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INSURANCE BASICS

2004 Insurance Australia Group Limited ABN 60 090 739 927

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Contents

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Introduction: Insurance helping you through life.

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Part 1 - Insurance basics

What is insurance?

History of insurance

Important parts of insurance

What is risk?

What is an insurance premium?

How do insurance companies calculate the insurance premium they charge?

What is a claim?

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Types of insurance claims

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What can be insured?

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What do insurance companies do?

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How much of the premiums customers pay goes back into paying claims?

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How to reduce risk

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Part 1 Revision

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Part 2 - Insurance industry overview

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Part 3 - Premiums, prots and losses

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Part 4 - Risk

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Part 5 - Business and Community Sustainability

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Part 6 - Glossary

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DISCLAIMER
The information contained within this document is of a general nature.
It is for educational purposes only and is not intended to be comprehensive, complete or advice.
While all due care has been taken in the preparation of this document, we take no responsibility and expressly disclaim
all liability incurred by any person in connection with the document or its contents to the extent permitted by law.

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Introduction

Insurance helping you through life

Insurance plays an important part in peoples lives by taking out the worry and helping
the whole community.
Insurance is all about pooling.
A large number of people pay a small amount of money into a pool.
For example if their property is damaged, stolen or destroyed or if someone suffers an injury,
the pool is there to help pay for repairs, replacement or compensation for injury.
This means those who put money into the pool may not have to pay some or all of the
repair, replacement or in case of injury, the medical and associated costs.
Insurance gives peace of mind, letting people get on with their lives.
While this basic pooling principle of insurance is simple, the workings behind insurance
are fairly complex.
This document is designed to provide a better understanding of insurance, including car,
home & contents and business insurance.
This document has information about:
the history of insurance and how it has developed over the centuries;
how insurance works, including how the price of insurance is set and the differences
between the various types of insurance available;
how an insurance company runs;
the insurance industry in general;
why and how insurance companies try to reduce risk to make communities safer on the
road, in the home and in workplaces.
This document has been developed by CGU Insurance and has been reviewed by National
Curriculum Services, a group that professionally design and produce curriculum materials
and address the professional development of schoolteachers nationally.

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The idea of pooling.

People pay an insurance premium to an insurance company,
but not all those people will make a claim.
What is insurance?
In broad terms, insurance is about a person putting a small amount of money into a pool with other
people to cover, for example some or all of the cost of repairing or replacing their valuables if they are
lost, damaged or stolen, or to help pay compensation to a person if they are injured.
Insurance is all about a group of people or a community sharing risk. In this sense insurance is a
community product. Through an insurance company, people in the community, pool their premiums to
pay the claims of those insured with that insurance company.
When a person needs to make a claim, insurance companies must ensure that there is enough money
in the pool to meet the cost of that claim. Insurance involves a large number of people paying a small
amount of money to make sure the few who need to make a claim are covered.

Most people own something valuable, such as a car, house, furniture, boat or a business.
They also have other valuable things, such as their health and the ability to work.
It is important to protect what is valuable.
One of the ways people protect what is valuable is by taking out insurance.
The advantage of having insurance is that it allows the community to pool risks. This takes away the
need for people to pay the full cost of loss or damage on their own, which in some cases, could, if it
occurred, leave people in great nancial difculty.

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History of insurance
Insurance has been around for a long time.
Since the time of Chinese traders 7,000 years ago, insurance has been used to reduce the risk of the
traders getting into nancial trouble and going broke.
Over the centuries, people have joined together and cooperated to reduce risks, such as accidents or
theft. This included living in groups to reduce the risk of attacks from wild animals or other people,
and to increase the amount of food they could gather or hunt.
Similarly today, people buy insurance by paying some money into a pool to replace or repair damaged
or stolen cars or belongings, to rebuild houses or help them recover from an accident.
Insurance is pooling the money of many to support those, who have put money into the pool, that
are unfortunate enough to have an accident or be affected by a disaster or suffer a loss.

History of insurance - Ancient China

In about 5,000 BC, instead of putting all their property in just one boat, Chinese traders spread their
goods over several boats.
If one boat sank, no individual trader went broke.
If two traders spread their goods over two boats and one boat sank, each would lose only a half of
their goods rather than everything they owned.
Each of these traders had to sell their goods far from home. The only way they could get their goods
to the buyers was by boat. Many risks were involved in sailing the boats from port to port, through
rough seas, chance of shipwreck, getting lost or being raided by pirates.
These traders could do business in two ways. The high risk way was to go alone and have all their
goods in just one boat and do nothing about reducing their risk. The low risk way involved the
traders pooling their risk by placing their goods on several boats.
Sharing the risk of losing goods was an early form of insurance. In the high-risk situation, the boat might
not make it and the one trader could lose everything and go broke. In a low risk situation, even if a boat
did sink in rough seas, each trader would only lose a portion of their goods and none would go broke.

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History of insurance Great Fire of London

In 17th century London, insurance companies did more than take a small amount of money from
many people to compensate them if their home burnt down. Some insurance companies directly paid
for some of Londons city re brigades.
People who paid insurance companies to insure their home were given a re plate showing the
insurance companys logo. This re plate was xed near the front door of their house.
If a house caught re, the re brigade would check if the house had a re plate. If the house did not
have a re plate, or had the re plate of another insurance company, the re brigade would let the
house burn down.
People who wanted the re brigade to help them if their home caught re, would each put in a little
money to help pay for the re brigade to protect their house.
The idea was simple. If people pooled their money there would be enough to pay the re brigade to
put out res. The pool of money would also provide enough to help the house owner rebuild their
home if it was damaged or destroyed by re.

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Important parts of insurance

Insurance is about people each pooling a small amount of their money to reduce the risk of them
being nancially impacted if, for example something valuable to them is damaged, destroyed
or stolen.
It can also include pooling money to reduce the risk of someone being nancially impacted if they are
injured at work or in a car accident.
To help explain insurance, terms such as risk, premium and claims need to be explained.
In the following pages, we will describe insurance as it relates to motor, home and injury or disability
to people.

