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Insurance is a kind of risk management basically applied in hedging against the risk of a conditional uncertain loss. Insurance can be regarded as the evenhanded risk transfer, as a result of this unknown loss, from one entity to another in a swap over for payment (Gollier, 2003). The insurer sells insurance while the policy holder or the insured is basically the entity or the person buying the insurance policy. The amount, which has been agreed upon as charges for a specific insurance amount, is known as the premium. Risk management is the process of appraising, evaluating and controlling risks (Vaughan, 1997). The transaction essentially links the insured, in an assumption that takes on a guaranteed and established comparatively small loss in the nature of payment, to the insurer in the faith that the latter will compensate or what in insurance terms is known as “indemnify” the insured in the case when a financial loss has been realized. The insured receives the insurance policy that serves as a contract. This insurance policy contains details about the circumstances and conditions under which the insured will be compensated financially.
The management of risks through insurance has been ongoing since the dawn of civilization. The transfer of risks has been a gradual practice for many centuries. Private insurance companies have been in the industry insuring risks that have about seven common characteristics. One of the characteristics is, 1) a risk with a large number of same exposure units. Insurance companies operate by pooling resources and, therefore, the majority of policies are offered for individuals forming part of a huge class (Schindler, 1994). This allows the insurers to gain from the principle of huge figures where losses are equal to the real losses. One significant figure in the insurance world is Lloyd’s of London. Lloyd’s of London is famous for insuring the health and the life of sports personalities, famous people and actors. All the same, all exposures will have specific disparities, which could amount to disparate rates of premium.
Another risk characteristic is 2) that which has a definite loss. The loss occurs at a specific known time, in a place that is known and from a cause that can be established. An example is the death of an insured individual based on a life insurance policy. Thirdly, 3) an accidental loss is also factored in. This is where the event that triggers an insurance claim must be unexpected, or may be beyond the beneficiary control. Thus, such things like the purchase of a lottery ticket cannot be insured. Another characteristic is 4) a huge loss. The loss size should be great causing a significant financial loss to the client. Additionally, these risks 5) must have a premium that is affordable. If the risk is too high, it will attract high premiums. Under such circumstances, the insurance may not be purchased. Again, 6) the risk must involve a calculable loss. This means that the loss profitability and the attendant cost must be estimable (Kunreuther, 1996).
Loss profitability is basically an empirical exercise, whereas the cost refers to the ability of a reasonable individual with the policy copy and a loss proof, linked with a claim offered under that policy, to make a convincingly objective and definite evaluation of the loss extent that can be recovered from the claim. The last characteristic is 7) having a limited chance of disastrously large losses. Thus, the insurable losses are supremely independent and not catastrophic, implying that the losses do not occur simultaneously and personal losses are not relentless enough for the insurer to become broke (Abramovsky, 2008).
Insurance industry has legal implications. The insurance company must indemnify the insured in the cases of particular losses based on the interest of the client. Another aspect is the insurable interest. The insured usually should suffer directly from the loss. Insurable interest should exist regardless of the property or person insurance involvement. The insured should have a “stake” in the damage or loss to the property or life insured. The policy should also be issued in utmost good faith. The insurer and the insured are both bound through a good faith bond of fairness and honesty. Material facts should be disclosed. On matters of contribution, insurers, who have the same obligations to the insured, make contributions to the indemnification based on some method. Subrogation is another legal requirement where the insurance company gets legal rights to follow up recoveries for the client. For instance, the insurer could sue the people who are liable for the loss incurred by the insured (Gregory, 2003). Moreover, causa proxima or proximate cause is applied. The cause of the peril should be covered under the policy insuring agreement, and the overriding cause should not be excluded. On issues of mitigation, the asset owner should attempt to maintain the loss at low levels as though the asset was not initially insured in the event a casualty or loss occurs.
