Insurance, legal and regulatory IF1 Study text: 2011-12 the 2011-12 examination syllabus wich wil be examined from 1 September 2011 ud tet encrent is access to Revsontate, the C's easy-4o-useonine study suppor tol, ‘ete a st of on Services fo lp improve your ehences of exam success, | | ese tyicly aclu: a study planner 2 browtsege check (nlp choice test facty covering each cheer | Setinons okey teas, mack eam ad ints er ps I | Too! vo benoit for yours oltow thls ou 1. Goto worm evisionmateco 2. Use your CPI” as your fog name Bul in your Cl PA on he ‘study materia akoowladyment eter indaded wit is study txt ' shoud thereto, checkthefllosng websi egutacy vwonciLeous/uptes© The Chartered insurance institute 2011, All ights reserved. Watetial published in this study text is copyright and may not be reproduced in vihn!e oF in pert including photocopying or recording, for any purpose without the written permission ofthe copyright holder. Such written permission must also be obtained before any part of this publication is store retrieval system of any nature. This study text is supplied for study by the original purchaser of the book only ‘and rust not be sotd, lent, hired or given to anyone else Every allempt has been made to ensure the accuracy ofthis study text, however no lability can be accepted for any oss incurred in any way whatsoever by any person relying solely on the information contained within it.The study text has been produced selely forthe purpose of exam preparation and should not be taken as definitive of the legal position, Specific advice should always be obtained before undertaking ary investments. ISBN: 978 085713 0945 This revised and updated edition printed in 2012 Previcus edition printed in 2009 (ISBN 978 1 85369 962 7) ‘The author David Ransom FCII Chartered Insurance Practitioner ~ David is # fellow ofthe Chartered Insurance Institute and a Chartered Insurance Practitioner. He worked for Royal Insurance Group for more than 20 years, both as an underwriter and in development management roles heading up a team of underwriters writing ‘multi-national businessand global programmes. He moved to the Cll and developed the Cl Distance Learning Division, subsequently heading up, at different times, the Examinations Oivision and College of Insurance (forerunner of Face to Face Training) ofthe Cll, David isthe author ofthe original text for Legal aspects of insurance and numerous other techricat publications and articles, He lectures extensively on many insurance subjects around the world and trains both trainers and examiners, He also acts asa moderator for the examinations of another professional body. Currently he runs 2 training company and provides consultancy services in technical insurance areas 2s well as FSA regulation and compliance, He Is an independent non-executive director of one ofthe largest ‘whotesale Lloyd's brokers in the London insurance market. i Reviewers ‘The Cll would lke to thankcStephen Mason FCI, FCIPD for his assistance with this study text Acknowledgement ‘The Cll thanks the Financiel Services Authority for is kind permission to draw on material thats available from the Financial Services Authority website: wwvw.sa.gov.Uk and to include extracts where appropriate, Where extracts appear, they do so without emendment. The FSA holds the copyright forall such materia. Use of FSA material does not indicate any endorsement by the FSA ofthis publication, or the material or views contained within it” ‘While every effort has been made to trace the owners of copyright material, we regretthat this may not have been possible in every instance and welcome any information that would enable us to do so. Unless otherwise stated, the authors have drawn material attributed to other sources from lectures, conferences, or private communtcations, “Typesetting, poge make-up and editorial services Cll Learning Solutions. 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Stents shut terete, check he fotowing webs regular fr any ants is sty eat nul ent shown under Learning Solutions© The Chartered Insurance Insitute 2092 All rights reserved. Material published inthis study text is copyright and ma in part including photocopying 0° recording, or any purpose without the written poreission of the copyright holder. Such witten perinission must also be obtained before any part of this publication is stored in a retrieval system of any nature. This study texts supplied for study by the original purchaser of the book only and must not be sol lent, hired or given to anyone else. Every atternpt has been made to ensure the accuracy ofthis study text, however no liability can be accepted for any loss incurred in any way whatsoever by any person relying solely on the information contained vithin i. The study text has been produced sclely for the purpose of exam preparation and should not be taken as definitive of the legal position, Speciic advice should always be obtained before undertaking any investments. ISBN: 978 0.95713 0945 This revised and updated ecition printed in 2011 Previous edition printed in 2009 (ISBN 978 1 85369 962 7) The author David Ransom FCI! Chartered Insurance Practtioner~ Davi isa fellow af the Chartered Insurance Institute and a Chartered Insurance Practitioner. He worked for Royal Insurance Group for more than 20 years, both as an underwriter and in development management roles heading up a team of underwriters writing ‘multi-national business and global programmes. He moves te the Cit and devotoped the Cl Distance Learning Division, subsequently heading vp, at different times, the Examinations Division and College of Insurance (iorerurmner of Face to Face Training) ofthe Ci David is the author ofthe original text for Legal aspects of insurance and nuinerous ether technical publications and articles. He lectures extensively on many insurance subjects around the world and trains both trainers ancl examiners. He also acts 2s 2 moderator for the examinations af anaiher professional body. Currently he runs a training company and provides consultancy services in technical insurance areas as well as FSA regulation and compliance, He is en independent non-executive dicector af one of the largest wholesale Lloyd's brokers in the London insurance market. Reviewers The Cit would ke to thank Stephen Mason FCI, FCIPD for his assistance with this study text. Acknowledgement The Cl thanks the Financial Services Authority for its kind permission to draw on material thats available fom the Financial Services Authority website: wow.fsa.govaik and to Include extracts where appropiate. ‘Where extracts appear, they do so without amendment. The FSA holds the copyright for all such material. Use of FSA material does not indicate any endorsement by the FSA of this publication, or the material or vlews contained withinit” While every effort has been made to trace the owners of copyright material, we regret that this may not have been possible in every instance and welcome any information that would enable us to do so. Unless otherwise stated, the authors have drawn material attributed to other sources from lectures, conferences, or private communications. ‘Typeseiting, page make-up and editorial services Cll Learning Solutions. Printed and collated in Great Bri ‘This paper has been manufactured using raw materials