What is risk?
Risk is a word that is used often by insurance companies.
In insurance, risk means the chance of something unpleasant or unwelcome happening.
Risk is the chance that something valuable to a person might be lost, stolen, damaged or destroyed. It
can also mean the chance of a person being injured.
One of the things insurance companies do is to work out the cost of insurance premiums by assessing
and pricing risk. In other words, putting a nancial value on the risk.
Assessing and pricing risk involves working out the chance of whatever is insured becoming accidentally
injured, lost, damaged or stolen, and how much it will cost to repair or replace what is insured.
Working out how much it costs to pay claims and how often people are likely to be injured or have
their property lost or damaged is a very important part of an insurance companys work. This is called
pricing risk.
By pricing risk, insurance companies know how much money they need in the pool to pay claims.
The better insurance companies are at pricing risk, the better they know how much money needs to
be in the pool to pay their customers when they make a claim.

What is an insurance premium?

An insurance premium is an amount of money a person pays to an insurance company for an
insurance policy. This payment could be regarded as transferring some or all of the risk (or cost) of
loss or damage. For example replacing, repairing or rebuilding a particular valuable if it is lost stolen,
damaged or destroyed.
This is also the same for insurance against accidents at work or on the road that may hurt and
injure people.
The cost of an insurance premium needs to take into account the:
Expected number of claims multiplied by the expected average claim size.

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How do insurance companies calculate the insurance premium they

charge?
No one knows for sure if or when what is valuable to someone will be accidentally lost, stolen,
damaged or destroyed or when someone could be injured on the road or at work.
Because of this, insurance is based on what may or may not happen in the future. Insurance
companies spend a lot of time trying to work out the chances of their customers having to make a
claim and the potential cost of that claim.
Generally the higher the risk of loss, theft, damage, destruction or injury, the higher the insurance
premium.
Not everyones risk is equal. So the amount people pay for their insurance cover or premium, may
differ depending on their own circumstances.
Insurance companies should try to make sure that every individual who has insurance pays a premium
that reects their risk.
Insurance premiums are made up of different parts, including the cost of estimating, collecting and
managing the premiums, the cost of paying the claims, taxes, levies, duties, reinsurance costs, the
prot margin and the cost of the insurance company administering the insurance cover, and the cost
of insuring the particular valuable.

How premiums are set Car insurance

Insurance companies typically set premiums depending on the amount of risk the insured valuable has
of being damaged, lost, stolen or injured.
For instance, with car insurance, premiums may be based on:
the age and sex of the main driver and their driving experience and accident or trafc conviction
record;
who else may be driving the vehicle;
where the vehicle is used or kept;
what the vehicle is used for, for instance if the vehicle is used for business purposes, as this may
mean it will be driven more and is more likely to be involved in an accident;
the vehicles value, if the car is an exotic import with expensive and hard-to-get parts; and
previous claims record.
Family cars with moderate repair costs may be cheaper to insure than large or powerful cars, which
may be more expensive to repair.
Some people may pay more for their insurance than others because their risk of an accident or theft is
higher. Others, for example, older drivers, may pay less, because they are statistically less likely to have
a car accident.
Insurance claims are typically more frequent in urban areas so motorists in cities may pay more for
their insurance than those who live in the country.
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Speeding Convictions - Insurers believe that there is a likely connection between the number of
speeding convictions a person may have and their likelihood of making an insurance claim. Sometimes
people with speeding convictions may pay higher premiums until their driving record improves.
Drink Driving Convictions - Drink driving convictions are taken very seriously by insurers. Convicted
drivers returning to the roads may face difculty in obtaining insurance and may have to pay far higher
premiums than before their conviction. The level of cover available may be reduced - for example from
comprehensive down to third party re and theft. These higher premiums and cover restrictions may
apply for a number of years.
People should look after their car - Insurance policies may require that the car is in a roadworthy
condition. If the car is not roadworthy, it may affect the insurance cover.
When buying or renewing motor insurance, the insurers questions need to be answered truthfully. For
instance the insurer needs to be informed about the details, or any changes to details such as address,
occupation, type of car and motoring convictions.

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How premiums are set Home and house contents insurance

In setting premiums for homes and house contents, insurers may start with the postcode of the
property to be insured. Postcodes enable insurers to identify a geographical area, thereby allowing
premiums to better reect the claims experience in that locality.
Insurance companies may take into account a number of factors when setting premiums for home and
house contents insurance.
Some of these factors may include: the policyholders previous claims history, the houses postcode,
the sum(s) insured and the nature of the items insured, the size and style of the house, whether the
house is rented, or is occupied by the owner, if the house has a monitored security alarm and the
houses location; for example, whether it is in a bushre or storm prone area.
For example, a person may discover they are paying more for their home insurance than their
neighbour is, even though they have the same kind of policy from the same insurance company.
There may be a logical explanation for this difference.
Perhaps one persons house has a monitored security alarm, while their neighbour does not; maybe
their house is larger in square footage than their neighbours; or they have some valuable jewellery
listed on their insurance policy that their neighbour does not.
Some of these factors outlined above may be why a large country mansion may cost more to insure
than a smaller suburban unit.
There are certain risks that some insurers will not agree to cover, because the odds are too great that a
loss will occur; for example, a home that is near a river that oods a lot.

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How premiums are set Injury / Disability insurance

In a similar way to how motor and home insurance premiums are set, some types of injury / disability
insurance premiums may be set depending on risk factors, including:
persons age;
whether the person smokes;
persons medical history;
persons occupation, for example some occupations may be considered more risky and dangerous;
and
persons hobby, (they may like to indulge in what is considered a risky hobby, like skydiving).
Also with some types of injury / disability insurance, if the person has what is called a pre-existing
condition an existing or previous illness that the insurer believes is likely to worsen or recur - there
may be some insurers that will not cover this risk.

How premiums are set Business Insurance

A business insurance policy combines a number of insurance covers into the one policy. This includes
re, business interruption, theft, money and liability to name a few.
When establishing the premium for business insurance, a number of factors will be taken into
account. This will include the types of covers selected, the nature of the business, the types of
products produced and the past claims history.
Each business is different and rating factors will vary. The exposure presented by an ofce are
completely different to those presented by a woodworking factory where machinery is used as well as
various paints and ammable liquids such as lacquers.

