CHAPTER 1 - INTRODUCTION TO INSURANCE

OVERVIEW

Overview

1.1. Introduction

1.2. Importance of Insurance

1.3. How Insurance Works

1.4. What is Insurance?

This chapter provides an introduction to the

wide range of topics which the book covers.
Emphasis is placed on the following areas:

Importance of Insurance

How Insurance Works

1.5.

Functions of Insurance

What Insurance Is

1.6.

1.7.

Classes of Insurance

Functions of Insurance

Historical Aspects of Insurance

Classes of Insurance

1.8.

The Role of an Insurance Agent

Historical Aspects of Insurance

The Role of an Insurance Agent

1.1. INTRODUCTION

Human beings are exposed to various kinds of

risks in their daily lives and activities and have
to endure the consequences of such misfortune.
Misfortune can arise in many forms which,
inevitably, lead to different types and nature of
losses.
Some examples are:

A sole breadwinner of a family is

involved in an accident and dies
prematurely.
Undoubtedly,
the
dependents will face two immediate
obvious forms of losses emotional
and financial.
The premises of a factory may be
destroyed by fire. The owners of the
factory will face, besides other losses,
the loss of income which the factory
1

CHAPTER 1 - INTRODUCTION TO INSURANCE

would have been able to generate if

the fire had not occurred. On the
other hand, those employed by the
factory may face the prospect of
redundancy
and
unemployment.

We can give countless examples of events

which lead to human grievances and financial
losses.
The natural question to ask then is
What arrangement(s) can be made to
overcome or at least reduce the consequences
of misfortune that may befall any one person?
In answering the above question, we have to
admit that not all forms of loss can be made
good or be expressed in pecuniary terms. For
instance, the emotional trauma arising from the
death of loved one cannot be made good by
any conceivable compensatory system.
Perhaps, what can be done is to devise a
compensatory system which will at least seek
-

to reduce the impact of financial

loss consequent to an unfortunate
event; and

to prepare or free oneself for the

forthcoming and unexpected financial
burden or losses.

One such possible arrangement, whereby the

financial loss is in consequence of an unfortunate
incident such as death or a fire, can be through
the purchase of insurance.

1.2. IMPORTANCE OF INSURANCE

The Need for Income

Every moment, individuals, families and
business units are exposed to losses arising
from their property, occupations, activities and

responsibilities. Who will bear these financial

losses and where will the funds be obtained from
to offset such losses? Usually, in the absence
of legal remedies, contract arrangements
or cooperative efforts, losses will fall on the
individual or business unit concerned. To solve
this problem, an arrangement is introduced for
coping with some of the risks and possible losses
faced by individuals and business enterprises.
This arrangement works on the law of large
numbers, i.e. by spreading the risk of loss faced
by a specific person or enterprise to all parties
who pool their resources to pay for individual
losses. This loss sharing arrangement is called
insurance.
The insurer is the intermediary who manages
this risk pool. The insurer holds and invests the
premiums in trust for policyowners, and pays
them in the event that these losses for which
insurance protection is taken, occur.
Let us consider for a moment as to what would
happen in modern society without insurance
organization.
Living costs money. Money is required to
buy essential needs like food, clothing and
accommodation, as well as to acquire other
comforts of life. If one wants to have a decent
life, one should have a continuous flow of income
as long as one is alive. This continuous flow of
income can be ensured only in two ways.
Sources of Income
A person may create his source of income by
either setting up his own business or working
for other people where, upon completion for the
jobs done, he will receive payment in the form of
a salary, wages, allowances or commissions.
The other means is through investment income
by way of dividends, bonuses or interest on the
capital invested.

CHAPTER 1 - INTRODUCTION TO INSURANCE

However, both sources are always at the risk of
being affected by circumstances over which the
individual has no control.
Unfortunate Events or Risks
Earning capacity may be ended abruptly due to
death, old age, sickness or accident that may
result in disability (permanent or temporary).
Likewise, the investments may suddenly
depreciate in value or the goods in which capital
is invested may be destroyed by fire.
In any of these contingencies, the individual or
the dependents have to bear the consequences
of the financial or emotional losses. Those
affected have no other sources to which they
can look for relief for sharing part or all of the
loss.
The painful experience as a consequence of
losses is obvious to anyone.