harvested from certified sources oF controlled wood sources.The Certificate in Insurance Welcome to the Ci's Certificate in Insurance which isa core qualification for insurance stall working gerose all sectors of the industry. It has been developed by practtionars to provide a grounding in basic insurance principles ineuding the regulatory environment, key insurance disciplines and popular products. It supports ‘ote specific earning which will assist individuals and their employers to develop relevant competences. The Certificate is modular in structure, each unit has a credit value and the accumulation ofthe stipulated number of credits leads to the avvard of the Certificate and entitles the holder to apply to use the designation “Cert CIP" (CII membership and Continuing Professional Development requirements spply). Successful candidates also satisfy the entry requirements of the next qualification in the framework of Cl! qualifications, ‘the Diptoma in Insurance, and will gain recognition far thetr accumulated credits. To achieve the Certificate candidates must achieve a minimum of 40 credits, Candidates are required to take (IF1) Insurance, {egal and regulatory - worth 15 credits, the balance may come from any combination of the available units which are also worth 15 credits each: (UF2) General insurance business: (FS) Insurance underviiting process (VFA) Insurance claims handling process (1F5) Motor insurance products (IF6} Household insurance products GF?) Healtheare insurance products © (F8) Packaged commercial insurances For further details, please see the Certificate in surance handbook (vewetitco.ul). ‘Theres no proscribed order in which units must he taken, but itis strongly recommended that (1) 'nsurance, legal and regulatory is sat first as this provides the foundation knowledge ugon which the other units build All certificate exams are two hours in duration, the format (multiple choice questions and mini case study ‘multiple chotce questions) differs between units with each developed to ensure they are relevant to the ‘material being covered and are appropriate to the level of learning being undertaken. The exams are based fn the published syllabuses which are themselves important ails to preparation and evision. i ie essential ‘hat you familiarise yourself with this before commencing study (provided overtead. You are also urged to give careful thought to your chosen method of study. The Chas developed a portfolio (of study options and revision aids to support learning for the Certificate. Full details of ali of these can be found at wrow.ci.co.uk within the section on the Certificate in insurance,insurance, legal and requiatory Objective “To presid innledge ad undstaning fhe bse pnp of ewer idaving te mnogo riciples related toinsarance contol tha ala egultoy pela asodtneance sine’ and ey elereants to prtec cans Summary of learning outcomes umber of ‘westions in the examination” Underneath te ce > 2 cap he mln eas ol 8k mi 2 2. derstand the mala features afteurnce e 4, Kaow the cinctrs nd mia featera ofthe ncuance mare 4 dettond contatand agency ° | Uadarstaed insole interest an plein insurance 5 . he prince of uost ge faith a 8 proximate cause ard ts applestionto 2 ndertané het enya hw thse spat catacts 7 10, Undextaed the pricper of centbuion and subrogtin 4 14, Undestand therela epulatry and eal easement ppeabe othe 15 lravzncton finance 22, Understand cansumerpreteton ae dete rez 1 Kec the aln ated af prevetng hong ed eel censoner 4 complaints 14, Understand the Cl Code of this and be ate o apply the plese 4 snon-conplexscentos pot at asteroids Important notes + Hothed af assesment £00 mall choles quetlans (NC). 2 hor re allowed lr thie examinaton. + This sytabes willbe examined fom 1 September 201% uni 3: Dreamer 2022. + Canute wil be erannedenthe bass eEaglic nw and race wlec thers sated, + Candidates shuld referto the cll update wesite eden sh eedaee eth ltest information on changes to land pate an when thy wil be esseep et Examination syllabus Undorstnd the nature aad main Feateres ors nthin the instance 13 osathesrmngament fe 24 deserts on cempsit rk 34 Uplntheveteship bevtenbeueny ane 2 Know howto apply the man eotres ofeiek ond fk management to given set of circumstances 3: Understand the main features ef 32 tsibenrdtrincace 22 Sheba cme Seperate ne see ne ers {hd ean isto, Peatrens consid oe Fospeweoes 4. Kou the suture and main features ofthe insurance market, 41 cee tetanic mat {nlite Pe ainropst pte re ‘Wamets sper hase emir) 42 beseie eteretgoteret rnin of nn 19 elnino tintr natant AA cee the Landi 45 Sblnbegpezand eves nts 44 Deaton cians ear Etienne pine, Nese seen 60 + iro Untied andon a + ican nat rake fsa A) + teens Reson ies 20 sree + tae steuc ete 8) 1 tit en 8) + chateed rele herd tele ates * sistas mtn Cente HE ‘Understand contract and ageney poetic ntact eaten {wenger ule edetectan aeons pie Eth eccegens anaes oes geen OOO terres ed ‘Understand iasurableiterast and Re place in insurance ‘pale sbi cee ‘pha appellee neste opr sa ayn conta Understand the principte of utmost 00d ft spate pce atu rotate ‘ailapastocoleaeetienone pas enh day dade pets icon Litineraeepebecstndhoiesnon atts mel et ersExamination syllabus 7S lenlyantubtoguh tne pgsatane 1 Gehman tera ng ‘stuceteatateateiiaas Understand the doce of proximate cause andits epliaton fonor-camplex dates 15 spsyrmecmaeinecnonti 9. Undststand the principle of indemnity snd how this applied to contacts of 94 Sei teptinietideraty 52 Galan cetlenentotne res fete saktw pene cd wah 8 ‘Set ny 2A cota tats mony tea pts, Fitsepoes nat oe 29 dalueareyansecingarne site 30. Understand the pincpies of contribution and subrogation 11, Understand the main regulatory and {egal requirements applicable tothe ‘eansactlon af fasurance business 114. Spans rexenferonpny eens Ssaeie tesco ‘use Caee Reies 9959 al 382 Spl cena nse ae At $84, Specie nt ener Asha feticaatoeton prin ndreptenel setae 129 Gelaherearnestrepring wee Hej! isansndeenstne sda Baesanenca COE eye 12, Understand consume petertion and Aispate racolation meter toaan tay syaytote reson 124 platen! inne Pe Eat 428, Sotthecnanats eesnace Pasa Tak 1B, Knorr the main methods of preventing, handing r@ resolving consumer complaints ie saeco te Yh. Underctond the Cll Code of Ethics and beable to aply the principles on-cauplex scenarios 282 upbremesinpiepesetccctet 182 dpy tn ees tb ote es Eager (Siabbrsecrennereenarst Pubtshed jane 201 ateHF YBO1-2012 sues! ang Examination syllabus ‘dtm seat des Powell ‘ittaatabescanin oe sseatloe vee ule: he ion ete at Wealmeciiptermeeaseaion ono cas eft eevee eon sere ene Soy mn Reeron works Seater | etourneme vs enitiee utara enero en ye te te Periodicals ‘grand Stee Abo aa (Groom anes rey mace ‘Souham Fete el nits, Examination guides Yorsstonaste sey te ‘Gaetan Serra ot ‘Sivoo, Exam technique/study skills Biygernrmtetreict de eatin ‘e ort abled Jane 2023 actaing this study text Welcome to the IF1: Insurance, legs anu regulatory study text which is designed ta support you in your study for the Cll Certificate in insurance. This study test breaks down the examination syllabus into concise sections with each chapter containing defined lezining outcomes, The syllabus learning outcomes covered ia leach chapter are listed on the chapter title p Making the most of your