An insurance premium is not like paying for a typical service or product because:
Insurance companies are selling the customer a promise to cover what is insured by the insurance
policy. For example if the customers insured property is accidentally lost, stolen or damaged and
the customer makes a claim.
The cost of paying a claim is not certain at the time the insurance policy (coverage) is sold.
Insurance companies do not know what misfortune any of their customers may encounter.
Therefore, insurance companies may not know exactly how often a customer may make a claim.
Insurance companies usually offer insurance cover for 12 months at a time and insurance premiums
usually need to be paid and renewed every 12 months.

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What is a claim?
A claim occurs when a person contacts their insurance company seeking what they are entitled to
under a policy of insurance because, for example, the property they have insured with that insurance
company is lost, stolen, damaged or destroyed. For instance, a person damages their car in an
accident. They have an insurance policy that covers the damage caused by the accident. They contact
the insurance company to request it repair the vehicle or pay for the repairs.
A person, who has paid a premium to an insurance company, to cover a loss, can go to the insurance
company and make a claim. If their claim falls within the insurance cover offered by the insurance
policy, the insurance company can use the money from the pool to pay the claim.
Paying the claim is the moment of truth for the insurance company.
When an insurance company pays a claim, it is keeping its promise to pay the claims of those who
have suffered a loss from the pool created by many.
Paying claims is what insurance companies do. Making sure enough money is in the pool to pay
claims should be a main task of an insurance company.

Making a claim
An insurance claim can only be made if a premium has been paid for an up-to-date insurance policy
that covers risk. This means that a person has to contribute to the pool before they are eligible to
make a claim.
Some general steps that may be relevant in making a claim include:
Contacting the police, for instance, if the claim involves theft, a serious car accident or any crime;
Trying to prevent further damage or loss if it can be done safely;
Contacting the insurance company as soon as possible. Some insurance companies allow certain
claims to be made over the telephone, meaning there may not be a need to ll out a claim form. It
also means that the insurance company can begin processing the claim immediately. However if a
claim form needs to be lled out the insurance company should be able to send a claim form when
they are contacted or there may be downloadable claim forms on the insurance companys website;
and
Keeping a written record of what happened, as it is easy to forget about some small details that
might prove to be important later on. Also any supporting evidence, such as receipts should be kept.
The insurance policy needs to be read. Insurance policy holders would have received one when they
paid their insurance premium. Of course, its in everyones best interests if people check what is
covered in their insurance policy when they rst buy, or renew their insurance. The insurance company
may send out a loss or claims assessor to look at and check the claim for the loss or damage. The
Insurance Council of Australia has a General Insurance Code of Practice, which sets out rules that
insurance companies, that are members of the Insurance Council of Australia, must follow. The
General Insurance Code of Practice outlines principles and standards about the insurance claims
handling process.
The Insurance Code of Practice can be found at: http://www.ica.com.au/codepractice/.
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Types of insurance claims

Insurance companies sometimes categorise claims into two groups, known in the insurance industry as
short tail and long tail. The tail refers to the time it takes for the claim to be settled.

In broad terms short tail claims are generally:

claims usually known and settled within a short period of time, usually within 12 months;
not hard to manage;
easy to work out the exact amount to be paid out; and
are often based around property.

In broad terms long tail claims generally:

often relate to personal injuries;
are sometimes not even reported within 12 months, (like the effects of an injury);
are claims that can take three to four years and sometimes as long as 20 years to settle;
are harder to work out the nal amount to be paid out; and
are sometimes based around medical and legal outcomes.

What can be insured?

Almost anything that is valuable can be insured, including a persons health.
However, not all insurance companies provide insurance for everything.
Below is a list of some of the things that insurance companies may cover.

SHORT TAIL

LONG TAIL

PERSONAL LINES

COMMERCIAL

Private Motor
Home, Contents
Personal Effects
Boat
Caravan / Trailer
Health
Travel
Transport Accident
Consumer Credit

Fleet Motor
Fire, Explosion
Burglary, Theft
Goods in Transit
Construction
Personal Accident / Travel
Credit
Machinery Breakdown
Livestock
Crop
Marine Cargo

Compulsory Third Party (statutory)

Home Liability

Workers Compensation (statutory)

Public & Products Liability
Product Recall
Professional Liability
Defamation
Environmental Impairment
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Anything that is insured generally has some basic features:

the risk is common to a large number of people, for example, car crashes, burglaries or house res;
it involves a loss or damage that can be worked out in dollar terms;
a person(s) owns, or is responsible for whatever is insured;
the loss is not too small; and
the premium paid to insure the valuable(s) should be affordable.

What do insurance companies do?

Insurance is all about pooling
Insurance companies provide a way for people to pool money. In the case of motor, home or
business insurance, this allows people to avoid paying the full cost of replacing, repairing, rebuilding or
restoring valuable things if they are lost, stolen, damaged or destroyed.
People who buy insurance each put in a little of their money into a pool.
If someones property is accidentally lost, stolen, damaged or destroyed, these people can draw on the
pooled money to help pay for the repair or replacement costs.

Large and infrequent losses

Home insurance against re is an example where there is a risk of a large and infrequent loss. This is
because houses are expensive to replace or repair, and house res do not happen very often.

FOR EXAMPLE
Say every year one in every 800
houses suffers a re (1:800 loss) at a
cost of $100,000 per housere.

If a homeowner has no insurance, they

risk having to pay the full $100,000 if
they experience the 1:800 loss, due to
their house burning down.
However if the homeowner has home
insurance and if the home insurance
policy costs, say $125 per house per
year, then a group of 800 homeowners
pooling together pays only $125
each a year, to rebuild the house
burnt down. Even after 10 years each
individual homeowner has only paid
$1250 to protect their risk of $100,000.

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Small and frequent losses

Home contents insurance against burglary is an example where the risk is of small and frequent loss. It
does not usually cost too much to replace what is stolen from a house, but burglary is not uncommon.

FOR EXAMPLE
Say every year 100 in every 1,000
houses suffers a burglary (1:10 loss),
at a cost of $900 per burglary.

If a householder has no insurance,

they risk having to pay the full $900 if
they experience the 1:10 loss, due to
their house being burgled.
However if the householder has home
contents insurance and if the home
contents insurance costs, say, $90 per
householder per year, then a group of
1,000 householders pooling together
pays $90 each to pay for the costs
of goods stolen. Over 10 years the
individual householder has paid $900.

