because it would be exposed to excessive risk (and therefore places a limit on its indemnity) or moral hazard (and therefore insists on a compulsory "policy excess" whereby the insured pays the first £x of the loss). It may not be desirable for the insured because he/she feels that their own valuation is appropriate (in which case they stipulate a maximum "sum insured" into the policy). If so the insurer will often then apply a rule of "average" if it turns out that the sum insured was inadequate to cover the full value. Finally, full indemnity may not be desirable for an insured person who wishes to signal to the insurer that he/she is a low risk; this can be done by voluntarily opting for a high "policy excess" to show that the insured is confident that a claim is unlikely. In this way the problem of adverse selection can be minimised through the selective use of "partial indemnity contracts".

How does an injured party obtain compensation from liability insurance?

In the U.K there is no automatic right to obtain compensation for injury or damage. To do so, the third party must prove that the policyholder has committed a civil wrong by one or more of the following breaches under tort law: negligence, nuisance, and trespass (in which case, the 1st party, policyholder or wrong-doer is sometimes called a tortfeasor). In these cases, the 1st party is only liable if she is at fault and has acted in a way which is unlawful, negligent, and/or unreasonable. In addition the 1st party may have to pay compensation arising from a breach of statutory or contractual liability

Difference between Financial conduct authority (FCA) and Prudential Regulatory Authority (PRA)?

In the UK, the Financial Conduct Authority (FCA) and the Prudential Regulatory Authority (PRA) are the regulators responsible for authorising and monitoring insurance companies. Any insurer wishing to transact business in the UK must be authorised by both the FCA and the PRA, and must submit annual financial statements to the PRA for scrutiny. Policyholders will be protected both by the PRA as prudential regulator and by the Financial Conduct Authority (FCA) as conduct regulator. The FCA will seek to ensure that consumers are treated fairly in their dealings with insurers, whereas the PRA's focus will be to ensure that policyholders have an appropriate degree of continuity of cover for the risks they are insured against. Ensuring continuity of cover requires insurers to be able to meet claims from, and material obligations to, policyholders as they fall due, which, in the case of some policies, may emerge after many years.

How do insurance companies get their capital?

In the case of mutual insurers, their main resources come from premiums paid by policyholders, and any borrowing that the insurer can arrange. The capital of mutual insurers is entirely due to any initial subscriptions from members and subsequent retained profits. Mutual insurers may be at risk if their ex post claims turn out to exceed their initial ex ante estimates - because they can't turn to shareholders for more capital. This has been a common problem in recent years for mutual life insurers (whose members don't have sufficient capital to contribute) and many mutual life offices have demutualised (i.e. transferred to proprietary status) and have then been acquired by or merged with another stock insurer.

What was the origin of underwriting?

In the early stages, the risk was accepted not by insurance companies but by merchants. Brokers would negotiate a deal between a ship owner and one or more merchants, who would accept the risk. The process of considering whether to accept the risk, and what premium to charge, was known as 'underwriting', because the merchant wrote his signature under the description of what was being insured, namely the ship and its contents, on the document that set out the deal. The document would also set out information on the voyage being undertaken, which was the period for which the insurance cover was being provided.

Is life insurance contracts ones of indemnity?

Insurance contracts of the person on your own life are not ones of indemnity, and you don't need to demonstrate an insurable interest in your own life. However it is still relevant to ask what the financial 'distress' would be if the adverse event were to occur. There may be no point in purchasing an insurance of the person unless such a financial distress would occur. In the case of life insurance for example (where the various contracts pay a claim in the event of death1), a financial distress may arise because the family would incur funeral expenses or because of the loss of a breadwinner's income.

How do insurers make their profits?

Insurers plan to make a profit when they collect more revenue (in terms of premiums and investment income) than they expect to incur in costs (in terms of claims and expenses). Whether they actually make a profit or not depends on the random outcome of their costs and revenues in the year - and claims are often highly volatile

Problems with Liability Insurance: delays

It is common for claims to be made many years after the 'injury' was incurred since cancers and other disease can take a long time to display symptoms. Such claims are termed 'long-tailed' because of this long time delay. Employer's liability insurance and other liability insurance is written on what is known as an occurrence basis. This means that the insurer which meets a claim is the one that was on risk when the injury or disease was caused, rather than at the date when the harm became apparent or the claim was made, both of which may be much later. On the face of it, the occurrence basis gives good security to employers and employees: provided EL insurance was in place when the injured employee was working, the insurer will always be liable to meet a claim, even if it is made many years later and even if the policy has been cancelled in the meantime. However, potential security problems remain - for example, when insurance records have been lost or doubt exists about the precise time when the injury was caused. Furthermore, this arrangement creates severe pricing problems for insurers, who have to collect premiums that are sufficient to fund 'long-tail' claims - especially for disease claims that may still be coming in decades later. The longer the potential time span for claims, the greater is the level of uncertainty for insurers The pricing of liability insurance is generally more problematic than that of property. The potentially long delay between underwriting a risk or group of risks and settling the last claims that arise from the years of insurance in question creates considerable uncertainty as regards the final cost of such claims and the level of premium that is necessary to cover them.

What did Bailey (1863) do?

It was Bailey (1863) who first set out "the principles on which the funds of life assurance societies should be invested". He expressed five principles ("Bailey's Cannons"): security of capital; - obtaining the highest practicable rate of interest (subordinate to the above); - a small proportion of funds should be held in readily convertible securities [i.e. readily convertible into cash] to pay current claims and loan transactions; - the remaining and much larger proportion should be invested in securities that are not readily convertible; and - as far as practicable, the capital should be used to aid the life assurance business.

