PB502 - INSURANCE AND TAKAFUL : PRINCIPLE AND PRACTICE CHAPTER 1 INTRODUCTION TO INSURANCE

DEFINITION OF INSURANCE
Having seen the role of insurance and how it works in very general terms, it is now appropriate
to put down in precise terms what insurance is all about. Insurance, as an organizational, seeks to
provide protection against financial loss caused by fortuitous[1]events.
Insurance can therefore defined as: An economic institution based on the principle of
mutuality, performed for the purpose of establishing a common fund, the need for which arises
from chance occurrences[2] of nature, whose probability can be fairly estimated.
The insurance service, therefore involves payment of contracted benefits of compensation
to the insured or a third party against unforeseen losses.
ESSENTIAL FEATURES OF INSURANCE:
The essential features of insurance therefore are:

It is an economic institutions

It is based on the principle of mutuality or cooperation

Its objective is to accumulate funds to pay for claims that arise as a result of the operation of
specific risks.

Only certain risks can be insured against, namely those whose occurrence with a certain degree
of accuracy.
HISTORY OF INSURANCE
The earliest evidence of insurance contracts dates back to the period around 2,800 B.C. where
the Babylonian legal code showed regulations on insurance. Basically the concept of insurance was
developed to deal with perils faced by merchants and traders at sea. This varied from protection of the
cargo and goods carried by ships to the protection against the loss of lives of sailors and officers
There is evidence showing that such practices were also prevalent among the Chinese, Greeks
and Europeans. The first case of life insurance dates back to 1583 in England where a term contract
was issued on the life of a certain William Gybbon. A significant development in the life insurance
industry was the development of the mortality table by Edmund Halley in 1693. However, it was about
a century later that any degree of accuracy was achieved in predicting mortality rates.
The Government subsequently intervened and the Insurance Act, 1963 was introduced.
Under the Act, the general conduct and supervision of the insurance industry was vested in the
Director-General of Insurance under the Ministry of Finance.

THE IMPORTANCE OF INSURANCE

While approaching to the consumer throughout the world, and to the market of insurance as a scope, it
can be concluded it is important to both individual and business. Some of the importance is:
a) The need for income :Every moment, individuals, families and business are exposed to losses arising from their property,
occupations, activities and responsibilities. Who will bear these financial losses and where will the
funds be obtained from to offset such losses? Usually, in the absence of legal remedies, contract
arrangements or cooperative efforts, losses will fall on the individual or business unit concerned. To

solve this problem, an arrangement is introduced for coping with some of the risks and possible losses
faced by individuals and business enterprises.
This arrangement works on the law of large numbers, i.e. by spreading the risk of loss faced by a
specific person or enterprise to all parties who pool their resources to pay for individual losses. This
loss sharing arrangement is called insurance
The insurer is the intermediary who manages this risk pool. The insurer holds and invests the premiums
in trust for policyowners, and pays them in the event that these losses, for which insurance protection
is taken, occur.
b)

Source of income
A person may create his source of income by either setting up his own business or working for other
people where, upon completion for the jobs done, he will receive payment in the form of a salary,
wages, allowances or commissions.
The other means is though investment income by way of dividends bonuses or interest on the capital
invested.
However, both sources are always at the risk of being affected by circumstances over which the
individual has no control.

c)

Unfortunate Event or Risks

Earning capacity may be ended abruptly[3] due to death, old age, sickness or accident that may result
in disability (permanent or temporary)
Likewise, the investment may suddenly depreciate in value or the goods in which capital is invested
may be destroyed by fire
In any of these contingencies, the individual or the dependents have to bear the consequences of the
financial or emotional losses. Those affected have no other sources to which they can look for relief for
sharing part of all the loss.
The painful experience as a consequence of losses is obvious to anyone.
HOW INSURANCE CONDUCTED / HOW INSURANCE WORKS
Let us next understand how insurance works to compensate for the financial losses consequent to the
occurrence of a risk or perils.
Rather than providing a more formal definition of the risk and peril now (see chapter 2),
we shall look at some instances where we can say that a risk or peril has occurred.

Some forms of risk

Shipwreck[4] at sea
An outbreak of fire resulting in material damage;
Loss of income due to disability or premature death.
Pooling of risks
It is not possible for an individual to predict or prevent such occurrences but through insurance,
arrangements can be made to provide against their financial effects, i.e. loss of property and/or
earning.
Insurance in its various forms aims at safeguarding the interest of the individuals who are insured. This
is achieved by having losses experienced by the unfortunate few compensated by the contributions,
i.e. the premium, of the many that are exposed to the same risk.

