Insurance

Accounting and
Finance
Lecture#1
By
Dr. Muhammad Usman
Introduction

In one form or another, we all own insurance. Whether it's auto, medical, liability or
disability or life, insurance serves as an excellent risk-management and wealth
preservation tool. Having the right kind of insurance is a critical component of any
good financial plan. While most of us own insurance, many of us don't
understand what it is or how it works.

What Is Insurance?

Insurance is a form of risk management in which the insured transfers the cost of
potential loss to another entity in exchange for monetary compensation known as
the premium.

Insurance allows individuals, businesses and other entities to protect themselves

against significant potential losses and financial hardship at a reasonably
affordable rate. We say "significant" because if the potential loss is small, then it
doesn't make sense to pay a premium to protect against the loss.

Insurance is appropriate when you want to protect against a significant monetary

loss. Take life insurance as an example. If you are the primary breadwinner in
your home, the loss of income that your family would experience as a result of
our premature death is considered a significant loss and hardship that you should
protect them against. It would be very difficult for your family to replace your
income, so the monthly premiums ensure that if you die, your income will be
replaced by the insured amount. The same principle applies to many other forms
of insurance. If the potential loss will have a detrimental effect on the person or
entity, insurance makes sense.
Everyone that wants to protect themselves or someone else against financial
hardship should consider insurance. This may include:

Protecting family after one's death from loss of income

Ensuring debt repayment after death
Covering contingent liabilities
Protecting against the death of a key employee or person in your business
Buying out a partner or co-shareholder after his or her death
Protecting your business from business interruption and loss of income
Protecting yourself against unforeseeable health expenses
Protecting your home against theft, fire, flood and other hazards
Protecting yourself against lawsuits
Protecting yourself in the event of disability
Protecting your car against theft or losses incurred because of accidents
And many more

Fundamentals of Insurance

How does insurance work?

Insurance works by pooling risk. What does this mean? It simply means that a large
group of people who want to insure against a particular loss pay their
premiums into what we will call the insurance bucket, or pool. Because the
number of insured individuals is so large, insurance companies can use
statistical analysis to project what their actual losses will be within the given
class. They know that not all insured individuals will suffer losses at the same
time or at all. This allows the insurance companies to operate profitably and at
the same time pay for claims that may arise. For instance, most people have
auto insurance but only a few actually get into an accident. You pay for the
probability of the loss and for the protection that you will be paid for losses in the
event they occur.
Risks

Life is full of risks - some are preventable or can at least be minimized, some are
avoidable and some are completely unforeseeable. What's important to know
about risk when thinking about insurance is the type of risk, the effect of that risk,
the cost of the risk and what you can do to mitigate the risk. Let's take the
example of driving a car.

Let's explore this concept of risk management (or mitigation) principles a little
deeper and look at how you may apply them. The basic risk management tools
indicate that risks that could bring financial losses and whose severity cannot be
reduced should be transferred. You should also consider the relationship
between the cost of risk transfer and the value of transferring that risk.

Risk Control
There are two ways that risks can be controlled. You can avoid the risk
altogether, or you can choose to reduce your risk.

Risk Financing
If you decide to retain your risk exposures, then you can either transfer that risk
(ie. to an insurance company), or you retain that risk either voluntarily (ie. you
identify and accept the risk) or involuntarily (you identify the risk, but no insurance is
available).

Risk Sharing
Finally, you may also decide to share risk. For example, a business owner may
decide that while he is willing to assume the risk of a new venture, he may want
to share the risk with other owners by incorporating his business.

For risks that involve a high severity of loss and a low frequency of loss, then risk
transference (ie. insurance) is probably the most appropriate protection
technique. Insurance is appropriate if the loss will cause you or your loved ones a
significant financial loss or inconvenience. Do keep in mind that in some
instances, you are required to purchase insurance (i.e. if operating a motor
vehicle). For risks that are of low loss severity but high loss frequency, the most
suitable method is either retention or reduction because the cost to transfer (or
insure) the risk might be costly. In other words, some damages are so
inexpensive that it's worth taking the risk of having to pay for them yourself,
rather than forking extra money over to the insurance company each month.

The Risk Management Process

After you have determined that you would like to insure against a loss, the next
step is to seek out insurance coverage. Here you have many options available to
you but it's always best to shop around. You can go directly to the insurer
through an agent, who can bind the policy. The process of binding a policy is
simply a written acknowledgement identifying the main components of your
insurance contract. It is intended to provide temporary insurance protection to the
consumer pending a formal policy being issued by the insurance company. It
should be noted that agents work exclusively for the insurance company.

There are two types of agents:

1. Captive Agents: Captive agents represent a single insurance company

and are required to only do business with that one company.
2. Independent Agent: Independent agents represent multiple companies
and work on behalf of the client (not the insurance company) to find the
most appropriate policy.
Underwriting

Underwriting is the process of evaluating the risk to be insured. This is done by

the insurer when determining how likely it is that the loss will occur, how much
the loss could be and then using this information to determine how much you should
pay to insure against the risk. The underwriting process will enable the
insurer to determine what applicants meet their approval standards. For example,
an insurance company might only accept applicants that they estimate will have
actual loss experiences that are comparable to the expected loss experience
factored into the company's premium fees. Depending on the type of insurance
product you are buying, the underwriting process may examine your health
records, driving history, insurable interest etc.

The concept of "insurable interest" stems from the idea that insurance is meant
to protect and compensate for losses for an individual or individuals who may be
adversely affected by a specific loss. Insurance is not meant to be a profit center
for the policy's beneficiary. People are considered to have an insurable interest
on their lives, the life of their spouses (possibly domestic partners) and dependents.
Business partners may also have an insurable interest on each other and businesses
can have an insurable interest in the lives of their employees, especially any key
employees.

Insurance Contract

The insurance contract is a legal document that spells out the coverage,
features, conditions and limitations of an insurance policy. It is critical that you
read the contract and ask questions if you don't understand the coverage. You
don't want to pay for the insurance and then find out that what you thought was
covered isn't included.
Insurance terminology you should know:

Bound:

Once the insurance has been accepted and is in place, it is called

"bound". The process of being bound is called the binding process.
Insurer: A person or company that accepts the risk of loss and compensates the
insured in the event of loss in exchange for a premium or payment. This is
usually an insurance company.

Insured:

The person or company transferring the risk of loss to a third party

through a contractual agreement (insurance policy). This is the person or
entity who will be compensated for loss by an insurer under the terms of the
insurance contract.

Insurance Rider/Endorsement:

An attachment to an insurance policy that alters the policy's coverage or terms.

Insurance Umbrella Policy:

When insurance coverage is insufficient, an umbrella policy may be purchased to cover

losses above the limit of an underlying policy or policies, such as homeowners and auto
insurance. While it applies to losses over the dollar amount in the underlying policies,
terms of coverage are sometimes broader than those of underlying policies.
Insurable Interest:

In order to insure something or someone, the insured must provide proof that the loss
will have a genuine economic impact in the event the loss occurs. Without an insurable
interest, insurers will not cover the loss. It is worth noting that for property insurance
policies, an insurable interest must exist during the underwriting process and at the time
of loss. However, unlike with property insurance, with life insurance, an insurable
interest must exist at the time of purchase only.