What are insurance companies expected to do?

Although most people may not see it as such, insurance could be regarded as the ultimate
community product.
Customers and the community should expect insurance companies to:

Affordable
Price Risk Fairly
Pay Claims
Insurance companies need to make sure they have enough
money to pay claims, otherwise they are not living up
to their promise to the community.

Some people will pay higher premiums into the pool because
their risk is higher. If insurance companies price risk fairly, they
will stay in business and can continue to pay claims.
If insurance companies underprice, they may not
survive as they will pay out more in claims than they
are taking in premiums.
If insurance companies overprice, people may not be
able to insure their valuables at all.

Help Reduce Risk

Minimise Cost
There are costs involved in running an insurance company.
If insurance companies minimise costs, they will be
able to do business with less costs. This will help keep
insurance affordable.

Helping reduce risk is an integral part of what insurance

companies should do.
If insurance companies work with customers and the
community to make homes, workplaces and roads
safer, fewer people will have to make a claim, insurance
companies can keep the costs of insurance down. This is a
benet to the community.

Accessible
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How much of the premiums customers pay goes back into paying claims?
As an example the graph below shows that about 54% of all the money paid into the pool from
Insurance Australia Groups customers goes back into paying claims.

CONTRIBUTIONS TO THE COST OF RUNNING

THE INSURANCE AUSTRALIA GROUPS BUSINESS (2004)
Underwriting Prot
Commissions

5%

Reinsurance Expenses

6%

5%

Underwriting &
Administration

12%

Claims Expenses

54%
Government Levies
& Taxes

18%

Source: IAG SUSTAINABILITY REPORT 2004 (Page 28 on the full PDF REPORT):
www.iag.com.au/sustyreport04
Disclaimer: This graph is indicative only and constructed for educational purposes.

What is the difference between insurance companies and other nancial businesses
such as banks?
Insurance, unlike banking, is not a guaranteed investment. Money will only be taken out of the pool
if there is a claim that is covered by the insurance policy. Also there is the possibility that a particular
person, who has put money in the pool may never make a claim.
If everyone made a claim every year, there may not be enough money in the pool and insurance
companies may not be able to operate.
With a bank, customers pay money into their bank savings account.
That money, plus interest, will be available to them whenever they decide to withdraw that money.
When people pay an insurance premium to an insurance company, they are getting a promise from
the company that they will pay if the customer makes a claim that falls within what is covered in their
insurance policy.
Insurance is often referred to as buying peace of mind in case of an accident, loss or disaster.
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An insurance companys work

An insurance company needs to do many things to full its promise to its customers and return prots
to its shareholders or members.
These tasks include:
Pricing risk (working out the right price of insurance premiums);
generally if the cost of premiums is too high, fewer people will pay for the insurance and the pool
may not have enough money in it to pay claims;
generally if the cost of premiums is too low, there may not be enough money in the pool to pay for
claims.
Paying claims that fall within what is covered in the insurance policy;
if the insurance company does not pay fair and honest claims, covered by the policy, it will lose
customers, and be held accountable by the Government Regulators and industry associations.
Administration of insurance policies;
insurance companies must be efcient and not use too much of the pooled money to pay the
costs of running the company.
Investing pooled funds (premiums);
if the insurance company is good at investing some of the pooled money waiting to pay claims,
then the interest from that money can help ensure there is enough money in case many people
make a claim at the same time, or can be used as prot.
Managing capital;
insurance companies need money set aside to ensure that there is always enough money in the
pool even if there are many claims all at the same time. This may happen if a large natural disaster
like a bushre or big storm or cyclone occurs. The money that is set aside by insurance companies is
called capital.

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How to reduce risk
Insurance is one way of managing risk.
The best way to reduce the risk of loss or damage to things that are valuable is to take precautions
against mishaps, accidents or theft happening at all.

Many insurers provide their customers with information to help them reduce risk and improve security
in the home, on the road and in their business.
Some insurers are also helping to reduce the risk of injuries in the workplace, an example is at: https://
www.cgu.com.au/cgu/cgu/linkAuthContent.do?contentId=%2FOurProducts%2FSafetyandRiskServices

How do insurance companies work out the risk?

This is called underwriting
Not all risks are the same. Insurance companies need to consider many things when they are pricing
the risk of a person who wants insurance for something valuable to them.
Below are some of the things insurance companies may look at when they are working out how to
match up the amount of premium customers pay to the risk that these customers have:

Specic

Socio Demographic

Economic

Catastrophic

Individual Risk
Driver ability
Driver age
Gender

Area

Ination
Exchange rates
Cost of parts
Fuel prices

Hail
Earthquake
Bushres
Cyclone

Asset Risk
Type of car
Type of nance

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What is underinsurance? How could underinsurance affect you?

Underinsurance is when a customer pays an insurance company an insurance premium for an insurance
policy that does not cover the full cost of the customers loss. For instance if the insurance cover does not
match the cost of replacing a house, contents or a car.
For example; a house owner may have an insurance policy that will pay $100,000 if their home is
destroyed in a re and another $25,000 to replace or repair the contents of the house.
If the house burns down, and it costs $150,000 to rebuild and $50,000 to replace the contents, the
customer will have to make up the shortfall. In this case, the true cost is $200,000, but the customer
was only covered for $125,000. This means they will need to nd $75,000 of their own money to
rebuild their homes and replace their contents.
People should review their insurance regularly, at least once a year to make sure they have the right
amount of insurance.

What is overinsurance?
Overinsurance is also an issue. If it costs $90,000 to rebuild a house and $20,000 to replace the
contents, but it is insured for $100,000 to rebuild and $50,000 to replace the contents, then there
may be overinsurance.
In this case, the house and contents are insured for $150,000 (which is called the sum insured).
However the true cost of rebuilding and replacing the contents is $110,000. This means the house
and contents is overinsured by $40,000. In this example, if the house did burn down, the insurance
company may only cover the true costs of rebuilding the house and replacing the contents, (in this
example $110,000), and not the sum insured.