How does probability and risk work?

It's only possible to measure the "known unknowns", so let's say that the possible future events or outcomes can be listed as x1 x2 ... xn (mathematicians call this list of possibilities the 'sample space'). The three dots ... indicate all the other values between x2 and xn are also included. All this means is that we can work out that there are n possible alternative values of the (random) variable x - but we don't know which one will occur Clearly "unknown unknowns" can't be included in the sample space because we can't imagine them. Let's also say that we can assign probabilities to each of these outcomes p1 p2 ... pn. These probabilities reflect the chance that each event will occur in the specified context (see below for a brief discussion of where these probabilities could come from). Obviously "unknown unknowns" can't be given a probability; furthermore, if unknown unknowns have been omitted from our list, then all our other probabilities will be wrong. These probabilities have to obey certain rules, including: o All probabilities must be ≥ 0 and ≤ 1 o A probability p1 = 0 means that event 1 will never occur: this means "never ever", "completely impossible" etc. Put another way, even the person who disliked risk most in this room would bet all her wealth and that of her family that this event would not occur! Similarly a probability p1 = 1 means that event 1 is certain to occur. o Something is certain to occur: in other words, the probability that either event 1 or event 2 or ... or event n will occur = 1. Similarly, the probability that nothing (i.e. not 1, not 2, ... not n) will occur =0

What is the London Insurance Market?

LIM is more of a global insurance marketplace. It is a group of insurers, based exclusively in the City of London, which sell contracts to domestic and international commercial and non-commercial organisations and to other insurers worldwide, using customised contracts which are more 'tailor-made' to the needs of the client, and where the risks are shared among a number of insurers on a subscription (co-insurance) basis. The London Insurance Market comprises: - Around 90 Lloyd's of London syndicates (backed by individual Names or corporate capital), managed by around 60 managing agents - UK-domiciled insurers and reinsurers with contact offices in London - UK subsidiaries and branches of US, European and international insurers and reinsurers; many of which are members of the International Underwriting Association of London (IUA). Virtually all the world's large general insurers have a presence in the London Market - Protection & Indemnity Clubs, which are mutual associations of ship-owners and charterers, providing specialist marine insurance to their owners. Nothing more will be said about these specialist organisations. - A large number of support services (such as insurance broking, loss adjusting, insurance law specialists, actuaries and statisticians, finance companies etc). Most of the business on the Market is placed by specialist insurance brokers - which are crucial to the operation of the subscription system.

What is liability insurance?

Liability insurance is designed to protect and compensate the policyholder against legal liability for omissions or acts causing death, bodily injury or disease to third parties or loss of or damage to their property. In general, any insurance compensation is paid by the insurer direct to the third party. Most contracts last for one year and must then be renewed. A key feature of liability insurance is that the amount of compensation for the harm suffered by the injured 3rd party may exceed the assets of the wrong-doer (the policyholder). So we see straight away that liability insurance protects two stakeholders: the policyholder and the injured third parties. Unlike property insurance, liability insurance does not have a sums insured.

Life insurance vs. general (non-life) insurance

Life insurance covers instances where the insured event depends on human life. In other words, whether a claim is payable under the policy depends on whether an individual is alive or dead, or is (or is not) suffering some form of ill-health. Life insurance contracts are not normally ones of indemnity. It is common for life insurance policies to have a term of many years, which commits the insurer to providing cover over that long period: possibly 25 years or more (perhaps for the whole of his life). For this reason, life insurance is often categorised as long-term insurance. Insurance that is not life insurance is non-life insurance, sometimes referred to as general insurance, or property-liability, or property casualty insurance (the latter being the American term). Most general insurance contracts are of a short term, such as one year. Some general insurance contracts do have a longer term, such as three or five years, particularly where insurance is provided for a firm (commercial) rather than for an individual. The provider is known as the general insurer or non-life insurer.

What is life insurance?

Life insurance, pensions and health insurance are types of so-called 'insurances of the person' where the risk involves an adverse event involving a human body - usually the policyholder's death, life, ill-health, injury etc. Obviously this risk affects us throughout our lives, and any insurance protection will therefore normally need to be extended over more than one year - they are therefore termed long-term insurance. This means that such contracts have the usual element of protection (that is, the substitution of money in the 'no loss' state for money in the 'loss' state) but also have an element of temporal substitution (that is, the substitution of money 'now' for money in the future).

Who provides life insurance?

Life, health and pensions policies are provided by insurance companies and friendly societies. These companies may be specialists in long-term insurance, or may sell general insurance as well (in which case, they are known as composite insurers). As in many other countries, the long-term insurance market in the U.K. used to be dominated by mutual companies, but the market share of mutuals has declined substantially in the last 20 years and most companies selling long-term insurance in the UK are now proprietary (stock) companies.

Problems with Liability Insurance: Catastrophes

Like property insurance, liability insurance markets are vulnerable to systematic factors that can affect many policyholders at the same time, and this puts enormous strain on the insurance market. The cause here is not natural catastrophes of course, but man-made ones such as asbestos and thalidomide, and systematic changes in the legal system and national culture.

What are the Core competences of Lloyd's of London?