course Contained within the study text are ‘How It works’, ‘Activities’, Thinks" and intext ‘Questions’. These are all designed to help your understanding ofthe material, The ‘Quastions' will test your ablity to apply the material you have just read while ‘How tt Works’ and ‘Activities’ are designed to illustrate how insurance ‘orks in practice and to help you think aroun the subject (you can make your evn notes if you wish), ‘Ansivers to ie ‘Questions’ canbe found at the end of each chapter Atthe end of every chapter there is also set of self knowdedge and understanding of what you have jus back of the book, : {est questions which you should use to check your died. Compare your answers with those given at the Alist of ‘Key terms’ which introduce the main Ideas covered In the chapter appears at the beginning of each chapter. Asummary of ‘Key points’ also provided atthe end of each chapter as a quick memory jogger. By referring back to the learning outcomes after you have completed your study of each chapter and altempting the end of chapter self-test questions, you vill be able to assess your progicss and identity any areas that you may need t0 revisit. General study techniques ‘You will need to put in time and effort ifyou are to master the contents of the course and apply itto ifferent situations. This should not worry you, but you should recognise that your learning and examination preparation needs to be thorough. + Drawing up a plan can help you to study regularly and systematically, Make a timetable covering when you vill study and for hove long, and try to adhere to it. Try to make up for any lost time as you go along. + Itis better (o have frequent shert learning sessions than p long ones. « Study in blocks of ne more than 45 minutes, witha break of 5~10 minutes between biocks, Start the study sessiof with the task you least want to do. Be steet with your use of time. Use of the study materials * Before commencing your studies, take a look at the overall structure and contents of the study text and the topics covered. Briefly scan the material to give yourself an idea ofits scope. Now you will be ready to study the course chapter by chapter. + Make your awn notes on what you read. This makes It easier to remember. * Use your course materials actively: wiite on therm, deaw on them or highlight them, co anything which will help with your revision. + Study under conditions that suit you best and do what you know works for you! Revision * Moe full use of your onn notes. This means keeping them in an orderly way, and ensuring thal you are able to find particular topics easily: perhaps by using different coloured markers. + So ver ateral eared regulary, though qu, This helps to tin your longterm emery. + te doxn impostent ats ane carry them around so that you can test yourself wien you have afew spare moments, + Test your understanding by thinking the material though n your head an by talking though with ether people. * Don't leave revision until the day before the examination, and try not to do too much last-minute revision: Intends to confuse rather than help.roo -2012 sues eed reitoy Use any support available + [tis important fora practical subject fike insurance to recognise thal in order to gain the most from - your studies you need to build on your formal learning by drawing on the additional resources that are available, this may include talking to your colleagues at work, reading workplace publications and raferring ta professional journals and websites. Don’t forget that the syllabus at the front of this study text also 7 containsa list of useful additional reading. t [ I |A The concept of isk B Aisk management Catagories of risk 1 Typos of tsks that can bo insured Summaty of insuraile and wninsurable risks F Components of risk The need fr insurance 1 Pooling af isks 1 Benefits of asurance 1b sharing Dut insurance 1 Seltineurance Wictases of insuranee ‘A Stsuoture ofthe insurance matket we @ inswress 2 € tyes 2 ® The Landen Markt a E tlemetiros wa F Disbuon chanel at 6 Areirs aie 1 instance 2a 1 Proesinasin insurance 26 4 att eranzations 28 tr inser Bara are A cniactaw 7” B Offer and aoseptance 8 consideration Ea 1 Cancion ef insane contac wi E Agenoy 3 F Terms of Business Agroements (TOBAs) anu‘2014-2012 ewan rd eg Aes A Dsinon tins inet 18 Timing of insurable interest © Creation of insurable interest D Application of insurable interest Litter aet ea of ulmast good faith B Duly of disclosure © Malet fact 1D Faots thal donot need tobe disclosed E Consequences of non-tisclosure F iistepresentation 6 Compulsory insurances Rounenen | | SIS/S/8|S/8/8 A Meaning of proximate cause ' Application osiuple cis 6 Mouieaton by poy wordings Appendic 6.1: Standard Fre Pot (ater Damage) AA Doffoton of indemnity me 3 Appian of demniy 18 © Measuringindemnity 18 toying idemiy " “Liming tears 78 ae 3B Applleaton of te priaept of contbution ws © Subrogation an 1D tnsurers’subrogtion rights we Insurers’ rights arising trom he subjec-mater aig F Market agreements _| sa G Precluded subrogation rights aioEe fmnnnqeeu ti 1 Comgulsry nsrenco 1 Unis Genet Fs Consumer Conte! Renlaons 1309 - % & onto itso Td Fare) At 1898 ac D Finacial Series Astor 9A) % “E Distipine an enareerent fee an “F paterson nd requaon ofisurers a 1 Authorisation snd regulation ol intermediaries Tops 1 Traian and Competence 76 1 nsoraes: Conde of usneseSauecboo (C085) wt PAGE meleam iy ‘ata poeatien 1072 D Money! ‘aundering 19/4 € Insurance premium tex 10/7 0 Etial tenders ive “5 Comltsproedes 0/14 F The Financial Ombudsman Service (FOS) 10/13 G The Financia! Services Cempensation Scheme (FSCS) tard Zpped 104: Cal fee aavig Self-tost answers FE 1 eer) a aces x Sates x Indo wG ks It’s important to have the credentials. Join the growing community of insurance professionals by becoming a member of the Cll. Statistics show that a member's pass rate is higher than a non member's. Join up to get help passing exams: + Discounts on learning materials, exams, seminars, study and revision days — membership can pay for itself + Free access to exam guides for written exams + Recommended textbooks and online fact files * Technical reference books and newsletters + Support from other local institute members » Coaching on exam technique and revision courses, ‘And ongoing support for your career: © Use our world renowned designations ~ Cert Cll, Dip Cll, ACII and Chartered Status + News and regulatory updates © Online career support centre + UK taxpayers can claim income tax relief on membership fees. Membership trom as litile as £5.84* a month by Direct Debit. To sign up please contact us on 020 8989 8464 of visit www.cii.co.uk/join *Hemibership prices are reviewed on 1 January each year and are subject to an overall maximum increase of5% in ine with our Royal Charter,STATS ee ‘outcomes: : Learning oboctives Tnoduton ey tere 2 1A Tho cacent fi 124,32 8 isk management 12,21 6 Categories of sk 13,24 Types of ks tal ean be sured a2 “E Surat of neural and urncurebe rsks 12a F Gomponents of sk 15,18, 17,24 6 Tw med or swance He an.az 1 Pooling its a2 1 Benes onsurane aa J flskshering 84 Dua eure a5 1 Seinsurance a5 lass of nsucance a6 Key pins Tuestonenwers Solest questions Learning objectives After studying this chapter, you shauld be able to: * list the main components of isk; © describe