LM1: 2025 London Market Insurance Essentials PDF

London Market insurance essentials LM1: 2025 Study text RevisionMate Provided as part of an enrolment, RevisionMate offers online services to support your studies and improve your chances of exam success. Access to RevisionMate is only available until 31 De...

London Market insurance essentials LM1: 2025 Study text RevisionMate Provided as part of an enrolment, RevisionMate offers online services to support your studies and improve your chances of exam success. Access to RevisionMate is only available until 31 December 2025. This includes: Printable PDF and ebook of the study text. Student discussion forum – share common queries and learn with your peers. For reference only Examination guide – practise your exam technique. To explore the benefits for yourself, you can access RevisionMate via your MyCII page, using your login details: ciigroup.org/login Updates and amendments As part of your enrolment, any changes to the exam or syllabus, and any updates to the content of this course, will be posted online so that you have access to the latest information. You will be notified via email when an update has been published. To view updates: 1. Visit www.cii.co.uk/qualifications 2. Select the appropriate qualification 3. Select your unit from the list provided Under ‘Unit updates’, examination changes and the testing position are shown under ‘Qualifications update’; study text updates are shown under ‘Learning solutions update’. Please ensure your email address is current to receive notifications. 2 LM1/October 2024 London Market insurance essentials © The Chartered Insurance Institute 2024 All rights reserved. Material included in this publication is copyright and may not be reproduced in whole or in part including photocopying or recording, for any purpose without the written permission of the copyright holder. Such written permission must also be obtained before any part of this publication is stored in a retrieval system of any nature. No part of this publication may be copied or reproduced in a generative AI tool. This publication is supplied for study by the original purchaser only and must not be sold, lent, hired or given to anyone else. Every attempt has been made to ensure the accuracy of this publication. However, no liability can be accepted for any loss incurred in any way whatsoever by any person relying solely on the information contained within it. The publication has been produced solely for the purpose of examination and should not be taken as definitive of the legal position. Specific advice should always be obtained before undertaking any investments. Print edition ISBN: 978 1 83727 201 3 Electronic edition ISBN: 978 1 83727 202 0 This edition published in 2024 The author Charlotte Warr, LLB (Hons) FCII, Solicitor, Chartered Insurer, Senior Associate of the Association of Average Adjusters. Charlotte is a highly experienced claims adjuster with significant knowledge of both the Company and Lloyd’s Markets as well as both marine and non-marine classes of business. Charlotte has authored articles for technical journals and has spoken on a variety of insurance, legal and training subjects around the world. Acknowledgements The CII gratefully acknowledges the contributions of technical reviewers Simon Penaluna, Terry Webb and Terry Hayday to the production of previous editions of this text. The CII would also like to thank the authors and reviewers of study texts IF1 and IF2, on which parts of this text rely. The CII thanks the Financial Conduct Authority (FCA) and the Prudential Regulation Authority (PRA) for their kind permission to draw on material that is available from the FCA website: www.fca.org.uk (FCA Handbook: www.handbook.fca.org.uk/handbook) and the PRA Rulebook site: www.prarulebook.co.uk and to include extracts where appropriate. Where extracts appear, they do so without amendment. The FCA and PRA hold the copyright For reference only for all such material. Use of FCA or PRA material does not indicate any endorsement by the FCA or PRA of this publication, or the material or views contained within it. While every effort has been made to trace the owners of copyright material, we regret that this may not have been possible in every instance and welcome any information that would enable us to do so. Typesetting, page make-up and editorial services CII Learning Solutions. Printed and collated in Great Britain. This paper has been manufactured using raw materials harvested from certified sources or controlled wood sources.  3 Using this study text Welcome to the LM1: London Market insurance essentials study text which is designed to support the LM1 syllabus, a copy of which is included in the next section. Please note that in order to create a logical and effective study path, the contents of this study text do not necessarily mirror the order of the syllabus, which forms the basis of the assessment. To assist you in your learning we have followed the syllabus with a table that indicates where each syllabus learning outcome is covered in the study text. These are also listed on the first page of each chapter. Each chapter also has stated learning objectives to help you further assess your progress in understanding the topics covered. Contained within the study text are a number of features which we hope will enhance your study: Activities: reinforce learning through Key points: act as a memory jogger at practical exercises. the end of each chapter. Be aware: draws attention to important Key terms: introduce the key concepts points or areas that may need further and specialist terms covered in each clarification or consideration. chapter. Case studies: short scenarios that will Refer to: Refer to: section/chapter that provides test your understanding of what you valuable information on or background have read in a real life context. to the topic, from either within this or another CII study text. Sections/chapters from other study texts are available for you to view and download on For reference only RevisionMate. Consider this: stimulating thought Reinforce: encourages you to revisit a around points made in the text for which point previously learned in the course to there is no absolute right or wrong embed understanding. answer. Examples: provide practical illustrations Sources/quotations: cast further light of points made in the text. on the subject from industry sources. In-text questions: to test your recall of On the Web: introduce you to topics. other information sources that help to supplement the text. At the end of every chapter there is also a set of self-test questions that you should use to check your knowledge and understanding of what you have just studied. Compare your answers with those given at the back of the book. By referring back to the learning outcomes after you have completed your study of each chapter and attempting the end of chapter self-test questions, you will be able to assess your progress and identify any areas that you may need to revisit. Not all features appear in every study text. Note Website references correct at the time of publication. For reference only  5 Examination syllabus London Market insurance essentials Objective To provide an essential grounding in the operation of the London insurance market. Summary of learning outcomes Number of questions in the examination* 1. Understand basic terminology used within the general insurance market 6 2. Understand the fundamental principles 10 of insurance 3. Understand the main classes of insurance written in the London Market 4 4. Understand the insurance cycle 1 5. Understand reinsurance within the insurance market 3 6. Understand the structure of the 5 London Market For reference only 7. Understand the London Market regulatory and legal environment 10 8. Understand the importance of appropriate systems and controls 2 9. Understand data protection and money laundering legislation and requirements 2 10. Understand the broker’s role in the 4 way that business is conducted in the London Market 11. Understand the underwriter’s role in the way that business is conducted in the 3 London Market * The test specification has an in-built element of flexibility. It is designed to be used as a guide for study and is not a statement of actual number of questions that will appear in every exam. However, the number of questions testing each learning outcome will generally be within the range plus or minus 2 of the number indicated. Important notes Method of assessment: 50 multiple choice questions (MCQs). 