Lloyd's of London has a number of characteristics which provide it with competitive advantage, particularly in insuring new and unusual risks. These are summarised in the Lloyd's Three-Year Plans. - The subscription system - The experience of specialist underwriters and their willingness and ability to take risk. - Lloyd's has a reputation for insuring unusual risks (see the box below). Lloyd's and the London Insurance Market are the world's acknowledged leaders in developing innovative insurance products. - Efficient outsourcing. Essentially the insurance businesses operating at Lloyd's operate almost like virtual organisations. Each insurance business (the managing agent) effectively outsources many of the activities which 'normal' insurance companies have to provide internally. Thus the managing agents outsource their selling (to brokers), their capital raising (to the members' agents), their facilities management (to the Corporation of Lloyd's), and their regulation and compliance (to the Franchisor). - The annual venture. Unlike a 'normal' insurance company, a Lloyd's syndicate only exists as a legal entity for one year, and provides insurance contracts for one year only (which of course is the standard anyway). Only the members who have contributed capital to the syndicate in that year are entitled to the profit from that year's trading (or are liable for the losses). It is very common however for a syndicate to re-form the next year (with the same identifying number, managing agent, underwriters and members) - but this is legally separate from the previous year's incarnation. In theory this means that the capital providers for this year's venture are not saddled with losses or debts carried over from previous years. This solves the classic underinvestment problem which arises when investors are unwilling to provide risk capital to organisations already in debt - since that capital would then be used to make payments to creditors rather than funding new investment to generate future profits. - Deeper capital. As previously noted, syndicates which were funded by unlimited liability names were much less likely to default on their claims payments in comparison with a limited liability company. Even though Lloyd's syndicates are now mainly funded by limited liability corporate capital, the market has put additional mechanisms in place (including the Central Fund) to ensure that valid claims will always be paid. - Attractiveness to investors. When investors purchase shares in a 'normal' insurance company, they usually have to part with their money - which either goes to the company (in the case of a new issue) or to the previous owner of the shares. However a member at Lloyd's is not required to hand over assets unless required to do so - all that is required is that their capital be held in trust and be readily realisable. Historically the members have also been able to enjoy exceptionally high returns, although with a considerable degree of risk which was not always appreciated (see the Rachel Stevenson article). - Three-year, fund accounting. Lloyd's syndicates operate on the basis of a three year accounting cycle (fund accounting). Each calendar year a Lloyd's syndicate starts a new insurance venture with a clean book containing no assets or liabilities. In the first year of account, the venture accepts premiums from customers to insure risks for one year (the annual venture). At the end of the year, the venture stops writing new business, but continues to exist to pay claims for the next two years of account. After three years (one year of writing and two years of paying claims) the venture is closed. Its books are balanced, any profits left over after paying out claims and reinsurance-to-close are paid out to members.

How is Lloyd's of London different to other insurance companies?

Lloyd's of London is not an insurance company - it's more like a marketplace where those who want to buy and sell insurance can meet. Lloyd's describes itself as a society of members, both corporate and individual, who underwrite in syndicates on whose behalf professional underwriters accept risk. Supporting capital is provided by investment institutions, specialist investors, international insurance companies, and individuals.

Means of controlling moral hazard

Moral hazard arises because of a lack of incentive for the policyholder to reduce risk. A standard control is to require the policyholder to have an excess or deductible. In such cases, the insured would pay some of the claim themselves and would therefore have an incentive to take care. [The amount of claim paid by the insurer would be the amount of loss minus the excess]. Another approach is to limit the claim to some proportion of the loss suffered by the insured. The Gambling Act of 1774 required those applying for life insurance to have a financial interest in the life to be insured. This was to prevent people insuring the life of the King or Prime Minister, for example, who then might be a target murder. An extreme form of moral hazard is fraud. In marine insurance, there was concern that ships might go 'missing' some thousands of miles away from where the insurance was arranged. One of the conditions of the insurance was, therefore, that the cargo had to be documented carefully, to reduce the potential for fraud.

Explain moral hazard

Moral hazard is another case of information asymmetry. It arises when people's behaviour changes once they have acquired insurance. For example, if you have car insurance which pays the cost of replacing your car if it is stolen, you may decide that it is not worth the effort of locking your car when you leave it for a short time. However, the car is then more susceptible to theft, thereby undermining the insurer's calculation of its expected claims. Similarly, if you have insurance that pays a monthly amount to you if you are sick and unable to work, then you may not feel motivated to undertake rehabilitation in order to get back to work (when the monthly payments from the insurer cease). Again, the insurer's claims will be more than it had expected.

What is the impact of catastrophes on insurance markets?

Not all catastrophes have an appreciable impact on worldwide insurance markets (because many occur in uninsured regions). However when they do, the impact tends to follow a recognisable progression: 1. Insurance share prices fall. 2. Insurers try to bargain over claims. 3. Insurance liabilities increase and their assets fall - squeezing solvency margins. Some insurers go bust. 4. Since it's now difficult to issue new share capital, insurance supply contracts. 5. Insurance prices thus rise. 6. Customers want more cover, and are prepared to pay higher prices. 7. New insurers and products enter the market, and competition eventually chokes off the price rises.

Why did equitable life insurance arise?

One of those involved early on was James Dodson, who was unable to join the already-established Amicable Society. That firm charged the same premium for all ages but stopped people over a certain age from joining, and Dodson's age was above that limit. He was, however, convinced of the need for a more scientific and equitable way of operating life insurance. He had a scheme for basing life insurance premiums on the age of lives insured. His proposed new firm was refused a royal charter in 1761 after protests by the Amicable and the two corporations (Royal Exchange Assurance and London Assurance). Dodson had died in 1757 (justifying the caution of the Amicable), but his recommendations were adopted in the formation of Equitable Life in 1762. It pioneered the scientific selection, rating and valuation of life insurance business. Equitable Life was the first life insurer to introduce reversionary bonuses, this becoming standard practice for many other life insurers subsequently. This was the beginning of what we now call 'with-profits policies'. In other words, the profits of the insurer are distributed to policyholders by increasing the benefits under their policies.