1.3 HOW INSURANCE WORKS

Let us next understand how insurance works to

compensate for the financial losses consequent
to the occurrence of a risk or perils.
Rather than providing a more formal definition
of the terms risk and peril now (see Chapter
2), we shall look at some instances where we
can say that a risk or peril has occurred.
Some Forms of Risk

Pooling of Risks
It is not possible for an individual to predict or
prevent such occurrences but through insurance,
arrangements can be made to provide against
their financial effects, i.e. loss of property and /
or earning.
Insurance in its various forms aims at
safeguarding the interest of the individuals
who are insured. This is achieved by having
losses experienced by the unfortunate few
compensated by the contributions, i.e. the
premium, of the many that are exposed to the
same risk.
The Concepts of Insurance Explained
The concept of insurance is illustrated in
Figure 1.1 in relation to a house owner or a
term life insurance portfolio. For the purpose
of illustration, it is assumed that the portfolio
consists of 1000 houses of identical value, say
RM100,000 each or 1000 life assured with
identical capital sum, and a premium of RM200
is charged for each or life assured per year.
House owners
or term life

Premiums
Claims

#1
#2

RM 200

#3

RM 200

RM 200

1000
x
RM200
=RM200,000

# 999
# 1000

Expenses
and other
Outgoes

Profits
RM 200
RM 200

Figure 1.1. Concept of Insurance Illustrated

Shipwreck at sea;

The Fund has to meet:

An outbreak of fire resulting in

material damage;

The contribution from the 1000 house owners

or life assured results in the creation of an
insurance fund of RM200,000. The insurer
uses this amount of money to pay for claims,
management expenses and other outgoes such
as commission, taxes, etc. The balance, if any,
constitutes the insurers profit.

Loss of income due to disability or

premature death.

CHAPTER 1 - INTRODUCTION TO INSURANCE

The Fund Can Become Deficit
Thus, in the situation illustrated earlier, the fund
created is just sufficient to pay for a maximum
of two claims and this leaves the expenses and
other outgoes of the insurer uncovered. If more
than two claims were to arise, the insurance
fund would be in deficit and clearly, the insurer
would experience a loss on this portfolio.

The operation of the law of large numbers will

ensure better prediction of future losses. This is
important to insurers because they must charge
a premium (based on predicted future losses)
that will be adequate for paying losses for the
period of insurance.

Premiums have to be Adequate in a

Competitive Business Environment
It becomes clear from the above that for the
insurer to operate profitably in a competitive
environment, premiums have to be fixed at
adequate levels, and management and
other expenses controlled. It is beyond the
scope of this book to explore the question of
what could constitute an adequate premium for
a given risk; however, we will look at the basics
of the techniques and the terminology involved in
subsequent chapters. For now, let us acquaint
ourselves with the law of large numbers.

There is a random or chance

occurrence of loss.

1.4. WHAT IS INSURANCE?

Having seen the role of insurance and how it

works in very general terms, it is now appropriate
to put down in precise terms what insurance is
all about.
Insurance, as an organization, seeks to provide
protection against financial loss caused by
fortuitous events.
Insurance Defined

The Law of Large Numbers

Insurance can therefore be defined as:

Insurance as a device for spreading the loss

of a few among many can only work when
insurers are able to underwrite a large number
of similar risks. When insurers are able to write
a large number of similar risks, the law of large
numbers operates.

An economic institution based on the

principal of mutuality, formed for the purpose of
establishing a common fund, the need for which
arises from chance occurrences of nature,
whose probability can be fairly estimated.

The law of large numbers states that as the

number of loss exposures increases, the
predicted loss tends to approach the actual
loss. Although the law of large numbers is a
simple concept, it can only operate efficiently
if the following requirements are fulfilled:

There are a large number of similar

loss exposures.
The loss exposures must be
independent.

