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Lecture 6

Insurance

Dr Jacinta Nwachukwu

Principal Lecturer in Finance

School of Economics, Finance and Accounting

[email protected]

Lecture outline

Defining risk

The drivers of insurance premium

The problem in providing insurance

Types of protection insurance

Challenges facing the UK insurance industry in the future

1. Risk Defined

Risk is typically defined in terms of the following characteristics:

1. Risk arises from uncertainty about which many of the possible outcomes will occur in the future

2. Risk relates to future payoff of an investment, which is unknown. But, it is important that investors attempt to identify the possible payoffs and assign the likelihood of each one occurring

3. Risk is assessed over the time period for which an investment is held, say short or long term

4. Risk is a measure that can be quantified, say in terms of variance or standard deviation. The higher the risk, the less desirable the investment and so should command a lower price

5. Risk is assessed relative to a benchmark rather than in isolation. The common practice is to relate the risk of an investment to an asset of the same time horizon with no risk (such as Treasury bonds) or the general market. This risk difference is known as the “risk premium”

1. The principles of insurance

Insurance definition

The drivers of insurance premium

What is an insurance?

Insurance is a system by which individuals, households or organisations pay a sum of money (known as premium) to an investor in return for a “guaranteed” protection against losses that result from specific threats under conditions specified in a contract (known as insurance policy)

Thus, an insurance policy allows individuals to transfer the risk of financial loss arising from an unpredictable life-event to the insurer. Such reduces the potential consequences for the policy holder

Actuarial data provides the information which helps insurers to quantify the risks of paying out on a claim.

https://www.gov.uk/government/organisations/government-actuarys-department

The Drivers of Insurance Premium

The factors influencing the premium charged by insurance providers may include:

(i) Cost of paying out for claims

(ii) Building up reserve assets

(iii) Increasing profit margin using new IT, better staff training, improving consumer services, etc.,

(iv) Competition: To maintain their competitiveness, insurance companies will offer policies for different perils to many individuals and households with different characteristics in an attempt to spread the risk of potential losses.

The risk which can be reduced through aggregation are uncorrelated and so are known as independent risk

At the extreme is the state pension system which has the largest possible pool of people that are collectively insured through the National Insurance Scheme.

(v) The cost of Re-insurance: This refers to the process of using very large insurance firms to provide insurance to smaller insurance to help the latter reduce their risk and protect them against exceptionally large losses

2. The problems in providing insurance

Adverse selection

Moral hazard

Adverse Selection

Adverse selection is where people who take out an insurance policy are those at greatest risk of suffering the perils for which they seek protection

This is an example of the problem of asymmetric information in which one party knows something that another does not

It is fair to say that if insurance was offered against redundancy, those with the least secure jobs would be most likely to take it out

To compensate for the problems of adverse selection, insurers build in higher premiums.

But this means that individuals who know themselves to be of low risk will not take out the particular type of insurance, while those who know themselves to be of high risk will continue taking out such insurance, say accident, sickness and/or unemployment.

This will raise the average risk for all policy holders and in turn the premium charged.

Policies for dealing with adverse selection

(i) Insurers could group people into different risk categories depending on the insurer’s assessment of the individual’s risk factor

Insurance premiums can then be charged accordingly

(ii) Enforcing the legal obligations which requires individuals to truthfully disclose any detail that may be of some importance to the insurer, whether or not it is requested.

This is the so-called principle of “utmost good faith”

Failure to comply often means that the insurer could reject liability in the event of a claim

(iii) Make insurance compulsory for everyone regardless of their risk category

Compulsory insurance schemes in the UK include:

(1) National insurance for all workers

(2) Car drivers insurance to take out third-party insurance

(3) Mortgage borrowers are required by their lenders to take out building insurance

Moral hazard

Moral hazard is the tendency for insured persons to become willing to take on more risk because they are covered by insurance

Question: Do you agree that people’s behaviour become more careless when they have an insurance safety net?

Policies for Dealing with Moral Hazard

1. Requiring excess on insurance claims. Most individuals are required by their insurers to pay the initial monetary amount of an insured loss before the insurer settles the claim

2. No claims discount on premium offered to those who take risk-avoidance measures such as fitting a house alarm, secure locks to their homes

3. Excluding cover for those who do not take precautions to protect their property

3. Types of insurance protection

Life insurance

Income protection insurance

Critical illness cover

Accident, sickness and unemployment insurance

Life insurance

Life Insurance

This is taken up by individuals to protect their family and business partners against financial consequences of a premature death within a specified term of say, 5, 10, 15 or 20 years.

In general, the “total sum insured” should cover the following items

(1) The insured’s income in full in order to allow the family to maintain its standard living when the policyholder dies

(2) Outstanding debt including mortgages

(3) The cost of education for dependents

(4) The cost of childcare

(5) Other family expenses which are considered important for maintaining their standard of living

Thus, the basic calculation for life insurance is equal to:

Sum covered = Income requirement + debt outstanding + cost of dependents’ education+ cost of childcare+ other family cost expenditures – any existing cover from state benefits, company pension schemes and other private insurance schemes.