What are the types/products of pensions?

Private (personal or employer) pensions always have two components, often unbundled into separate products: 1) The accumulation stage, which enables individuals to save for their pensions (i.e. build up a fund), while they are earning; and 2) The decumulation stage, which enables individuals to turn their accumulated fund into a regular income (i.e. a pension) and possibly take a lump sum too.

When the insurer's information on the probability distribution of loss is incorrect or asymmetric...

Problems can arise when insurers do not have the correct information on the probability distribution of loss: 1. The problem of general ignorance 2. The problem of adverse selection. 3. The problem of moral hazard. In all three cases, it is vital that the insurer charges a price which is related to the policyholder's individual level of risk - via a process known as risk classification or risk-based pricing.

What is "The insurer's right of subrogation"?

Property Claims: The Insurer's Right of Subrogation. If an insured person suffers a loss which is the subject of a valid insurance contract, and that loss was caused by someone else, then the legal doctrine of subrogation provides the insurer with a right to recover the payment made to the insured from the person responsible for the loss. So, for example, if your house is damaged as the result of a neighbour's negligence, the insurer can take legal proceedings on your behalf in order to recover from the neighbour the amount due to you from your household buildings insurance policy. This doctrine complements the indemnity principle - by preventing the insured from making a double recovery of losses (once from the insurer, and once from the negligent third party) it avoids the risk of moral hazard when individuals who are over-insured find it in their interest to make a claim. It also allows the insured to receive immediate compensation, while the insurer pursues the claim against the third party in an action which may take many years in some cases. The subrogation doctrine applies to most property and liability insurance contracts, but it does not apply to life insurance; it is possible for a surviving dependent to benefit from a life insurance policy in the name of a relative killed in a road accident, and at the same time to recover damages from whoever was responsible.

Problems with Property Insurance: Catastrophes

Property insurance markets are extremely vulnerable to natural catastrophes due to the weather (flooding, windstorm) and earthquake risks, and terrorism (the 9/11 attacks were thought to have cost a total of $80 billion in 2001). The main issue is that a catastrophe affects many insured properties at the same time (the same 'event') and this puts enormous strain on the insurance market, and contributes to an 'underwriting cycle' (the movement up and down over time in insurance profits and prices). More on this in the next lecture.

What is the RSA [Royal Sun Alliance]?

RSA is one of the largest general insurers in the UK (Aviva is the largest). It was known as Royal Sun Alliance until 2008. Like most major UK insurers, it is the result of many mergers and acquisitions over the years.

What is risk aversion?

Risk aversion measures the degree to which someone dislikes risk and is prepared to pay to get rid of it. Although it is not immediately obvious from the definition, risk aversion essentially conceptualises risk as a variation.

Definitions of risk

Risk is a construct, used to describe the possibility that something may happen, in the future, that could have undesirable consequences for us.

Just because an individual or organisation experiences risk doesn't mean that they will avoid risk completely or pay to get rid of it. Why is this?

Some of the possible unknown future outcomes may be highly desirable, and the benefits of the risk outweigh the costs The costs involved in removing risk may be too great. Some individuals (gamblers) occasionally like to take risk. Note though that people cannot do this continually - because they would be quickly bankrupt. More importantly, people often gain pleasure/thrill from undertaking the risky activity

What is PPI (Payment Protection Insurance) ?

Some reasons why PPI may have been miss-sold include: • You were pressured into taking out PPI; • It was not made clear that PPI was optional; • You were advised to take out PPI but it was not suitable for you; • You thought buying PPI was a condition, or would increase your chances, of obtaining a loan or other type of credit; • Any significant exclusions were not explained, such as being self-employed or pre-existing medical conditions; • The policy was added to your loan without your knowledge; • It was not made clear that you would pay interest on the cost of PPI if it was added to the loan; and • It was not made clear that the PPI cover would end before the loan or credit was repaid

What are the issues with indemnity? How are they solved?

Sometimes the task of deciding on an appropriate valuation in order to fully compensate the insured for his/her loss is simply too difficult. For example, if an individual wishes to insure against the loss of an antique or work of art which is a much loved family heirloom, then the insurer may find it impossible to place a value on the item at the time of its loss using objective evidence. In those circumstances the indemnity principle is usually modified such that an agreed valuation is simply stated in advance and incorporated into the policy document: this is known as an "agreed value policy". This value may or may not fully compensate the insured for the loss, so it is not technically a true indemnity policy. Similarly, when the valuation of an adjustment for "wear and tear" is difficult, then household policies often substitute an agreement to pay on the basis of "new for old" - the insurer pays the market value of replacing what is damaged or lost at the market value without adjustment. Again this is not a true indemnity policy, but one where the indemnity principle has been modified on pragmatic grounds. Finally, when monetary valuation is fundamentally impossible (or ethically undesirable), such as any attempt to place a monetary value on life and limb, then the principle of indemnity is abandoned and the policies simply state the monetary benefit without reference to valuation - these policies are known as "benefit policies" and are used for all life and personal accident insurance.

When did employer's liability occur and why?

The Employers' Liability Act 1880 made an employer liable for injuries caused to certain classes of employees by the negligence of others. The effect was that an employee could sue his or her employer for injury caused by any defect in the plant, machinery, etc used in the business of the employer, provided that the defect arose from the negligence of the employer or of some other employee whose duty it was to ensure that the plant, machinery, etc were in proper condition. The maximum compensation which could be awarded by a county court was the earnings for the three years before the injury occurred. Some employers, such as railway companies, were sufficiently large to handle their own liability. Most employers needed insurance cover against the risk. One company was set up specifically to offer this class of business: the Employers' Liability Assurance Corporation, formed in 1880.

