Chapter 1

1: Insurance

Chapter section
A Risk and insurance
B Functions of insurance
C Risk management
D What can be insured?
E Parties involved in an insurance contract
F Premiums
G Physical and moral hazards
H Claims

Learning objectives
After studying this chapter, you should be able to:

j state the primary and secondary functions of insurance;

j explain the basic purpose and nature of insurance as a risk transfer process;
j identify and distinguish between insurable risks and uninsurable risks;
j discuss the methods of premium calculation;
j outline the difference between physical and moral hazards; and
j explain the nature of claims and the basic claims management process.

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 Lloyd’s and London Market Introductory Test

A Risk and insurance

Insurance exists to cover the financial consequences of an uncertain event (one not within the
insured’s control) which is undesired by the insured person or organisation. We can refer to
these events as risks. Each of the following is a different way of looking at ‘risk’:

• The possibility of an unfortunate event.

• Doubt concerning the outcome of an event.
• Unpredictability.
• The possibility of a loss.

However this is viewed, the key is to recognise elements of uncertainty, unpredictability or even
danger.

The second aspect of risk relates to the different levels of risk that exist. We know that there is
a greater likelihood of some things happening than others and this is what we mean by level of
risk. Risk is often assessed in terms of frequency (how often it will happen) and severity (how
serious it will be if it happens).

The term ‘risk’ is also used when referring to a complete insurance product, or, alternatively, to
just some of its components. Examples of these components include the subject matter of the
insurance (e.g. a property, an oil rig, employers’ liability), or the type of insured peril and cover
provided (e.g. a fire ‘risk’, a theft ‘risk’).

Some risks may be avoided, but there is a limit to risk avoidance. Risk is inevitable and the
concept of transferring the financial consequences of some risks to an insurer is attractive, or
often a necessity, and occasionally compulsory in the modern world.

Insurable risks are those where the insured suffers some physical loss or damage which can be
measured in monetary terms. These are known as pure risks and refer to risks where there is a
possibility of a loss, but not of a gain.

There are many situations in life where we speculate with a view to making some kind of gain.
An obvious example would be the National Lottery, or investing in the stock market. Each of
these has the aim of making a gain. These can be referred to as speculative risks. Whilst there
are many aspects of business activity that can be insured, this does not extend to things such as
business failure due to competition, or misreading the position of the market. Insurance does
not apply to speculative risks. There are some other types of risk that cannot be insured, or
which insurers choose not to insure and we will discuss these in section D2.

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A1 What is insurance?
Insurance is a risk transfer mechanism whereby the insurer, in return for payment, agrees to
pay (or provide a benefit to, or for) the insured if a particular event should happen. In other
words, insurers are the ‘risk takers’ or risk bearers in return for the premiums paid by the
insureds.

Transferring the risk does not take away any risk or prevent an event from occurring, but
insurance can protect individuals and businesses from the financial consequences arising from
an event.

Examples include:

• Property insurance will reimburse a property owner who suffers a loss arising from a
property being damaged, or destroyed in extreme weather, but it will not stop the wind
blowing in the first place.

• Liability insurance will assist a car owner if they are held responsible for an accident but will
not stop the accident happening.

• Personal accident insurance can provide compensation to a professional footballer if his

career is ended by injury but will not stop the tackle taking place on the football field.

Insurers are like other commercial enterprises in that they sell products and aim to make a
profit. In return for the protection given by insurance, the insurer receives a payment known as
the premium.

The basic concept of insurance is that the losses of the few are met by the contributions of the
many. The premiums paid by many insureds form a common pool of funds, from which valid
claims are paid. For each premium paid, the insurer accepts the risk of a considerably larger
claim being made against his funds, should misfortune strike the insured.

Each insured should make a fair contribution to the insurers’ funds based on the degree of
hazard associated with the risk and the values or liabilities at risk. The term hazard in this
context refers to the potential exposure or vulnerability to injury, loss or damage.

