The Mechanism of Insurance Companies for Insurance of Business - Literature review Example

? INSURANCE Choose a particular form of insurance and analyze in depth the mechanism that insurance companies use to underwrite and price that of business. Your name …………………. Course Name and Number …………….. Date of submission …………. Word-counts: 3061 Table of Contents Table of Contents 2 Introduction 3 Insurance and Risk Management 3 Marine Insurance and the Mechanism of Underwriting and Pricing of it 5 Marine Insurance 5 Major Classifications of Marine Insurance 7 Underwriting and Pricing Mechanism of Marine Insurance 7 Underwriting: The logic and the practical applicability 7 7 Underwriting mechanism 8 How Underwriting Works in Marine Insurance 9 Pricing the Marine Insurance 11 Basic Principles applicable to underwriting and pricing of an insurance contract 12 1- Utmost Good Faith: 12 2- Insurable Interest 13 Conclusion 13 References 14 Introduction In the view of Economics, Insurance is a technique of risk management that is basically used for compensating the risks of a contingent and uncertain financial risk. Insurance is social in nature and economic in practical since it represents the mutual cooperation and collaboration of various individuals as well as groups from their benefits by combining together with a view to reduce the consequences of financial risks. As Owojori and Oluwagbuyi (2011, P. 275) pointed out, Insurance is a comprehensive economic and social device for handling various risks that affect life, property and so on. This piece of research paper explains conceptual framework and theoretical underpinning of Insurance and its basic principles in relation to explaining the mechanism of underwriting and pricing Marine insurance by an insurance company. Insurance and Risk Management Insurance is a contract between insurer and insured by which the former agrees to undertake to give compensation to the latter for any financial loss or economic risk and contingencies such as damages, accident etc. Insurance is the business of pooling of risk between individuals or groups. Vaughan and Vaughan (2007, p. 35) found that the very basic underlying function of insurance is the creation of the counterpart of the risk and thus ensures security to the life, properties or other valuable possessions of general public or businesses. Insurance company doesn’t guarantee decreasing of the uncertainty for the individual as to whether the financial risk will occur and it doesn’t alter the probability of risk-occurrence, but it reduces the probability of the financial risk that is connected to the specific event-occurrence (Vaughan and Vaughan, 2007, p. 35). For instance, from the business point of view, when the business man insures his ship against perils at sea, the uncertainty regarding the financial loss in that event will be eliminated. Insurance plays imperative role in the development of economy for the following reasons: Insurance helps pooling of the risks and ensures indemnifying the financial loss against risk of life or property, Insurance gives confidence to entrepreneurs that their loss, which may affect their continuity of the business, will be compensated, Ensures greater flow of money as surplus money in various insurance companies are widely used for economic and government related investments, Risk, loss and contingencies, if they are not compensated, will cause many companies or businesses go out of their operation which in turn adversely affects the development of the economy. Risk Management is wider term as it encompasses variety of tools including insurance too. Insurance is one of the techniques for risk management. According to ISO Guide 73, risk management is a coordinated, systematic and structured activities that direct and control a business or other organization with regard to the risk it faced (Reuvid, 2010, p. 58). An organization can take any of different forms of risk management tools. The optimum approach to the risk management is to seek attaining a balanced position, by protecting the firm from the impacts of any negative effects of the event. Insurance is more appropriate and effective way for managing the risk, because it directly helps the firm balance the financial position and to ensure success and continuous effectiveness of the organization (Berwick, 2006, p. 6). Insurance has long been used as a tool of risk management by businesses with a view to mitigate the risks associated with certain event occurring to properties. But, insurance is available only to certain risks called insurable risks. Insurance company doesn’t provide insurance against risks that cannot be estimated or calculated in advance. From the business point of view, only insurable risks such as fire, burglary, motor accident, marine accident etc can be uninsured (Doherty, 2000, p. 4) but other risks such as risk due to bad management, war or loss due to seasonal variation etc cannot be insured since they are non-insurable risks. Insurance provides a source of finance to pay for losses. Insurance company finds sources for financing and compensation form large numbers of firms that have already agreed to pay premium in expectation of gaining compensation if they too face loss. Marine Insurance and the Mechanism of Underwriting and Pricing of it Marine Insurance Marine insurance is a legally binding contract between the insurer, which is normally the insurance company, and the insured who is a ship owner, ship company or agency or sea transportation operator