how risks perceived; «state the function of risk management; * describe the process of risk managements + demonstrate how Insurance relates to rsks * identity the categories into which risks are divided; © compare insurable and uninsurable risks: * describe the relationship between frequency, severly, risk and insursnes; distinguish the terms peril nd hazard as they relate to insurances describe how? insurance operates as a risk transfer mechanism; describe how the common pool operates; describe how insurance benefits policyholders and society; describe what is meant by co-insurance, dual insurance and setf.insurence; ‘describe the main classes of insurance= we Veatie ‘eclons based Spo a ssessest ork Irvanteror2 sane, pte introduction ‘Speculatve risk Packer ik eee ae itis ‘soety | Pe g nia a ‘Dual insurance ‘Solf-insurance A The concept of risk “The word ‘risk’ Is used ina number of different ways in the insurance market place and we need to look at each of these in turn, Firstly ve ml examine the term in its everyday sense and here we find our frst problem. There is no universally recognised definition for the term, Al Risk perception Ifyou were to ask inyoné winat the term ‘isk’ means fo them you are likely to receive a wide varlaty of ansivers =everything from ike owner of the business being concertied about the possiblity of recession to ‘worried parents concerned about all kinds of dangers faced by ther children. Yet others may identify the risks inherent in running a business, perhaps the demand for their products or obsolescence issues. The list ‘of risks that we face is almost endless. {na personal sense we al ake decisions based upon an assessment of risk. Most of this is ceried out informally. We assess the kelIhood of rain occurring and decide whether to take an umbrella with us when we {eave our home in the morning. There may be some data involved (a weather forecest from a reliable source} ‘or we may have merely looked out of the window to make the judgment about the Ukelihoad of rela, This Informality may be acceptabicin“low risk’ situations where the ultimate calamity is something ke wet clothing, but in many contexts we need better measurement tools, especlally where the potential for loss fs significant. Risk measurement and the means of attempting to deal with the risks we face are collectively termed risk. management. In a commercial context this is often a well-definad and sclentife process, attempting to answer questions such as ‘How much wilt cost If things go wrong?’ and ‘What are the chances af the isk becoming reality? We will deal with these issues in greater detail later in the course. Ina personal sense most individuals make less precise calculations, often preferring instead to simply protect against those ‘things that seem capable of inflicting some kind of nancial disaster, such as fire or theft. We begin by considering just what is meant by the term ‘risk. A2_ Definition of risk Consider the following statements, each giving a different slant to the term ‘isi’ + The possibilty ofan unfortunate occurrence. + Doubt concerning the outcome ofa situation. * Unpredictabitity. + The possibilty of oss. +The chance of gain (suchas hoped for benefit from gamble or investment strategy). Whichever we choose, we need to recognise the elements of uncertainty and unpredictability or in some of our definitions, danger. The term often implies something that we do not want to happen. AS we shall see tater, not every typeof risks insurable. ust think fr the moment, however, about owing a car. There are many risks associated wih this, including: » the thatthe car wil be stolen in the future; * the risk of a car accident with or without injury tothe driver; «the csk of injuring others as@ result ofa car accident; and + the risk of damage tothe car caused by another driver.Each of these represents a sisk so far as the over is concerned. ln each case itis possible to insure {transfer the risk, This is done by the ovener paying a known premium to an Inswer i return forthe insurer sccepting the future ar. now cost af te insured rish, The insurer does this by promising to pay for loss, Jomege or ability as defined by the policy terms. insurance therefore isa means of transfering the risk. The eceepting of an unknown future potential ‘by an insurer for an agreed premium isa way of detining insurance as a risk transfer mechanism. It brings peace of mind to the insured because they have replaced ‘ive uncertainty of possible future toss withthe certainty cf the agreed premium, We consider this aspect loter in the chapter, ‘isk transterod Pays premium A3 Other meanings of the term ‘risk’ ‘Although this section is devoted to risk in its generic sense, there are three other ways in which the term is used in the market plas * Tho first refers to the peril or contingency thatis insured ~ the fire risk, the theft risk and so on. » The second use of the term relates to the thing (or lability) actually insured. In this context the ‘risk’ could be a fattory ora manufacturer's ability tothe publi * Whefian underwriter quotes for‘a risk? an even wider definition Is implied, The underwriter will mean both {he thing insured, such as the property itself, and the range of contingencies or scope of cover required, Ad Altitude to risk Each person's attitude to risks alferent, Therefore, we all respond to risk in a different way. Some people are willing to carry certain tisks themselves and are termed risk-seakdng, while others lean more towards being risk-averse, feeling happier minimising the risk to which they are exposed (perhaps by transferring the ‘isk, asin insurance}. Very few individuals are in a position to evaluate, with any accuracy, the risks to wich ‘they are exposed. Hoivever, as we shall now see, many companies attempt to achieve this as part oftheir risk ‘management process. B Risk managemeni ‘There s a continuing trend! towards taking control and developing a formal strategy for managing the various risks that affect businesses, The appointment of risk managers in industry and commerce is now commonplace. Many are members of Armic, an assaclation of insurance and risk managers. This organisation has been influential in setting standards in areas of risk menagement and, with other organisations, has published a Risk Management Standard that has been widely adopted. Risk management is important for a number of reasons: * Itreduces the potential for loss by entifying and managing hazards. * It gives shareholders a greater degree of confidence ina company’s ability to manage its risks. for companies quoted on the stock market there isa legal requirement to identity all significant risks to which the business is exposed and lo explain in the annual report how these are being managed. * Itprovides a disciplined approach to quantifying risks, The decision to transfer risks for example, by insurance) is an important final stage inthe risk management process,‘tateoor tie ‘mena et {eendestay and Weoit-2012 sane, wal andagry ‘Wiien it comes to general Insurance, isk managemient is. significantly diferent concept for individuals than itis for businesses. Many individuals, when they consider their own financial planning, personal pi and wealth management issues, tend to adopt a formalised approach, often facilitated by = financial