Insurance

Insurance

• A legal contract that protects people from the monetary costs that result from loss of life, lose of property and loss of business etc.


• Provides security against loss of property through natural causes such as fire, flood, earthquake, war, burglary etc and also provides the financial security against the loss of life due to accidents, decrease etc.


• Also provides financial security for unemployment and elderliness.


• It is the risk transfer process where insurance companies are willing to accept the risk associated with individual policyholders in exchange of the premium.


• The essential feature of the risk transfer process is that, while individuals may not be able to diversify a risk, insurance companies do have that diversification ability.

Economics of Insurance

Purchaser of insurance pays a fixed premium in exchange for a promise of compensation in the event of some specified economic loss. By pooling such risk of loss, insurance convert the uncertainty of an individual loss into a predictable expense. The economics of insurance includes pricing of premium, marketing of insurance and incentive problems.

1.         Pricing of premium

·         For an insurance company, the proper pricing of premiums is a necessary condition for profitability.

·         If company set too low premium and company will make a loss and if company sets too high premium, one will not buy policies. So, the pricing of should be optimum.

·         Pure premium is the present value of the expected cost of a claim. The cost of claim is the product of the amount of loses and expected cost of processing the claim. When a claim is made, the insurer must determine the extent of the loss. The expected cost is calculated as follows:

      Expected cost        = Probability ´ (Loss + Processing cost)

      Note: Probability of loss will vary with insurance companies.

      The present value of expected cost is calculated as follows:

      The present value of the expected cost      =

      This present value of the expected cost is called the pure premium. This method of calculating the pure premium is only an approximation.

·         To price premium accurately, the insurer needs to know the probability of a loss and the size of the claim.

·         The actual premium charged is the pure premium plus administrative expenses. Total administrative expenses may amount to 25% to 35% of the actual premiums. They may be adding to 50% to the pure premium.

·         Insurance Reserves: Insurance reserves are the policyholders' funds that insurance companies are holding in anticipation of paying claims (insurance company liabilities).  For example, if claims are paid on average 3 months after premiums are received, the insurer will have on average a fund equal in value to 3 months' premiums. This fund is called insurance reserves.

·         Premium smoothing: Charging a fixed premium over time when the pure premium is changing.

2.         Marketing of insurance

·         Marketing involves selling the insurance, screening risks, and writing policies.

·         Marketing has a large part of administrative costs.

·         Marketing costs included 15% to 20% of premiums.

·         Insurance is marketed in a number of different ways:

o   Independent agent: Independent agent is an insurance agent that represents several companies. One agent represents six insurance companies in average.

o   Exclusive agent: Exclusive agent is an insurance agent that represents a single company. For example an agent represents only Rastria Beema Santhan.

o   Direct writing: Marketing of insurance directly by the insurance company over the telephone over the telephone or by mail.

o   Insurance broker: Someone who represents the purchaser of insurance rather than the seller (as the agent does)

3.         Incentive problems

·         Situation in which incentives of owners (shareholders), managers and other stakeholders are misaligned leading to a potential conflict of interest

·         Problem arises when a management team act to pursue their own interest rather than in the best interest of the shareholders

·         In insurance, incentive problems explain the nature of insurance contract, preference for the mutual form of organization among lives, and survival of cost-inefficient independent insurance agents.

·         There are three parties involved in the insurance, they are owners of insurance companies, their managers and policyholders.

o   Owners of insurance companies: provide capital and bear risk in exchange for a residual claim on income

o   Managers:  set rates and are responsible for marketing and administration and for investing reserves

o   Policyholders: pay a premium in exchange for coverage

·         Each party has its own interests, and these interests may adversely affect the others

o   Owners may want managers to invest in risky assets. This increases the expected return to the owners, but it would reduce the security of policyholders and the risk of the job of managers.

o   Managers may be lazy in performing their duties, to protect their jobs; they may be excessively cautions in investing reserves. As a result, premiums will be higher and profits will be lower than they might have been.

o   Moral hazard and adverse selection on the part of policyholders may impose losses on owners and threaten the jobs of the managers.

·         There are two mechanisms that can create incentives to the different parties, they are;

i)                    Insurance Contract

ii)                  Organizational form of Insurer

i)    Insurance contract:

·         The insurance contract may include deductibles or coinsurance.

o   Deductible is an initial amount of a loss to be paid by the insured. E.g., with a deductible, an initial amount, say, Rs. 1,000 of a loss in not covered.

o   Coinsurance is the percentage of a loss to be paid by the insured. E.g., with coinsurance, the insurer pays only a part of the loss, say 90%.

o   With a deductible or coinsurance, the insured still faces a cost if there is loss, and therefore has an incentive to exercise care.

ii)   Organizational form of Insurer

·         Insurance companies come in two major varieties, according to their ownership:

i)                    Stock Company

ii)                  Mutual Company

·         A stock insurance company is very similar to other corporations. For example, its main goal is to maximize the value of its stock, and it is controlled by the stockholders.

·         A mutual insurance company is owned by its policyholders and is a non-profit organization. In practice, however, the management of a mutual insurance company makes most of the decisions with little or no opposition from its policyholders/owners.

·         Advantages of mutual insurance company is that as the policyholders are also its owners, conflicts between policyholders and owners are reduced.