What is the Treating Customers Fairly (TCF) initiative?

The FCA has recently implemented a new initiative designed to highlight the fair treatment of customers (Treating Customers Fairly - TCF). Delivery of TCF will be tested as part of firms' usual supervision by the FCA. Firms are required to: - demonstrate that senior management have instilled a culture within the firm whereby they understand what the fair treatment of customers means; where they expect their staff to achieve this at all times; and where errors are promptly found by firms, put right and learned from; - be appropriately and accurately measuring performance against all customer fairness issues materially relevant to their business, and be acting on the results; - be demonstrating through those measures that they are delivering fair outcomes.

Case study: Marine and General Mutual Life Assurance Society.

The Marine Life and Casualty Mutual Assurance Society (as it was originally called) was formed in 1852. In 2015, it was the UK's oldest surviving registered company, although it will disappear when the takeover by Scottish Friendly is completed in 2015. The founders were directors of shipping companies, who were concerned that seamen were unable to obtain life insurance from the insurance companies then in existence, or were charged substantial additional premiums. They felt that insuring the lives of seamen was not only desirable for reasons of social equity but was also a sound business proposition. The Society was a mutual life insurer. In 1880 the company began accepting insurances on lives not connected with the shipping business; it was recognised that, otherwise, the activities of the society would be unduly constrained. It also made an acquisition, taking over the business of the Briton Life Association. The company was (and remains) a mutual, and offered with-profits policies, with bonuses from the surpluses that were distributed. Immediately following the quinquennial valuation in 1919, there was no bonus. The surplus had been depleted for three reasons. First, there had been additional claims as a result of deaths in World War I; higher payments of income tax; but, most importantly, depreciation of the investments

Why is the UK special when it comes to insurance?

The United Kingdom is almost unique in the world in having two distinct markets for general insurance (which is also known as non-life, property-liability, or property-casualty insurance): the national market and the London Insurance Market (LIM). The national market comprises a collection of small to very large multinational insurers (possibly with regional branch offices around the country), which sell contracts to individuals and small businesses based in the UK, using largely standardized contracts, and where the primary risk is borne by the insurer.

Who buys insurance?

The buyers of insurance are individuals, firms and other organisations, and even governments. Buyers may be referred to as policyholders because they have the policy document that the insurer issues. Many types of insurance are compulsory in law, in that the persons or firms commit an offence if they perform certain activities without purchasing insurance cover. Thus no person or firm is able to employ staff without purchasing employer's liability insurance, and no motorist can operate a motor vehicle without third-party motor insurance.

What is the decumulation stage?

The decumulation phase is when the policyholder has retired, and wishes to receive a regular payment, which is the pension. The insurance contract that provides this is known as an annuity. The premium payable is a single premium at retirement, and the benefit payable under an annuity is a regular payment, typically monthly, for as long as the person is alive. The term annuity rate refers to the amount of annual annuity that can be bought from a given amount of single premium. The annuity rate depends mainly on mortality rates and on the investment return that insurers can achieve. Low mortality rates result in lower annuity rates; low interest rates also result in low annuity rates. For example, a single premium of £100,000 paid for a man at age 65 might produce an annuity rate of say £6000 p.a. The advantage of annuities is that they protect policyholders from running out of money if they live longer than expected. The annuity bought at retirement using a tax-approved accumulation pension policy is known as a compulsory purchase annuity. Alternatively, a purchased life annuity is an annuity purchased by someone using their own (non-pension) money to pay the premium.

Syndicate?

The members of Lloyd's provide the capital to support the insurance business undertaken in the Lloyd's syndicates. Members accept insurance business through these syndicates on a 'several' basis for their own profit and loss: in other words, members of Lloyd's are not jointly responsible for each other's losses. The membership of Lloyd's is currently made up of companies with limited liability (many of which are owned by insurance companies) and very rich individuals (some of which have limited liability and others whose personal liability is unlimited). Individual members or Names tend to support a number of syndicates, whereas some corporate members only underwrite through a single syndicate. Lloyd's members conduct their insurance business in syndicates, each of which is run by a managing agent. The syndicates operate in many specialist areas including marine, aviation, catastrophe, professional indemnity, and motor. Syndicates tailor solutions to respond to the specific risks of the client base, and compete for business - thus offering choice, flexibility and continuing innovation. Syndicates cover either all or a portion of the risk and are staffed by underwriters - the insurance professionals on whose expertise and judgment the market depends.

In what form does one receive their insurance?

The payment under the policy is normally in the form of cash. In some classes of insurance (e.g. life insurance) the claim may be a predefined figure (e.g. £100,000 payable in the event of the death of the buyer - the sum insured) - particularly if the principle of indemnity does not apply. However in most classes of insurance, the principle of indemnity requires that the claim payment will be that amount of cash which is just sufficient to put the insured back into the same financial position that they were before the loss (e.g. to buy goods equivalent to those that have been stolen, or to repair property that has been damaged). Some policies may give the insurer the right not to pay cash but to use an alternative method of compensating the buyer, for example by replacing goods that have been stolen or by repairing a car that has been damaged. In some cases, the payment from the policy takes the form of regular cash payments over a period of time. For example, under an income protection policy, the policy pays a regular monthly amount where the insured is ill and unable to work. Under an annuity, the policy will pay regular instalments until the buyer dies.

What is the role of a policy?

The policy defines the circumstances (insured events) in which the insurer is liable to make a payment to the buyer. The policy also defines the 'term' of the policy, i.e. the period of time from when the insurance begins to when it ceases. Life insurance policies usually have a term running over several years. Non-life insurance (e.g motor, property, liability etc) usually has a term of one year, after which the policy must be renewed.