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 Lloyd’s and London Market Introductory Test

B Functions of insurance
B1 Primary functions
There are two primary functions of insurance, namely:

• to spread losses that a small number of insureds incur among many insureds; and
• to provide the security of insurance cover for the insureds by, reducing the risk of serious
personal financial damage.

B1A Spreading of losses

By pooling or combining together the premiums paid by many insureds, the insurer forms a
large pool of premiums. The financial losses of the few insureds who have suffered a loss are
spread amongst all those who insure and claims are met from the common pool.

Premiums are not normally set at an equal level, but are calculated to reflect each individual
risk. To ensure that the spread of losses is equitable, each insured pays a premium based upon
the risk introduced. For example, a shop insured for fire damage that has a monitored fire alarm
is likely to pose a lower risk (and is likely to pay a lower premium) than one without. In motor
insurance, an experienced driver with a clean driving licence and good claims history will
represent a better risk than an inexperienced driver who has just passed the driving test.

Insurers generally tend to deal with a large number of risk exposures, whether ships, properties,
motor vehicles, commercial liabilities or insured lives. By underwriting a large number of
similar risks, the insurer builds up a level of claims experience that enables it to determine a
more accurate assessment of likely claims and, therefore, a more realistic premium base than if
its experience was limited to a few risks.

Insurers may also specialise in ‘one-off ’, events, where the calculation of the premium cannot so
easily be based on past loss experience (see chapter 9).

The function of the insurer is to manage the common pool. This includes assessing if risks are
acceptable, determining the premium for each risk to be insured and making sure that the pool
is large enough to meet all valid claims.

Figure 1.1: spreading of losses

�
PREMIUM CLAIMS FOR
PAYMENTS LOSSES

£ £
£ £ £
INSURER’S
£ £ FUNDS
£
£ £

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B1B Providing security

Insurance cannot remove a risk; but it can provide financial security and give peace of mind.
A house or factory may still burn down, but if it is insured the owners will receive financial
compensation. An accident in the workplace, or on the road, will still occur, but the person who
is found to be at fault may have their legal liability protected by insurance. Without insurance
these types of losses could jeopardise the financial position of a private individual or enterprise.

Protection from insurable losses will encourage business confidence, for example, the purchase
of new production machinery tying up the firm’s financial resources is made in the confidence
that most aspects of damage to the machinery are protected by insurance. The business can
enter into the purchase, safe in the knowledge that the asset is protected.

B2 Secondary functions
The secondary functions of insurance include the following:

• Industries can avoid the need to maintain funds to cover all possible losses. Instead, they
can choose to pay a fixed contribution by way of a premium and obtain financial security
against the insured risks. Capital is, therefore, freed for the further development of the
business.
• The investment by insurers of their funds provides capital to industry and commerce.
Insurers are the custodians of the insureds’ premium funds. These funds are often very
substantial and they invest these prudently in return for the interest and growth that the
investments provide.
• A substantial contribution is made to the economic position of the country. The London
insurance market makes a significant contribution to invisible exports and is a substantial
employer.
• Insurance encourages and facilitates trade and enterprise. Banks and other financial
organisations that lend money require the security provided by their borrowers’ insurance to
protect their investment when financing home and overseas trade.
• Surveys and underwriting advice by insurers assist in prevention of loss and injury.
For many types of insurance, insurers will survey the risk before deciding whether to
accept it and their comments and feedback assist the insured in improving their own risk
management, for example, by recommending the installation of sprinklers in a factory or
improving packing on a certain type of cargo.

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 Lloyd’s and London Market Introductory Test

C Risk management
Taking steps to avoid the consequences of risks is a natural human response to the dangers we
all face. Often, basic risk avoidance can be supplemented with active risk reduction, or control
measures, that reduce risks to an acceptable level. This is known as risk management.

