What is insurance and how it is used as risk transfer method


The following essay will look at what is insurance and how it is used as risk transfer method by commercial organisations and why it is still used to such a large extent despite its weaknesses. Finally the essay will discuss the advantages and disadvantages of insurance along with the different types of insurance.

One of the main reasons for Insurance is to act as a risk transfer method to enable organisations to be compensated for any future loss in return for a premium. It is used to protect the financial status of an individual or company due to an unexpected loss. Certain forms of insurance are purchased on an optional basis where as others are required by law.

As stated by Thoyts (2010a, p10) "there's a common misconception amongst Insurance policy holders, that it is an individual arrangement with their insurance company". Even though this is how the law views the relationship. However this is not the case. It starts from the fact that a situation exits whereby a group of individuals are facing the same risk but there is a reasonably low probability of occurrence, due to the financial risk it is transferred from individuals to a collective pool. According to Thoyts (2010a, p11) "the pool contains the collective risk of its members, together with the collective resources these members have set aside to meet the occurrence of such risk." Appendix 1 shows a diagram of this insurance concept. For insurers to cover the potential loss there are two methods. The first method is to charge everybody in the pool the average amount of each member's loss. This is where the issue of not all risks in the pool might not be exactly identical but they maybe similar therefore if a flat based premium is charged then members with high average risks will be compensating for members with below average risks. The second method is charging a flat rate premium, this is usually done when the premium is small and any differences between premiums would hardly have an effect on the overall pool. Travel insurance is a good example of this as everybody pays the same amount even if it involves lost luggage or hospital treatment.

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Underwriting is the process which insurers use to calculate whether a customer is eligible to receive their product. The insurance cycle has been recognized since 1920 and the name was derived from the Lloyds of London insurance market. An underwriting cycle can be described as when insurers start to become strict on their underwriting techniques and increase insurance premiums after a period of drastic underwriting losses. This helps create large increases in profit and will attract more capital in the industry and also increase the companies underwriting capacity. Whereas when Insurers are trying to write more premiums with higher profits, premium rates may start falling and underwriting techniques become more relaxed to attract more business.

In order for Insurance companies to make a profit they are continuously trying to guarantee the amount paid out is less than premiums and investment income (Skipper &Kwon,2007). Hidden costs are one of the main disadvantages of insurance according to Corvino (2007). For example many motor insurance companies and house insurance are covering their cost through insignificant charges made up through the policies small print such as cancellation fees or exit fees for policy holders who wish to opt out before the policy ends. Other examples of hidden costs are when banks unfairly marketed and mis-sold payment protection insurance to customers often implying it was compulsory. One of the companies involved was Egg, who was fined £30 million in 2008 as a result of their Payment Protection Insurance practices.

A common example of commercial insurance is public liability insurance which most businesses need to protect them from potential compensation claims if they injure or damage another person or their property. A contract is created once the insured and the insurer agree to the terms of the policy. Most of the time the insured is required to cover a certain amount of the cost when they make a claim and the rest is covered by the insurer. Non Life Insurance Market

Both organisations and individuals purchase non life insurance policies in order to protect themselves against any future loss. An individual will purchase home insurance to cover their contents. Drivers purchase motor insurance in order to provide cover against any future unexpected accidents and people purchase travel insurance when they go on holiday to cover the cost of treatment if they fall ill.

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In addition to this non life insurance policies are crucial to provide cover for organisations against any claims made by the public or the staff. An example is that many organisations are advised to purchase public liability insurance to protect themselves from future claims by customers or guests entering their premises that have an accident or injury in their building. The organisation can tailor the Public Liability Insurance according the risks that are inherent in the business.

However public liability insurance will not cover the employees therefore further insurance must be purchased in case the employee has accident on the premises. Therefore, the organisation must purchase Employee Liability insurance to protect their workforce and to provide compensation due to an accident in the workplace. Furthermore, certain organisations need to purchase Professional Indemnity Insurance. This type of insurance is vital if an organisation provides a consultancy service. Clients may make a claim against a company on the basis that the advice they provided caused them to make loss. Therefore a consultancy firm must take precautions as they could possibly be held liable if such case is taken to court. The disadvantage of purchasing all these different policies is that organisations end up paying high premiums and in some cases not a single claim is made during the policy. However this is a risk the organisation must be prepared to take as it may only take one claim to bring down the company and cause damage to their reputation.