How does adverse selection arise?

The problem of adverse selection arises because, when estimating the expected claim, the insurer has not recognised the difference between high risk and low risk buyers. This is one example of the problem of information asymmetry, where the holders of private information (in this case the buyer) use that information to their own advantage. This information might be ignored by the insurer because it is difficult to obtain, or because the insurer is using inadequate technology, or because the buyer is allowed to withhold it. The insurer will then quote a premium based on the assumption that all buyers have the same level of risk. However this means that buyers who know themselves to be high risks have a greater incentive to seek insurance (and the opposite for low risk buyers). The insurer then ends up with too many high-risk and too few low risk policies, and will make a loss Adverse selection arises if an insurer's contracts attract high risks that undermine the insurer's calculation of expected claims. A number of techniques are available to insurers to address this problem. In particular, the insurer can charge risk-related premiums, i.e. the premium reflects the circumstances of the risk more precisely - unless they are prevented by law from doing so.

What is underwriting?

The process where the insurance provider considers the application for insurance, and decides what premium to charge, is called underwriting.

Who are the sellers of insurance?

The seller of insurance, that is the person who is in direct contact with the buyer, is either: • The provider of the insurance, i.e. the insurer; or • An intermediary (e.g. Endsleigh Insurance) selling on behalf of the insurer. • Some intermediaries are not tied to selling the products of only one insurance company but are independent and may consider a number of insurance companies - possibly the whole market - and then recommend an insurer (these are often termed insurance brokers). • Insurance is increasingly sold via price comparison websites such as Compare the Market (sometimes known as aggregators)

What determines whether catastrophes are insurable or not?

The so-called insurability of potentially catastrophic losses depends on a number of factors, which vary in importance, and which may or may not be controllable by varying the terms and conditions of the insurance contract. Insurability problems can arise if insurance buyers are unable to purchase all the cover they require in the private insurance market, or can only do so at a price which is unaffordable. Insurability can be a problem if one or more of the following conditions arise: Insurability can be a problem if one or more of the following conditions arise: 1. Losses cannot be pooled - either because they are highly positively correlated or because the insurance pool is not large enough relative to the losses involved. 2. The probability of loss is so large as to make premiums unaffordable 3. Losses are large in relation to the capital available in the insurance market (causing bankruptcy problems). 4. Information asymmetries are severe. In the case of moral hazard, the main problem arises when the very existence of insurance increases the chances or size of any loss. Ex post moral hazard is a mundane consequence of a natural catastrophe, as householders often take little care to keep the repair bill down. Ex ante moral hazard is also a key issue in insuring against terrorism (which may be designed to damage the financial system e.g. the terrorist bombs in the financial districts of London in April 1992, April 1993 and February 1996, and the 11 September 2001 attack on the World Trade Centre, New York). The recent experience of UK insurers in relation to flooding has also raised another ex ante moral hazard problem: the widespread existence of flood insurance reduces the government's incentives to invest in flood-protection programmes. 5. In the case of adverse selection, the problem arises when the insurer cannot distinguish between high-risk and low-risk activities (either because of a lack of information, or as a result of the regulation of the market). 6. Insurers cannot spread losses over time (as described above). This may be because the losses are so severe that they cause bankruptcy, or because the price rises are so severe that policyholders cease purchasing cover.

Definitions of risk differ, but they generally have the following features...

The term relates to our reactions now in relation to the unknown future: that is, risk is anticipatory or ex ante It arises because of our inability to foresee or control the future It is the result of a random or stochastic world. The future holds out many different possibilities (which may be influenced to some extent by what we do now) but, even if we could list the possible outcomes, we don't know which will occur The random future outcomes include the possibility of an adverse result for us - as individuals, firms or even countries. Although this does not apply to all definitions and all people, most discussions about risk add that people mostly dislike risk. Since this is mainly an emotional response, it isn't appropriate to say that organisations or countries dislike risk - so their reactions may be driven by more prosaic financial factor

Insurance of flood risks - what are the possibilities?

There are many different approaches to insurance in different countries around the world. Where private flood insurance cover is available (and it is not available in all countries, for example Holland) such different approaches can be categorised into two basic types: the option and bundle systems. • The option system - catastrophe cover is an optional extra on top of property insurance and priced according to risk. For example in USA, flooding is excluded from homeowners property insurance (much of the damage from Superstorm Sandy in October 2012 was flooding from the storm surge) • The bundle system - catastrophe cover is bundled with property insurance, and everybody pays the same (except possibly the very highest risk). This solves adverse selection (so long as all insurers 'play') but encourages moral hazard. Of course, the 'bundle' system essentially prevents adverse selection since existing low-risk customers can only opt out of flood cover by not buying any property insurance. Looked at another way, the system protects insurers from some of the damaging effects of adverse selection, and means they can avoid the costs involved in charging risk-based prices

Problems with Property Insurance: Underinsurance

This arises where the sum insured S falls short of the 'full' value of the property V by a substantial margin. Since the premium is often calculated as a percentage of the sum insured, the policyholder would be able to reduce premiums by reducing S. Obviously if S=50 in the previous example, the policyholder would have still recovered 45 but the premium would have only been £1. Insurers solve this by implementing an 'average' clause; usually only for commercial customers. This involves scaling every claim payment by the ratio S/V if there is underinsurance. Thus in the previous example, an insured subject to an average clause would have only received (50).(50/100) - 5 = 20 instead of 45 following the loss. In household insurance, insurers manage the problem of underinsurance in a variety of ways. One approach is to fix S as the rebuilding cost and automatically link it to some form of price For your notes index (such as a rebuilding cost index). Another is outlined by the ABI (2012) Is your home underinsured?: some insurers set the sums insured on a "notional" basis, that is they calculate the sum insured and advise policyholders that they are covered up to say £50,000 for contents and £500,000 for buildings [however, this looks suspiciously like passive selling].

