understanding insurance

Learn Insurance

INSURANCE BASICS

2004 Insurance Australia Group Limited ABN 60 090 739 927

Learn Insurance

2

Introduction: Insurance helping you through life. 3

Part 1 - Insurance basics 4What is insurance? 4

History of insurance 5

Important parts of insurance 7

What is risk? 7

What is an insurance premium? 7

How do insurance companies calculate the insurance premium they charge? 8

What is a claim? 12

Types of insurance claims 13

What can be insured? 13

What do insurance companies do? 14

How much of the premiums customers pay goes back into paying claims? 16

How to reduce risk 18

Part 1 Revision 23

Part 2 - Insurance industry overview 24

Part 3 - Premiums, prots and losses 28

Part 4 - Risk 33

Part 5 - Business and Community Sustainability 34

Part 6 - Glossary 38

GO!

GO!

GO!

GO!

GO!

GO!

GO!

Contents

DISCLAIMER

The information contained within this document is of a general nature.

It is for educational purposes only and is not intended to be comprehensive, complete or advice.

While all due care has been taken in the preparation of this document, we take no responsibility and expressly disclaim all liability incurred by any person in connection with the document or its contents to the extent permitted by law.

Learn Insurance

Introduction

3

Insurance helping you through lifeInsurance plays an important part in peoples lives by taking out the worry and helping the whole community.

Insurance is all about pooling.

A large number of people pay a small amount of money into a pool.

For example if their property is damaged, stolen or destroyed or if someone suffers an injury, the pool is there to help pay for repairs, replacement or compensation for injury.

This means those who put money into the pool may not have to pay some or all of the repair, replacement or in case of injury, the medical and associated costs.

Insurance gives peace of mind, letting people get on with their lives.

While this basic pooling principle of insurance is simple, the workings behind insurance are fairly complex.

This document is designed to provide a better understanding of insurance, including car, home & contents and business insurance.

This document has information about:

the history of insurance and how it has developed over the centuries;

how insurance works, including how the price of insurance is set and the differences between the various types of insurance available;

how an insurance company runs;

the insurance industry in general;

why and how insurance companies try to reduce risk to make communities safer on the road, in the home and in workplaces.

This document has been developed by CGU Insurance and has been reviewed by National Curriculum Services, a group that professionally design and produce curriculum materials and address the professional development of schoolteachers nationally.

Part 1 - Insurance Basics

4

1Learn Insurance Contents

The idea of pooling.

People pay an insurance premium to an insurance company,

but not all those people will make a claim.

What is insurance? In broad terms, insurance is about a person putting a small amount of money into a pool with other people to cover, for example some or all of the cost of repairing or replacing their valuables if they are lost, damaged or stolen, or to help pay compensation to a person if they are injured.

Insurance is all about a group of people or a community sharing risk. In this sense insurance is a community product. Through an insurance company, people in the community, pool their premiums to pay the claims of those insured with that insurance company.

When a person needs to make a claim, insurance companies must ensure that there is enough money in the pool to meet the cost of that claim. Insurance involves a large number of people paying a small amount of money to make sure the few who need to make a claim are covered.

Most people own something valuable, such as a car, house, furniture, boat or a business.

They also have other valuable things, such as their health and the ability to work.

It is important to protect what is valuable.

One of the ways people protect what is valuable is by taking out insurance.

The advantage of having insurance is that it allows the community to pool risks. This takes away the need for people to pay the full cost of loss or damage on their own, which in some cases, could, if it occurred, leave people in great nancial difculty.


5


History of insuranceInsurance has been around for a long time.

Since the time of Chinese traders 7,000 years ago, insurance has been used to reduce the risk of the traders getting into nancial trouble and going broke.

Over the centuries, people have joined together and cooperated to reduce risks, such as accidents or theft. This included living in groups to reduce the risk of attacks from wild animals or other people, and to increase the amount of food they could gather or hunt.

Similarly today, people buy insurance by paying some money into a pool to replace or repair damaged or stolen cars or belongings, to rebuild houses or help them recover from an accident.

Insurance is pooling the money of many to support those, who have put money into the pool, that are unfortunate enough to have an accident or be affected by a disaster or suffer a loss.

History of insurance - Ancient China

In about 5,000 BC, instead of putting all their property in just one boat, Chinese traders spread their goods over several boats.

If one boat sank, no individual trader went broke.

If two traders spread their goods over two boats and one boat sank, each would lose only a half of their goods rather than everything they owned.

Each of these traders had to sell their goods far from home. The only way they could get their goods to the buyers was by boat. Many risks were involved in sailing the boats from port to port, through rough seas, chance of shipwreck, getting lost or being raided by pirates.

These traders could do business in two ways. The high risk way was to go alone and have all their goods in just one boat and do nothing about reducing their risk. The low risk way involved the traders pooling their risk by placing their goods on several boats.

Sharing the risk of losing goods was an early form of insurance. In the high-risk situation, the boat might not make it and the one trader could lose everything and go broke. In a low risk situation, even if a boat did sink in rough seas, each trader would only lose a portion of their goods and none would go broke.


6


History of insurance Great Fire of London

In 17th century London, insurance companies did more than take a small amount of money from many people to compensate them if their home burnt down. Some insurance companies directly paid for some of Londons city re brigades.

People who paid insurance companies to insure their home were given a re plate showing the insurance companys logo. This re plate was xed near the front door of their house.

If a house caught re, the re brigade would check if the house had a re plate. If the house did not have a re plate, or had the re plate of another insurance company, the re brigade would let the house burn down.

People who wanted the re brigade to help them if their home caught re, would each put in a little money to help pay for the re brigade to protect their house.

The idea was simple. If people pooled their money there would be enough to pay the re brigade to put out res. The pool of money would also provide enough to help the house owner rebuild their home if it was damaged or destroyed by re.


7


Important parts of insurance Insurance is about people each pooling a small amount of their money to reduce the risk of them being nancially impacted if, for example something valuable to them is damaged, destroyed or stolen.