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Some commercial policies contain an average or underinsurance clause. This means that the sum
insured must reect the full insurable value of the item being insured. If your sum insured does not
meet the full insurable valuable, your claim may be reduced in proportion to the amount by which
you have underinsured when compared to the full insurable value.
In some policies, this clause is not applied where the sum insured represents 80% of the full insurable
value. An example of the average or underinsurance clause is as follows:
Item value

$200,000

80% of value

$160,000

Sum Insured

$144,000

Therefore, if a $100,000 loss occurs, the insurance policy would pay:

$144,000

$100,000

$90,000

$160,000

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Reinsurance
What is reinsurance?
Reinsurance is insurance for insurers.
It is a way of moving the risk that one insurance company takes on from its customers into a pool that
other insurance companies also share.
Reinsurance is just the same as insurance for people; each insurance company puts some money into a
pool that is then shared by all the other insurance companies that have put money in.
Reinsurance helps to make sure that an insurance company has enough money to pay claims if many
of its customers make claims at the same time.
Each insurance company puts some money into a pool. This way, just like individuals, insurance
companies can spread some of the risk.
Below are some examples of how reinsurance works:
1. A man pays an insurance company an insurance premium to have his large cargo ship insured for
$20 million in case it sinks. The insurance company believes this is too great a risk, so it pays a
reinsurance premium to a reinsurance company to cover $18 million of this risk. If the ship does
sink, the insurance company will pay the customer $20 million but will get back $18 million from
the reinsurance company.
2. An insurance company may insure a number of homes and cars in your suburb or town. If there
is a large storm, many of the houses and cars may be damaged. The insurance company will pay
the claims from the home and car owners, then the insurance company, if they are reinsured for
this loss, will claim some of this money from the reinsurance company. This reinsurance covers
catastrophes. Catastrophes are natural disasters such as large hailstorms, earthquakes and
bushres.
Insurance is a truly global business and this is particularly evident in reinsurance where insurers spread
their risk across a number of reinsurers throughout the world. This is why events such as Hurricane
Andrew in the 90s and the terrorist attacks on the world trade centre can have an effect on and
inuence the local Australian market.

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Part 1 - Insurance Basics

What rules do insurance companies have to follow?

Insurance companies must obey the law.
Laws that are relevant to insurance companies include:
nancial services legislation;
privacy laws;
trade practice; and
insurance contracts law.
Regulators that oversee the conduct of insurance companies include:
Australian Prudential Regulatory Authority (APRA) http://www.apra.gov.au
Australian Securities and Investments Commission (ASIC) http://www.asic.gov.au
Note:
Australian Securities and Investments Commission (ASIC) have an informative Financial Tips and Safety
Checks (FIDO) website http://www.do.asic.gov.au.
ASICs FIDO website includes good information about insurance and other consumer education
information.

In Australia there is legislation regulating insurance companies. Some of this

legislation and some areas covered by that legislation is outlined below.
CORPORATIONS
ACT 2001

Financial Services Law

INSURANCE ACT 1973

Regulation of general insurance companies, including regulating

capital adequacy of those insurance companies

INSURANCE CONTRACTS Regulation of information provided to consumers

Denes duty of disclosure for consumers
ACT 1984
Limits areas in which a claim may be denied or policy cancelled

AUSTRALIAN SECURITIES Misleading and deceptive conduct

Unconscionable conduct.
AND INVESTMENTS
COMMISSIONS ACT 2001
PRIVACY ACT 1988

Regulating the collection, use and disclosure of personal

information.

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Part 1 - Insurance Basics

Part 1 Revision
What is insurance?
Insurance is about a person putting a small amount of money into a pool with other people to cover
the cost of claims. For example when a persons property is lost, stolen, damaged or destroyed, or if
they are injured, that person can draw from the pool of money to replace or x their property or fund
their recovery.
People who have put money in the pool should not have to pay the full amount to cover their loss
or accident.

What is a premium?
A premium is the amount of money a customer pays an insurance company for the insurance policy.
For example to cover the customers property if it is lost, stolen, damaged or destroyed or help them
recover from an accident.
The premium is the amount of money the person puts into the pool of money. Once this premium is
paid the customer receives an insurance policy from the insurance company.
An insurance policy is an agreement setting out what is covered, under what circumstances, for how
much and for how long.

What is a claim?
A claim occurs when a person contacts their insurance company seeking what they are entitled to
under a policy of insurance because, for example, the property they have insured with that insurance
company is lost, stolen, damaged or destroyed. For instance, a person damages their car in an
accident. They have an insurance policy that covers the damage caused by the accident. They contact
the insurance company to request it repair the vehicle or pay for the repairs.
If the person has an insurance policy that covers the particular valuable being claimed, they should
expect the insurance company to honour the agreement, (policy) and repair or replace the lost or
damaged item, or pay the customer the amount of money set out in the insurance policy.

What is an insurer and what should an insurer do?

An insurer accepts a premium from a person or a business to cover, for instance, property if it is lost,
stolen, damaged or destroyed or for compensation for a person if they are injured.
The insurer/insurance company manages a pool of money.
The insurer/insurance company pays claims covered by the insurance policy, and prices risk (the premium).
An insurer should help the community manage and reduce risk (accidents, crimes, disasters)
through education.

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Part 2 - Insurance Industry Overview

Insurance Industry Overview The World
How much is spent on insurance a year?
Total Insurance Market Size in 2003 US$ Billions

Life Insurance

General Insurance

$1,673
57%

$1,268
43%

Source: Swiss Re, Economic Research and Consulting,

Sigma No 3/2004 Refer to www.swissre.com Research & Publications
Although all the information used in this study was taken from reliable sources, Swiss Reinsurance Company does not accept any
responsibility for the accuracy or comprehensiveness of the details given. The information provided is for informational purposes
only and in no way constitutes Swiss Res position. In no event shall Swiss Re be liable for any loss or damage arising in connection
with the use of this information.

Top 5 General Insurance Markets vs Australia 2003 (US$ Billions)

JAPAN

$98

AUSTRALIA
UK

CHINA

$14

$18

$92

FRANCE

$58

GERMANY

USA

$637

$94
TOTAL

$1,268

Source: Swiss Re, Economic Research and Consulting,

Sigma No 3/2004 Refer to www.swissre.com Research & Publications
Although all the information used in this study was taken from reliable sources, Swiss Reinsurance Company does not accept any
responsibility for the accuracy or comprehensiveness of the details given. The information provided is for informational purposes
only and in no way constitutes Swiss Res position. In no event shall Swiss Re be liable for any loss or damage arising in connection
with the use of this information.

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Part 2 - Insurance Industry Overview

Insurance Industry Overview Australia
Geographical Spread of Premiums
WA

8%

TAS
SA

NT

5%

0.5%

ACT

2%

2%

QLD

13%

NSW

51%
VIC

19%
Source; Selected Statistics on the General Insurance Industry, June 2002, produced by the Australian Prudential Regulation Authority.
Australian Prudential Regulation Authority (APRA) 2005.
The copyright in this material belongs to APRA.
Reproduction in unaltered form for your personal, non-commercial use is permitted.
Other than for any use permitted under the Copyright Act 1968, all other rights are reserved.

Classes of Insurance (% of total $18 billion premiums)

Accident

Workers

5%

5%

Professional Indemnity

3%
Liability

6%
Inward Treaty

14%
Motor
(Domestic & Commercial)

Other

7%
Fire

9%
Home

14%
Compulsory Third Party

11%

26%
Source; Selected Statistics on the General Insurance Industry, June 2002, produced by the Australian Prudential Regulation Authority.
Australian Prudential Regulation Authority (APRA) 2005.
The copyright in this material belongs to APRA.
Reproduction in unaltered form for your personal, non-commercial use is permitted.
Other than for any use permitted under the Copyright Act 1968, all other rights are reserved.

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Part 2 - Insurance Industry Overview

Insurance Industry Overview
Is the general insurance pool growing?
Yes. Historically the market has grown 11% each year despite the
collapse of HIH Insurance in 2001, the industry has recovered quickly.
Australian general insurance industry growth by line of business

Gross Written Premium in $Billions

25

20

Other
Employers Liability

15

Public & Product Liability

Professional Indemnity

10

Domestic Motor Vehicle

Commercial Motor Vehicle
CTP

Householders
0

Fire and Industrial Special Risk

1992

1995

1996

1997

1998

1999

2000

2001

2002

Fire and Industrial Special Risk

Householders

CTP - Compulsory Third Party Insurance

Commercial Motor Vehicle

Domestic Motor Vehicle

Professional Indemnity

Public & Product Liability

Employers Liability

Other

Source; Selected Statistics on the General Insurance Industry, June 2002, produced by the Australian Prudential Regulation Authority.
*HIH not included in 2002.
Australian Prudential Regulation Authority (APRA) 2005.
The copyright in this material belongs to APRA.
Reproduction in unaltered form for your personal, non-commercial use is permitted.
Other than for any use permitted under the Copyright Act 1968, all other rights are reserved.

Insurance industry overview trends

Price Increases - The Insurance Market Cycle
Underwriting Prots Peak

Underwriting Prots Peak

Loss Ratio Improves

Capacity Increases
Competition Increases
/Rates Deteriorate

Rates Rise

Loss Ratio Begins to Rise

/Rates Continue to Fall

Capacity Leaves

Major Underwriting Losses

Source: JP MORGAN 2002

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Part 2 - Insurance Industry Overview

Insurance industry overview trends
The impact of September 11, 2001:
Reinsurers increased pricing and reduced capacity worldwide.
Increased nancial instability of reinsurers as a direct result of September 11, 2001 losses.

Largest insurance losses internationally trends $ billions (as at 2003)

2001 September 11, New York, USA

30+

1999 Storms - Lother & Martin, Western Europe

15.8

1994 Northridge Earthquake, California, USA

30.3

1992 Hurricane Andrew, Miami, USA

1991 Typhoon Mireille, Japan

13.3

1990 Storm Daria, UK

36.6

11.3
10

20

30

40

Source: PWC Insurance facts and gures 2003.

Converted to Australian dollar from Swiss Re Sigma no.2/2003
Although all the information used in this study was taken from reliable sources, Swiss Reinsurance Company does not accept any
responsibility for the accuracy or comprehensiveness of the details given. The information provided is for informational purposes
only and in no way constitutes Swiss Res position. In no event shall Swiss Re be liable for any loss or damage arising in connection
with the use of this information.

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Part 3 - Premiums, prots and losses

How insurance companies operate
The different nancial parts of an insurance premium
Gross Written Premium (GWP)

Premiums

Is the total amount the insurance company receives from customers for
the payment of their insurance policies.
Net Written Premium (NWP)
Is the proportion of gross written premiums received by the insurance
company, within the nancial year, minus the reinsurance expenses.

How insurance companies work out their underwriting prot/loss

Net Written
Premium

Net Claims
Expense

Underwriting
Expenses

Underwriting
Prot/Loss

Is the proportion
of gross written
premiums
received by
the insurance
company, within
the nancial
year, minus the
reinsurance
expenses.

The amount paid

out in claims
during the year, as
well as an estimate
of how much
the insurance
company need to
pay on unsettled
claims, plus claims
handling costs
such as legal
and adminsitrative
expenses, less
recoveries from
reinsurers and
other parties.

The costs
associated with
researching risk
and determining
appropriate
premiums,
underwriting
administering the
policy information
required to run
the insurance
company business,
marketing,
commissions,
distribution
and meeting
compliance
requirements.

The prot or loss

the insurance
company makes
from the premium
income before
they consider
related investment
income.

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Part 3 - Premiums, prots and losses

How insurance companies operate
How insurance companies work out their insurance prot/loss
Investment Income from
Technical Reserves

Underwriting Prot/Loss
The prot or loss the
insurance company makes
from the premium income
before they consider related
investment income.
(Net Written Premium
minus the claims and
underwriting expenses - as
shown on previous page)

Technical reserves are the

funds held by an insurance
company. They represent
the money customers
have paid through their
premiums that has not yet
been paid out to customers
who may one day make a
claim. Insurance companies
make money on these
investments.

Insurance Prot

The insurance company

prot is worked out by
adding the Underwriting
Prot/Loss to the
Investments Income the
insurance company make
from their technical reserves.

How insurance companies work out their net prot/loss

Investment
Income from
Shareholders
Fund

Insurance Prot
The insurance
company prot
is worked out
by adding the
Underwriting
Prot/Loss to
the Investments
Income the
insurance
company make
from their
technical reserves.

This is the income

received from the
capital supporting
the business.