adviser - This will involve the completion of detailed ‘fect find’ and an equally detailed consideration of the income, savings, assets, health and future aspirations ofan individual, However, the issue of personal genecal insurance does not very often follow this detailed pattern, Oftenit is nat bought as the result oF a made decision that insurance isthe best solution to particular financial problem. Instead its bought because certain elements of cover may be compulsory, such as third party motor insurance, which the lavr requires everyone to have. Alternatively, it may be that another party has a financial interest i the iter lo be insured, for example fan individual buys a house, there is usually a mortgagee whe will insistaypon insurance being effected ‘ iy Of course there are areas where there Is real choice as to whether to insure or manage the rsiin same other way. However, even hei itis highly unlikely that a scientific approach willbe taken to assessing isk. The ‘mest dominant factors likely to be an individual’ risk appetite or an inability to afford insurance pratection, Individuals with very substantial physical assets may adopt a more formalised system. These types oF policyholders are often termed ‘high net worth’ individuels and certain insurance products have been developed specifically for them. B1 Function of risk management Risk management may be defined as: ‘The entiation, analysis and economic contro of those risks which can tiredten te assets or earning capacity of an enterprise ‘The Focus of good risk management is ne identification and treatment of defined risks. Risk management should be @ continuous and developing process embedded in the firm's strategy. It should adress ‘methodically all the risks surrounding the firm's current, past and future activities. This definition identifies the three steps involved in managing the risk Let us look at these in more detal. BIA Risk identification Risk identification involves eiscovering for the company the threats tai that may already exis, ane the potential threats that may exist in the future. Not all ofthese risks willbe Insurable, but they must all be ‘managed. For the retail shop, petty theft and shoplifting may be real risks and will need to be managed in ‘some way or funding set aside to cover their costs. For many corwentional risks, an insurer may become. Involved in helping to identity existing and potential risks through carrying out a physical examination oF survey. Insurers also play a role in relation to risk control when they provide reports following the survey. BIB Risk analysis Risk managers will exemine past data to evaluate or analyse the risk For example, they can look atthe past loss patterns of, say, motor accidents involving drivers under the age of 25 years, and so predict what is, likely to happen inthe future for drivers who fall nto this category. Equally, patterns of reported accidents inthe accldent ragister may be analysed for future trends. Insurers will look at many ofthe came elements ‘ulien considering the rating of risk. B1C Risk control = Ifthe risks seen to have the potential for adverse consequences, some course of action should be put inplace to control, reduce or even eliminate the risk, Elimination is the most effective, but may be costly - ‘oF impracticable. For example, if manufacturer caries out some palnt spraying activity thats highly hazardous, it may be possible to outsource that part of the process and in so doing eliminate that clement of the risk. The elimination of risk, or even its reduction, wil always be subjac to the test of whether the cost of doing so is reasonable compared to the cost ofthe feared event happening,There are 10 distinet aspects to the comtaling of ris = phy and iel control measures: such as puiting specific locks on the doaus o tory to reduce the thet isk, * financiat control measutes: such as transferting the risk by ether toking aut insurance or by contract (@.. aitonging for a security rm to accept responsibility for cosh whils in its contro). st in the area of loss prevention and control. They do so by imposing requirements and making recommendations designed to improve the risk, following the conmpletion of a survey. These are important parts ofthe surveyors report and will ether be aimed at improving the risk to an zeceptable standard! from ihe insurer's point of vies, or wil offer premium teduetion as an incentive far warthvshile risk improvements. In a wider contest, insurers are involved in researching areas of loss prevention and contral. Much ofthe work is caried out on their behalf by the Loss Prevention Council (LPC), which forms pat ofthe Building, Research Establishment (BRE), and the Fire Protection Association (FPA), The kind of work these bodies undertoke includes: + researching new materials and methods of construction and secing how they behave in afi * providing rules that set standards of construction; + reporting on new industrial pracesses and machinery: and * providing rules for the const sorinkler systems. installation and operation of fire extinguishing appliances, G Categories of risk ltdoes not follow that, having identified a risk, tt wlll automatically be insurable, Not every type of risk oF eventvaity is insurable, It will help our understanding if we ook at (and contrast) diferent types of risk to identify those that are insurable and those that are not, The groupings that we will look at are + financial and non-financtal; ‘+ pure and specutativej and * particular and fundamental. C1 Financial and non-financial risks ‘Some of the risks that we face are not capable of financial measurement, They may have a financial aspect to them, butitis incidental. The real risk arises from decisions and actions motivated by other considerations, Take for example the choice of a martiage pariner er our enjoyment of a holiday. We cannot measure these in financial terms. Inthe same way, the value we might place on an heltloom that has been in the family for years, may be far beyond its intrinsic or market value, Insurance is not appropriate for such risks. The heirloom could indeed be insured but only fr is intrinsic value, not forthe sentimental value we place on it. Fora risk to be insurable the outcome of adverse events must be capable of measurement in Financial terms. ‘Most generat insurances are compensatory in nature, as we shall sce later. This means that the value placed ‘on the ioss Is not determined in advance. important exceptions to this general tule are personal accident and sickness policies. This is because there is no way of valuing preciselfthe loss of a Ife or the loss of sight so these policies are taken out in order to provide pre-agreéd amounts in the event ofan accident or sickness. They are known as benefit policies. Similar considerations apply to life assurance policies. Let us look at seme examples of fancl ks to help us understand this concept: + Accidental damage to a motor car: the financial value ofthe risk isthe cost of repairing or replacing the vehicle. + Theit of property: the Financial value ofthe risk of theft of zr. item of jewellery i its current market value. This is measurable in financial terms. it would not include sentimental value because, as we have seen, {his isnot precisely measurable fa financial terms. * Loss of