Insurance companies expect insureds to safeguard themselves, but may also sometimes
require additional risk controls. In property insurance, risk control starts with the design
and construction of the building, where fire-resisting components, such as concrete and steel
frames, are preferred to wooden structures. Other examples of risk control include:

• intruder alarms and specialist locks to reduce theft risk;

• sprinkler systems and fire doors to limit potential fire damage;
• health and safety training for staff to help prevent accidents and injury; and
• the separation of duties in an accounts department to reduce the risk of financial crime.

The key issues for insurers are that the risk management actions reduce the likelihood
and potential severity of a loss, should a risk event occur. Where there is proven good risk
management insurers may offer a reduction in premium.

D What can be insured?

D1 Insurable risks
To be insurable, risks must have certain characteristics, which normally include the following:

• The event must be uncertain (uncertain as to whether it will occur at all, or its timing.
It must not be deliberate on the part of the insured).
• The event must lead to a loss as far as the insured is concerned.
• The loss must be capable of being measured in monetary terms.
• The insured must have a financial interest in the loss (termed insurable interest – see chapter
3, section C).

With the exception of certain long-term life assurance contracts, it is not possible to insure
against a specific loss which will definitely occur, as that involves no uncertainty of a loss.
Deliberate acts, such as arson, by persons other than the insured may be insured since these
would be uncertain as far as the insured is concerned.

Insurance does not remove risk, but it does provide financial compensation against the
consequences. For example, the likely cost of rebuilding a property is known in advance and
would be the maximum extent of an insurer’s liability (the sum insured). In liability insurance,
the actual financial value cannot be calculated in the same way. In some cases, a court will decide
the level of compensation due to an injured person, or the matter will be agreed out of court by
way of mediation, arbitration or the parties’ lawyers. In either case, it is the potential legal liability
to pay damages which is the monetary value at risk and which is covered by the insurance.

In life assurance, the level of financial compensation (the policy ‘benefit’) is agreed at the
commencement of the policy term.

Over time, people have devised ways of reducing the risk inherent in ventures of all kinds, and new
types of insurance cover are continually developed to respond to new risks and customers’ needs.

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D2 Risks that cannot be insured

Where a genuine interest exists and the would-be insured can show that he would suffer
financially if the event insured against were to occur, then the risk can usually be covered.
However, there are some risks that cannot be insured, and these include:

• risks which are contrary to the public interest, whether or not a specific exclusion is
embodied in legislation;
• risks where the would-be insured has no insurable interest in the subject matter
(e.g. Mr Smith cannot insure Mr Green’s house because if Mr Green’s house is destroyed in a
fire, Mr Smith will not suffer any loss).

Fundamental risks are risks that occur on such a vast scale that they are generally uninsurable
due to a lack of willingness or capacity on the part of insurers - for example, those arising from
social, economic, political or natural causes that are widespread in their effect, such as nuclear
risks and floods. There is nothing to prevent an insurer writing such business; however, it
becomes impossible to rate and manage.

International trading relationships and contracts may be suspended or interrupted by

the imposition of bans, embargoes or other interference by national governments. Often
international trade is used, in effect, as an incentive to behave in an acceptable way – for
example, some countries refuse to trade with others who are at war or who have poor records in
the field of human rights (e.g. use of torture, holding political prisoners).

Insurers operating in the London market need to be aware of trade sanctions which may be in
force and issued by the UK government. These sanctions are usually to be found on the Bank
of England website. Additionally, sanctions are imposed by supra-national bodies such as the
United Nations or the EU. Further, insurers based in London but whose capital is provided by
investors from another country, in particular the USA, may find themselves subject to US trade
sanctions too (for example, US-backed insurers working in the London market must be careful
of any involvement with Cuban risks).

In addition to imposing trade sanctions against countries, national governments typically

maintain and issue lists of individual persons with criminal or terrorist involvement, or bodies
such as corporations which are deemed to behave unethically. It is illegal for an entity such as an
insurer to trade with or provide services to sanctioned individuals.