It can also include pooling money to reduce the risk of someone being nancially impacted if they are injured at work or in a car accident.

To help explain insurance, terms such as risk, premium and claims need to be explained.

In the following pages, we will describe insurance as it relates to motor, home and injury or disability to people.

What is risk?Risk is a word that is used often by insurance companies.

In insurance, risk means the chance of something unpleasant or unwelcome happening.

Risk is the chance that something valuable to a person might be lost, stolen, damaged or destroyed. It can also mean the chance of a person being injured.

One of the things insurance companies do is to work out the cost of insurance premiums by assessing and pricing risk. In other words, putting a nancial value on the risk.

Assessing and pricing risk involves working out the chance of whatever is insured becoming accidentally injured, lost, damaged or stolen, and how much it will cost to repair or replace what is insured.

Working out how much it costs to pay claims and how often people are likely to be injured or have their property lost or damaged is a very important part of an insurance companys work. This is called pricing risk.

By pricing risk, insurance companies know how much money they need in the pool to pay claims.

The better insurance companies are at pricing risk, the better they know how much money needs to be in the pool to pay their customers when they make a claim.

What is an insurance premium?An insurance premium is an amount of money a person pays to an insurance company for an insurance policy. This payment could be regarded as transferring some or all of the risk (or cost) of loss or damage. For example replacing, repairing or rebuilding a particular valuable if it is lost stolen, damaged or destroyed.

This is also the same for insurance against accidents at work or on the road that may hurt and injure people.

The cost of an insurance premium needs to take into account the:

Expected number of claims multiplied by the expected average claim size.


8


How do insurance companies calculate the insurance premium they charge?No one knows for sure if or when what is valuable to someone will be accidentally lost, stolen, damaged or destroyed or when someone could be injured on the road or at work.

Because of this, insurance is based on what may or may not happen in the future. Insurance companies spend a lot of time trying to work out the chances of their customers having to make a claim and the potential cost of that claim.

Generally the higher the risk of loss, theft, damage, destruction or injury, the higher the insurance premium.

Not everyones risk is equal. So the amount people pay for their insurance cover or premium, may differ depending on their own circumstances.

Insurance companies should try to make sure that every individual who has insurance pays a premium that reects their risk.

Insurance premiums are made up of different parts, including the cost of estimating, collecting and managing the premiums, the cost of paying the claims, taxes, levies, duties, reinsurance costs, the prot margin and the cost of the insurance company administering the insurance cover, and the cost of insuring the particular valuable.

How premiums are set Car insurance

Insurance companies typically set premiums depending on the amount of risk the insured valuable has of being damaged, lost, stolen or injured.

For instance, with car insurance, premiums may be based on:

the age and sex of the main driver and their driving experience and accident or trafc conviction record;

who else may be driving the vehicle;

where the vehicle is used or kept;

what the vehicle is used for, for instance if the vehicle is used for business purposes, as this may mean it will be driven more and is more likely to be involved in an accident;

the vehicles value, if the car is an exotic import with expensive and hard-to-get parts; and

previous claims record.

Family cars with moderate repair costs may be cheaper to insure than large or powerful cars, which may be more expensive to repair.

Some people may pay more for their insurance than others because their risk of an accident or theft is higher. Others, for example, older drivers, may pay less, because they are statistically less likely to have a car accident.

Insurance claims are typically more frequent in urban areas so motorists in cities may pay more for their insurance than those who live in the country.


9


Speeding Convictions - Insurers believe that there is a likely connection between the number of speeding convictions a person may have and their likelihood of making an insurance claim. Sometimes people with speeding convictions may pay higher premiums until their driving record improves.

Drink Driving Convictions - Drink driving convictions are taken very seriously by insurers. Convicted drivers returning to the roads may face difculty in obtaining insurance and may have to pay far higher premiums than before their conviction. The level of cover available may be reduced - for example from comprehensive down to third party re and theft. These higher premiums and cover restrictions may apply for a number of years.

People should look after their car - Insurance policies may require that the car is in a roadworthy condition. If the car is not roadworthy, it may affect the insurance cover.

When buying or renewing motor insurance, the insurers questions need to be answered truthfully. For instance the insurer needs to be informed about the details, or any changes to details such as address, occupation, type of car and motoring convictions.


10


How premiums are set Home and house contents insurance

In setting premiums for homes and house contents, insurers may start with the postcode of the property to be insured. Postcodes enable insurers to identify a geographical area, thereby allowing premiums to better reect the claims experience in that locality.

Insurance companies may take into account a number of factors when setting premiums for home and house contents insurance.

Some of these factors may include: the policyholders previous claims history, the houses postcode, the sum(s) insured and the nature of the items insured, the size and style of the house, whether the house is rented, or is occupied by the owner, if the house has a monitored security alarm and the houses location; for example, whether it is in a bushre or storm prone area.

For example, a person may discover they are paying more for their home insurance than their neighbour is, even though they have the same kind of policy from the same insurance company.

There may be a logical explanation for this difference.

Perhaps one persons house has a monitored security alarm, while their neighbour does not; maybe their house is larger in square footage than their neighbours; or they have some valuable jewellery listed on their insurance policy that their neighbour does not.

Some of these factors outlined above may be why a large country mansion may cost more to insure than a smaller suburban unit.

There are certain risks that some insurers will not agree to cover, because the odds are too great that a loss will occur; for example, a home that is near a river that oods a lot.


11


How premiums are set Injury / Disability insurance

In a similar way to how motor and home insurance premiums are set, some types of injury / disability insurance premiums may be set depending on risk factors, including:

persons age;

whether the person smokes;

persons medical history;

persons occupation, for example some occupations may be considered more risky and dangerous;

and

persons hobby, (they may like to indulge in what is considered a risky hobby, like skydiving).

Also with some types of injury / disability insurance, if the person has what is called a pre-existing condition an existing or previous illness that the insurer believes is likely to worsen or recur - there may be some insurers that will not cover this risk.