1 hour is allowed for this examination. This syllabus will be examined from 1 January 2025 until 31 December 2025. Candidates will be examined on the basis of English law and practice unless otherwise stated. This PDF document has been designed to be accessible with screen reader technology. If for accessibility reasons you require this document in an alternative format, please contact us at [email protected] to discuss your needs. Candidates should refer to the CII website for the latest information on changes to law and practice and when they will be examined: 1. Visit www.cii.co.uk/qualifications 2. Select the appropriate qualification 3. Select your unit from the list provided 4. Select qualification update on the right hand side of the page Published October 2024 ©2024 The Chartered Insurance Institute. All rights reserved. LM1 6 LM1/October 2024 London Market insurance essentials 1. Understand basic terminology used 7.3 Explain the governance of the Lloyd’s Market. within the general insurance market 7.4 Examine and explain the role of the Financial 1.1 Explain the principle of good faith. Ombudsman Service and the Financial Services Compensation Scheme. 1.2 Explain the meaning and application of proximate cause. 7.5 Explain the basic powers of the industry regulator for the authorisation, supervision and regulation 1.3 Describe the principle of indemnity and how it is of insurers. modified. 7.6 Explain the basic powers of the industry regulator 1.4 Explain the concept of contribution and how it is for the authorisation, supervision and regulation of applied. insurance intermediaries. 1.5 Explain what is meant by subrogation. 7.7 Describe the essentials of a valid contract of insurance 2. Understand the fundamental principles of insurance 8. Understand the importance of 2.1 Describe the concept of risk. appropriate systems and controls 2.2 Explain the categories of risk. 8.1 Explain the purpose of sanctions. 2.3 Explain the principle of the pooling of risks. 8.2 Examine and describe the basic systems and 2.4 Explain the difference between a peril and a hazard controls to ensure adherence to EU, US and UK as this relates to insurance. legislation. 2.5 Explain what moral and physical hazard is and identify good and poor examples of each. 9. Understand data protection and money 2.6 List the types of insurable and uninsurable risks. laundering legislation and requirements 9.1 Explain the principles, rights and restrictions of data 2.7 Explain the basic purpose of insurance. protection legislation and its impact on transacting 2.8 Explain the primary and secondary functions of business. insurance. 9.2 Explain the various requirements to ensure money For reference only 2.9 Explain the importance of the claims handling laundering compliance when dealing with clients. process. 10. Understand the broker’s role in the 3. Understand the main classes of way that business is conducted in the insurance written in the London Market London Market 3.1 Describe the main classes of insurance written in the 10.1 Explain the role and responsibilities of brokers. London Market and their main features. 10.2 Explain the business process of broking and the 4. Understand the insurance cycle parties involved. 4.1 Outline and explain the insurance cycle. 10.3 Explain the broker’s role in the handling of premiums. 5. Understand reinsurance within the 10.4 Explain the broker’s role in claims notification, insurance market investigation and settlement. 5.1 Explain the purpose of reinsurance. 11. Understand the underwriter’s role in the 5.2 Describe the main terminology used in connection with reinsurance transactions and know their way that business is conducted in the meaning. London Market 11.1 Explain the role and responsibilities of underwriters. 6. Understand the structure of the 11.2 Explain the role and responsibilities of the lead and London Market following underwriters within the London Market. 6.1 Describe the main participants in the London Market and the implications of their participation. 6.2 Explain the importance of the London Market and why clients may decide to place their business within this market. 6.3 Explain the role of the London Market associations. 6.4 Explain the way that business is transacted in the London Market. 7. Understand the London Market regulatory and legal environment 7.1 Describe the role, aims, approach to regulation; and principles for business of the industry regulator. 7.2 Describe the role of major international regulators, including licensing. Published October 2024 2 of 3 ©2024 The Chartered Insurance Institute. All rights reserved.  7 Reading list Exam technique/study skills There are many modestly priced guides The following list provides details of further reading which may assist you with your available in bookshops. You should choose studies. one which suits your requirements. Note: The examination will test the syllabus alone. The reading list is provided for guidance only and is not in itself the subject of the examination. The resources listed here will help you keep up-to-date with developments and provide a wider coverage of syllabus topics. CII study texts London Market insurance essentials. London: CII. Study text LM1. Books and eBooks Bird’s modern insurance law. 12th ed. John Birds. Sweet and Maxwell, 2022. Insurance theory and practice. Rob Thoyts. Routledge, 2010.* Lloyd’s: law and practice. 1st ed. Julian For reference only Burling. Oxon: Informa Law, 2013.* Periodicals The Journal. London: CII. Six issues a year. Market magazine. Lloyd's of London. Quarterly. InsurancePOST. London: Incisive Financial Publishing. Monthly. Contents searchable online at www.postonline.co.uk. Reference materials Concise encyclopedia of insurance terms. Laurence S. Silver, et al. New York: Routledge, 2010.* Dictionary of insurance. C Bennett. 2nd ed. London: Pearson Education, 2004. Examination guide If you have a current study text enrolment, the current examination guide is included and is accessible via Revisionmate (ciigroup.org/login). Details of how to access Revisionmate are on the first page of your study text. It is recommended that you only study from the most recent version of the examination guide. * Also available as an eBook through eLibrary via www.cii.co.uk/elibrary (CII/PFS members only). Published October 2024 3 of 3 ©2024 The Chartered Insurance Institute. All rights reserved. For reference only  9 LM1 syllabus quick-reference guide Syllabus learning outcome Study text chapter and section 1. Understand basic terminology used within the general insurance market 1.1 Explain the principle of good faith. 2D 1.2 Explain the meaning and application of proximate cause. 2F 1.3 Describe the principle of indemnity and how it is modified. 2G 1.4 Explain the concept of contribution and how it is applied. 2H 1.5 Explain what is meant by subrogation. 2I 2. Understand the fundamental principles of insurance 2.1 Describe the concept of risk. 1A, 1B, 1C 2.2 Explain the categories of risk. 1D 2.3 Explain the principle of the pooling of risks. 1F 2.4 Explain the difference between a peril and a hazard as this 1C relates to insurance. 2.5 Explain what moral and physical hazard is and identify good and 1C poor examples of each. For reference only 2.6 List the types of insurable and uninsurable risks. 1E 2.7 Explain the basic purpose of insurance. 1G 2.8 Explain the primary and secondary functions of insurance. 1H, 1I 2.9 Explain the importance of the claims handling process. 1J 3. Understand the main classes of insurance written in the London Market 3.1 Describe the main classes of insurance written in the London 3A, 3B, 3C Market and their main features. 4. Understand the insurance cycle 4.1 Outline and explain the insurance cycle. 4A, 4B, 4C 5. Understand reinsurance within the insurance market 5.1 Explain the purpose of reinsurance. 3D 5.2 Describe the main terminology used in connection with 3D reinsurance transactions and know their meaning. 6. Understand the structure of the London Market 6.1 Describe the main participants in the London Market and the 5A, 5B, 5C, 5D, 5E implications of their participation. 6.2 Explain the importance of the London Market and 5E, 5G why clients may decide to place their business within this market. 6.3 Explain the role of the London Market associations. 5F 6.4 Explain the way that business is transacted in the 5G, 8D, 8E, 9C London Market. 7. Understand the London Market regulatory and legal environment 7.1 Describe the role, aims, approach to regulation; and principles for 6A, 6B business of the industry regulator. 7.2 Describe the role of major international regulators, including 6C licensing. 7.3 Explain the governance of the Lloyd’s Market. 6D 10 LM1/October 2024 London Market insurance essentials Syllabus learning outcome Study text chapter and section 7.4 Examine and explain the role of the Financial Ombudsman 6F Service and the Financial Services Compensation Scheme. 7.5 Explain the basic powers of the industry regulator for the 6E authorisation, supervision and regulation of insurers. 