D3 Insurance risks written in the London market

London market insurers are known throughout the world for their willingness to insure unusual
risks and for their flexibility. Insurable risks of every conceivable description are accepted from
most countries by London market insurers, either directly or by way of reinsurance (covered in
chapter 4).

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 Lloyd’s and London Market Introductory Test

E Parties involved in an insurance contract

When an individual or company requires insurance, they must contact insurers. This can
either be directly between the prospective insured and the insurer, or through a professional
intermediary such as a broker. The scale and complexity of the risks that come into the London
market involve brokers in the vast majority of cases.

An insurance broker acts as agent for his client (i.e. the prospective insured) and the broker’s
role includes advice on insurance options, choice of cover and risks to be insured. The broker
is able to obtain quotations from a number of insurers and advise his client on the available
terms. The broker also passes on the insured’s premium to the insurer. The role of the broker is
discussed in more detail in chapter 8.

In the event of a claim, a broker will assist his client in submitting the claim details and, if
necessary, in negotiating a settlement. Insurers will either settle the claim direct with the client,
or through the broker who will pay the money to his client.

Figure 1.2: parties involved in an insurance contract

Policy holder Producing broker Insurance companies/

Lloyd’s broker
Lloyd’s syndicates

F Premiums
F1 Calculation of premiums
In setting the premium, the insurer must take into account a number of factors. The premium
needs to reflect the underlying risk being brought to the pool, but it must also provide for the
insurer’s operating expenses and the insurer’s profit, as well as some provision for larger than
anticipated claims.

There are different ways of calculating the premium. Premiums are normally arrived at by the
application of a premium rate to a premium base (for example, the market value of a boat or
car). The rate could be expressed as X pounds for each hundred pounds of risk insured. (rate
per cent) or X pounds per thousand pounds insured (rate per mille). The rate is intended to
reflect the hazard associated with the particular risk and the premium base is the measure of
the exposure. Therefore, the greater the risk to the insurer, the higher the rate per cent, and
vice versa. When calculating the premium, it is important to note that both the insurer and the
potential insured (the proposer) contribute something to the calculation. The proposer is often
asked to indicate the sum insured (the value of the property or car, or level of life assurance
required) and the insurer sets the rate to charge on that risk.

This is calculated as follows:

Premium = sum insured × rate per cent

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While the sum insured is a suitable premium base for many property insurances, it is not always
the appropriate measure. For example:

1. In the case of employers’ liability, the wage roll of the insured is normally used.

2. Public liability insurance is often rated on the sales turnover of the business and professional
indemnity is rated on fees earned.

3. Life premiums are based on mortality tables (which show the number of people in an age
group who will survive for a given number of years), with allowances for expenses and
reserves for unexpected contingencies.

Minimum premiums may be charged in some cases, such as with household contents, to reflect
the cost of acceptance of the business.

F2 Calculation of rate per cent

Taking property insurance as an example, the rate per cent is calculated from statistics that have
been collected over many years and which detail the amount of claims actually paid out over a
given period (losses) compared with the total values insured (values-at-risk). The formula used
is to multiply by 100 the ratio of losses to values at risk:

Losses (actual claims made) × 100 = Rate per cent

Values-at-risk

For example, if £450 million worth of property values insured give rise to £9 million in actual
claims, then the rate per cent for future premiums on this type of property insurance would be
worked out as follows:

  £9,000,000  × 100 = Rate per cent

£450,000,000

This simplifies to:

  £9  × 100 = Rate per cent

£450

which is:

£900 = 2%
£450

Thus the rate per cent is 2%.

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 Lloyd’s and London Market Introductory Test

In general, the premium must be sufficient to cover expected claims. The law of large numbers,
which is outside of the scope of the syllabus, allows the insurer to make a reasonably accurate
assessment of the likely claims costs and, at the very minimum, the premium must be sufficient
to meet these expected claims.