etc, by which the insurer guarantees to compensate any financial loss that happens accidental to a marine adventure. Marine insurance is an insurance contract whereby the insurer agrees to indemnify the insured against marine losses (Branch, 2006, p. 255). Marine insurance is similar to fire insurance as they both are designed to protect against financial loss resulting from damage to owned property, but the difference is that marine insurance is related to risks or loss associated with transportation either in ocean or inland. Marine insurance is primarily classified in to two, ocean marine and inland marine. Ocean marine insurance provides coverage to all different types of ocean-going vessels, their fixtures and fittings and their cargoes. Ship owner’s liability is also covered in some policies. Inland marine insurance provides coverage to goods that are carried by railroads, motor vehicles or ships or barges through the inland waterways or coastal trades (Vaughan and Vaughan, 2007, p. 46). Within the last 10 years, inland marine insurance has reported a growth rate of 60 percent. Inland marine insurance is now a $6.3 billion industry and it holds around 2.5 percent property and casualty insurance (Hogue, 1999, p. 40). All the insurance contracts are legally binding contracts as both the parties to the insurance contract, namely insurer and insured are to fulfill their duties and responsibilities required by the prevailing legal systems. More specifically, the insurer is required to pay compensation to the insured on the occurrence of the specific event and insured is required to make regular premium payments to the company. The same legal requirements are applicable to marine insurance as well. Insurer and insured are also legally bound to comply with the insurance basic principles and legal boundaries of indemnity, utmost good faith, insurable interest and proximate cause. Stempel (1993, p. 340) noted that marine insurance was designed to provide coverage to properties that are in transit on the sea. According to Marine Insurance Act 1906, marine insurance contract can be extended, through either express or implied contract, to facilitate coverage to both sea and land risks in order to give greater convenience to the customers that they may not need a separate insurance policy to cover land transportation risks. Major Classifications of Marine Insurance Hull Insurance: Hull Insurance protects the owner of a water-going vessel against loss to the ship itself. Hull insurance is often extended to include the coverage of liability coverage for third party claims arising out of collisions or other kinds damages to the vessels. Cargo Insurance: It provides fuller coverage for the goods or merchandise carried by the ships. It thus protects the owners of cargoes from financial risks. Freight Insurance: It provides coverage to the risks and financial losses that are caused by the failure to accept the freight charged by the shipping company, and Ship owner’s liability insurances: It protects and indemnifies multitude of events faced by the shipping company, arising out of its own or its employees’ faults (Vaughan and Vaughan, 2007, p. 590). Underwriting and Pricing Mechanism of Marine Insurance Underwriting: The logic and the practical applicability Insurance underwriting is a process of choosing and deciding who and what the insurance company has to insure. According to the market structure where underwriters work for insurance companies, customers who propose to take a marine insurance, for instance, needs to meet brokers for seeking information about available policies, premium prices etc, brokers meet underwriters to get decided who and what polices are to be given. Underwriters thus possess decision making role in an insurance company. Underwriters decide who to be insured and how much premium to be charged by the company and who the insurance company will not decide (Corporation Ltd Essvale Corporation Ltd, 2009, p. 101). Underwriters function as assessor of risks involved and decide whether to insure or not based on the information given in the proposal form. An underwriter is, therefore, required to be skilled and qualified in valuing the risk factors, probability of financial loss to the customer and thus taking decision based on the given information. Underwriting is strategically important to the business of insurance. As Konnor (2006, p. 105) detailed, insurance company functions by pooling of risks as it collects large numbers of premiums from individuals and businesses, but statistically, only small amounts of these firms or individuals will have claims with in a specific period of time. More specifically, underwriters of the insurance company doesn’t provide insurance to a customer if his risk possibility is greater according to the information he produced to the company. Thus, underwriting is critically strategic to insurance business. A customer who seeks a marine policy, but his ship is very old or is very likely to face peril at sea due to some other reasons, the company is very less likely to provide insurance coverage for that or is more likely to charge higher premium for that since the risk is higher. In short, the underwriter looks at the very basic principle that ‘higher the risk, higher the premium’. Underwriting mechanism Harris, Licata and Nichols (2011) quoted: “Running an insurance company is like managing a supermarket, where the price of the product is determined by the checkout clerk (p. 1). From the business