7.6 Explain the basic powers of the industry regulator for 8B the authorisation, supervision and regulation of insurance intermediaries. 7.7 Describe the essentials of a valid contract of insurance 2A, 2B, 2C, 2E 8. Understand the importance of appropriate systems and controls 8.1 Explain the purpose of sanctions. 7B 8.2 Examine and describe the basic systems and controls to ensure 7A, 7E adherence to EU, US and UK legislation. 9. Understand data protection and money laundering legislation and requirements 9.1 Explain the principles, rights and restrictions of data protection 7C legislation and its impact on transacting business. 9.2 Explain the various requirements to ensure money laundering 7D compliance when dealing with clients. 10. Understand the broker’s role in the way that business is conducted in the London Market 10.1 Explain the role and responsibilities of brokers. 8A 10.2 Explain the business process of broking and the 8C, 8D For reference only parties involved. 10.3 Explain the broker’s role in the handling of premiums. 8D 10.4 Explain the broker’s role in claims notification, investigation and 8E settlement. 11. Understand the underwriter’s role in the way that business is conducted in the London Market 11.1 Explain the role and responsibilities of underwriters. 9A, 9B 11.2 Explain the role and responsibilities of the lead and following 9C underwriters within the London Market.  11 Exam guidance and accessibility Before you begin the study text, we would encourage you to read about how to approach the exam. Study skills While the text will give you a foundation of facts and viewpoints, your understanding of the issues raised will be richer through adopting a range of study skills. They will also make studying more interesting! We will focus here on the need for active learning in order for you to get the most out of this core text. Active learning is experiential, mindful and engaging Underline or highlight key words and phrases as you read – many of the key words have been highlighted in the text for you, so you can easily spot the sections where key terms arise; boxed text indicates extra or important information that you might want to be aware of. Make notes in the text, attach notes to the pages that you want to go back to – chapter numbers are clearly marked on the margins. Make connections to other CII units – throughout the text you may find ‘refer to’ boxes that tell you the chapters in other books that provide background to, or further information on, the area dealt with in that section of the study text. Take notice of headings and subheadings. Use the clues in the text to engage in some further reading (refer to the syllabus reading For reference only list) to increase your knowledge of a particular area and add to your notes – be proactive! Relate what you’re learning to your own work and organisation. Be critical – question what you’re reading and your understanding of it. Five steps to better reading Scan: look at the text quickly – notice the headings (they correlate with the syllabus learning outcomes), pictures, images and key words to get an overall impression. Question: read any questions related to the section you are reading to get a feel for the subjects tackled. Read: in a relaxed way – don’t worry about taking notes first time round, just get a feel for the topics and the style the book is written in. Remember: test your memory by jotting down some notes without looking at the text. Review: read the text again, this time in more depth by taking brief notes and paraphrasing. On the Web Visit here for more detail on study skills: www.open.ac.uk/skillsforstudy. Note: website reference correct at the time of publication. 12 LM1/October 2024 London Market insurance essentials Exam guidance Answering multiple-choice questions When preparing for the examination, candidates should ensure that they are aware of what typically constitutes each type of product listed in the syllabus and ascertain whether the products with which they come into contact during the normal course of their work deviate from the norm, since questions in the examination test generic product knowledge. Some questions are simply questions of fact, whereas others may be more progressive in nature, requiring reasoning to determine the correct option or, perhaps, being answerable by a process of elimination. Whatever the question, read it carefully to identify what it is really asking. Do not assume that you 'know' what it is asking, even if the question is on a topic about which you feel very confident; answer the question exactly as it is asked. Also, look out for the occasional negative question (Which of the following is not …?). Try to answer all of the questions. While there is no substitute for a good grasp of the subject matter, and you cannot expect to pass the examination purely on guesswork, you do not lose marks for giving a wrong answer! You can find more information on the specific unit in the exam guide (available on the unit page on the CII website and on RevisionMate). On the Web You can find more on preparing for your exam by visiting: https://www.cii.co.uk/learning/ qualifications/assessment-information/before-the-exam/. Note: website reference correct at the time of publication. Accessibility For reference only The CII has produced a policy and guidance document on accessibility and reasonable/ special adjustments. The purpose of this is to ensure that you have fair access to CII qualifications and assessments. On the Web The ‘Qualifications accessibility and special circumstances policy and guidance’ document can be found here: www.cii.co.uk/media/bxsjd2e2/cii-qualifications-accessibility- and-special-circumstances-policy-and-guidance.pdf. Note: website reference correct at the time of publication.  13 Introduction LM1: London Market insurance essentials starts the student on their learning journey within the London Market and is the first unit in both the Award in London Market Insurance and Certificate in Insurance (London Market). It begins by introducing fundamental principles of insurance and risk as well as the reasons for buying and selling insurance. It will consider the challenges presented to the marketplace as a whole by the pandemic as well as the opportunities that it might also present. Your study text will also discuss the function of insurance within the wider economy and its further role to protect citizens. Legal principles and terminology are also introduced as well as the main classes of business written in the London Market and the theory of the insurance business cycle. The structure of the London Market is looked at in some detail to identify the various players and the flow of business around the market. The regulatory framework is also introduced and an overview is given of both national and international regulation as it might apply to both brokers and insurers operating in the London Market. Finally, the unit will give the student a firm understanding of the role of the broker and underwriter within the wider context of the market. Some of the concepts outlined within this unit will be built on in more detail within unit LM2: London Market insurance principles and practices, and encourage all students to better understand their role within the marketplace and how it operates around them. For reference only For reference only  15 Contents 1: Fundamental principles of insurance A Concept of risk and risk transfer 1/2 B Risk management 1/4 C Components of risk 1/8 D Categories of risk 1/12 E Features of insurable risks 1/14 F Pooling of risk 1/15 G Reasons for buying insurance 1/17 H Primary and secondary functions of insurance 1/17 I Compulsory insurance 1/18 J The claims handling process 1/21 2: Basic insurance legal principles and terminology A Contract law 2/2 B Consideration 2/5 C Insurable interest 2/6 For reference only D Duties of disclosure during contract negotiation 2/8 E Cancellation of insurance contracts 2/17 F Proximate cause 2/18 G Indemnity 2/21 H Contribution 2/31 I Subrogation 2/34 3: Main classes of business written in the London Market A Marine insurance 3/2 B Non-marine insurance 3/11 C Aviation insurance 3/21 D Reinsurance 3/22 4: The insurance cycle A Supply and demand 4/2 B Supply and demand in the insurance marketplace 4/5 C Reasons why the insurance cycle might vary 4/8 16 LM1/October 2024 London Market insurance essentials 5: Structure of the London Market A Lloyd’s Market 5/2 B Company market 5/8 C Brokers 5/10 D Managing general agents 5/10 E International aspects of the London Market 5/10 F Market associations 5/11 G Flow of business in the London Market 5/13 6: Legal and regulatory environment A Overview of the UK regulatory framework 6/2 B Operation of the FCA and PRA 6/3 C Overseas regulation 6/13 D Lloyd’s Market