The concept of Insurance explained

The concept of insurance is illustrated in figure 1.1 in relation to a house owner or a term life
insurance portfolio. For the purpose of illustration, it is assumed that the portfolio consists of 1000
houses of identical value, say RM100,000 each or 100 life assured with identical capital sum, and
premium of RM200 is charged for each of life assured per year.

The fund has to meet:

The contribution from the 1000 house owners or life assured results in the creation of an insurance
fund on RM200, 000. The insurer uses this amount of money to pay for claims, management expenses
and other outgoes such as commission, taxes, etc. The balance, if any, constitutes the insurers profit.
The fund can become deficit
Thus, in the situation illustrated earlier, the fund created is just sufficient to pay for a maximum of
two claims and this leaves the expenses and other outgoes of the insured uncovered. If more than two

claims were arise, the insurance fund would be in deficit and clearly, the insurer would experience a
loss on his portfolio.
Premiums have to be adequate in a competitive business environment
It becomes clear from the above that for the insurer to operate profitably in a competitive
environment, premiums have to be fixed at adequate levels, and management and other expenses
controlled.
The law of large numbers
Insurance as a device for spreading the loss of a few among many can only work when insurers are able
to underwrite a large number of similar risks. When insurers are able to write a large number of similar
risks the law of large numbers operates.

The law of large numbers states that as the number of loss exposures increases, the predicted loss tend
to approach the actual loss. Although the law of large numbers is a simple concept, it can only operate
efficiently in the following requirements are fulfilled:
There are a large number of similar loss exposures
The loss exposures must be independent
There is a random or chance occurrence of loss.
The operation of the law of large numbers will ensure will better prediction of future losses. This is
important to insurer because they must charge a premium (based on predicted future losses) that will
be adequate for paying losses for the period of insurance.

FUNCTION OF INSURANCE

The function of insurance can be look closely in two perspective, (primary

and secondary)

Primary Function

Stabilization of costs
Stimulation of
Business Enterprise
Provision of
Security for

Functions of insurance
The primary function of insurance is the equitable distribution of the financial losses of the
few who are insured among the many insured.
The secondary functions
Through purchase of insurance, business enterprise avoids the necessity of having protection
against losses. This provides a means of stabilizing the costs involved in managing risks.
The risks transfer mechanism provided by insurance has made possible the present-day
large-scale commercial and industrial enterprises. These large-scale enterprises would not
have started if the owner were not able to transfer their risks through insurance.
Insurance helps to remove the fears and worries of losses of individuals and business
executives. This removal of fear and worries helps to establish confidence and enables the

Expansion of
Business
Reduction of Losses
Provision of a means
of saving

forward-planning of economic activities.

Insurer helps to reduce losses (both in frequency and security) through their action and
recommendations in rating, survey, inspection service and salvage[5].
Insurance function as a means of saving, primarily through the use of
endowment[6] insurance. Endowment insurance is a combination of protection plus savings.
The investment part of the contract is a savings accumulation. By combining the two
features in a single plan, endowment assurance provides both protection and savings to the
insured.
Provision of Sources - Insurers accumulate large funds which they hold as custodians and out of which claims and
of Capital for
losses are met. These funds are usually invested (to earn interest) in the public and private
Investment
sectors. Such investment helps considerably in the overall development of the economy.
Provision of
The insurance industry in Malaysia has created various categories of employment
Employment for
opportunities. Following are the statistics for 2007;
many
Market Structure
No. of personnel
employed
Insurers
20,600
Insurance brokers
1162
Adjusters
1844
Registered life agents
78,587
Registered general
39,165
agents
While the nature of jobs for brokers and adjusters are independents and more of specialized
roles, the various job function in an insurance company such as underwriting, claims
handling, accounts, audit/compliance, human resource/administration, electronic data
processing, marketing and servicing, investment and other support functions are interindependent
CLASSES OF INSURANCE
Life Insurance
General Insurance
Life insurance can be defined as a contract which pays
an agreed sum of money on the happening of a
contingency (event), or of a variety of contingencies,
General
insurance
dependent on a human life.
business can be taken to be all other forms of insurance
As we progress through the book, you may note that the
business (including the reinsurance of liabilities under a
above definition is not precise in relation to with profit
policy in respect thereof) which is not life insurance
policies, for there is no agreed sum of money at the
business as defined in the insurance Act 1996.
outset
Risk Covered
Premature death

Loss or damage to property, e.g. to motor vehicles,

ships, buildings, stock-in-trade;
Loss of a continuous stream of income during
retirement (i.e. during old age)

Legal liability caused by products or goods sold, or the

process carried out;
Sickness or disability

Death or injury to a person by an accident

[1]
[2]
[3]
[4]
[5]
[6]

Synonyms = accidental
Synonyms = incident
Synonym= Shortly
Synonym = Ruin
Synonym=Recover
Synonym=Gift