perspective, profit is imperative and that ensures stability of insurance business in its concerned market. An insurance company can further expand the possibility of making the year good-profitable by selling its insurance policies only to those businesses or people who are very less likely to have claims within the period. Underwriting also helps the insurance company reinsure some of the policies in other insurance companies so that risk can be spread among more than one companies. In simple term, underwriting is the process of selecting the best risk (Konnor, 2006, p. 105). According to Vaughan and Vaughan (2007, p.135), underwriting is the process of selecting and classifying exposures, as the goal of underwriting is not the selection of risks that will not have losses, but rather, it is to avoid a disproportionate number of bad risks and thence to equalize the actual losses with the expected ones. But, Squires (1997, p. 119) argued that many insurance companies make underwriting decisions based on all kinds of factors that have nothing to do with statistically measured probability of risks. In underwriting marine insurance- for instance, the underwriter is required to follow the underwriting policy which is normally established by the officer in charge for underwriting. The underwriting policy will provide a specific framework within that the underwriter is legally bound to make decisions. The policy generally specifies the types of policies that can be granted, amounts of coverage that can be permitted etc (Vaughan and Vaughan, 2007, p.137). How Underwriting Works in Marine Insurance In marine insurance, underwriters can make binding decisions in the field and these decisions some times will be subject to post-underwriting at a higher level. It is because the contract can be cancelled on due notice to the insured (Trieschmann, Hoyt and Sommer, 2005, p. 473). The underwriter while underwriting the marine insurance has the services of reinsurance facilities and credit department as well so that he can review the financial stand of applicant and his loss histories. For almost all different types of insurances, underwriter has to follow almost similar steps in underwriting the insurance. Following are the steps involved in underwriting marine insurance: 1- First of all, when a proposer seeks to take an insurance policy through an agent or broker and they contact the underwriter, underwriter has to gather sufficient information about the customer and in particular about the risk-related factors. He can gather information mainly from 1) application –proposal form- that contains statements of the applicant, 2) information from the agent or broker, 3) information from external parties or agencies and 4) inspection or direct observation or physical examination (Vaughan and Vaughan, 2007, p.137). 2- Once he collected information about the insured, ship or other subject matter he likes to insure and the risk-occurrence possibility, he calculates the risks associated with it and evaluates whether the company can afford it or not. 3- Based on the risk, its possibility and its severity, the underwriter decides whether to insure or not. It the risk-possibility is very high, insurance company may avoid giving the insurance. 4- If the underwriter has decided to issue the policy, the underwriter will then go for calculating the premium with the help of an expert called actuary, based on the risk-factors. Higher the risk, higher the premium is the basic principle in fixing the premium. Fixing the premium is similar to that of pricing the goods or service in a business. Pricing the Marine Insurance According to the basic concept of pooling of risk, large numbers of people contribute small amounts of premiums, but this becomes larger amounts in the central pool, and make these amounts available for meeting the need for compensation. The money collected by the insurance company must be sufficient to meet the needs of compensation to be paid to customers who will come to claim within a specific period of time, meet company expanse and also to generate a reasonable amounts of the profit. The money collected by the insurance company must be sufficient to meet these needs. In order to ensure the effectiveness in operation, insurance company and underwriters assess the probability of risk for the property that the insurer proposes to insure. All the insurance companies are fixing the price for an insurance by calculating the risk-factors associated with the subject matter and then fixing the premium that is to be paid by the insured. Premium payable by the insured is the price of that policy. When it comes to marine insurance, the company will consider those factors that may influence the risk-occurrence possibility and thus it will fix the premium based on ‘higher the premium and higher the price’. Factors that influence the premium-fixing of marine insurance are detailed below: Age of the ship or sea-going vessel: Age of the subject matter that the insured is going to insure in the company is critically important to calculating the premium for that, since older the age higher the risks and therefore premium will be high. If the ship, for instance, is older in age, it is more likely to face damage or accident and hence the premium to be paid will be higher. Sea or route of the ship: The route as well as transportation area of the ship is also critically important. It is because, some areas in the sea may seem to have greater risk possibility such as Bermuda Triangle. A ship