governance 6/16 E Authorisation of new insurers 6/19 F The Financial Ombudsman Service (FOS) and Financial Services 6/22 Compensation Scheme (FSCS) 7: Regulatory processes, systems and controls For reference only A Impact of UK, EU and US regulation 7/2 B Sanctions 7/5 C Data protection 7/10 D Anti-money laundering 7/14 E Bribery 7/19 8: Role of a broker A Legal basis of the broker’s role 8/2 B Regulation 8/7 C Services provided by intermediaries 8/9 D Broker’s role in the placing process 8/10 E Broker’s role in the claims process 8/14 9: Underwriters A Role of an underwriter 9/2 B Functions of an underwriter 9/2 C Subscription market 9/2 Self-test answers i Cases xi Legislation xiii Index xv  Chapter 1 Fundamental principles of 1 insurance Contents Syllabus learning outcomes Introduction A Concept of risk and risk transfer 2.1 B Risk management 2.1 C Components of risk 2.1 D Categories of risk 2.2 E Features of insurable risks 2.6 F Pooling of risk 2.3 G Reasons for buying insurance 2.7 For reference only H Primary and secondary functions of insurance 2.8 I Compulsory insurance 2.8 J The claims handling process 2.9 Key points Question answers Self-test questions Learning objectives After studying this chapter, you should be able to: describe the concept of risk and risk transfer; explain the components of risk and the concept of risk management; explain the categories of risk and those that can be insured; explain the pooling of risk; explain the difference between peril and hazard and give examples; explain the basic purpose of insurance and the reasons for its purchase; list the various types of compulsory insurance; and explain the importance of the claims handling process. Chapter 1 1/2 LM1/October 2024 London Market insurance essentials Introduction We start our studies by exploring the concept of risk and the various ways in which this word is used within the insurance business. We will look at the different types of risk and which are insurable, together with the things that enhance the risk itself. In this first chapter, we will also look at the types of insurance that are compulsory, and the purposes and functions of insurance. Key terms This chapter features explanations of the following terms: Financial risks Fortuitous event Frequency Fundamental risks Hazard Homogeneous Insurable interest Non-financial risks exposures Particular risks Peril Pooling of risk Pure risks Risk Risk transfer Severity Speculative risks Uncertainty A Concept of risk and risk transfer The word ‘risk’ is used in many different ways in the insurance marketplace and we need to look at each of these in turn. Here we will examine the term in its everyday sense and find our first problem. There is no universally recognised definition for the term risk. For reference only A1 Risk perception If you were to ask anyone what the term ‘risk’ means to them you are likely to receive a wide variety of answers – everything from the owner of the business being concerned about the possibility of recession to worried parents concerned about all kinds of dangers faced by their children. Yet others may identify the risks inherent in running a business – perhaps the demand for their products or obsolescence issues. The list of risks that we face in everyday life is almost endless. In a personal sense, we all take decisions based upon an assessment of risk, albeit that it is usually carried out informally. We assess the likelihood of rain occurring and decide whether to take an umbrella when we leave home in the morning. There may be some data involved (a weather forecast) or we may have merely looked out of the window to make a judgment about the likelihood of rain. This informality may be acceptable in 'low risk' situations where the ultimate calamity is something like wet clothing, but in many contexts, we need better measurement tools, especially where the potential for loss is significant. Risk measurement and the means of attempting to deal with the risks we face are collectively termed risk management. In a commercial context, this is often a well-defined and scientific process, attempting to answer questions such as ‘How much will it cost if things go wrong?’ and ‘What are the chances of the risk becoming a reality?’ We will deal with these issues in greater detail later in the study text. In a personal sense, most individuals make less precise calculations, often preferring instead simply to protect against those things that seem capable of inflicting some kind of financial disaster, such as fire or theft. We begin by considering just what is meant by the term ‘risk’. Chapter 1 Fundamental principles of insurance 1/3 Chapter 1 A2 Definition of risk Consider the following statements, each giving a different slant to the term ‘risk’: possibility of something unfortunate happening; doubt concerning how something will turn out; unpredictability; possibility of a loss; and chance that there might be a gain (the horse you backed might win). Refer to Types of risk that can be insured are covered in Features of insurable risks on page 1/14. Whichever choice we make (umbrella or no umbrella for example), we need to recognise the elements of uncertainty and unpredictability or, in some cases, danger. The term often implies something that we do not want to happen. Consider for example the many risks associated with owning a building. These include the risk that: the building might be damaged by fire or flood; someone working in or visiting the building might get injured; or someone else’s property might get damaged either by parts of the building falling on it or whilst being stored in the building. Each of these represents a risk so far as the owner is concerned and in each case it is possible to insure (transfer) the risk. This is done by the owner paying a known premium to an insurer in return for the insurer accepting the future unknown cost of the insured risk. The For reference only insurer does this by promising to pay for loss, damage or liability as defined by the policy terms. Insurance, therefore, is a means of transferring the risk. The acceptance of an unknown future potential risk by an insurer for an agreed premium is a way of defining insurance as a risk transfer mechanism. It brings peace of mind to the insured because they have replaced the uncertainty of possible future loss with the certainty of the agreed premium. We consider this aspect later in the chapter in Reasons for buying insurance on page 1/17. Activity If you were the owner of the building in which your office is located, consider all the bad things that could happen – what might go wrong? A3 Other meanings of the term ‘risk’ There are three other ways in which the term is used in the insurance marketplace: peril being insured (e.g. fire or collision); subject-matter of insurance (e.g. the factory, ship or potential liability); and the thing insured, such as the property itself, and the range of contingencies or scope of cover required (if the term is used by an insurer, they often mean both of these). A4 Attitude to risk Each person’s attitude to risk is different. Therefore, we all respond to risk in a different way. Some people are willing to carry certain risks themselves and are termed risk-seeking, while others lean more towards being risk-averse, feeling happier minimising the risk to which they are exposed (perhaps by transferring the risk by means of insurance – see Reasons for buying insurance on page 1/17). Very few individuals are in a position to evaluate, with any accuracy, the risks to which they are exposed. However, many companies attempt to achieve this as part of their risk management process. Chapter 1 1/4 LM1/October 2024 London Market insurance essentials Consider this… What is your personal view of risk – do you consider yourself to be risk-averse or risk- seeking? Will you go out without an umbrella? Does your view change if the risk involves any potential financial loss aspects? Question 1.1 Which of these terms describes an individual who is keen to remove risk where possible? a. Risk unhappy. □ b. Risk-averse. □ c. Risk-seeking. □ d. Risk confident. □ B Risk management There is a continuing trend towards taking control and developing a formal strategy for managing the various risks that affect businesses. The appointment of risk managers in industry and commerce is now commonplace. Many are members of the Association of Insurance Risk Managers. This organisation shortened its name by the omission of the words 'in Industry and Commerce' but has kept its old acronym of AIRMIC. For reference only On the Web www.airmic.com Risk management is important for a number of reasons: It reduces the It gives shareholders It provides a potential for loss confidence that the disciplined business is being approach to run properly* quantifying