How to calculate how much an insurance company needs to charge to pay its expected claims

This can be calculated as: The probability that an insured event takes place, multiplied by The average claim that it pays if an insured event takes place. If, for example, the insurer estimates the probability of an insured event as 6% (p=0.06), and the average claim as £1000, then its expected claims payments are estimated as 0.06 x £1000 = £60.

What is liability insurance?

Type of non-life insurance that provides insurance to meet legal obligations to third parties arising from nonintentional acts or wrongs, e.g. negligence by the insured

The insurer's liability for the claimant's legal costs

Under English law, the losing party in any dispute pays the legal costs of both parties (this is known as "cost shifting"). Insurers who defend their policyholders are therefore liable for the claimant's legal costs on cases they lose. This includes: a. base fees (i.e. the total hourly fees incurred by the claimant's lawyer) b. disbursements (i.e. the expenses incurred by the claimant's lawyer) Prior to April 2013, insurers who lost cases also had to pay: c. the "success fee" (a percentage of base fees) paid to the claimant's lawyer under any "no-win, no-fee" arrangements (often referred to as "conditional fee arrangements" or CFAs). d. payment of an "after the event" insurance premium, which claimants purchase in order to insure against the risk of losing the case and having to pay the insurer's legal costs. However, concern about the extent of this combined cost burden led to pressure for reform from liability insurers. Lord Justice Jackson's Review of civil litigation costs (reported January 2010), made many recommendations about the need for changes to insurers' liability for claimants' legal costs. Most importantly, it recommended that success fees and ATE premiums should not be recoverable from defendant insurers. This recommendation was included in the Legal Aid, Sentencing and Punishment of Offenders Act, 2012, and has been implemented from April 2013

Other liability insurance is written on a claims-made basis. How does this work?

Under this arrangement the insurer that meets a claim is the one on risk at the date of that claim. Under a claims-made policy, insurers effectively go on risk for only one year at a time (assuming that the policy is an annual one). Cover continues only if the policy is renewed. This arrangement is advantageous to insurers, because it allows them to re-price the risk at each renewal - there is no possibility of having to pay claims under policies issued at the wrong price many years ago. Because claims are met by the current insurer, claims-made cover also has some advantages for buyers of insurance: the policy will be an up-to-date one, cover limits should be adequate and the risk of the insurer becoming insolvent is likely to be small. However, there is a key disadvantage to buyers of claims-made insurance: that is the possibility that the insurers will 'walk away' from the risk - and refuse to renew or agree to do so only on terms that are very disadvantageous to the insured. This might happen, for example, if claims experience starts to deteriorate rapidly. Owing to this difficulty, claims-made policies have sometimes been declared illegal in jurisdictions outside the UK. In practice the problem is alleviated by the use of clauses that protect the insured from any sudden withdrawal of cover.

Explain risk management in firms

While firms need to manage risks, this does not mean that they have to eliminate all the risks to which they are exposed. Indeed, you would expect firms to be content to accept risks in areas where they have expertise; after all, that is how firms make a profit. Nevertheless, there are a number of ways in which it makes sense for firms to reduce risks. They may well wish to reduce the likelihood of the occurrence of risks that affect them adversely. For example, a firm can do market research to reduce the likelihood of it launching a new product for which there is little customer demand. A firm can also take steps to ensure that, if an adverse event arises, the impact on the firm is lessened. For example, it may diversify its product range, so that the impact of one product failing is not unduly severe. Another example is that a manufacturing firm may install sprinklers so that in the event of a fire, the fire damage is limited. However, we also see that risk management has costs: sprinklers cost money to install and, if there is a fire, there can be water damage

Varieties of risk measures are... (there are 2)

o Risk as variation: In this case, risk is measured using measures of variation such as range of outcomes (greatest possible less smallest), the variance or its square root (standard deviation). These could be calculated from the probabilities, or estimated directly from data. o Risk as the probability of an adverse event (downside risk): if events 1 to k are the adverse ones (and k+1 to n are OK) [the decision on what constitutes 'adverse' is obviously subjective] , then the risk = {probability of 1 or 2 ... or k} = p1+ ... +pk if the k events are independent of each other.

What is a Catastrophe?

• A catastrophe can be defined as a sudden, unforeseen destructive event. It affects multiple stakeholders - bringing death, injury, health problems, environmental damage, huge liability costs, and dramatic reduction in profits. • Catastrophes can be caused by natural forces ('natural catastrophes') or are man-made. Often there is a mixture of both factors. • The number of man-made and natural catastrophic events has risen substantially over the last 35 years • More catastrophes are occurring due to climate change

Who pays for catastrophes?

• Detailed figures on who pays the losses arising from catastrophes are very hard to find. However it is usually suggested that the vast majority of losses are uninsured. Munich Re reported in 2000 that only 20% of worldwide losses from natural catastrophes in the 1990s were insured, however the Swiss Re noted recently that the figure had risen to 33%. • The World Bank suggests that the world's poor suffer disproportionately from natural disasters, while not being able to benefit from organised markets in insurance and hedging. • In more advanced economies, about one-half of all catastrophes are self-funded • Insurance demand is inversely related to post-disaster government assistance The operation of catastrophe insurance markets (and the pooling of losses across policyholders) was assisted by a variety of mechanisms including packaging catastrophe and property insurance together, not relating the price of catastrophe insurance closely to the risk (so that low-risks subsidised the high-risks), and various public-private schemes to improve insurability and increase the take-up of private insurance.