·         The main disadvantage of a mutual insurance company is the difficulty of monitoring management. Because managers have virtually a free hand, efficiency of the insurance company is likely to be low

Types of Insurance

1.         Life Insurance

·         Life insurance is a contract whereby an insurer promises to pay the defined amount either on the maturity of policy to policyholder or to his/her nominee in case of the premature death of the policyholder, in consideration of premium paid.

·         This life insurance has both elements i.e. protection as well as investment.

·         Key points of life insurance:

o   It is a contract between insurers and insured

o   Subject matter is life

o   Insurer guarantees a specified sum of money on the event of death of insured or expiry of fixed period.

o   Insured pays premium according to a contract.

·         Life Insurance policies are;

o   Term insurance policy:

§  Issued for short term such as 3 months to 7 years

§  Benefits are paid only if the policyholder dies when the policy is intact and the policy has no value if the policyholder do not die during the policy period

§  No cash value or investment value

§  Policyholder cannot borrow against the policy and only protection element is present in this policy

§  The fair premium is calculated using the following equation;

Fair premium =

o   Whole life insurance policy:

§  Also called cash-value or permanent or straight or ordinary or investment life insurance

§  Oldest and most traditional form of insurance

§  Issued for the whole life of person

§  The premiums are payable only once or throughout the life of the assured or for certain period of time

§  Assured amount becomes payable only on the death of the policyholders to his/her nominee or assignee

§  If the loan is issued against the value of policy, it is called policy loan

o   Other life insurance policies:

§  Endowment life:

·         Combination of term insurance element and saving element

·         Guarantees a payout to the beneficiaries of the policy if death occurs during the policy period and pays face amount if insured lives to the endowment date

§  Universal life:

·         Very flexible type of policy that allows the insured to pay in excess of the pure premium each year or not to pay a premium on any given year

·         Excess funds can be used to invest in money market instruments or other investments that the policyholder chooses

·         Insurance company does not guarantee a fixed rate of return on the funds, rather, the policyholders, bears interest rate risk and default risk on the investments.

§  Variable life:

·         A life insurance contract that provides financial compensation to the named beneficiaries in the event of the insured's death

·         Insurance company guarantees payment of a minimum amount plus an additional sum according to the performance of a separate account, usually invested in equities or other relatively high-yielding securities.

§  Variable universal:

·         Unique blending of permanent life insurance and investment flexibility

·         Provides lifetime insurance protection, as well as an opportunity to invest in tomorrow

·         Divided into two parts; first part pays for the cost of policy and the second part is distributed among sub accounts that are invested in cash equivalent vehicles of policyholders choice

·         Popular portfolios include stock, bond, balanced, international and money-market accounts

2.         Non-life Insurance

i)                    Health Insurance

ii)                  Property and liability insurance

i)          Health Insurance

·         Consists of three basic types of coverage: medical expenses, loss of income, and dental

·         Medical insurance includes medical, hospital, and surgical expenses

·         Loss of income insurance includes accidental death, disability, and dismemberment coverage

·         Dental coverage includes regular check-ups and oral surgery.

ii)         Property-liability insurance

·         The various types of insurance other than life and health are called collectively property-liability insurance

·         Covers the damage to property

·         Includes;

o   Marine insurance:

§  It is a contract between insurer and insured

§  Insurer promises to indemnify the insured against marine losses

§  Losses are incidental to marine adventures

§  Insured pays certain premium as per contract

o   Fire insurance:

§  Insurance against any loss of or damage to the property by fire

§  Insurance company makes payment of loss of property when loss is caused by fire

§  Benefit paid does not exceed the insured sum

§  Insured pays specified premium

Regulation of insurance industry in Nepal

1.   Regulatory Framework:

·         Insurance Act, 2049 (with amendment)

·         Insurance regulation, 2049 (with amendment)

·         Policies and directives, issued by Insurance Board from time to time

·         Other related acts:

o   Company Act, 2064

o   Contract Act, 2056

2.   Regulator:

·         Insurance Board (Beema Sameeti)

o   Established under Insurance Act, 2049

o   Functions, duties and rights includes;

·         Suggesting government in policy formulation for insurance business

·         Determining policies for investment

·         Focus on priority sector for investment

·         Authority for registration, renewal and discharge of insurer, agent, surveyor

3.   Major provisions for Regulation

·         Insurance board administers the Insurance Act

·         Insurance Board has supreme to develop insurance business and permit, monitor and control the activities of insurance companies

·         All the insurance businesses should be operated only after taking registration certificate from Insurance Board, which should be renewed every year

·         Insurance business is classified in to life and non-life and one company cannot operate both the businesses

·          Life insurance businesses include, whole life insurance business, endowment life insurance business and term life insurance business

·         Non-life insurance businesses include, fire insurance, motor insurance, marine insurance, engineering and contractor's risk insurance, aviation insurance and other miscellaneous

·         Provision for reinsurance has also been made in the Act

·         Insurance company should submit financial statement to the Insurance Board every year

·         Insurance company needs to keep certain amount as reserve

·         Certain limitations has been made in the management cost

·         Insurance company offers the policies approved by Insurance Board. To offer new policies to expand or open branches; insurance company needs to get approval from Insurance Board.

·         Provision of insurance agent, their qualification and certification process, and their commission

·         Provision of surveyor, their qualification and certification process, and their classification into "a", "b", "c" and "d" categories