The insurance service, therefore, involves

payment of contracted benefits or
compensation to the insured or a third party
against unforeseen losses.
Essential Features of Insurance
The essential features of insurance, therefore,
are:
i.

It is an economic institution.

ii.

It is based on the principle of mutuality

or cooperation.

CHAPTER 1 - INTRODUCTION TO INSURANCE

iii.


iv.

Its objective is to accumulate funds to

pay for claims that arise as a result of
the operation of specific risks.
Only certain risks can be insured
against,
namely
those
whose
occurrence
can
be
confidently
estimated with a certain degree of
accuracy.

if the owners were not able to transfer

their risks through insurance.

Insurance helps to remove the fears

and worries of losses of individuals
and business executives. This removal
of fears and worries helps to establish
confidence and enables the forwardplanning of economic activities.

1.5. FUNCTIONS OF INSURANCE

In this section we will look at the various

functions of insurance.

An endowment insurance is a
combination of protection plus savings.
The investment part of the contract is a
savings accumulation. By combining the
two features in a single plan, endowment
assurance provides both protection and
savings to the insured.

Stabilization of Costs
Through the purchase of insurance,
business enterprises avoid the necessity
of having to freeze capital to provide for
financial protection against losses. This
provides a means of stabilizing the costs
involved in managing risks.

Stimulation of Business
Enterprise
The risk transfer mechanism provided
by insurance has made possible
the present-day large-scale commercial
and industrial enterprises. These largescale enterprises would not have started

Provision of a Means of Saving

Insurance functions as a means of
saving, primarily through the use of
endowment insurance.

1.5.2. Secondary Functions

Reduction of Losses
Insurers help to reduce losses (both
in frequency and security) through
their actions and recommendations in
rating, survey, inspection services and
salvage.

1.5.1. Primary Function

The primary function of insurance is the

equitable distribution of the financial losses
of the few who are insured among the many
insured. This immediately leads to the
secondary functions stated below.

Provision of Security for

Expansion of Business

Provision of Sources of Capital for

Investment
Insurers accumulate large funds which
they hold as custodians and out of which
claims and losses are met. These funds
are usually invested (to earn interest)
in the public and private sectors. Such
investments help considerably in the
overall development of the economy.

CHAPTER 1 - INTRODUCTION TO INSURANCE

Provision of Employment for

Many
The insurance industry in Malaysia
has created various categories of
employment opportunities. Following
are the statistics for 2007:

Market Structure

1.Insurers
2.Insurance Brokers
3.Adjusters
4.Registered Life Agents
5.Registered General Agents

No. of Personnel
Employed
20,600
1,162
1,844
78,587
39,165

While the nature of jobs for brokers and adjusters

are independent and more of specialized
roles, the various job functions in an insurance
company such as underwriting, claims handling,
accounts, audit/compliance, human resource/
administration, electronic data processing,
marketing and servicing, investment and other
support functions are inter-dependent.

1.6. CLASSES OF INSURANCE

The pooling of risk is the fundamental principle

underlying the insurance business and it is
useful to classify insurance business broadly
into Life Insurance and General Insurance.
What is Life Insurance?
Life insurance can be defined as a contract
which pays an agreed sum of money on the
happening of a contingency (event), or of a
variety of contingencies, dependent on a human
life.

As we progress through the book, you may note

that the above definition is not precise in relation
to with profit policies, for there is no agreed sum
of money at the outset.
Life insurance contracts can be arranged to
provide cover against the following forms of
risks:

Premature death

Loss of a continuous stream of income

during retirement (i.e. during old age)

Sickness or disability

What is General Insurance?

General insurance business can be taken to be
all other forms of insurance business (including
the reinsurance of liabilities under a policy in respect
thereof) which is not life insurance business as
defined in the Insurance Act 1996.
Risks Covered by General Insurance
General insurance contracts, to mention a few,
can be arranged to provide cover against the
following forms of risk to the insured and/or third
parties in respect of

loss or damage to property, e.g. to

motor vehicles, ships, buildings,
stocks-in-trade;
legal liability caused by products or
goods sold, or the process carried
out;
death or injury to a person by an
accident.