risk Be aware * For companies quoted on the stock market there is a legal requirement to identify all significant risks to which the business is exposed and to explain in the annual report how these are being managed. The decision to transfer risks (for example, by insurance) is an important final stage in the risk management process. When it comes to general insurance, risk management is a significantly different concept for individuals than it is for businesses. Many individuals, when they consider their own financial planning, personal protection and wealth management issues, tend to adopt a formalised approach – often facilitated by a financial adviser. The decision-making process involves the completion of a detailed ‘fact-find’ and an equally detailed consideration of their income, savings, assets, health and future aspirations. However, the issue of personal general insurance does not very often follow this detailed process. Often it is not bought as the result of a carefully made decision that insurance is the best solution to a particular financial problem. Instead, it is bought because certain elements of cover may be compulsory, such as third party motor insurance, which the law requires everyone to have (see Compulsory insurance on page 1/18 for more information). Alternatively, it may be that another party has a financial interest in the item to be insured; Chapter 1 Fundamental principles of insurance 1/5 Chapter 1 for example, a homeowner’s mortgagee (such as a bank) who will insist upon insurance being effected. Of course, there are areas where there is real choice as to whether to insure or manage the risk in some other way. However, even here it is highly unlikely that a scientific approach will be taken to assessing risk. The most dominant factor is likely to be an individual’s risk appetite or an inability to afford insurance protection. Individuals with very substantial physical assets may adopt a more formalised system. These types of policyholders are often termed ‘high net worth individuals' (HNWIs) and certain insurance products have been developed specifically for them. Activity Conduct a poll of your colleagues, family or friends in relation to their motor insurance. How many of them have fully comprehensive insurance as opposed to the legal minimum of third party insurance? Ask them why they have more insurance than the law requires and how they came to make their purchasing decision. Is there any pattern in their answers? B1 Function of risk management Risk management may be defined as: ‘The identification, analysis and economic control of those risks which can threaten the assets or earning capacity of an enterprise.’ The focus of good risk management is the identification and treatment of defined risks. Risk management should be a continuous and developing process embedded in a firm’s strategy. It should address methodically all the risks surrounding the firm’s current, past and future activities. This definition identifies the three steps involved in managing the risk, namely: For reference only identification analysis control Let us look at these in more detail. Think of risk as the bad things that could happen. B1A Risk identification This step involves the company discovering its possible existing and potential future threats. Not all of these risks will be insurable, but they must all be managed. For example, in the case of a retail shop, petty theft and shoplifting may be real risks and will need to be managed in some way or funding set aside to cover their costs. For many conventional risks, such as a factory owner looking for physical damage insurance for their buildings, an insurer may become involved in helping to identify existing and potential risks through carrying out a physical examination or survey. Insurers also play a role in relation to risk control when they provide reports following the survey. Even if the risk is not ultimately insured, the client still has the benefit of the insurer’s advice concerning the risk. B1B Risk analysis Risk managers examine past data to evaluate or analyse the risk. For example, they can look at the past loss patterns of, say, hurricanes on the east coast of the USA, and so predict likely losses in the future. Insurers will look at many of the same elements when considering the rating of a risk. Chapter 1 1/6 LM1/October 2024 London Market insurance essentials B1C Risk control If the risk is seen to have the potential for adverse consequences, some course of action should be put in place to control, reduce or even eliminate the risk. Elimination is the most effective, but may be costly or impracticable. For example, if a manufacturer carries out some paint-spraying. This activity has the following risks (not a complete list): Spraying other items because the area has not been sealed and the paint has moved in the wind perhaps onto other people’s property. Employees becoming ill because they have breathed in paint vapours. The manufacturer has the choice not to perform the process altogether and in so doing eliminate that element of the risk. Alternatively, they can analyse, assess and manage the risk to prevent or minimise the occurrence of any adverse things. This analysis should consider: First, what is the likelihood of the risk actually happening – using, for example, a scale of 1–3, with 3 being the most likely. Secondly, considering the likely impact on the same scale of 1–3. These two numbers can then be multiplied allowing the business to rank in order the risks it faces. This allows the business to undertake any analysis of the costs of minimising or mitigating losses. A typical cost cost-based analysis using our scenario above is, for example, how much does it cost to enclose entirely the spraying area to prevent over-spray? Is the multiplier of likelihood X impact serious enough to warrant this expense? Does it make more practical For reference only sense to have the spraying done by another organisation? The elimination of risk, or even its reduction, will always be subject to the test of whether the cost of doing so is reasonable compared to the cost of the feared event happening. There are two distinct aspects to the controlling of risk: financial controls such as making sure that physical controls such contracts are well-worded as installing sprinklers (e.g. arranging for a and alarm systems security firm to accept responsibility for cash whilst in its control) Insurers (and to an increasing degree, insurance brokers) assist in the area of loss prevention and control. They do so by imposing requirements and making recommendations designed to improve the risk, following the completion of a survey. These are important parts of the pre-risk surveyor’s report and are aimed at either improving the risk to an acceptable standard from the insurer’s point of view, or offer premium reduction as an incentive for worthwhile risk improvements. In a wider context, insurers are involved in researching areas of loss prevention and control through their work with organisations such as the Building Research Establishment (BRE) and the Fire Protection Association (FPA). Chapter 1 Fundamental principles of insurance 1/7 Chapter 1 providing construction guidelines The type of work that these bodies undertake includes: providing researching new reports on new construction industrial methods processes Insurers must strive constantly to ensure that their knowledge of their potential clients’ businesses remains up-to-date, whether that is in relation to new types of building construction, the further development of offshore drilling technology or the law changing so as to extend potential liabilities. Activity For reference only Think about how building construction has changed in the last few years – look around you and see the different materials that are going into modern building construction. How do you think this affects the risks presented by clients to insurers? Use this link to access guidance provided by the Fire Protection Association: www.thefpa.co.uk/advice-and-guidance. Question 1.2 A factory installing sprinklers into its premises is an example of which activity? a. Risk transfer. □ b. Risk modelling. □ c. Risk control. □ d. Risk analysis. □ Chapter 1 1/8 LM1/October 2024 London Market insurance essentials C Components of risk In order to gain a deeper understanding of the meaning of risk, we need to take a closer look at the various components of risk. These include: uncertainty level of risk peril and hazard C1 Uncertainty The concept of uncertainty implies doubt about the future, as a result of our incomplete ability to predict what is going to happen. If we could say with certainty what was going to happen, there would be no element of risk involved. If we know that our factory will burn down at 4pm tomorrow, or