What are the main types of liability insurance?

• Employers' liability (EL) which covers the cost of compensating employees who are injured at or become ill through work (it is compulsory by law, and liability is strict in that employees do not have to prove negligence/fault); • Public liability covers the cost of claims made by members of the public for incidents that occur in connection with business activities; • Product liability covers the cost of compensating anyone who is injured by a faulty product that a business designs, manufactures or supplies In this case, the liability is strict so that the 3rd party does not need to prove that the manufacturer or supplier acted negligently; • Professional indemnity covers the cost of compensating clients for loss or damage resulting from services or advice provided by a business or individual; and • Directors' and officers' liability covers the cost of compensation claims made against a business's directors and officers for alleged wrongful acts.

Flooding in London - case study

• Flooding is one of London's highest risks with up to 680,000 properties at risk of flooding across the capital. Three types of flooding may affect London: o Flooding from rivers - fluvial flooding o Surface water flooding, when the draining network becomes overloaded in heavy rainfall o Tidal flooding from River Thames surges - this is what the Thames Barrier protects London against. • Official estimates indicate a 1-in-1000 chance that London will be inundated, even with the Barrier closed • Flooding in London would bankrupt the entire UK insurance industry. • It is London's greatest risk.

There are four ways in which the amount of benefit under a life or pensions policy can be determined. What are they?

• Guaranteed (often known as non-profit or non-participating) • With-profits (also known as participating) • Linked policies, comprising: Unit-linked or Index-linked. These differences represent different ways of risk-sharing between the policyholder and the insurer. All such benefits represent the insurer's promise to pay the policyholder, and therefore represent a liability to the insurer.

How have the Social insurance against the consequences of ill health systems have changed over the past years.

• In recent years, have changed the system. • All you needed in the past was a doctors note for a claim for incapacity benefits. It was felt that people abuse this, and be classed as unfit for work and get the benefits. • Benefits have now been capped. • Companies today often give you, as a benefit, private health insurance. The quicker you are fixed, the quicker you will go back to work - cheaper than sick-leave.

Controlling adverse selection - how did they deal with the problem?

• Information asymmetry controlled by utmost good faith - this requires the buyer to give all the information to the insurance company. • Insurance can decide to limit the insurance. Limitations on the risk to be insured. Insuring theatres: no fireworks, firearms discharge, illuminated scenery • Contract design - to be attractive to low risk only (e.g. with high excess or deductible) • Extra information gathering can impose costs on insurers. So the benefits have to be balanced against these costs (e.g. telematics)

What would a firm need insurance for?

• Its liability if a member of staff is injured on their duties (this is employer's liability insurance - and is compulsory); • It's liability if a student or visitor is injured as a result of the firm's negligence (this is public liability insurance) • Liability to others for injury and property damage arising from the use of firm's motor vehicles (this is third-party motor insurance - this is compulsory too); and • The cost of damage to property arising from a fire, flood or explosion (property insurance - not compulsory)

Where do probabilities come from? (2 answers)

• Probability as a frequency. In this case, the probability of an event is defined as the number of times it has occurred or can occur divided by the number of possible outcomes (n). • Probability as a degree of belief (subjective probability). In circumstances when accurate measurement is impossible (and/or that you have no reasonable beliefs about the equal probability of the outcomes), the probability might reflect the judgment or belief - perhaps of an expert.

What are the different types/products of life insurance?

• Term assurance pays (e.g.) £100,000 (the 'sum insured') on the death of the life insured in next (e.g.) 10 years (the 'term') - no payment if the life insured does not die • Endowment assurance pays on death in next 10 years or on survival to end of 10 years. Work like term insurance, but will give compensation if they live after the fixed term. - most people survive; there is a large element of saving in this product • Premiums typically paid monthly • Whole life policy: provide benefits whenever death occurs, paid on death. Pays (say) £100,000 on death whenever that occurs - policyholder pays monthly premiums to say age 85 - Good for places where there are taxes to pay on death, e.g. inheritance tax. - In poorer communities it is used to py for funeral expenses. • Investment bond: a whole life policy where the policyholder pays one premium only of say £10,000; the benefit on death depends on the value of the fund that is built up from the insurer's investments - primarily a means of saving

Regulating Conduct for insurance companies

• The FCA is also responsible for regulating the conduct of authorised insurers - rules that must be followed for insurance companies. • Rules governing conduct are set out in the FCA's Handbook - Insurance Conduct of Business Sourcebook (ICOBS) • ICOBS includes rules on: - Advertising, marketing and selling conduct - Product disclosure - Claims handling and policy cancellation • The FCA has introduced an initiative on Treating Customers Fairly (TCF) which also applies to insurance companies - applies to any insurance product or company in the UK. • The Financial Ombudsman Service - Available to those customers of insurance companies who feel that they have a valid complaint and that this complaint has not been dealt with satisfactorily by the insurer

Regulating: Solvency?

• The policyholder has an entitlement to be made aware of the possibility that an insurer might not be able to deliver on its promises due to insolvency • Assessing solvency is complex - requires regulation - Any insurer wishing to transact business in the UK must be authorised by both the FCA (Financial Conduct Authority) and the PRA (Prudential Regulation Authority), and must submit annual financial statements to the PRA for scrutiny - The PRA requires insurers to maintain adequate solvency margins: the surplus of assets over liabilities - If insurers fail to meet these requirements, the PRA can take action to restrict the company's premium income or investment strategy