How premiums are set Business Insurance

A business insurance policy combines a number of insurance covers into the one policy. This includes re, business interruption, theft, money and liability to name a few.

When establishing the premium for business insurance, a number of factors will be taken into account. This will include the types of covers selected, the nature of the business, the types of products produced and the past claims history.

Each business is different and rating factors will vary. The exposure presented by an ofce are completely different to those presented by a woodworking factory where machinery is used as well as various paints and ammable liquids such as lacquers.

An insurance premium is not like paying for a typical service or product because:

Insurance companies are selling the customer a promise to cover what is insured by the insurance policy. For example if the customers insured property is accidentally lost, stolen or damaged and the customer makes a claim.

The cost of paying a claim is not certain at the time the insurance policy (coverage) is sold.

Insurance companies do not know what misfortune any of their customers may encounter. Therefore, insurance companies may not know exactly how often a customer may make a claim.

Insurance companies usually offer insurance cover for 12 months at a time and insurance premiums usually need to be paid and renewed every 12 months.


12


What is a claim?A claim occurs when a person contacts their insurance company seeking what they are entitled to under a policy of insurance because, for example, the property they have insured with that insurance company is lost, stolen, damaged or destroyed. For instance, a person damages their car in an accident. They have an insurance policy that covers the damage caused by the accident. They contact the insurance company to request it repair the vehicle or pay for the repairs.

A person, who has paid a premium to an insurance company, to cover a loss, can go to the insurance company and make a claim. If their claim falls within the insurance cover offered by the insurance policy, the insurance company can use the money from the pool to pay the claim.

Paying the claim is the moment of truth for the insurance company.

When an insurance company pays a claim, it is keeping its promise to pay the claims of those who have suffered a loss from the pool created by many.

Paying claims is what insurance companies do. Making sure enough money is in the pool to pay claims should be a main task of an insurance company.

Making a claim

An insurance claim can only be made if a premium has been paid for an up-to-date insurance policy that covers risk. This means that a person has to contribute to the pool before they are eligible to make a claim.

Some general steps that may be relevant in making a claim include:

Contacting the police, for instance, if the claim involves theft, a serious car accident or any crime; Trying to prevent further damage or loss if it can be done safely;

Contacting the insurance company as soon as possible. Some insurance companies allow certain claims to be made over the telephone, meaning there may not be a need to ll out a claim form. It also means that the insurance company can begin processing the claim immediately. However if a claim form needs to be lled out the insurance company should be able to send a claim form when they are contacted or there may be downloadable claim forms on the insurance companys website; and

Keeping a written record of what happened, as it is easy to forget about some small details that might prove to be important later on. Also any supporting evidence, such as receipts should be kept.

The insurance policy needs to be read. Insurance policy holders would have received one when they paid their insurance premium. Of course, its in everyones best interests if people check what is covered in their insurance policy when they rst buy, or renew their insurance. The insurance company may send out a loss or claims assessor to look at and check the claim for the loss or damage. The Insurance Council of Australia has a General Insurance Code of Practice, which sets out rules that insurance companies, that are members of the Insurance Council of Australia, must follow. The General Insurance Code of Practice outlines principles and standards about the insurance claims handling process.

The Insurance Code of Practice can be found at: http://www.ica.com.au/codepractice/.


13


Types of insurance claimsInsurance companies sometimes categorise claims into two groups, known in the insurance industry as short tail and long tail. The tail refers to the time it takes for the claim to be settled.

In broad terms short tail claims are generally:

claims usually known and settled within a short period of time, usually within 12 months;

not hard to manage;

easy to work out the exact amount to be paid out; and

are often based around property.

In broad terms long tail claims generally:

often relate to personal injuries;

are sometimes not even reported within 12 months, (like the effects of an injury);

are claims that can take three to four years and sometimes as long as 20 years to settle;

are harder to work out the nal amount to be paid out; and

are sometimes based around medical and legal outcomes.

What can be insured?Almost anything that is valuable can be insured, including a persons health.

However, not all insurance companies provide insurance for everything.

Below is a list of some of the things that insurance companies may cover.

PERSONAL LINES COMMERCIAL

SHORT TAIL

Private Motor Home, Contents Personal Effects Boat Caravan / Trailer Health Travel Transport Accident Consumer Credit

Fleet Motor Fire, Explosion Burglary, Theft Goods in Transit Construction Personal Accident / Travel Credit Machinery Breakdown Livestock Crop Marine Cargo

LONG TAIL

Compulsory Third Party (statutory) Home Liability

Workers Compensation (statutory) Public & Products Liability Product Recall Professional Liability Defamation Environmental Impairment


14


Anything that is insured generally has some basic features:

the risk is common to a large number of people, for example, car crashes, burglaries or house res;

it involves a loss or damage that can be worked out in dollar terms;

a person(s) owns, or is responsible for whatever is insured;

the loss is not too small; and

the premium paid to insure the valuable(s) should be affordable.

What do insurance companies do?

Insurance is all about pooling

Insurance companies provide a way for people to pool money. In the case of motor, home or business insurance, this allows people to avoid paying the full cost of replacing, repairing, rebuilding or restoring valuable things if they are lost, stolen, damaged or destroyed.

People who buy insurance each put in a little of their money into a pool.

If someones property is accidentally lost, stolen, damaged or destroyed, these people can draw on the pooled money to help pay for the repair or replacement costs.

Large and infrequent losses

Home insurance against re is an example where there is a risk of a large and infrequent loss. This is because houses are expensive to replace or repair, and house res do not happen very often.

FOR EXAMPLE Say every year one in every 800

houses suffers a re (1:800 loss) at a cost of $100,000 per housere.

If a homeowner has no insurance, they risk having to pay the full $100,000 if they experience the 1:800 loss, due to

their house burning down.

However if the homeowner has home insurance and if the home insurance policy costs, say $125 per house per

year, then a group of 800 homeowners pooling together pays only $125 each a year, to rebuild the house

burnt down. Even after 10 years each individual homeowner has only paid

$1250 to protect their risk of $100,000.