that on the way home we will have a car accident, there is no risk of the event happening, as the event would become a certainty. As we do not have this prior knowledge, we can say that we live in an uncertain or risky environment and that risk exists separately from the individual. Even in the context of life insurance there is uncertainty. We know that we will all die one day but we do not know when. C2 Level of risk 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 the level of risk involved. For reference only Risk is usually assessed in terms of: frequency – how often it will happen; and severity – how serious it will be if it does happen. These are the measurement criteria used in the risk management process. Example 1.1 Frequency Imagine a building situated by the side of a river which is known to be prone to overflowing its banks. This situation involves risk. There is some doubt as to the future outcome because it is uncertain whether the river will ever overflow and (if it does) when this will happen. The fact that the river is prone to overflowing increases the chance that damage will occur. Imagine a second building which is 100 metres away from the riverbank and on a slight hill. This building will be less at risk from flooding because of its position. Example 1.2 Severity Our judgment as to the level of risk posed may change if we consider the potential amount of loss, damage or destruction. For example, if the first building close to the river is valued at £90,000 and the second building, further away, is valued at £250,000, we might modify our view as to which building represents the higher risk, in view of the higher potential severity of loss. Consider this… What is your common sense view of which building is potentially safer from the flooding risk? Chapter 1 Fundamental principles of insurance 1/9 Chapter 1 Therefore, factors relating to both frequency and severity must be taken into account in our assessment of risk. The relationship between frequency and severity varies from one risk to another. High frequency and low severity An example of high frequency and low severity of loss could be comprehensive private motor insurance, where there are many losses for damage to the insured's own vehicle which are low in value, but relatively few third party personal injury claims which will be far higher in value. Figure 1.1: The relationship between severity and frequency A Frequency Severity B Low frequency and high severity In this case, a small number of events would result in very high costs. Accidents involving aircraft are good examples of this type of risk profile because, when a loss occurs, the cost could be substantial. However, technological advance helps to reduce the frequency For reference only of accidents. Activity Look at this page from the Civil Aviation Authority (CAA) website and see how the aviation industry is trying to understand and control risk and hazard: bit.ly/2NuttPa. Significance of frequency and severity The different frequency and severity profiles are important to insurers. This is because they wish their businesses to be, as far as possible, free from great peaks and troughs in relation to claim payments made from one year to the next. Smooth trends in trading patterns tend to encourage investors to support an insurer. An insurer often bases its decisions on how much of a risk it can prudently accept on factors relating to frequency and severity. Insurers have various ways of dealing with a risk that is offered to them where the amount involved exceeds their normal acceptance limits. We will review this further in Reinsurance on page 3/22. A key reason for an insurer to be able to predict the frequency and severity of losses is to forward plan in order to be able to respond to infrequent large catastrophe-type claims. It is also important that an insurer can calculate its financial exposure to risks; this subject is reviewed further in study text LM2: London Market insurance principles and practice. The potential for a particular risk to occur (frequency) can be graded on a scale (for example, 1–3 where 1 indicates a small likelihood and 3 is a higher likelihood). The likely impact if that risk were to occur (severity) can also be graded (using the same scale of 1–3). By multiplying the two numbers together a final grading for any risk can be obtained, which then allows risk managers to consider where to concentrate their efforts on control, management and mitigation. Activity Try and find a copy of your company’s risk register and see which risks are listed and their relative grading. Chapter 1 1/10 LM1/October 2024 London Market insurance essentials Question 1.3 An aviation insurer does not expect many losses in a year but knows that they are likely to be of a high value when they do occur. Which of these describes this pattern of losses? a. High frequency and high severity. □ b. Low frequency and high severity. □ c. High frequency and low severity. □ d. Low frequency and low severity. □ C3 Peril and hazard Let's start with a brief definition for both peril and hazard. Peril can be defined as that which gives rise to a loss, i.e. fire or flood. Hazard can be defined as that which influences the operation or effect of the peril. Consider this… Consider a factory insured against fire which has no sprinklers installed. If a fire breaks out – that is the peril. The lack of sprinklers is a hazard in this scenario as it has the potential to make the fire cause more damage than it otherwise would. For reference only Here are some other examples of peril: Explosion this is the event insured against, which may give rise to loss. Lightning when it occurs, this natural peril can result in damage. Collision whether between ships, aircraft, or vehicles. Dishonesty either employees or external parties stealing from a company for example. C3A Physical and moral hazard Physical hazard relates to the physical characteristics of the risk and includes any measurable dimension of the risk. Examples include the following: Security protection the greater the security protection, the better the physical hazard. at a shop The construction of the higher the standard of building construction the less likely it is that it will suffer damage. the property These standards can apply to both the materials used and the building process itself. Age of a proposer these are factual, measurable dimensions. and type of car for motor insurance Moral hazard arises from the attitude and behaviour of people. In insurance, this is usually the conduct of the insured. Moral hazard also arises from the conduct of the insured’s employees and that of society as a whole. Chapter 1 Fundamental principles of insurance 1/11 Chapter 1 For example: Carelessness a driver’s lack of care can increase the chance of an accident happening and its severity. Dishonesty a person who has previously made fraudulent or exaggerated claims represents a poor moral hazard. Social attitudes a person who regards insurance fraud as acceptable and not immoral. The way in which a business is run is also an example of moral hazard. For example, careless or lax management in a factory represents poor moral hazard. This is clearly something relating to attitude and behaviour, but it may be evident because of unguarded machinery or a lack of control of smoking by employees, for example. It is unsafe to jump to the conclusion that there is an adverse moral aspect to a risk, merely because the risk is an obviously heavy one. For example, a fireworks factory represents a very heavy fire risk, but it does not follow that there is a poor moral aspect to the risk. The safety and security within the factory may be world class, and therefore the hazard is low and mitigates the apparent size of the risk. Equally, a young driver who is driving a high-performance car certainly represents a poor moral hazard on the face of it as the statistics show that a large proportion of car accidents are caused by young drivers. The car itself will be in a high rating group because of its value and performance. These two aspects are physical because they are measurable. It is, of course, important to factor into the equation other key information such as the proposer’s loss history and any serious motoring convictions. Looking again at some of the perils identified above, some of the hazards which can be linked with them are: Explosion this is the event insured against, which may give rise to loss. The hazards that might be For reference only linked with this are the storage of dangerous chemicals or not ensuring that there is no smoking in certain areas. Lightning when it occurs, this natural peril can result in damage. Hazards would be the construction of any buildings struck by the lightning or the inadequacy of any lightning conductors being used. Collision whether between ships, aircraft, or vehicles. The hazards are in relation to speed, behaviour, extent of training for example. Having a relaxed attitude to the speed limit as a driver is an example of bad moral hazard. Dishonesty either employees or external parties stealing from a company for example. The hazards are things like poor security in place or inadequate operational controls. A lax corporate attitude to security is an example of bad moral hazard. Question 1.4 A factory manufacturing fireworks is inspected by insurers and found to have excellent safety protocols and good training for the staff. What are the protocols and training examples of? a. Good moral hazard. □ b. Poor moral hazard. □ c. Good physical hazard. □ d. Poor physical hazard. □ Chapter 1 1/12 LM1/October 2024 London Market insurance essentials D Categories of risk Not every type of risk or eventuality is insurable. It will help our understanding if we look at (and contrast) different types of risk to identify those that are insurable and those that are not. The groupings that we will look at are: financial and non-financial risks; pure and speculative risks; and particular and fundamental risks. D1 Financial and non-financial risks Some of the risks that we face are not capable of financial measurement. They may have a financial aspect to them, but it is incidental. The real risk arises from decisions and actions motivated by other considerations. Take for example the choice of a marriage partner or our enjoyment of a holiday. We cannot measure these in financial terms. In the same way, the value we might place on an heirloom that has been in the family for years, may be far beyond its intrinsic or market value. Insurance is not appropriate for such risks. The heirloom could indeed be insured but only for its market value, not for the sentimental value we place on it. For a risk to be insurable the outcome of adverse events must be capable of measurement in financial terms. Most general insurances are compensatory in nature – this means that the value placed on the loss is not determined in advance. Important exceptions to this general rule are personal accident and sickness policies that we will touch on in chapter 2. This is because there is no way of valuing precisely the loss of a life or the loss of sight so these policies are taken out in order to provide pre-agreed amounts in the event of an accident or sickness and are known as benefit policies. Similar For reference only considerations apply to life insurance policies. Let us look at some examples of financial risks to help us understand this concept. Loss What is insurable? Accidental damage to a The financial value of the risk is the cost of repairing or replacing the vehicle. motor car Theft of property The financial value of the risk of theft of an item of jewellery is its current market value. This is measurable in financial terms. It would not include sentimental value because, as we have seen, this is not precisely measurable in financial terms. Loss of business profits This risk is measurable since comparisons can be made to similar trading periods to following a fire devise a fair estimate of the loss to be paid by the insurer as compensation. Legal liability to The courts measure the value of damages applicable for the loss of a leg, for pay compensation for example, against compensation payments made previously by the courts. The courts personal injury to others calculate damages that will take account of financial circumstances as well as the injury itself, for example covered future medical payments or special equipment. D2 Pure and speculative risks There are many situations in life when we speculate with a view to making some kind of gain. Obvious examples are the National Lottery or other forms of gambling. There are also situations such as investing in the stock market or starting up a new business that fall into this category, as well as pricing decisions and other aspects of marketing. With each activity we aim to make a gain, but each carries the possibility of break-even or failure. Consequently, although there are some aspects of business activity that can be insured, this does not include things such as misreading the market or a business failing because of local competition. These are called speculative risks and they cannot be insured. Pure risks, on the other hand, are those where there is the possibility of a loss but not of gain, and where the best that we can achieve is a break-even situation. Travelling in an aircraft is a good example. The best that we can hope for is a safe arrival. The possibility exists however, that there might be an accident and the aircraft damaged or someone injured. It is these types of risk that are generally insurable. Chapter 1 Fundamental principles of insurance 1/13 Chapter 1 You may have already thought of these, but here are some examples of pure risks. Pure risk Information Risk of fire This could damage or destroy property or cause an interruption to the running of the business, both risks are measurable in financial terms. Risk of machinery This could lead to actual damage or business interruption and is measurable in breakdown financial terms. Risk of injury to If such injury is caused by the negligence of the company, a court may award employees at work damages and costs. These risks are measurable in financial terms. Consider this… If you decide to abandon your career in insurance and become a fashion designer – you can insure the pure risks associated with your workshop and equipment, but you cannot insure against the risk of your first collection being a disaster – this would be speculative risk. D3 Particular and fundamental risks There are some risks that occur on such a vast scale that they are uninsurable. These are called fundamental risks. Take for example the risk of famine or economic recession. Fundamental risks can be defined as those that arise from social, economic, political or natural causes and are widespread in their effect. As we have seen, non-financial or speculative risks are uninsurable as a matter of principle. In contrast, the problem with fundamental risks is that it is often a lack of appetite or capacity on the part of insurers that causes such risks to be difficult to insure or even completely For reference only uninsurable. An example of this would be the risk of war. It is not an easily defined category and there seem to be, on the face of it, many exceptions to the general rule, particularly in the London Market. Just think of the fact that marine insurers will often grant war risks cover for vessels and cargo, or even the fact it is possible to be insured for earthquake cover in California. Nevertheless, the fact remains that those risks that tend to affect whole countries, regions or communities are classified as fundamental and therefore generally difficult to obtain insurance for in the commercial market. Fundamental risks Two risks automatically categorised in this way for non-marine policies are war risks and nuclear risks. Reinforce Think about some of the widespread natural disasters, wars and economic recessions of the past 15 years. What might the claims impact have been on the insurance industry? Activity Visit the Sigma website: www.swissre.com/institute/research/sigma-research.html. Locate and read the latest report concerning catastrophe losses and see how many of them might fall into this category of fundamental risk. How many of the catastrophes listed was your organisation involved with? Unlike fundamental risks, particular risks are localised or even personal in their cause and effect. Sometimes the cause may be more widespread (a storm over a whole region), but the effect is localised or even related to an individual. For example, not all properties in the region will have been damaged. Let’s look at some examples of particular risks. Chapter 1 1/14 LM1/October 2024 London Market insurance essentials Particular risk Information Factory fire This would cause localised damage to the factory and possibly to its surroundings, but would not affect the whole community. Car collision Damage to the vehicles and any third party liability are localised events affecting relatively few individuals. Theft of An event that only affects an individual or family. personal possessions from a home We have established that only certain classifications of risk are insurable: those that are financial, pure and particular. There are certain other things that need to be in place for a risk to be insurable – which we’ll examine in the next section. Question 1.5 Why is the chance of winning the lottery uninsurable? a. The underwriter cannot calculate the chance of it happening to quote a premium. □ b. You cannot insure risks where there is a chance