that may have to take route near to Bermuda Triangle, for instance, will have greater risk and therefore insurance company will fix relatively higher premium. Types of cargoes the ship carries: If ship has to carry petroleum or gas or other types of inflammable items, the risk possibility is higher than others. Similarly, if the ship has to carry very valuable goods such as electronic items, technology or other most values items, company may require higher amounts to compensate for that. For these factors, the risk factor is higher and the premium will be charged higher. Basic Principles applicable to underwriting and pricing of an insurance contract From a general business contract, insurance contract is very different as insurance contract has to fulfill certain specific rules and principles such as utmost good faith, insurable interest. All these principles, more or less, influence the underwriting and pricing mechanism of an insurance policy. How the insurance company, underwriters and customers have to consider these principles are detailed below; 1- Utmost Good Faith: Utmost Good Faith is an extremely important principle that is applicable to all insurance policies. This rule states that both the parties to the contract, namely insurer and insured are legally required to keep good faith in all the contractual relationship between both the parties (Harrington and Niehaus, 2004, p. 195). Insurer gathers information from his application form or from agents and brokers who also collected information from him directly. But, if he didn’t keep good faith and has hidden some facts, insurance company will not be able to assess the real risk factors. Utmost good faith principle undertakes that the insured must disclose all relevant material facts known to him to the insurer through proposal form as well as other communication. Insurer also required to disclose relevant facts to the insured. If any of the party is found to have breached this requirement, the other party is legally rightful to cancel the contract. As Merkin and Stuart-Smith (2004, p. 52) emphasized, marine insurance is a contract based on utmost good faith and if it is not observed by either party, the contract may be avoided by the party. 2- Insurable Interest Insurable interest is also another important principle that is to be considered by underwriters while taking decision whether to insure or not. Noussia (2008, p. 82) found that insurable interest is to be taken in to account while underwriting the marine insurance. Insurable interest states that an insured can take insurance only for those that he has insurable interest in them. It means, when the property or subject matter experiences the loss, he must suffer a financial loss. Conclusion This piece Of research paper explained theoretical ad conceptual framework of insurance, marine insurance and risk management and then detailed how the mechanism of underwriting and pricing of marine insurance works. Underwriting is basically a process that the underwriter chooses and decides who are to be insured and what insurance is to be provided. It is strategically important since some time the company has to avoid providing insurance if the risk possibility is very higher. This paper concluded that, while pricing any insurance contract, in another word while calculating the premium, the very underlying principle is that ‘higher the risk, higher the premium’. For both the underwriting and pricing, utmost good faith and insurable interest principles need to be considered. References Berwick, G, 2006, The Executives Guide to Insurance and Risk Management, QR Consulting Branch, A.E, 2006, Export practice and management, Fifth illustrated edition, Cengage Learning EMEA Corporation Ltd Essvale Corporation Ltd, 2009, Business Knowledge for It in Insurance, Essvale Corporation Limited, Doherty, N.A, 2000, Integrated risk management: techniques and strategies for managing corporate risk, Illustrated edition, McGraw-Hill Professional Harrington, S.E and Niehaus, G.R, 2004, Risk Management and Insurance, Second edition, The McGraw Hill Companies Harris, G,C, Licata, R.C, and Nichols, R.S, 2011, Underwriting—A Profit Engine or Lost Opportunity? Current Challenges and Potential Solutions to an Evolving Underwriting Environment, CPCU Society, Hogue, R.D, 1999, Marine Insurance, Insurance Advocate Konnor, D.D, 2006, Pharmacy Law Desk Reference, Routledge Merkin, R.M and Stuart-Smith, J,2004, The law of motor insurance, Sweet & Maxwell Noussia, K, 2008, Insurable Interest in Marine Insurance Contracts: Modern Commercial Needs Versus Tradition, Journal of Maritime Law & Commerce, Vol. 39, No. 1, Owojori, A.A and Oluwagbuyi, L.O, 2011, The Effect of Insurance Business on Economic Development in Nigeria, Journal of Emerging Trends in Economics and Management Sciences, Scholarlink Research Institute Journals Reuvid, K, 2010, Managing Business Risk: A Practical Guide to Protecting Your Business, Seventh Edition, Managing Business Risk: A Practical Guide to Protecting Your Business Squires, G.D, 1997, Insurance redlining: disinvestment, reinvestment, and the evolving role of financial institutions, The Urban Insitute, 1997 Stempel, J.W, 1999, Law of insurance contract disputes, Volume 2, Second edition, Aspen Publishers Online Trieschmann, J.S, Hoyt, R.E and Sommer, D.W, 2005, Risk management and Insurance, Twelfth edition, Thomson, South Western Vaughan, E.J and Vaughan, T.M, 2007, Fundamentals of Risk and Insurance, Tenth edition, John Wiley and Sons Read More