Using the same figures as above, if the rate per cent is 2, then the rate per mille would be 0.2%.
This means that the same premium would actually be calculated irrespective of whether the rate
was being applied per £1000 of the values or per £100 of the values.

F3 Additions to rate per cent

Added to the basic premium figure of rate per cent calculated in this way is an additional
percentage, which is to cover items such as:

• operating expenses (including commissions paid to a broker or other intermediary);

• profit for the insurer; and
• an amount for the potential for claims to vary materially from the expected amounts.

F4 Outstanding liabilities
Not all claims will be settled during the period over which the rate is being calculated. This is
particularly true in the case of claims involving personal injury and legal liabilities, as these
often take several years to settle and the insurer must take this into account when calculating the
premium by making a best estimate of the ultimate total claims costs once they are all settled.

F5 Expenses
The insurer has a number of operational expenses to meet in the running of the business which
are typical of any commercial enterprise and include:

• staff salaries and other employment costs;

• premises costs;
• business acquisition costs - brokerage/commission to brokers or agents;
• IT and other office equipment;
• professional fees (accountants, auditors, legal advisors, etc.); and
• provision for profit.

The insurer must ensure that there is provision for a reasonable profit. The insurer must also
consider some other factors in calculating the premium. These include:

• the fact that the premium is paid now for losses which may arise in the future (i.e. the effect
of inflation);
• possible changing exchange rates; and
• the effect of competition where charging too high a premium could result in loss of business
but charging too low a premium is likely to produce excessive losses for the insurer.

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F6 Gross and net premiums

The insurer then uses his determined rate per cent together with the additional items referred
to in section F3 to calculate the gross premium to be charged to the insured. The gross
premium includes the amount of money paid to the broker for bringing this particular piece
of business to the insurer. This amount of money is called the brokerage and usually is quoted
as a percentage of the gross premium. For example, in a particular case the brokerage might be
described as 20%, which means that the broker will be paid 20% of the gross premium and the
insurer will take the remaining 80%. The amount of the premium left after the brokerage and
any other deductions are removed, such as other commissions, is called the net premium.

This can be expressed as:

Net premium = gross premium minus brokerage and deductions

Example
The hull value on a small pleasure boat is £2,000. The insurer sets a rate per cent of 10% and agrees a
brokerage of 20%. What is the net premium?

Gross premium = sum insured × rate per cent

= £2,000 × 10%
= £200

Brokerage = 20% of gross premium

= 20% of £200
= £40

Net premium = gross premium – brokerage

= £200 – £40
= £160

The insured will pay 100% of the gross figure and then the insurer pays the broker his
brokerage, keeping the net premium. In practice, however, when the broker passes the premium
to the insurers, he, in fact, only remits the net figure, rather than waiting for the insurers to
repay the brokerage to him.

F7 Adjustable premiums
In some cases the final premium will not be known at the commencement of the contract of
insurance. This applies to employers’ liability risks, for example, where a deposit premium is based
on the estimated wage roll at the beginning of the period of insurance and adjusted up or down on
the known final wage roll figure at expiry. Some public liability risks are also subject to adjustment.

For example, on an employers’ liability risk, a deposit premium may be payable at the start of
the year of £15,000. At the end of the year the insurers work out that the total premium due is,
in fact, £18,000. As £15,000 has already been paid as a deposit, the insured just has to pay the
‘top up’ or adjustment of £3,000.

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Similarly, the premium in respect of money insurance is based on an estimate of the annual
total amount expected to be taken to the bank at the beginning of the period of insurance and is
then adjusted on the basis of the actual aggregate amount of money in transit during the policy
period, as declared by the insured.

This allows flexibility for both parties in that insurers can ensure that they ultimately receive
the correct amount of premium for the risk, but the insured does not have to speculate how his
business might perform in terms of, for example, staff numbers or revenues generated during
any policy period at the start of that period.

F8 Return of premiums
Partial returns of premium may be allowed under cancellation conditions in some policies.
Under motor and home insurance policies, for example, if insurers cancel the insurance then
they may return a pro rata premium. However, if the insured cancels then the return is based
on ‘short period’ rates to cover the insurer’s expenses. Short period rates of premium are higher
than an exact proportional (pro rata) basis, e.g. 3 months cover may be charged at 40% of the
annual premium, 6 months at 75% etc.

Marine hull policies also contain provision for return of premium if the policy is cancelled by
agreement and in certain cases when the vessel is ‘laid-up’ in port.

F9 Taxes and other charges

Premiums may be subject to tax. With direct insurance, a tax may be paid by the insured in
conjunction with the premium. The tax usually follows the location of the risk so, for example,
UK insurance premium tax (IPT) is applied to most general insurances where the insured risk
is located in the UK (though not to reinsurance or direct life insurance). For risks located in
another country, the tax of that other country will apply. So, for example, the premium paid on
a property risk located in Italy would still be subject to Italian premium tax, even though the
risk is underwritten in the London market. There are standard rules governing how to locate a
risk in a country which we will deal with later, but for now it is simply important to understand
that taxes exist; and it is generally the responsibility of the brokers to know about them and for
underwriters to collect them with the premium and pay them on to the tax authorities. With
reinsurance business there is sometimes a tax on premiums being transferred internationally,
which is collected by the local broker or bank when the premium is wired to London.

Additionally, there may be other charges or levies known as ‘para fiscal charges’, which are
collected with the premium, such as Fire Brigade Charges (FBC), which are a compulsory levy
to assist the funding of State or local firefighting services. For example, there is a charge related
to the sum insured on risks located in the inner London Boroughs of Greater London, which is
put towards the operating costs of the London Fire Brigade.

It is important for underwriters and brokers to understand this since mistakes in stating the
correct tax in a policy and/or collecting it can be very costly. If they fail to collect the tax from
the insured, then underwriters may become liable and it must be appreciated that in some
countries the rate of tax is not as low as the 5% currently in force in the UK. Taxes in excess of
15% apply in some countries – so it is important to get this right!

See also chapter 9, section C6 for further information about risk pricing.

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G Physical and moral hazards

G1 Physical hazards
An insurer considering a proposal for insurance must gain an understanding of the level of
physical risks and the controls over those risks, in order to price the insurance correctly. Take,
for example, a proposal of insurance for the construction of a multi-storey office building
in central London. The insurer will, typically, review a range of factors such as the type of
construction methods, depth of foundations and access to the construction site. The insurer’s
assessment of physical hazards will also include looking at safe working practices, dangers to the
public and neighbouring property.

Other examples of physical hazards would include:

• thatch roof on a property;

• no sprinklers or other fire suppression equipment;
• old ship;
• retail properties with no burglar alarms.

G2 Moral hazards
Insurers also consider the moral hazard present in a contract of insurance. This can be thought
of as the attitude of an insured in regard to compliance with reasonable risk control measures,
or how an insured approaches making a claim.

Insurers expect (and it is a requirement of the policy) that steps are taken to prevent loss. An
insured who fails to maintain his property ‘because it is insured’ is a poor moral hazard for
insurers. Similarly, if, after a loss, an insured inflates his claim, or is uncooperative (for example,
in helping insurers minimise the loss) then this is also a poor moral hazard. Of course, if a
fraudulent claim is brought then this is the worst form of moral hazard for insurers.

Physical and moral hazards will influence whether an insurer will be prepared to offer cover. An
insurer may still decide to offer cover where there are adverse hazards, but, typically, will load
(increase) the premium to reflect the additional risk represented.

The following are examples of bad moral hazards:

• Individuals or organisations who fail to take steps to protect their property (i.e. by not
having alarms or sprinklers) even if they are aware of the risks or not maintaining their
vessels.
• Young drivers in powerful cars.
• Insureds who attempt to defraud insurers.