Tax

Net Prot/Loss

This is the income

tax expense on the
companys prot.

This is the nal

amount after
allowing for
income taxes and
the share of prot
owing to minority
shareholders/unit
holders within the
company.

A working example of this can be seen on the Insurance Australia Group Annual Report 2005 (page 11).
Refer: http://www.iag.com.au/annualreport

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Part 3 - Premiums, prots and losses

How much does it cost an insurance company to run its business?

Insurance companies try and keep the costs of running their business low. This means that less of the
premiums they charge customers is eaten up in administration costs. Lower administration costs can
mean lower insurance premiums.
The cost of running an insurance company of selling and collecting premiums, paying claims and
administration costs is sometimes called an insurers combined operating ratio or COR.

IAGs Combined Operating Ratio (COR)

The sum of all claims, administration and underwriting costs as a percentage of Net Earned Premium.
120%
115%
110%
105%
100%
95%
90%
85%
80%
1998

1999

2000
Short Tail

2001

2002

2003

2004

Long Tail

Data is for Insurance Australia Group (IAG) only as at the year end 30 June 2004

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Part 3 - Premiums, prots and losses

Insurance companies requirement for capital

What is capital?
Capital is the money any company uses to invest in, to start or expand its business. In an insurance
company, capital is what the company needs to set aside or reserve in addition to the money in the
pool collected from customers who have paid their insurance premiums.
Capital gives an insurance companys customers security that the insurance company should have
enough money to pay claims covered within their insurance policies.

Why do insurance companies have capital?

Capital provides a buffer against a large number of claims occurring at the same time. This could
happen after a natural disaster, such as a large storm, earthquake or bushre.
Capital is also held to fund future growth.
Usually to determine the amount of money needed in the pool to pay claims, insurance companies
look at all the different risks of their customers and average them out.
How much capital an insurance company needs is inuenced by the type of risks its customers face.
If the loss or damage is small but happens frequently, such as car insurance claims, then the total
amount required in the pool for the claims, is easier to work out; and
If the loss or damage is larger, but happens less often, such as an earthquake or large storm,
then the total amount required in the pool for the claims is much harder to work out.
The premiums insurance companies charge customers go into the pool and pay for EXPECTED losses
(through customers making a claim) plus the administration expenses of running the insurance company.
EXPECTED losses have about a 50 per cent chance of occurring. This involves half of all customers
making a claim at the same time.
However, insurance companies must also have capital in reserve to pay for UNEXPECTED losses. That is
when the number of claims by customers is more than the expected number of claims.

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Part 3 - Premiums, prots and losses

How do insurance companies work out how much capital they need?

Usually the insurance companies prot margins from the premiums they charge customers is enough
to top up the pool when UNEXPECTED losses arise from there being many more claims from
customers than expected.

How much capital is enough?

Customers who have paid their premiums and government regulators, such as the Australian Prudential
Regulatory Authority (APRA), have the right to expect insurance companies to have enough capital to
pay claims.
This is because it is important for Australians to know there will always be enough money in the pool
to pay all claims, no matter how many claims are made.

The higher the amount reserved in capital, the greater the chance
there will always be enough money to pay claims.
It is important for insurance companies to be able to calculate and balance how much capital they
should keep.

Too little capital

Means the pool is too small and the
insurance company runs the risk of not
having enough money in this pool,
particularly if most of their customers
make a claim at the same time.

Too much capital

Means the pool is too big and the
insurance company needs to make more
money, or take away money from its
prots, to ll this bigger pool.

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Part 4 - Risk

Why insurance companies should help the community reduce risk

Helping reduce risk in the community is an important role for an insurance company.
When insurance companies help customers and the community make homes, workplaces and roads
safer, fewer people should have accidents, mishaps or losses and make fewer insurance claims. If there
are fewer claims, insurance companies should be able to keep the price of insurance premiums lower.

Insurance companies and communities working together to reduce risk may result in:
= the community understanding more about reducing risk
= fewer accidents, injuries and losses
= fewer insurance claims
= cheaper and more accessible insurance.
Insurance companies can educate the community and raise its awareness about reducing risk through:
Programs with police, neighbourhood groups, schools and authorities that:
reduce the frequency of crime;
increase awareness of better home and car security; and
encourage offenders to develop work skills.
Programs with re services, customers, schools and community groups that:
help pay for re-ghting equipment; and
develop educational material about re awareness.
Partnerships with young driver education programs and authorities about:
road and pedestrian safety; and
vehicle modications and how that may impact the safety and insurance of cars.
Partnerships with community safety groups such as:
rst aid groups that help provide training and equipment to people at work and in the
community; and
local community groups that encourage people to lead a safer and healthier lifestyle.
Partnerships with schools that:
increase students nancial literacy levels; and
increase understanding of the links between climate change and natural insurable events such
as storms, oods and bushres.

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Part 5 - Business and Community Sustainability

Sustainability and insurance companies

Sustainability for insurance companies is about ensuring they are around in the future for the benet
of their shareholders, customers, employees and the community.
Insurance companies are sustainable when they recognise a clear link between their business and the
social, environmental and economic well being of the communities they serve.
For an insurance company, a healthy and secure community is an essential part of sustainability.

Sustainability in the community

Economic
Insurance in one sense can be regarded as a community product. It makes economic and social sense
to pool effort and resources. This leads to a less risky way of life. If a society has a healthy economy,
then our resources may be used more sustainably and the social and environmental risks are reduced.

Environmental
A balanced healthy environment is very important to the sustainability of the community and to business.
Climate change has a signicant impact on the environment, communities and insurance companies.
Climate change continues with increasing amounts of greenhouse gases in the atmosphere.
This global temperature warming is creating more weather related disasters more frequently.
When storms, bushres and oods occur more frequently, insurance companies face more insurance
claims. This will result in higher premiums to cover the increased amounts of money that is required in
the pool to pay these claims.

Social and Safety

Social sustainability is linked to the health and safety of everybody in the community. A safer
community is in everyones interest.
The incidence of crime and accidents in the community directly affects how insurance companies
calculate risk and set insurance premiums.
Insurance companies have a responsibility to help create safe communities by helping people
understand and manage the risks they face in their daily lives at home, at work and on the roads.

What are some insurance companies doing about sustainability?

