Insurance is indeed a universally essential business. Sequel to this fact, if you really want to appreciate financial complexity, look at the contract wording of an Insurance policy. It epitomizes this to the core. Insurance, though regarded as having ‘’fine small print’’ has a legitimate reason. Truth be told, insurance has its own terminologies and idiosyncrasies. It is a different kind of business. The following as gleaned from Atkins and Bates (2007) in their book ‘Management of Insurance Operations’ brings this subject a little home by demystifying it:
- INSURANCE IS A RISK BUSINESS.
Isn’t it strange that insurance claim payments far exceed most times the paltry premiums paid by policyholders in most cases? Though the premiums are paid at the onset of the contract, the amount payable in claims is indeterminable and can be quite astronomical especially with liability claims. The insurance company does not know and cannot fathom the amount of claim within any specific period. This shows pure risk (uncertainty with outcome which is unfavorable) absorbed by insurance companies. Typical example could be that when a commercial driver causes series of accidents, some involving death and injury claims, which could run into millions in claims, having paid premium from the onset.
- INSURANCE RUNS ON ITS CAPITAL.
The ability of insurers to supply insurance is determined by their capital. The global minimum solvency ratio (Shareholders funds to Net Premium Income) is 30%. Hence, to underwrite a large ticket business, the insurer needs commensurate capital. Insurers obtain funds from premium, capital or debt. Therefore they can encounter difficulties when they rely solely on premiums (technically called cash flow underwriting) without having adequate capital at their disposal. Larger losses such as hurricanes, flood, earthquake, conflagration, etc. can have the potential of reducing or depleting the capital of insurance companies. The more resourceful an insurance company, the more risks an insurer can underwrite. Thus, to confidently withstand the impact of large losses, insurance companies should have an outsized capital.
- INSURANCE PRODUCTS ARE COMPLEX.
Ever heard of insurance brokers? These are trained insurance professionals available often times to explain and make meaning to some of the elusive arguments in insurance, secure the appropriate cover and premium for policyholders. Insurance wordings involve a lot of do’s and don’ts (conditions, warranties, exclusions, etc.) which must be adhered to by the insured / claimant during the currency of the insurance contract. One of such important conditions is reasonable precautions which require that the insured should act as if uninsured at all times. For instance, in the event of theft or fire, first, report to the police or the fire service department.
- INSURANCE HAS A CYCLE:
This is not a fairy tale. Insurance operations have a cycle: Moments of high profit eventually leads to high capacity. This may lead to low premiums charged, making way for low profits. Capacity will subsequently be withdrawn which may lead to higher premiums and higher profits. Then the cycle begins again. Theoretically, the average time length for the cycle is 7 years but varies within different markets. When insurers have accumulated huge premiums without paying out substantial claim amounts, there is a clarion call to make hefty claim reserves as such times are bound to happen in the possible future. It’s imperative for insurance companies, especially new entrants, to make adequate provisions for reserves for such hard times.
- INSURANCE REINSURE:
When policyholders transfer their risk to insurance companies (insurers) by signing on to an insurance contract; they obtain ‘peace of mind’ instantaneously. Same, however, cannot be said for insurers until they reinsure. Insurers after taking up the risk from individuals also share the risk with re-insurance companies. An insurance company is as good as its reinsurers. Reinsurers provide solid capacity. Other well founded reasons for reinsurance include protection against catastrophe, security, stabilizing the accounts of the insurer, tax reasons, etc. Insurers after this arrangement are thus able to take up more risk.
- INSURANCE IS HIGLY REGULATED:
Inasmuch as it is a risky business, some form of regulations is anticipated and welcomed in the industry. With premiums of policyholders being underwritten by an insurer, there ought to be some checks and balances. The Insurer could renege on their promises. They, improbably, could be mismanaged and become insolvent. The regulator checks among other things that competent persons are appointed to manage the affairs of an insurer. Some form of insurance (motor insurance) is also compulsory making regulation an absolute necessity to protect victims of motor accidents. In Ghana for example, the sole regulator of insurance (except health insurance) is the National Insurance Commission (NIC). Current law giving this mandate is the Insurance Act, 2006 (Act 724).
Related: The Role of Marketing in Insurance