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Example of how hazard is used in rating

The calculation of motor insurance premiums is based on underwriting considerations relating
to hazard such as:

• The insurance grouping of the vehicle (derived from factors such as its power and the likely
cost of repair). (physical hazard).
• Key Characteristics of the driver(s) such as sex and occupation. (moral hazard).
• Claims history of the driver(s). (moral hazard.
• Any motoring convictions of the driver(s). (moral hazard).
• Type of cover required (e.g. comprehensive, third party, fire and theft or third party).

Discounts may be available for a record of claims-free driving, voluntary excesses and driving
limited to a single driver, or to two drivers.

It is sometimes difficult to distinguish between physical and moral hazard. This is because quite
often poor moral hazard will be accompanied by some kind of poor physical aspect. A good
example of this would be the lack of machinery guards in a factory which would be a physical
hazard, coupled with lax management not enforcing the need for guards which is poor moral
hazard. Age is another good example of something which should be carefully considered as a
young driver in a powerful car is a physical hazard but is not automatically a moral one.

H Claims
H1 What is a claim?
A loss is the occurrence of an insured event that results in financial disadvantage for the
insured. A claim occurs when an insured formally asks their insurer (a process known as a
claim notification) for reimbursement, or compensation, following a loss.

The handling of claims is one of the most important parts of an insurer’s business process and is
often called the ‘shop window’ of the insurance industry and the area on which reputations can
be made or broken. Good claims handling, reserving and management are key to the success of
any insurance business.

H2 Claims reserving
Claims reserving is the setting aside of adequate funds to meet estimated claims. Reserving for
losses allows insurers to:

• ensure that they have sufficient funds to cover their claims liabilities; and
• produce accurate financial reports for use by their management teams and their investors.

Reserving can be done on a claim by claim basis or across a whole account and should take into
consideration every element of claims cost, not just the indemnity or loss figure.

Insurers use a range of sophisticated statistical methods to ensure that their claims reserves are
adequate. These statistical methods also model catastrophe scenarios (for example, a property
insurer would model the effects of an earthquake, or flood, on their risk portfolio) to ensure
that insurers have adequate reserves to meet all future claims.

Loss modelling is addressed further in chapter 4.

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H3 Overview of the claims management process

The insurer will seek to establish in respect of the claim presented by the insured that:

• there was insurable interest;

• the subject of the claim was insured at the time of the loss;
• the loss was caused by an insured event, or peril (see chapter 3, section G on proximate
cause); and
• the timing of the loss falls within the policy period.

When managing claims, which insurers regard as sufficiently large or complex, or they are
suspicious about the honesty of a claim, they may wish to investigate the issues further. Such
investigation may be undertaken either by specialists from the insurer’s own staff, or by an
independent third party, such as a loss adjuster. Policies in the London market often cover risks
in other countries and it is impractical for underwriters to investigate claims themselves so they
will appoint a local expert.

H3A Lloyd’s minimum standards

Within the Lloyd’s market, Lloyd’s has introduced a set of claims management principles and
minimum standards with which all managing agents must comply. This was the result of a global
review of the Lloyd’s market in 2004 which highlighted the importance of the claims business and
the need to manage pro-actively both claims themselves and the use of experts within the process.

There are eight minimum standards which set out at a high level the matters that Lloyd’s
believes are key to successful claims management and against which the Lloyd’s Franchise
Performance Directorate review individual managing agents’ performance.

These are:

1. The claims philosophy should be clearly documented and communicated within the
syndicate, and reflected in the management and organisation.

2. Managing agents should have appropriate claims resources, skills and management controls
in each line of business they propose to write.

3. Claims should be adjusted and processed in an efficient and timely manner.

4. The handling of a claim should be appropriately documented and information relevant to

the management of the claim retained for a reasonable period.

5. Claim reserving should be undertaken with the goal of a consistent, timely and accurate result.

6. Disciplined procurement and pro-active management procedures should be employed in

the selection and use of third parties.