So what type of life insurance policy?

The term level insurance

The decreasing term insurance

The increasing term insurance

The family income benefit

Whole life or permanent insurance

Types of Life Insurance

(1) The level term where the amount covered will remain the same throughout the cover term.

(2) The decreasing term where the sum insured reduces at regular intervals during the cover term. It is used to protect against a loan that declines over time, such as repayment mortgages

(3) The increasing term where the sum insured rises in line with inflation or by a fixed amount, say 3 percent per annum.

(4) The family income benefit provides a level or increasing income from the date of the death until the end of the insurance term. This type of term insurance is favoured by higher rate tax payers because the income provided to family members is treated as a tax-free capital sum.

(5) Whole-life or permanent insurance cover does not have a specified end term. Such open-ended policies are designed to build up an investment rather than deal only with the consequences of an untimely death of the policyholder.

Income protection insurance

Income Protection Insurance

This is taken up to insure against loss of income through long-term illness or disability for a specified term while the policyholder is still within working age

The amount insured varies across countries. In the UK this is around two-thirds of the individuals salary less any state incapacity benefits and employer sickness payment.

It is possible to lower premium by opting for a deferment period between the date of illness and the date of first income protection payment.

Deferment period of say, 3, 6, or 12 months attract considerable reduction in premiums

Definition of disability varies along the following terms:

“Own occupation” pays out when the individual is unable to continue with own profession

“Suited occupation” pays out when the individual is unable to follow occupation suitable by training, education, experience and status

“Any occupation” pays when the individual is incapable of doing any type of work. This type of protection is less likely to pay out, so it is the cheaper

Critical illness insurance

It pays the policyholder a tax free lump sum on the diagnosis of a range of illnesses. The main conditions which are often covered include:

(i) Cancer

(ii) Heart attack

(iii) Stroke

(iv) Heart bypass surgery

(v) Kidney failure

(vi) major organ transplant

The problem with this form of insurance as opposed to the income protection insurance is that if the individual’s illness is not on the list of qualifying conditions, then they will not receive a payment, even if they are unable to work

Also with medical advances, the list of illness which qualify are getting smaller

Accident, sickness and unemployment insurance

Accident, Sickness and Unemployment Insurance (ASU)

This covers the aforementioned three unfortunate eventualities

The ASU insurance can be obtained as stand alone policy or sold as part of a loan payment protection insurance (LPPI) or as a mortgage payment protection insurance (MPPI)

The payout on ASU insurance is restricted to a maximum of 2 years

By contrast, the payout on the Income Protection Insurance (IPI) is until recovery and back to work or until retirement age, if full employment was not resumed.

In any event, care must be taken to avoid the replication of the benefits provided under the IPI scheme.

5. Challenges to the Insurance Industry

1. Discrimination on the grounds of gender, age, and disability is becoming illegal following the European Court of Justice ruling in 2011

2. Technological advances which is increasingly been used to assess risk and vary premium on a much more individual basis. This means that the pooling element of insurance might disappear

3. Technological advances in the field of genetic testing. For example, technology is now available in detecting the role of hereditary diseases such as cancer would affect the possibility of individual obtaining insurance in the future.

End of lecture

Take home assignment

(1). Explain the meaning and purpose of life assurance for an individual who has financial responsibility for his/her household

(2i). Explain the difference between income protection, critical illness and payment protection insurance.

(2ii) If an individual of working age can only afford to pay for one policy, which of these three insurance plans would you recommend and why?

(3i). Explain the term “self-insurance”.

(3ii) Assume that Mr Worry is concerned about his level of debt and his inability to meet repayment during periods of unemployment.

However, he considers the cost of purchasing the conventional types of payment protection insurance schemes to be two expensive.

What self-investment strategies would you recommend to him as a way to mitigate the risk and uncertainty surrounding this peril.

Take home assignment

4. Mr Smart wants to set up an insurance business and have asked your advice on how he should run his operation in order to make it profitable.

5. Differentiate between endowment policy and standard level term life insurance

6 (i). Explain the basic features and purpose of Payment Protection Insurance (PPI) from the consumers viewpoint.

6 (ii) Discuss the major concerns which underpin the media coverage of PPI mis-selling in the UK

6(iii) Identify the key regulatory tools and supervisory approaches used by the financial regulators in an attempt to crack-down on the PPI mis-selling scandal

Income protection insurance

https:// www.youtube.com/watch?v=CE3igAHQ2LU

https://www.youtube.com/watch?v=qpGekF7qcA0

https://www.youtube.com/watch?v=FSfL_HCtWQ8

https://www.youtube.com/watch?v=al1VZlJu_OE

Critical insurance explained

https://www.youtube.com/watch?v=1xQYSG9UATw

https://www.youtube.com/watch?v=RcFKdCwXtp8

Payment protection insurance

https://www.youtube.com/watch?v=15M9zpLW6ik

https://www.youtube.com/watch?v=IVjUnhBtyiA

https://www.youtube.com/watch?v=Nu_fMhGJ0cI