Furthermore, commercial insurance is purchased by organisations to protect them against theft and property damage. Therefore insurance can benefit the organisation in a number of ways as the company itself will not have to pay out of their pockets if they suffer any unexpected loss. They can continue their business processes without major disruption. However one drawback is that claims take a number of weeks to process due their nature and in that that time period it smaller organisation may be financially unstable and could find it difficult to continue some or all of their processes.

In addition to this one of the disadvantages of commercial health insurance is that the organisation will cover employees travelling to different parts of the world on business but the employee will have to pay for the costs from their own pocket if they fall ill. The main reason for this is that employees are not advised on the circumstances and limitations of the policies (Rediff, 2007). In some countries like India employees need to careful in choosing a suitable hospital that covers their treatment. One of the main costs is the room rent and employees need to be careful on choosing a specific room that matches the requirements in the policy in order to cover the individual. These limitations can make a significant difference when employees fall ill in a foreign country because if they fail to comply with the policy they will not be compensated for any of the treatment they receive and the policy would be of no use to the employees.

The need for a good insurance market is necessary for a successful market and economy as it is proved with its worldwide presence. According to Dickson 1991, there are a number of advantages of insurance which include peace of mind, loss control, social benefits, investment of funds and invisible earnings.

Insurance provides peace of mind to individuals and organisations as it takes away the risks associated with certain activities. This is vital to the daily operation of companies for example Insurance protects against issues such as, if a factory caught fire and all equipment and machinery were damaged or unsalvageable then the company may have to pay a substantial sum to get the business running again or claim bankruptcy. Insurance can help protect investments and may benefit the economy by efficiently managing a variety of risks can help organisations create new capital. Purchasing insurance facilitates the transfer of risks to an insurer. Insurance can also be used by existing businesses to diversify their risks to aid their business activities. With peace of mind the business can develop freely without having to hold reserves to cover operational or other risks inherent in their sector.

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In recent times the insurance company pools its funds to reducing the level and severity of risks. An example of this is when insurance companies pooled together to operate the first fire fighting services, this shows the loss control provided by insurers. This benefit of insurance is passed on to the clients taking out insurance in the form of specialised expertise from insurance companies to effectively manage loss control. Insurers employ surveyors in areas like fire, to inform and advice in the area of loss control (Dickson 1991). This service is a form of pre-loss control to reduce the probability of certain events occurring.

The social benefits of insurance are visible due to the ability of a business to keep operating in the event of an accident, which would have otherwise taken a large amount out of their capital reserves. This means that the business can keep the same amount of staff and maintain the same level of business as the insurer will cover a lot of the risks (Dickson 1991). The level of income will remain the same for the population of the economy as jobs will remain intact. The closure of a single factory will have repercussions on the community such as depression due to lack of employment which could cause crime rates to rise over a period of time. Insurance companies are inherently large organisations due to the need to cover many businesses and the fact that they receive large annual premiums and companies may not make claims. The insurance company can invest the accumulated premiums. By having a diversified spread of investments insurance companies help international markets and governments by injecting cash into them to help their economies and gain profits (Dickson 1991).

Insurance is crucial in this day and age, down to many reasons one of the main reasons being the compensation culture in our society and how easy it has become to make a potential claim. Other reasons why insurance is one of the main methods of risk financing is due to the fact that without the peace of mind knowing an organisation can still survive if it suffers a loss, the day to day operations of an organisation would suffer drastically. Legislations and laws are making insurance necessary in certain countries just like employers liability which is legally required if you have employees as it covers injury and property damage to your employee while working.


Appendix 1



A Large number of similar risks

Equitable Premium



Underwriting PREMIUM


Common pool management function provided by the insurer

(Thoyts. 2010b, p10)


Theory and practice of insurance By Jean François Outreville 19



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