The indemnification process involves taking the insured back to the normal status following damage incurred. It is an act of reinstatement to the former financial position of the client. All the same, indemnification cannot apply in a life nsurance policy. It is instead referred to as ‘contingent’ insurance meaning a claim occurs on the happening of a particular event. There are usually two forms of insurance contracts that are aimed at indemnifying the insured: an “indemnity” policy; and a “pay on behalf” policy. Although there is a big difference in literal terms, it is insignificant in practice. A policy of “indemnity” cannot pay claims till the insured has made payment to some third party. For instance, in the event when a company’s visitor loses a car following an explosion from the compound and wins a case against the insured, compensation will come out of the pocket of the insured and then only the insurance carrier would indemnify the costs for the client (Schindler, 1994). The case would be different for the “pay on behalf” policy where the insurance carrier would pay the visitor.
The Insurance Policy and Insurance Claim
The insurance policy is a schedule acting as a contract that is legally binding the two parties. This insurance contract must have the following mandatory requirements: identification of the parties involved, i.e. the insured, the insurer and the beneficiaries; the premium; the duration of coverage; the specific loss event that the policy covers, the sum insured or the amount that has been covered referring to the amount that the insured will pay to the insured or the indicated beneficiary if a loss occurs. The policy must also indicate the exclusions or the events that are not covered. Thus, the client can only be indemnified against the loss that has been included in the policy (Grace & Phillips, 2007a). When the parties of the insurance encounter a loss for a particular peril, the coverage expects the holder of the policy to launch a claim against the insurance company for the loss amount covered as detailed in the policy. The fee that the insured pays the insurance company for assuming the risk is known as the premium.
Insurance Business Model
Insurance involves the process of underwriting and investment. The business model is aimed at accumulating more premiums together with investment income than the payment made for losses, and also at providing a competitive price that is acceptable to consumers. The profit of the insurance business can be simplified in the equation: Profit = premiums earned + income invested – (loss incurred + underwriting expenses). Insurance companies make money due to two techniques. One of the ways to gain funds is through underwriting. Underwriting is the process through which insurers select the risks that should be insured and make a choice of the amount of premiums to be charged for accepting the defined risks. Through investments and the premiums, collected by the insurance company, more income can be generated (Berger, Cummins & Weiss, 1997).
Insurance business processes and procedures can be complicated. This is experienced ever more vividly when it comes to actuarial science. The actuarial science is commonly involved in the policies’ ratemaking, which is usually conducted through a process that is commonly known as price-setting (Brown, 1993). It uses probability and statistics to estimate the future rates for claims based on a specific risk. After these rates are produced, the insurance company uses its own discretion either to accept or reject risks through the process of underwriting. At the most fundamental level, initial ratemaking includes looking at the severity and frequency of insured perils and the anticipated average payout that results from such perils. Thereafter, the insurer normally collects a historical data loss, estimates its current value, and compares these initial losses to the premium gathered for the purpose of evaluating the rate adequacy.
Expense loads and loss ratios are also applied. The rating for various risk characteristics includes, at the most fundamental level, the comparison of losses incurred with the relativities of loss. Thus, A policy that is found to have many losses would be charged proportionally according to the losses. More multifaceted multivariate analysis is applied when many characteristics are taken into account and a univariate assessment could produce results that are confounded. Other statistical procedures could be employed in evaluating the probability of losses in future. After the termination of a particular policy, the premium amount and investment gains collected, the amount paid out as claims calculated, the insurance company can count its underwriting profit on that certain policy (Fitzpatrick, 2004). The performance of underwriting is evaluated through what is called the “combined ratio” which is basically the expenses’ ratio divided by the losses to premiums. Any combined ration that is less than 100% depicts an underwriting profit, while that exceeding 100% is indicative of an underwriting loss. However, investments earnings can still make the insurance company profitable.