7 Measurement of claims management performance and capabilities should be appropriate

and regular.

8. For subscription business, there should be an effective claims agreement process to protect
the interests of followers, supported by full co-operation of lead underwriters.

© The Chartered Insurance Institute 2008 LLMIT/February 2008 1/15

 Lloyd’s and London Market Introductory Test

H4 Claims settlement
Claims settlement generally results in the payment of a sum of money from the insurer to the
insured or possibly directly to a third party and this usually concludes the claims process. The
basis of settlement is generally set out in the policy.

In some circumstances, a claim may not be covered under the terms of the policy, but the
insurer will decide to make an ex gratia payment. These are goodwill payments made by an
insurer to an insured or possibly to a claimant in the case of a liability policy that are not within
the legal obligations defined by the insurance contract (the policy wording). They can occur in
all types of insurance and are made for a number of reasons. Primarily they are made to retain
good relationships with insureds; however it may also be more cost-effective for an insurer to
pay a claim in this way, than to expend the money to dispute the matter any further.

Summary
A number of important features have been dealt with in this chapter, including the functions of
insurance and the benefits to the individual person or company and to the economy. The basic
calculation of insurance premiums and the claims process has also been covered.

As we have seen, the insurer may also try to minimise any loss by insuring some of his
commitment. Such insurance by the original insurer is known as reinsurance, a concept which
is discussed in chapter 4.

1/16 LLMIT/February 2008 © The Chartered Insurance Institute 2008

 Chapter 1
1: Insurance

Glossary of terms

Brokerage The amount of money paid to the broker by the insurer for bringing a particular piece of
business to them is called the brokerage and is deducted from the gross premium.

Claim A claim occurs when an insured formally asks his insurer for reimbursement, or
compensation, following a loss.

Claimant An individual or business making a claim on the policy for a loss. Also used to refer to a
third party who is making a claim against an insured on a liability policy.

Ex gratia Effectively a goodwill payment made by the insurer to an insured where the insurer has
payment no liability under the contract but makes a payment to preserve goodwill.

Exposure The size of risk that insurers are facing - for example, a property valued at £450M is a
greater exposure to underwriters than a property valued at £20M.

Fundamental Risks that occur on such a vast scale that they are generally uninsurable due to a lack of
risks willingness or capacity on the part of insurers.

Gross premium The full amount of premium, ignoring taxes and before deductions.

Hazard The exposure or vulnerability to injury, loss or damage.

Insurable The relationship that the insured has with the subject matter of insurance, but which
interest does not need to be ownership, whereby the insured will suffer a financial loss if loss
or damage is caused to the subject matter. A policy where the insured is without such
interest is unenforceable.

Insurance A mechanism whereby the insurer, in return for payment, agrees to pay (or provide a
benefit to, or for) the insured if a particular event should happen.

Loss The financial consequences arising from an event.

Moral hazard The attitude of an insured in regard to compliance with reasonable risk control
measures, or how an insured approaches making a claim.

Premium The amount paid to an insurer or reinsurer in consideration of his acceptance of a risk.

Net premium The amount of the premium left after the brokerage and any other deductions are
removed.

Pure risks These are risks where the insured suffers some loss or damage which can be measured
in monetary terms. Pure risks can be insured.

Risk transfer Insurance is a form of risk transfer. Insurers are the ‘risk takers’ in return for the premiums
paid by insureds.

Rate per cent The price in pounds for each hundred pounds of insurance.

Rate per mille The price in pounds for each thousand pounds of insurance.

Risk An uncertain event - it does not embrace inevitable loss. The term is used to define
causes of loss covered by a policy.

Speculative This refers to situations where there is a possibility of gain. Insurance does not apply to
risks speculative risks.

Sum insured The maximum extent of an insurer’s liability under a contract of indemnity.

© The Chartered Insurance Institute 2008 LLMIT/February 2008 1/17