15


Small and frequent losses

Home contents insurance against burglary is an example where the risk is of small and frequent loss. It does not usually cost too much to replace what is stolen from a house, but burglary is not uncommon.

FOR EXAMPLE Say every year 100 in every 1,000

houses suffers a burglary (1:10 loss), at a cost of $900 per burglary.

If a householder has no insurance, they risk having to pay the full $900 if they experience the 1:10 loss, due to

their house being burgled.

However if the householder has home contents insurance and if the home

contents insurance costs, say, $90 per householder per year, then a group of 1,000 householders pooling together

pays $90 each to pay for the costs of goods stolen. Over 10 years the

individual householder has paid $900.

What are insurance companies expected to do?

Although most people may not see it as such, insurance could be regarded as the ultimate community product.

Customers and the community should expect insurance companies to:

Affordable

Pay Claims

Insurance companies need to make sure they have enough money to pay claims, otherwise they are not living up

to their promise to the community.

Price Risk Fairly

Some people will pay higher premiums into the pool because their risk is higher. If insurance companies price risk fairly, they

will stay in business and can continue to pay claims.

If insurance companies underprice, they may not survive as they will pay out more in claims than they

are taking in premiums.

If insurance companies overprice, people may not be able to insure their valuables at all.

Minimise Cost

There are costs involved in running an insurance company. If insurance companies minimise costs, they will be

able to do business with less costs. This will help keep insurance affordable.

Help Reduce Risk

Helping reduce risk is an integral part of what insurance companies should do.

If insurance companies work with customers and the community to make homes, workplaces and roads

safer, fewer people will have to make a claim, insurance companies can keep the costs of insurance down. This is a

benet to the community.

Accessible


16


How much of the premiums customers pay goes back into paying claims?As an example the graph below shows that about 54% of all the money paid into the pool from Insurance Australia Groups customers goes back into paying claims.

CONTRIBUTIONS TO THE COST OF RUNNING THE INSURANCE AUSTRALIA GROUPS BUSINESS (2004)

Source: IAG SUSTAINABILITY REPORT 2004 (Page 28 on the full PDF REPORT): www.iag.com.au/sustyreport04

Disclaimer: This graph is indicative only and constructed for educational purposes.

What is the difference between insurance companies and other nancial businesses such as banks?

Insurance, unlike banking, is not a guaranteed investment. Money will only be taken out of the pool if there is a claim that is covered by the insurance policy. Also there is the possibility that a particular person, who has put money in the pool may never make a claim.

If everyone made a claim every year, there may not be enough money in the pool and insurance companies may not be able to operate.

With a bank, customers pay money into their bank savings account.

That money, plus interest, will be available to them whenever they decide to withdraw that money.

When people pay an insurance premium to an insurance company, they are getting a promise from the company that they will pay if the customer makes a claim that falls within what is covered in their insurance policy.

Insurance is often referred to as buying peace of mind in case of an accident, loss or disaster.

Commissions

6%Reinsurance Expenses

5%

Underwriting & Administration

12% Claims Expenses54%

Government Levies & Taxes

18%

Underwriting Prot

5%


17


An insurance companys work

An insurance company needs to do many things to full its promise to its customers and return prots to its shareholders or members.

These tasks include:

Pricing risk (working out the right price of insurance premiums);

generally if the cost of premiums is too high, fewer people will pay for the insurance and the pool may not have enough money in it to pay claims;

generally if the cost of premiums is too low, there may not be enough money in the pool to pay for claims.

Paying claims that fall within what is covered in the insurance policy;

if the insurance company does not pay fair and honest claims, covered by the policy, it will lose customers, and be held accountable by the Government Regulators and industry associations.

Administration of insurance policies;

insurance companies must be efcient and not use too much of the pooled money to pay the costs of running the company.

Investing pooled funds (premiums);

if the insurance company is good at investing some of the pooled money waiting to pay claims, then the interest from that money can help ensure there is enough money in case many people make a claim at the same time, or can be used as prot.

Managing capital;

insurance companies need money set aside to ensure that there is always enough money in the pool even if there are many claims all at the same time. This may happen if a large natural disaster like a bushre or big storm or cyclone occurs. The money that is set aside by insurance companies is called capital.


18


How to reduce riskInsurance is one way of managing risk.

The best way to reduce the risk of loss or damage to things that are valuable is to take precautions against mishaps, accidents or theft happening at all.

Many insurers provide their customers with information to help them reduce risk and improve security in the home, on the road and in their business.

Some insurers are also helping to reduce the risk of injuries in the workplace, an example is at: https://www.cgu.com.au/cgu/cgu/linkAuthContent.do?contentId=%2FOurProducts%2FSafetyandRiskServices

How do insurance companies work out the risk?

This is called underwriting

Not all risks are the same. Insurance companies need to consider many things when they are pricing the risk of a person who wants insurance for something valuable to them.

Below are some of the things insurance companies may look at when they are working out how to match up the amount of premium customers pay to the risk that these customers have:

Specic Socio Demographic Economic Catastrophic

Individual Risk Driver ability Driver age Gender Asset Risk Type of car Type of nance

Area Ination Exchange rates Cost of parts Fuel prices

Hail Earthquake Bushres Cyclone


19


What is underinsurance? How could underinsurance affect you?

Underinsurance is when a customer pays an insurance company an insurance premium for an insurance policy that does not cover the full cost of the customers loss. For instance if the insurance cover does not match the cost of replacing a house, contents or a car.

For example; a house owner may have an insurance policy that will pay $100,000 if their home is destroyed in a re and another $25,000 to replace or repair the contents of the house.

If the house burns down, and it costs $150,000 to rebuild and $50,000 to replace the contents, the customer will have to make up the shortfall. In this case, the true cost is $200,000, but the customer was only covered for $125,000. This means they will need to nd $75,000 of their own money to rebuild their homes and replace their contents.