Insurance is not all about paying and investing the premiums. The insurance company is also involved in settling claims for the clients. The handling of losses and claims is the materialized insurance utility. It is ideally the real product that is paid for. Claims could be filed through the insured directly with the insurance coompany or through agents or brokers (Gregory, 2003). The insurance company could require that the claim be documented on its own proprietary documents, or could admit claims in a standard form as applicable in insurance industry. Claims adjusters take part in the handling of claims through records management staff and clerks involved in data entry. Classification of insurance claims is performed depending on severity and is assigned to the adjusters, whose authority of settlement differs with their experience and knowledge (Fitzpatrick, 2004). The loss adjuster carries out an investigation of a specific claim, normally in close collaboration with the insured, and determines whether the coverage is under the insurance contract term. If such a confirmation is made, the reasonable monetary worth of the claim is advised and payment authorized.
The insured could hire a personal public loss adjuster to advice on the manner in which the insurer will settle the claim on their behalf. For such complicated policies, where claims could be multifaceted, the client could take out a different policy of insurance to add on, known as loss recovery insurance policy, which takes cover over the cost of a public loss adjuster in the event that a claim is launched. The adjustment process of liability insurance is, in most cases, a challenge because a third party is involved. This is the plaintiff who has no contractual obligation that demands cooperation from him with the insurance company and could, in fact, regard the insurance company as a deep pocket. Thus, the insurer is expected to obtain a legal counsel for the policy holder either from a counsel on internal or external panel to monitor litigation that could take a long period to complete, and appear physically or contact by means of a mobile phone or the Internet with settlement authority at an obligatory settlement consultation if demanded by the judge (Grace & Phillips, 2007a).
In the case when a loss adjuster deduces under-insurance from the claim, the condition of average could come into effect to limit the exposure of the insurance company. In the claims handling process management, insurers seek to create a balance between the customer’s satisfaction elements, claims overpayment leakages and handling expenses incurred by the administration (Gregory, 2003). In the process of this act of balancing, insurance fraudulent practices are a big business risk that should be overcome through proper management. Disputes between the client and the insurance company on claims validity or the handling practices of claims rarely escalate into litigation.
Insurance companies need to market their products in order to strengthen their business. Marketing entails the performance of activities that direct the flow of products and services from the business to the customer. Insurance companies normally employ the services of insurance agents to primarily market and underwrite their regular customers. Insurance agents can be captive. This means that they can only be employed by only one insurance company. However, they can be independent, implying that they can give out policies on behalf of different companies. The success and existence of insurance companies making use of insurance agents is certainly a result of enhanced and personalized service. Thus, marketing is an important aspect to insurance companies to meet their business prospects (Berger et al., 1997).
The fundamentals and basics of insurance address the very basic challenges to risks and damage incurred either to life or property owned. It affects and forms a very important aspect of everyday business operations. The business world involves the taking of risks. This is the basic concept of entrepreneurship. It is the sphere where insurance takes over. The principle notion in insurance is to transfer the risk taken by business owners and individuals to the insurer, who will indemnify the insurer after encountering a loss. This is facilitated through the two parties coming up with a contract – a well written document known as a policy schedule. This policy schedule is legally binding and adherence to its contents is observed through the payment of premiums, as long as the relationship of the insurer and the client remains. Thus, insurance can be defined simply by stating that while an individual or business takes care of the profits or gains, insurance takes care of the losses upon some agreement with the insured, involving monetary fees (premium).
Therefore, insurance involves covering risks. Insurance companies have two sources of income as outlined in this paper: premiums, paid by the client, and the investment gains, accrued from the money earned by the company. Profits from the insurance company are realized after deducting all the expenses incurred in underwriting and paying off claims along with other administration expenses. Insurance can be complicated when it comes to the actuarial science application that takes into account various factors in underwriting process. However, with professionals in this filed, it ceases to be an issue of great concern. Generally, insurance takes the risk of the client and promises to pay for any loss occurring after the insured meets all the requirements as detailed in the policy schedule, acting as an agreement between the two parties. These are the principal characteristics of insurance and its methods.