business profits following 2 fire: ths risk is measurable since comparisons can be made to similar trading periods to devise a fir estimate ofthe loss to be pid by the insureras compensation, + Legal liability to pay compensation for personal injury to others: the courts measure the value of damages applicable for the loss of a leg, for example, agalnst compensation payments made previously in similar situations. Usually a standard Formula is apalied to calculate damages that will take account of financial circumstances as well as the injury itself. ‘Some sks a ot apt of anitincnenimediiunin Parodie we tir er the poset tose atnet eos FF V20A2012 tare el aap C2 Pure and speculative risks There aze many situations in fife when we speculate examples are the Nation Lottery or other forms of gambling. There are also situations suchas investing In the stock market or starting up a new business that fall into this category, as well as pricing decisions and other aspects of marketing. Each ofthese alms to make a gain, but carves the possibilty of break-even oF failure. Consequently though there are some aspects of business activity that can be insured, this daes nat include things such as misreading the market or a business ailing because of focal competition. Insurance does not apply to speculative risks, a view to making some kind of gain. Obvious Pure risks, on the other hand, ate those where there isthe pdésibilty of ¢ loss but not of gain, and where the best that we can achieve is @ break-even situation. Travelling home in a car is @ good example. The best that ‘we can hope fori a safe arrival. The possibility exists however, that there might be an accident and the car ‘damages or someone injured. Its these types of risk that are generally insurable. You may have already thought ofthese, but here are same examples of pure risks: * The risk of fire It could damage or destroy property or cause an interruption to the running of the business, both are measurable in financial terms. ‘+ The risk of machinery breakdown: this could lead to actual damage or business Interruption. + The risk of injury to employees at work: if such injury is caused by the negligence ofthe company, 2 court ‘may avtard damages and costs. These are measurable in financial terms, C3 Particular and fundamental risks ‘There are some risks that occur on such a vast scale that they are uninsureble, These ae called fundamental risks. Take for example the risk of earthquake in a region known to be prone to such risks, or famine, economic recession or 8 mare general risk that of war. However unlikely the risk of war may seem, its effects bring a catastrophe potential that insurers are not willing to carry We can, therefore, define fundamental risks as those that arise Irom social, economic, politcal or natural causes and are widespread in thelr effect As we have seen, nor-financial or speculative risks are uninsurabie asa matter of principle. In contrast, the problem with fundamental risks is that itis often a lack of willingness or capacity on the part of Insurers that causes such risks to be uninsurable, It's not an easily defined category and there seem to be, onthe face of it, many exceptions to the general rule. Just think of the terrorism cover provided on the World Trade Center, or the fact that marine insurers wilt ‘often grant war risks cover for vessels and cargo, or even the fact is possible to be insured for earthquake cover in Californiz. Nevertheless, the fact remains that those risks that tend to affect whole rountres, regions ‘oF communities are classified as fundamental and therefore, generally, uninsurable. ‘Two risks automatically categorised in this way for non-marine polices are war risks and nuclear risks. elds Geis {mn contrast to fundamental risks, particular risks are localised or even personal in thelr cause and effect. ‘Sometimes the cause may be more widespread (a storm over a whole region), butthe effect Is localised or even related to an individual. Not all properties in the region will have been damaged, ‘Again, to help us understand let us look at some examples of particular risks: + A factory fire: this would cause local would not affect the whole community. + Acar collision: damage to the vehicles and any thd party lability are localised events affecting relatively Few individuals + Theft of personal possessions from a home: an event that only afects an individual or family sd damage to the factory and possibly to its surcoundings, but ‘We have established that only certain classifications of risk are insurable: those that are financial, pure and particular. There are certain other things that need to be in place for a risk to be insurable. In section D we illlook at what these are,apie amd se ia ] D Types of risk that can be insured 113s important that you understand that not every risk is insurable. Fora isk to be incurable, in auditon ta being financil, pure and, generally speaking, particular, the following features must also apply: + the event insuved against must be fortuitous or unforeseen; * there must be insurable interest; and » insuring the risk must not be against public poticy. D1 A fortuitous event To be insurable, the happening ofthe event must be fortuitous. In other words, it must be accidental or ‘unexpected and not inevitable, so far as the insured is concerned. it must certainly not be deliberate on the part ofthe insured, An example of a non-fortitous loss is an insured who deliberately damages thelr car. Not all elements of loss or damage may be fortuitous; for example: a (hell may have required careful planaing by the thieves, but still be unexpected so far as the insured is concerned. D2 Insurable interest Insurable interest is the legally recognised financial relationship between the insured and the object or ‘ability thats being insured. For example, you can insure against the theft of yous own car, because you suffer financial loss fit is stolen. Other financial interests are also recognised as we shall see when we deal ‘with this subject more fully in chapter 4, 03 Public policy leis commonly recognised in law that contracts must not be against public policy or go against what society considers to be the right or moral thing te do. Insurers should no, therefore, cover risks that are against public potiey. For example, it would be against public policy to insure the risk of incuring a fine for a criminal offence. The risk may appear to have all the features ofan insurable risk, as the event may be considered fortuitous (accidental) and the insured has an insurable interest, since they suffer financial loss as 2 result of the fine. However, itis clearly unacceptable to be able to insure against paying fie, because the fine's purpose is to punish the indvidual. Providing insurance for it may encaurage people to break the law. ‘There is one other aspect ofa risk that insurers will examine when deciding whether it will considera risk insurable: the question of homogeneous exposutes. D4 Homogeneous exposures : A sufficient number of exposures to similar ists, historical patterns and trends will enable an Insurerte forecast the expected extent of future losses. We could cal such risks objective risks. n the absence of a large number of homogeneous exposures (.. similar risks) the taskis harder, as a pattern is more