People should review their insurance regularly, at least once a year to make sure they have the right amount of insurance.

What is overinsurance?Overinsurance is also an issue. If it costs $90,000 to rebuild a house and $20,000 to replace the contents, but it is insured for $100,000 to rebuild and $50,000 to replace the contents, then there may be overinsurance.

In this case, the house and contents are insured for $150,000 (which is called the sum insured). However the true cost of rebuilding and replacing the contents is $110,000. This means the house and contents is overinsured by $40,000. In this example, if the house did burn down, the insurance company may only cover the true costs of rebuilding the house and replacing the contents, (in this example $110,000), and not the sum insured.


20


Some commercial policies contain an average or underinsurance clause. This means that the sum insured must reect the full insurable value of the item being insured. If your sum insured does not meet the full insurable valuable, your claim may be reduced in proportion to the amount by which you have underinsured when compared to the full insurable value.

In some policies, this clause is not applied where the sum insured represents 80% of the full insurable value. An example of the average or underinsurance clause is as follows:

Item value = $200,000

80% of value = $160,000

Sum Insured = $144,000

Therefore, if a $100,000 loss occurs, the insurance policy would pay:

$144,000 x $100,000 = $90,000

$160,000


21


Reinsurance

What is reinsurance?

Reinsurance is insurance for insurers.

It is a way of moving the risk that one insurance company takes on from its customers into a pool that other insurance companies also share.

Reinsurance is just the same as insurance for people; each insurance company puts some money into a pool that is then shared by all the other insurance companies that have put money in.

Reinsurance helps to make sure that an insurance company has enough money to pay claims if many of its customers make claims at the same time.

Each insurance company puts some money into a pool. This way, just like individuals, insurance companies can spread some of the risk.

Below are some examples of how reinsurance works:

1. A man pays an insurance company an insurance premium to have his large cargo ship insured for $20 million in case it sinks. The insurance company believes this is too great a risk, so it pays a reinsurance premium to a reinsurance company to cover $18 million of this risk. If the ship does sink, the insurance company will pay the customer $20 million but will get back $18 million from the reinsurance company.

2. An insurance company may insure a number of homes and cars in your suburb or town. If there is a large storm, many of the houses and cars may be damaged. The insurance company will pay the claims from the home and car owners, then the insurance company, if they are reinsured for this loss, will claim some of this money from the reinsurance company. This reinsurance covers catastrophes. Catastrophes are natural disasters such as large hailstorms, earthquakes and bushres.

Insurance is a truly global business and this is particularly evident in reinsurance where insurers spread their risk across a number of reinsurers throughout the world. This is why events such as Hurricane Andrew in the 90s and the terrorist attacks on the world trade centre can have an effect on and inuence the local Australian market.


22


What rules do insurance companies have to follow?

Insurance companies must obey the law.

Laws that are relevant to insurance companies include:

nancial services legislation;

privacy laws;

trade practice; and

insurance contracts law.

Regulators that oversee the conduct of insurance companies include:

Australian Prudential Regulatory Authority (APRA) http://www.apra.gov.au

Australian Securities and Investments Commission (ASIC) http://www.asic.gov.au

Note: Australian Securities and Investments Commission (ASIC) have an informative Financial Tips and Safety Checks (FIDO) website http://www.do.asic.gov.au.

ASICs FIDO website includes good information about insurance and other consumer education information.

In Australia there is legislation regulating insurance companies. Some of this legislation and some areas covered by that legislation is outlined below.

CORPORATIONS ACT 2001

Financial Services Law

INSURANCE ACT 1973 Regulation of general insurance companies, including regulating capital adequacy of those insurance companies

INSURANCE CONTRACTS ACT 1984

Regulation of information provided to consumers Denes duty of disclosure for consumers Limits areas in which a claim may be denied or policy cancelled

AUSTRALIAN SECURITIES AND INVESTMENTS COMMISSIONS ACT 2001

Misleading and deceptive conduct Unconscionable conduct.

PRIVACY ACT 1988 Regulating the collection, use and disclosure of personal information.


23


Part 1 Revision

What is insurance?

Insurance is about a person putting a small amount of money into a pool with other people to cover the cost of claims. For example when a persons property is lost, stolen, damaged or destroyed, or if they are injured, that person can draw from the pool of money to replace or x their property or fund their recovery.

People who have put money in the pool should not have to pay the full amount to cover their loss or accident.

What is a premium?

A premium is the amount of money a customer pays an insurance company for the insurance policy. For example to cover the customers property if it is lost, stolen, damaged or destroyed or help them recover from an accident.

The premium is the amount of money the person puts into the pool of money. Once this premium is paid the customer receives an insurance policy from the insurance company.

An insurance policy is an agreement setting out what is covered, under what circumstances, for how much and for how long.

What is a claim?

A claim occurs when a person contacts their insurance company seeking what they are entitled to under a policy of insurance because, for example, the property they have insured with that insurance company is lost, stolen, damaged or destroyed. For instance, a person damages their car in an accident. They have an insurance policy that covers the damage caused by the accident. They contact the insurance company to request it repair the vehicle or pay for the repairs.

If the person has an insurance policy that covers the particular valuable being claimed, they should expect the insurance company to honour the agreement, (policy) and repair or replace the lost or damaged item, or pay the customer the amount of money set out in the insurance policy.

What is an insurer and what should an insurer do?

An insurer accepts a premium from a person or a business to cover, for instance, property if it is lost, stolen, damaged or destroyed or for compensation for a person if they are injured.

The insurer/insurance company manages a pool of money.

The insurer/insurance company pays claims covered by the insurance policy, and prices risk (the premium).

An insurer should help the community manage and reduce risk (accidents, crimes, disasters) through education.

Part 2 - Insurance Industry Overview

24


Insurance Industry Overview The World

How much is spent on insurance a year?

Total Insurance Market Size in 2003 US$ Billions

Source: Swiss Re, Economic Research and Consulting,

Sigma No 3/2004 Refer to www.swissre.com Research & Publications

Although all the information used in this study was taken from reliable sources, Swiss Reinsurance Company does not accept any responsibility for the accuracy or comprehensiveness of the details given. The information provided is for informational purposes only and in no way constitutes Swiss Res position. In no event shall Swiss Re be liable for any loss or damage arising in connection with the use of this information.

Top 5 General Insurance Markets vs Australia 2003 (US$ Billions)

Source: Swiss Re, Economic Research and Consulting,

Sigma No 3/2004 Refer to www.swissre.com Research & Publications


Life Insurance

$1,67357%

General Insurance

$1,26843%

JAPAN $98 CHINA $14

USA $637

GERMANY $94

FRANCE $58

UK $92

AUSTRALIA $18

TOTAL $1,268


25


Insurance Industry Overview Australia

Geographical Spread of Premiums

Source; Selected Statistics on the General Insurance Industry, June 2002, produced by the Australian Prudential Regulation Authority.

Australian Prudential Regulation Authority (APRA) 2005. The copyright in this material belongs to APRA. Reproduction in unaltered form for your personal, non-commercial use is permitted. Other than for any use permitted under the Copyright Act 1968, all other rights are reserved.

Classes of Insurance (% of total $18 billion premiums)

Source; Selected Statistics on the General Insurance Industry, June 2002, produced by the Australian Prudential Regulation Authority.


WA

8%TAS

2%

NSW

51%VIC

19%

ACT

2%NT0.5%

QLD

13%

SA

5%

Workers

5%Other

7%

Home

14%

Motor (Domestic & Commercial)

26%

Liability

6%

Professional Indemnity

3%Fire

9%

Compulsory Third Party

11%

Inward Treaty

14%

Accident

5%


26


Insurance Industry Overview

Is the general insurance pool growing?

Yes. Historically the market has grown 11% each year despite the collapse of HIH Insurance in 2001, the industry has recovered quickly.

Australian general insurance industry growth by line of business

Other

Employers Liability

Public & Product Liability

Professional Indemnity

Domestic Motor Vehicle

Commercial Motor Vehicle

CTP

Householders

Fire and Industrial Special Risk

Gro

ss W

ritt

en P

rem

ium

in $

Bill

ion

s

OtherEmployers LiabilityPublic & Product Liability

Professional IndemnityDomestic Motor VehicleCommercial Motor Vehicle

CTP - Compulsory Third Party InsuranceHouseholdersFire and Industrial Special Risk

1992

25

20

15

10

5

01995 1996 1997 1998 1999 2000 2001 2002

Source; Selected Statistics on the General Insurance Industry, June 2002, produced by the Australian Prudential Regulation Authority. *HIH not included in 2002.


Insurance industry overview trends

Price Increases - The Insurance Market Cycle

Source: JP MORGAN 2002

Underwriting Prots Peak

Capacity Increases

Competition Increases /Rates Deteriorate

Loss Ratio Begins to Rise /Rates Continue to Fall

Major Underwriting Losses

Capacity Leaves

Underwriting Prots Peak

Rates Rise

Loss Ratio Improves


27


Insurance industry overview trendsThe impact of September 11, 2001:

Reinsurers increased pricing and reduced capacity worldwide.

Increased nancial instability of reinsurers as a direct result of September 11, 2001 losses.

Largest insurance losses internationally trends $ billions (as at 2003)

Source: PWC Insurance facts and gures 2003.

Converted to Australian dollar from Swiss Re Sigma no.2/2003


2001

1999

1994

1992

1991

1990

0 10 20 30 40

September 11, New York, USA 30+

15.8

30.3

36.6

13.3

Storms - Lother & Martin, Western Europe

Northridge Earthquake, California, USA

Hurricane Andrew, Miami, USA

Typhoon Mireille, Japan

Storm Daria, UK 11.3

Part 3 - Premiums, prots and losses

28


How insurance companies operate

The different nancial parts of an insurance premium

Premiums =

Gross Written Premium (GWP)

Is the total amount the insurance company receives from customers for the payment of their insurance policies.

Net Written Premium (NWP)

Is the proportion of gross written premiums received by the insurance company, within the nancial year, minus the reinsurance expenses.

How insurance companies work out their underwriting prot/loss

Net Written Premium

Is the proportion of gross written premiums received by the insurance company, within the nancial year, minus the reinsurance expenses.

Net Claims Expense

The amount paid out in claims during the year, as well as an estimate of how much the insurance company need to pay on unsettled claims, plus claims handling costs such as legal and adminsitrative expenses, less recoveries from reinsurers and other parties.

Underwriting Expenses

The costs associated with researching risk and determining appropriate premiums, underwriting administering the policy information required to run the insurance company business, marketing, commissions, distribution and meeting compliance requirements.

=

Underwriting Prot/Loss

The prot or loss the insurance company makes from the premium income before they consider related investment income.


29


How insurance companies operate

How insurance companies work out their insurance prot/loss

Underwriting Prot/Loss

The prot or loss the insurance company makes from the premium income before they consider related investment income.

(Net Written Premium minus the claims and underwriting expenses - as shown on previous page)

+

Investment Income from Technical Reserves

Technical reserves are the funds held by an insurance company. They represent the money customers have paid through their premiums that has not yet been paid out to customers who may one day make a claim. Insurance companies make money on these investments.

=

Insurance Prot

The insurance company prot is worked out by adding the Underwriting Prot/Loss to the Investments Income the insurance company make from their technical reserves.

How insurance companies work out their net prot/loss

Insurance Prot

The insurance company prot is worked out by adding the Underwriting Prot/Loss to the Investments Income the insurance company make from their technical reserves.

+

Investment Income from Shareholders Fund

This is the income received from the capital supporting the business.

Tax

This is the income tax expense on the companys prot.

=

Net Prot/Loss

This is the nal amount after allowing for income taxes and the share of prot owing to minority shareholders/unit holders within the company.

A working example of this can be seen on the Insurance Australia Group Annual Report 2005 (page 11). Refer: http://www.iag.com.au/annualreport


30


How much does it cost an insurance company to run its business?Insurance companies try and keep the costs of running their business low. This means that less of the premiums they charge customers is eaten up in administration costs. Lower administration costs can mean lower insurance premiums.

The cost of running an insurance company of selling and collecting premiums, paying claims and administration costs is sometimes called an insurers combined operating ratio or COR.

IAGs Combined Operating Ratio (COR)

The sum of all claims, administration and underwriting costs as a percentage of Net Earned Premium.

85%80%

90%

95%

100%

105%

110%

115%

120%

1998 1999 2000 2001 2002 2003 2004

Short Tail Long Tail

Data is for Insurance Australia Group (IAG) only as at the year end 30 June 2004


31


Insurance companies requirement for capital

What is capital?

Capital is the money any company uses to invest in, to start or expand its business. In an insurance company, capital is what the company needs to set aside or reserve in addition to the money in the pool collected from customers who have paid their insurance premiums.

Capital gives an insurance companys customers security that the insurance company should have enough money to pay claims covered within their insurance policies.

Why do insurance companies have capital?

Capital provides a buffer against a large number of claims occurring at the same time. This could happen after a natural disaster, such as a large storm, earthquake or bushre.

Capital is also held to fund future growth.

Usually to determine the amount of money needed in the pool to pay claims, insurance companies look at all the different risks of their customers and average them out.

How much capital an insurance company needs is inuenced by the type of risks its customers face.

If the loss or damage is small but happens frequently, such as car insurance claims, then the total amount required in the pool for the claims, is easier to work out; and

If the loss or damage is larger, but happens less often, such as an earthquake or large storm, then the total amount required in the pool for the claims is much harder to work out.

The premiums insurance companies charge customers go into the pool and pay for EXPECTED losses (through customers making a claim) plus the administration expenses of running the insurance company.

EXPECTED losses have about a 50 per cent chance of occurring. This involves half of all customers making a claim at the same time.

However, insurance companies must also have capital in reserve to pay for UNEXPECTED losses. That is when the number of claims by customers is more than the expected number of claims.


32


How do insurance companies work out how much capital they need?

Usually the insurance companies prot margins from the premiums they charge customers is enough to top up the pool when UNEXPECTED losses arise from there being many more claims from customers than expected.

How much capital is enough?

Customers who have paid their premiums and government regulators, such as the Australian Prudential Regulatory Authority (APRA), have the right to expect insurance companies to have enough capital to pay claims.

This is because it is important for Australians to know there will always be enough money in the pool to pay all claims, no matter how many claims are made.

The higher the amount reserved in capital, the greater the chance

there will always be enough money to pay claims.

It is important for insurance companies to be able to calculate and balance how much capital they should keep.

Too little capital Too much capitalMeans the pool is too small and the insurance company runs the risk of not having enough money in this pool, particularly if most of their customers make a claim at the same time.

Means the pool is too big and the insurance company needs to make more

money, or take away money from its prots, to ll this bigger pool.

Part 4 - Risk

33


Why insurance companies should help the community reduce riskHelping reduce risk in the community is an important role for an insurance company.

When insurance companies help customers and the community make homes, workplaces and roads safer, fewer people should have accidents, mishaps or losses and make fewer insurance claims. If there are fewer claims, insurance companies should be able to keep the price of insurance premiums lower.

Insurance companies and communities working together to reduce risk may result in:

= the community understanding more about reducing risk

= fewer accidents, injuries and losses

= fewer insurance claims

= cheaper and more accessible insurance.

Insurance companies can educate the community and raise its awareness about reducing risk through:

Programs with police, neighbourhood groups, schools and authorities that:

reduce the frequency of crime;

increase awareness of better home and car security; and

encourage offenders to develop work skills.

Programs with re services, customers, schools and community groups that:

help pay for re-ghting equipment; and

develop educational material about re awareness.

Partnerships with young driver education programs and authorities about:

road and pedestrian safety; and

vehicle modications and how that may impact the safety and insurance of cars.

Partnerships with community safety groups such as:

rst aid groups that help provide training and equipment to people at work and in the community; and

local community groups that encourage people to lead a safer and healthier lifestyle.

Partnerships with schools that:

increase students nancial literacy levels; and

increase understanding of the links between climate change and natural insurable events such as storms, oods and bushres.

Part 5 - Business and Community Sustainability

34


Sustainability and insurance companiesSustainability for insurance companies is about ensuring they are around in the future for the benet of their shareholders, customers, employees and the community.

Insurance companies are sustainable when they recognise a clear link between their business and the social, environmental and economic well being of the communities they serve.

For an insurance company, a healthy and secure community is an essential part of sustainability.

Sustainability in the community

Economic

Insurance in one sense can be regarded as a community product. It makes economic and social sense to pool effort and resources. This leads to a less risky way of life. If a society has a healthy economy, then our resources may be used more sustainably and the social and environmental risks are reduced.

Environmental

A balanced healthy environment is very important to the sustainability of the community and to business.

Climate change has a signicant impact on the environment, communities and insurance companies. Climate change continues with increasing amounts of greenhouse gases in the atmosphere.

This global temperature warming is creating more weather related disasters more frequently.

When storms, bushres and oods occur more frequently, insurance companies face more insurance claims. This will result in higher premiums to cover the increased amounts of money that is required in the pool to pay these claims.

Social and Safety

Social sustainability is linked to the health and safety of everybody in the community. A safer community is in everyones interest.

The incidence of crime and accidents in the community directly affects how insurance companies calculate risk and set insurance premiums.

Insurance companies have a responsibility to help create safe communities by helping people understand and manage the risks they face in their daily lives at home, at work and on the roads.

What are some insurance companies doing about sustainability?

Insurance companies can play a signicant role in helping develop sustainable communities.

It makes good sense for an insurance company to help the community reduce social, environmental and economic risks.

The following examples show what insurance companies are doing to build sustainability:


35


Global warming / climate change:

Why is climate change important to insurance companies?

Climate and weather have direct impacts on insurance business.

Insurance is provided to cover damage or loss caused by storms and bushres. As weather patterns get less predictable it will be difcult for insurance companies to calculate the correct cost of insurance premiums.

A major hailstorm in Sydney in 1999 caused enormous damage to cars and homes. Claims totalled about $1.7 billion.

If storms like this increase in frequency, as predicted by scientic groups like the Intergovernmental Panel on Climate Change (IPCC), then the cost of premiums will inevitably rise.

Even small increases in wind strength, such as from 93kms/hour to 111kms/hour, can increase building damage by over sixfold.*

In the same way, there is a disproportionate increase in damage to motor cars as hail stones increase in size.*

Also, a one-degree rise in the average summer temperature results in a 17-28 per cent increase in bushres.*

* These ndings are outlined in the Insurance Australia Group - The Impacts of Climate Change on Insurance Against Catastrophe report. This can be found at: http://www.iag.com.au/climatechange


36


What are insurance companies doing about climate change?

Some insurance companies have spent a lot of money and time researching climate change and the impact it has on insurance.

The ndings from this research have encouraged insurance companies to help the community to reduce risks caused by climate change.

Some insurance companies sponsor community education programs that:

help people understand where to build and where not to build in ood prone areas;

help governments prepare enforceable building codes;

look at reducing customers car insurance premiums if they use the train or bus to get to work everyday rather then their car. This helps reduce pollution and, over time, global warming. It will also decrease the number of car crashes insurance companies have to pay claims for; and

support research into climate change and distribute the ndings broadly to assist the community understand the impacts of climate change.

Some insurance companies are also reducing the amount of pollution, waste and greenhouse gases they produce through their internal operations.

Programs to reduce their environmental impact include using more environmentally friendly cars, recycling paper in the ofce, installing energy efcient appliances, and minimising water use. All of this will reduce negative impacts on our natural environment.

Companies that have recognised the benets of sustainability know that they need to set an example if they expect to help the community reduce the risks of climate change and global warming.

An example of what an insurance company is doing in regards to climate change can be found at: http://www.iag.com.au/sustainability


37


Energy efcient home goods replacement in the insurance claims process.

Some insurance products cover the replacement of home contents such as microwaves, fridges, dishwashers and other whitegoods which may be stolen or damaged in occurrences such as house res.

This presents an opportunity for insurance companies to recommend products, which are more environmentally friendly either through reduced water usage or reduced energy consumption.

This has long-term benets for the environment and reduces the amount of coal red energy needed to produce the electricity to run these products.

This in turn reduces greenhouse gas emissions, which, of course benets the environment and reduces the impact on climate change.

Part 6 - Glossary

38


Compensation

Compensation is providing something (for instance money or payment) for a loss or as a result of a loss. For example in the case of an injury to a person payment for lost wages while the person cannot work or payment of medical expenses arising from the loss.

Insurance

Insurance is the idea of pooling. Insurance is when people pay an insurance premium to an insurance company. This small amount of money goes into a pool with payments from other people to cover, for example the cost of repairing or replacing their valuables if they are lost, damaged, stolen, or destroyed, or to compensate a person if they are injured. Not everyone will make a claim.

Insured

Is an person or organisation who has paid an insurance premium to an insurance company, and the insurance company has accepted to cover them by insurance.

Insurer

An insurer is the insurance company. An insurer is the company that offers protection through the sale of an insurance policy to an insured.

The insurer, (the insurance company) must provide sufcient capital and an efcient funding mechanism for pooling of individual risks.

The insurer should have core competencies in:

Underwriting and pricing of risks

Payment of claims covered by the insurance policy

Administration of insurance policies

Investment of pooled funds (premiums)

Claim recoveries

Capital management

Liability

Liability is when a person or organisation is responsible for something, especially in law.

Liability insurance can be designed to provide coverage for either the exposure on a business or personal basis.

Mitigation

Mitigation is the action that reduces the chance and the severity, seriousness, or painfulness of an accident or mishap happening.

Mitigation is also used to describe the action that reduces the effect of the accident after it happens.

Part 6 - Glossary

39


Policy

A policy is the contract of insurance. It is a written agreement between an insurance company and the insured that puts insurance coverage into effect.

Pooling

Pooling is when each member of a pool contributes to that pool. Pooling is when a group of people share (things) in common, for the benet of all those involved.

Premium

A premium is the amount to be paid for the contract, (or policy) of insurance.

An insurance premium is an amount of money a person pays to an insurance company for an insurance policy. This payment could be regarded as transferring some or all of the risk (or cost) of loss or damage. The insurance company will assume, (or take on, accept, provide a cover for) the risks of the insured (length of life, state of health, property damage or destruction, or liability exposure) in exchange for a premium payment.

Premiums are calculated by combining expectation of loss and expense and prot loadings.

Reinsurers

Reinsurers provide insurance for insurance companies. This is a means of transferring risk from one organisation to another.

Reinsurance enables insurance companies to absorb large losses and remove uncertainty. However, reinsurance does not enable the insurer to accept a risk it would otherwise not accept.

Reinsurance provides protection against:

Catastrophic events

Too much risk in one policy

Reinsurance is a form of insurance that insurance companies buy for their own protection, a sharing of insurance.

Risk

Risk is the uncertainty of nancial loss. Risk is any situation that involves the exposure to danger and the possibility of something unpleasant or unwelcome happening.

Underwriting

Underwriting is when insurance companies manage the pool to optimise the result. Because not all risks are the same, underwriting involves examining, accepting, or rejecting insurance risks, and classifying those selected, in order to charge the appropriate premium for each. The purpose of underwriting is to spread the risk among a pool of insureds in a manner that is equitable for the insureds and protable for the insurer.

GD1128-0306

understanding insurance

Documents

insurance premium

insurance companies

insurance company

business insurance

history of insurance

insurance works

price of insurance

cgu insurance