More about the basis underlying the conduct of

the Life Insurance and the General Insurance
classes of business is provided in Part B and
Part C of this book.

CHAPTER 1 - INTRODUCTION TO INSURANCE

1.7. HISTORICAL ASPECTS

OF INSURANCE

This section will provide a brief introduction to

the historical aspects of insurance.
The earliest beginnings of insurance were in
the field of marine insurance. Men engaged
in trade by sea attempted to minimize their
losses which resulted from the perils of the
sea, by spreading the losses amongst all who
were similarly engaged. In the normal course
of events, many ships arrived safely in port and
only a few suffered losses. The many who were
successful thus contributed to overcome the
suffering of those who were unsuccessful. In
other words, the misfortune of the unfortunate
few was borne by the many.
This was achieved by the payment of a premium
into a common fund. So much benefit followed
this action that traders adopted the idea in
many countries and gradually there came into
existence groups of men who specialized in
managing the fund and who studied the rates
of loss which occurred in different types of
maritime adventure. This was the beginning of
marine insurance.
At a much later date came life insurance and
other modern forms of insurance, all of which
worked on the principle of spreading the
losses of the few over the fund created by the
contribution of the many.
Initially life insurance policies were sold as shortterm policies, cover being renewed at the option
of the insurer at the end of the period. Such an
approach had disadvantages and perhaps,
was the only possible one that could be adopted
when there were no mortality tables.
The year 1706 marked the emergence of the
Amicable Society for a Perpetual Assurance,
which adopted a scheme under which each
member was required to contribute a fixed
sum annually. The accumulated contributions
were divided at the end of the year among

the dependents of the members who had died

during the year.
Membership was open to persons between
the ages of 12 and 45 and members
contributions were uniformly fixed at 5 per
annum (which was increased to 6.20 later on).
In the early years of its operation the company
did not guarantee a definite sum assured but
after 1757 a minimum sum assured at death
was laid down. A variable premium based on
age was fixed only in 1807.
An important landmark in the development of life
insurance related to the use of the Mortality
Table in conjunction with compound interest
rates, when in 1762 The Equitable Assurance
for the first time fixed premium rates based
on modern lines, adopting the level premium
system.

1.7.1. Insurance in Malaysia

The beginning of insurance in Malaysia can be

traced to the colonial period between the 18th and
19th centuries when British trading firms or agency
houses established in this country acted as agencies
for the UK-based insurance companies, among
which were Harrison & Crossfield, Boustead, and
Sime Darby.
The insurance industry in Malaysia had been
largely patterned on the British system whose
influence still continues to be felt. Even as late
as 1955, it was reported that foreign insurance
domination of the local insurance market was as
much as 95% of the total business transacted.
After independence in 1957, however, concerted
efforts were made to introduce domestic
insurance companies. The early 1960s
witnessed the growth of a few life insurance
companies which wound up soon after because
of their unsound operations and inadequate
technical background.

CHAPTER 1 - INTRODUCTION TO INSURANCE

Control of Insurance Business

These unhealthy features culminated in

the Governments intervention through the
enactment of the Insurance Act 1963 to regulate
the insurance industry. This 1963 Act has since
been replaced by the Insurance Act 1996.
Since January 1997, the Insurance Act 1996
has become the principal legislation governing
the conduct of insurance business in Malaysia

1.8. THE ROLE OF AN INSURANCE AGENT

The roles of an insurance agent are:

to bring financial relief to aggrieved

dependents of insured people who
may meet with untimely death;

to bring financial relief in the event

of property loss;
to inculcate the discipline of saving
amongst the working population;
to
provide
other
forms
insurance-related services to
public.

of
the

To be an effective agent, one should be able to

recognize the insuring needs of ones clients.
Clients should be advised of the right type of
products so that they meet their insuring needs
and the policies do not lapse. Insurance agents
are expected to provide, in a sense, the best
possible advice to their clients.
It is greatly hoped that the reader will persevere
through the rest of this book and acquire the
technical and sales-related knowledge to
achieve success in his or her career.