dificult to determine. n extreme cases where there fs no historical data, the risk becomes a subjective ane from an insurer's point of view Whereas fortuitous loss, insurable interest and not being against public interest are absolute requirements, the concept of homogeneous exposures is an ideal. There are occasions when an insurer will need to use less than fully reliable historical data when fixing premiums. ‘The UK insurance market is, infact, renowned fr its ability ta insure almost any risk. There are examples of unique risks, such as the fingers of a famous pianist, being insured in the UK market, Simitarly, insurance is available for satelite launches, even though instances of such launches are fall infrequent and any Faire, catastrophic. However, wherever possible, an insurer looks for homogeneous exposures in order to utilise as fully as possible the lav of large numbers, The greater the number of similar risks to insure, (he closer the actual outcome will be to what was expected in terms of losses.we Uaetieie then cave ohe scent st IFe2012012 Inte, gid elony Homogonaous exposures One-ifs(ganeraly) F Components of risk In orderto gain a deeper understanding of the meaning of risk, we must now take a closer look at the various ‘components of risk. These include: + uncertainty; * level of risks and + peril and hazard Fi Uncertainty ‘The concept of uncertainty implies doubt bout the future, a5 2 result of our incomplete knowledge. Uncertainty is atthe very core ofthe concept of risk for, if we know what is going tohappen, there is ne element of risk involved. Ifyou know that your house wil bucn down at 4.00pm tomorrow, or that on the way home you will have an accident in the car, there is no risk ofthe event happening, as the event would become a certainty. As we do not have this prior knowledge, we can say that we live in an uncertain or risky environment and that risk exists separately from the individual. Even in the context of tie assurance, there is uncertainty. We know that we wil all die at some time; the Uncertainty relates to the timing of our death, F2 Level of risk ‘The second espect of riskreletes to the different levels of risk that exist. We know that there is 2 greater Likelihood of some things happening than others and this s what we mean by the level of risk involved. Risk {s usually assessed in terms of frequency (how often It will happen) and severity (how serious itwill be ifit does happen). These are the measurement ctteria used inthe risk management process. F2A Frequency Imagine a house situated on the side ofa river which is known to be prone to overflowing its banks. This situation involves risk. There is some doubt as to the future outcome because itis uncertain whether the river wil ever overflow and fit does, when this will happen, The fact that the riveris prone to overflowing increases the chance that damage will occur. Imagine a second house which is 100 metres away from the river bank and on a slight hill. This house will be less at risk from flooding because ofits posit F2B Severity (Our judgment 2s to the level of risk posed may change if we consider the potential amount of loss, damage fr destruction. For example, ifthe frst house close to the river is valued at £90,000 and the second house, further away, is valued at £250,000, we might modify our view as to which house represents the higher risk, inview ofthe higher potential severity of oss, Therefore, factors relating to both frequency and severity must be taken into account in our assessment of risk. The relationship between frequency and severity vaties from tone risk to another.frequency and tow severity Ja large number of diferent risk situations, there is 2 high frequeney and low severity of fose wheve basse are a large number of small losses and relatively fe: large losses, Ths is Mutated in igatef.1. This could ‘relate to comprehensive private ear poticies, vinere there are many losses for damage tothe inswei"s in vehiele ata feirly modest level, but relatively few very cosily third party personal injury clams, Frequency Severity. Glen exuu ten This relationship between high frequency anc low soverty esses is not limited to property damage. In fact, ‘esearch into industrial injury incidents hes shown a very similar pattern. the Heinrich Tangle, developed in 1931 (given in Figure 1.2), shows that, at that time, for every one major Injury at work, there were 30 minor ones and 300 nor-njury ineidents, The tangle was created as the result of looking at several thousand incidents at work and similar studies have given similar results, The pattern shows fei serious incidents and very many minor ones, Similar research has been carries out in the area of motor accidents (by Frank E Bird in 1969) using the Statistics from 2 million accidents and near misses. Critically from aa insurer's perspective, the reletionshiig between serious and minor incidents is an important one, as we shall see. ‘Minor ingies on-injory ancientsv0 Frinamortae fecone en Ireqerey ad eve IF y201-20%2 lasses, leper Low frequency and high sevesi In some cases there is a low frequency andl Nigh severty of oss, Mlusireted in igure 1.3. The total number of such events Inet be as high 2s the events that we llustrated i figure 1.1. In this case, a small number of events would resutin very high costs. Accidents involving aircraft are good ‘examples of this type of risk profile because, when 2 loss occurs the cost could be substantial. However, technological advances help to reduce the frequency of accents. (OH Frequency F2C_ Significance of frequency and severity ‘The different frequency aad severity profiles are important fo Insurers. This is because they wish their businesses to be, as far as possible, ree from great peaks and troughs of claim payments niade from one year to the next, Smooth trends in reding pattems tend to encourage investors te support an insurer. An insurer will often base its decisions on how much ofa risk it can prudently accept on factors eelating to Frequency and severity. Insurers have verious ways of dealing witha risk thet is offered to them where the amount involved exceeds their normal acceptance limits. We will examine these later inthis course, F3_ Peril and hazard The concepts of peril and hazard together form the Final aspect of risk. This aspect relates te the causes of losses: ‘= A peril can be defined as that which gives rise to a less. + Ahazard can be defined as that which influences the operation or effect ofthe peril, At ist, the distinction between the tvro may not be that obvious. However, the following example should help. Here are some other examples of peril: + The overflows of water tanks: ths isthe event Insured against, which may give rise to loss. + Lightning: when it occurs, this natural peril ean result in damage. ‘And some other examples of hazard: + High value sports éars: the hazards in this motor insurance example are the potential for high speed, 7 which in turn increases the risk of accidents, and the high value and attractiveness that increases the risk of theft. * Asafari holiday: the climate, the existence of ocal diseases and the likelihood af injury all increase the possible extent of loss and are, therefore, hazards in travel insurance. Hazard breaks down into two further parts: it can be physical or