Insurance companies can play a signicant role in helping develop sustainable communities.
It makes good sense for an insurance company to help the community reduce social, environmental
and economic risks.
The following examples show what insurance companies are doing to build sustainability:

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Part 5 - Business and Community Sustainability

Global warming / climate change:

Why is climate change important to insurance companies?
Climate and weather have direct impacts on insurance business.
Insurance is provided to cover damage or loss caused by storms and bushres. As weather patterns
get less predictable it will be difcult for insurance companies to calculate the correct cost of
insurance premiums.
A major hailstorm in Sydney in 1999 caused enormous damage to cars and homes. Claims totalled
about $1.7 billion.
If storms like this increase in frequency, as predicted by scientic groups like the Intergovernmental
Panel on Climate Change (IPCC), then the cost of premiums will inevitably rise.
Even small increases in wind strength, such as from 93kms/hour to 111kms/hour, can increase building
damage by over sixfold.*
In the same way, there is a disproportionate increase in damage to motor cars as hail stones increase in size.*
Also, a one-degree rise in the average summer temperature results in a 17-28 per cent increase in
bushres.*
* These ndings are outlined in the Insurance Australia Group - The Impacts of Climate Change on
Insurance Against Catastrophe report. This can be found at:
http://www.iag.com.au/climatechange

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Part 5 - Business and Community Sustainability

What are insurance companies doing about climate change?

Some insurance companies have spent a lot of money and time researching climate change and the
impact it has on insurance.
The ndings from this research have encouraged insurance companies to help the community to
reduce risks caused by climate change.
Some insurance companies sponsor community education programs that:
help people understand where to build and where not to build in ood prone areas;
help governments prepare enforceable building codes;
look at reducing customers car insurance premiums if they use the train or bus to get to work
everyday rather then their car. This helps reduce pollution and, over time, global warming. It will
also decrease the number of car crashes insurance companies have to pay claims for; and
support research into climate change and distribute the ndings broadly to assist the community
understand the impacts of climate change.
Some insurance companies are also reducing the amount of pollution, waste and greenhouse gases
they produce through their internal operations.
Programs to reduce their environmental impact include using more environmentally friendly cars,
recycling paper in the ofce, installing energy efcient appliances, and minimising water use. All of
this will reduce negative impacts on our natural environment.
Companies that have recognised the benets of sustainability know that they need to set an example
if they expect to help the community reduce the risks of climate change and global warming.
An example of what an insurance company is doing in regards to climate change can be found at:
http://www.iag.com.au/sustainability

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Part 5 - Business and Community Sustainability

Energy efcient home goods replacement in the insurance claims process.

Some insurance products cover the replacement of home contents such as microwaves, fridges,
dishwashers and other whitegoods which may be stolen or damaged in occurrences such as house res.
This presents an opportunity for insurance companies to recommend products, which are more
environmentally friendly either through reduced water usage or reduced energy consumption.
This has long-term benets for the environment and reduces the amount of coal red energy needed
to produce the electricity to run these products.
This in turn reduces greenhouse gas emissions, which, of course benets the environment and reduces
the impact on climate change.

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Part 6 - Glossary

Compensation
Compensation is providing something (for instance money or payment) for a loss or as a result of a
loss. For example in the case of an injury to a person payment for lost wages while the person cannot
work or payment of medical expenses arising from the loss.

Insurance
Insurance is the idea of pooling. Insurance is when people pay an insurance premium to an insurance
company. This small amount of money goes into a pool with payments from other people to cover,
for example the cost of repairing or replacing their valuables if they are lost, damaged, stolen, or
destroyed, or to compensate a person if they are injured. Not everyone will make a claim.

Insured
Is an person or organisation who has paid an insurance premium to an insurance company, and the
insurance company has accepted to cover them by insurance.

Insurer
An insurer is the insurance company. An insurer is the company that offers protection through the sale
of an insurance policy to an insured.
The insurer, (the insurance company) must provide sufcient capital and an efcient funding
mechanism for pooling of individual risks.
The insurer should have core competencies in:
Underwriting and pricing of risks
Payment of claims covered by the insurance policy
Administration of insurance policies
Investment of pooled funds (premiums)
Claim recoveries
Capital management

Liability
Liability is when a person or organisation is responsible for something, especially in law.
Liability insurance can be designed to provide coverage for either the exposure on a business or
personal basis.

Mitigation
Mitigation is the action that reduces the chance and the severity, seriousness, or painfulness of an
accident or mishap happening.
Mitigation is also used to describe the action that reduces the effect of the accident after it happens.

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Part 6 - Glossary

Policy
A policy is the contract of insurance. It is a written agreement between an insurance company and the
insured that puts insurance coverage into effect.

Pooling
Pooling is when each member of a pool contributes to that pool. Pooling is when a group of people
share (things) in common, for the benet of all those involved.

Premium
A premium is the amount to be paid for the contract, (or policy) of insurance.
An insurance premium is an amount of money a person pays to an insurance company for an
insurance policy. This payment could be regarded as transferring some or all of the risk (or cost)
of loss or damage. The insurance company will assume, (or take on, accept, provide a cover for)
the risks of the insured (length of life, state of health, property damage or destruction, or liability
exposure) in exchange for a premium payment.
Premiums are calculated by combining expectation of loss and expense and prot loadings.

Reinsurers
Reinsurers provide insurance for insurance companies. This is a means of transferring risk from one
organisation to another.
Reinsurance enables insurance companies to absorb large losses and remove uncertainty. However,
reinsurance does not enable the insurer to accept a risk it would otherwise not accept.
Reinsurance provides protection against:
Catastrophic events
Too much risk in one policy
Reinsurance is a form of insurance that insurance companies buy for their own protection, a sharing
of insurance.

Risk
Risk is the uncertainty of nancial loss. Risk is any situation that involves the exposure to danger and
the possibility of something unpleasant or unwelcome happening.

Underwriting
Underwriting is when insurance companies manage the pool to optimise the result. Because not
all risks are the same, underwriting involves examining, accepting, or rejecting insurance risks, and
classifying those selected, in order to charge the appropriate premium for each. The purpose of
underwriting is to spread the risk among a pool of insureds in a manner that is equitable for the
insureds and protable for the insurer.

GD1128-0306

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