of making a gain. □ c. It is against public policy. □ d. The National Lottery organisers have their own insurance. □ E Features of insurable risks For reference only As we have just seen, not every risk is insurable. In addition to being financial, pure and (generally speaking) particular, the following features must also apply for a risk to be insurable: a fortuitous event; insurable interest; the risk itself must not be against public policy; and the risk must generally not be a one-off. E1 Fortuitous event To be insurable, the happening of the event must be fortuitous. In other words, it must be accidental or unexpected and not inevitable, for the insured. It must certainly not be deliberate on the part of the insured. An example of a non-fortuitous loss is an insured setting fire to their property. In contrast however, a theft may have required careful planning by the thieves, but still be unexpected for the insured. E2 Insurable interest Insurable interest is the legally recognised financial relationship between the insured and the object or liability that is being insured. Other examples of insurable interest not necessarily based on ownership would be: Having responsibility for someone else’s goods because they are stored in your warehouse. Having responsibility for maintaining the pavements, where you might have a legal liability should anyone fall over and damage themselves. Activity Make a note of the various ways you might think insurable interest can arise; then refer to your notes when you study chapter 2. Chapter 1 Fundamental principles of insurance 1/15 Chapter 1 E3 Public policy It is commonly recognised in law that contracts must not be against public policy or go against what society considers to be the right or moral thing to do. Insurers should not, therefore, cover risks that are against public policy. For example, it would be against public policy to insure the risk of incurring a fine for a criminal offence. The risk may appear to have all the features of an insurable risk, as the event may be considered fortuitous (accidental) and the insured has an insurable interest, since they suffer financial loss as a result of the fine. However, it is clearly unacceptable to be able to insure against paying a fine, because the purpose of the fine is to punish the individual. Providing insurance for this type of risk may encourage people to break the law. Insurance cover for fines You may see coverage for fines in some insurance policies that you review. This will be for administrative fines rather than criminal fines – an example of this might be a fine imposed by the customs officials at a port if shipping paperwork is not completed properly. Before we move on to consider the pooling of risks, let’s consider the importance of homogeneous (similar risks) exposures to insurers, as contrasted with one-off risks. E4 Homogeneous exposures A sufficient number of exposures to similar risks, historical patterns and trends will enable an insurer to forecast the expected extent of future losses. We could call such risks ‘objective risks’. In the absence of a large number of homogeneous exposures (i.e. similar risks) the task is harder, as a pattern is more difficult to determine. In extreme cases where there is no For reference only historical data, the risk becomes a subjective one from an insurer’s point of view. Whereas fortuitous loss, insurable interest and not being against public interest are absolute requirements, the concept of homogeneous exposures is an ideal. There are occasions when an insurer will need to use less than fully reliable historical data when fixing premiums, such as: a completely new risk (such as new technology); and risks in parts of the world not previously open to that insurer. For example, insurance is available for satellite launches, even though instances of such launches are fairly infrequent and any failure generally catastrophic. However, wherever possible, an insurer looks for homogeneous exposures in order to utilise as fully as possible the law of large numbers. The greater the number of similar risks to insure, the closer the actual outcome will be to what was expected in terms of losses. Question 1.6 What does the term 'homogeneous exposures' mean? a. Underwriters have never seen anything similar before. □ b. Underwriters have some historic data to work from. □ c. The risks are similar to those seen before. □ d. The risks are all from the same geographic location. □ F Pooling of risk The basic concept of insurance is that the losses of the few who suffer misfortune are met by the contributions of the many, who are exposed to similar potential loss. An insurer gathers together relatively small individual sums of money from people who want to be protected financially from similar kinds of perils. The insurer sets itself up to operate a pool. In fact, as we shall see, insurers operate a number of separate pools for each different class of insurance they underwrite. Chapter 1 1/16 LM1/October 2024 London Market insurance essentials Contributions, in the form of premiums from many insureds, go into this pool. From the pool, payments are made to compensate the losses of the few. The premiums must be large enough, in total, to meet the losses in any one year. In addition, they should cover the costs of operating the pool and provide an element of profit for the insurer. The insurer endeavours to make sure that the premium paid by the insured is proportionate to the risk which they introduce to the pool. Balancing the books for an insurer The basic business equation that the insurer has to balance is premium ≥ claims + operating costs. In words, the premium has to be greater than or equal to the total of claims and operating costs. F1 Law of large numbers In operating the pool, insurers benefit from the law of large numbers. This states that where there are a large number of similar situations, the actual number of events occurring tends towards the expected number. In operating the pool, insurers benefit from the law of large numbers. This states that where there are a large number of similar situations, the actual number of events occurring tends towards the expected number. The law of large numbers can be illustrated by considering the flip of a coin, which can result in a head or a tail combination. On the simple mathematics of the situation, you would expect to get the same number of heads and tails, because the chance of getting either is 50%. However, flipping the coin just 20 times may not give us the 50/50 split we would expect. For reference only Flipping the coin 10,000 times, we would almost certainly see a result of approximately 5,000 heads and 5,000 tails. The law of large numbers, therefore, operates to give a result which is in keeping with the underlying probability (likelihood of something happening) of, in this example, 50% heads and 50% tails. Applying the principle of large numbers to insurance enables the insurer to predict fairly confidently the final cost of claims in any one year. This is because insurers provide cover against a large number of similar risks, and the final number of actual loss events tends to be very close to the expected number – provided the conditions under which the original data were gathered remain constant. This enables the insurer to calculate likely losses and so confidently charge a fixed premium. In addition to the law of large numbers, the insurer also uses historic data to predict the pattern of claims payments and ultimate claims values. Obviously, this historic data is of limited use when the insurer moves into new classes of business; in this case, the law of large numbers becomes more of a key tool for calculating likely losses. F2 Equitable premiums To operate a pooling system successfully, a number of pools must be set up – one for each main group of risks being underwritten. For example, an individual pool for, say, marine or aviation hull insurance and another for property insurance must be set up. Marine and aviation hull insurance Marine or aviation hull insurance is insurance against physical damage to a ship or an aircraft. For more about classes of business see chapter 3. Each insured wishing to join the pool must be prepared to make an equitable (fair) contribution to that pool. When deciding on an equitable contribution, insurers take into account the different elements of risk brought into the pool by each of the insureds. These are often referred to as discrimination factors. Arriving at a premium is a complex process and the correct assessment of risk is extremely important. This will ensure that a fair premium is charged, that also allows for cost-covering and profit-making. This is the task of an underwriter when considering an individual risk. Chapter 1 Fundamental principles of