moral.Mey fe nateannes Physical hazard retates to the physical characteristics of the risk and incluces 0 the risk, Examples are: ry measurable dimension et + Security protection at a shop: the greater the security protection, th ‘may even prevent a loss altogether. beter the physical hazacd lev * The construction of the property: the higher the stanciard of building construction, the better the physical hazard for fire and similar risks, as the building will be more sesistant a damage, + The age of a proposer and type of car For motor insurance. These are Factush, measurable dimensions. ‘Moral hazard arises from the atitude and behaviour of people. In insurance, this i usually the conduct of ‘the person insured, However, the conduct ofthe insured's employees end that of society asa whole are also ‘aspects of moral hazard. Examples include the following: * Carelessness: a driver's lack of care can increase the chance of an accident happening and its severity. * Dishonesty: a person who has previously made fraudulent or exaggerated claims represents poorer moral hazard than one who has not » Social attitudes which, for example, da not regard cheating insurers immoral Itis sometimes diffcutt to distinguish between physical and moral hazard, This is because, quite often, poor ‘moral hazard will be eccompanied by some kind of poor physica aspect. Take the example of careless or lak rariagement In a factory. This is clearly something relating to attitude and behaviour, but it may be evident because of unguarded machinery ora lack of contro of smoking by employees, for example. ‘We must guard against the tendency to jump to the conclusion that there is an adverse moral aspect to 2risk, merely because the risk is an obviously heavy one, For example, a fireworks factory ceprecents a very heavy fire risk, but it does not follow that there is a poor moral aspect to the risk, Equally, a young river sho js driving a high performance car cettainly represents a peor physical hazard, Statistics shove that a disproportionately high number of accidents are caused by young drivers, The car itself willbe in @ high rating-group because ofits value and performance. These two aspects are physical because they ate measurable. Its, of course, possibte that some other factor may point towards poor moral hazard - pe:haps ' poor claims history or serious motoring convictions. & The need for insurance ‘eally need insurance? This is a question that is frequently asked, particulotly when an Insurance Fenewal notice drops through the letter-box. Whether an individual wants seme form of insurance depends fon thetr attitude to their potential risk, what price they are prepared to pay for the peace of mind wien insurance gives and the extent to which thay eel they have a choice about insuring the tsk. Insurance has been around fora very long time. ith its origins inthe éiferent kinds of situation where Financial protection is required against the possibilty of suffering some misfortune or loss. ‘We shall now look at how peace of mind is achieved. \We have already stated that the primary function of Insurance fs to aet as a risk transfer mechanism that 's, to transfer a risk from one person, the insured, fo another, the insurer. Transferring the risk to an insurer does not in itself prevent losses from occurring, but it provides a form of financial security and peace of mind for the insured. The large unknown financial risk that an Individuat faces of their home burning dovn, for ‘example, is transferred to the insurer and replaced by the much smaller and certain cost ofthe premium. In the next few sections we will move on to look at some other key concepts that undertine the way insurance works, Trepinay turn ot Ineazce ea cet seanittronter seetaasn‘sas a arent te “onl ne ‘ary 02 mares sey H_ Paoling of risks The basic concept af insurance is thatthe losses of the few who suffer misfortune ere met by the contributions of the many who are exposed te similar potential loss. An insurance company gathers together ely smal sums of money from people who wank to be protected financially from similar kinds of per ‘The insurer ses itself up to operate @ pool. in fact, as we shall see, insurers operate a number of separate pools for each differefit class of insurance. Contributions, inthe form of preiniums from many insured, go into {his pool. From the poal, payments are masde to compensate the losses of the few. These contributions, or premiums, must be large enough, in total, to meet the losses in any one year.In ‘addition, they must cover the costs of operating the pool and provide an element of profit forthe insurer. ‘The insurer endeavours to make sure that the premium which each insured pays is proportionate tothe risk which they introduce to the'poo! (sae section #2). Hi Law of large numbers: In operating the posh, insurers beneft from the law of large nurabers. This states that where there are a large ‘umber of similiar situations, the actual number of events occurring tends towards the expected number. The law of large numbers can be illustrated by considering the fip of 2 coin, which can result in a head or a tal Flipping a coin 20 times may result in any combination of heads and tails: there may be twelve heads and eight tails or any other combination. On the simple mathematics of the situation, you would expect to get the same number of heads and tals, because the chance of getting eltheris 50%. However, flipping the coin just 20 times may not give us the 50/50 split we would expect. Flipping the ci 110,000 times, we would almost ceitanly see a result of approximately 5,000 heads and 5,000 tails. The law of large numbers, therefore, operates to give a cesult which is In keeping with the underlying probability (liketinood of something happening) of, in this example, 50% heads and SO% tall, Applying the principle ef large numbers to insurance enables the insurer to predict fairly confidently the Final cast of claims in any one year. This is hecause insurers provide cover against a large numizer of similar fisks, and the inal number of actuat loss events tends to be very close to the expected number, provided the conditions under which the original data were gathered remain constant. This enables the insurer to calculate likely losses and so confidently charge a fixed premium, meaning thatthe insured knows what their Costs will bbe For the year, irespective of the number or size of thelr own particular losses from Insured causes. H2 Equitable premiums To operate a pooling system successfully, @ number of pools must be set up, one for each main group of risks, For example, an individual poo! for, say, motor insurance and another for household insurance must be set up. Esch person wishing to join the pool must be prepared to make an equitable (fel contribution to that pool. ‘When deciding on an equitable contribution, insurers take into account the different elements of rsk bbrought into the pool by each ofthe insured. These are often referred to 6s discrimination Factors. Arriving at a premium is @ complex process and the correct assesement of risks extremely important. The ccrrect assessment will ensure that flr premium is charge, and 2 fal profit can be made, This isthe task ofan ‘underwriter when considering an incividual risk. SEG PS (testa Senee oe Hives: