1. OVERVIEW
This chapter provides an introduction to the
wide range of topics which the book covers.
Emphasis is placed on the following areas:
• Importance of Insurance
• How Insurance Works
• What Insurance Is
• Functions of Insurance
• Classes of Insurance
• Historical Aspects of Insurance
• The Role of an Insurance Agent
1.1. INTRODUCTION
Human beings are exposed to various kinds of
risks in their daily lives and activities and have
to endure the consequences of such misfortune.
Misfortune can arise in many forms which,
inevitably, lead to different types and nature of
losses.
Some examples are:
• A sole breadwinner of a family is
involved in an accident and dies
prematurely. Undoubtedly, the
dependents will face two immediate
obvious forms of losses – emotional
and financial.
• The premises of a factory may be
destroyed by fire. The owners of the
factory will face, besides other losses,
the loss of income which the factory
Overview
1.1. Introduction
1.2. Importance of Insurance
1.3. How Insurance Works
1.4. What is Insurance?
1.5. Functions of Insurance
1.6. Classes of Insurance
1.7. Historical Aspects of Insurance
1.8. The Role of an Insurance Agent
1
CHAPTER 1 - INTRODUCTION TO INSURANCE
2. would have been able to generate if
the fire had not occurred. On the
other hand, those employed by the
factory may face the prospect of
redundancy and unemployment.
We can give countless examples of events
which lead to human grievances and financial
losses.
The natural question to ask then is
“What arrangement(s) can be made to
overcome or at least reduce the consequences
of misfortune that may befall any one person?”
In answering the above question, we have to
admit that not all forms of loss can be made
good or be expressed in pecuniary terms. For
instance, the emotional trauma arising from the
death of loved one cannot be made good by
any conceivable compensatory system.
Perhaps, what can be done is to devise a
compensatory system which will at least seek
- to reduce the impact of financial
loss consequent to an unfortunate
event; and
- to prepare or free oneself for the
forthcoming and unexpected financial
burden or losses.
One such possible arrangement, whereby the
financiallossisinconsequenceofanunfortunate
incident such as death or a fire, can be through
the purchase of insurance.
1.2. IMPORTANCE OF INSURANCE
The Need for Income
Every moment, individuals, families and
business units 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.
Let us consider for a moment as to what would
happen in modern society without insurance
organization.
Living costs money. Money is required to
buy essential needs like food, clothing and
accommodation, as well as to acquire other
comforts of life. If one wants to have a decent
life, one should have a continuous flow of income
as long as one is alive. This continuous flow of
income can be ensured only in two ways.
Sources 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 through investment income
by way of dividends, bonuses or interest on the
capital invested.
2
CHAPTER 1 - INTRODUCTION TO INSURANCE
3. However, both sources are always at the risk of
being affected by circumstances over which the
individual has no control.
Unfortunate Events or Risks
Earning capacity may be ended abruptly due to
death, old age, sickness or accident that may
result in disability (permanent or temporary).
Likewise, the investments 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 or all of the
loss.
The painful experience as a consequence of
losses is obvious to anyone.
1.3 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 terms “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 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
preventsuchoccurrencesbutthroughinsurance,
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 Concepts 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 1000 life assured with
identical capital sum, and a premium of RM200
is charged for each or life assured per year.
3
Figure 1.1. Concept of Insurance Illustrated
The Fund has to meet:
The contribution from the 1000 house owners
or life assured results in the creation of an
insurance fund of 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 insurer’s profit.
#1 RM 200
RM 200
RM 200
RM 200
RM 200
House owners
or term life Premiums
1000
x
RM200
=RM200,000
Claims
Expenses
and other
Outgoes
Profits
#3
#2
# 999
# 1000
CHAPTER 1 - INTRODUCTION TO INSURANCE
4. 4
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 insurer uncovered. If more
than two claims were to arise, the insurance
fund would be in deficit and clearly, the insurer
would experience a loss on this 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. It is beyond the
scope of this book to explore the question of
what could constitute an adequate premium for
a given risk; however, we will look at the basics
of the techniques and the terminology involved in
subsequent chapters. For now, let us acquaint
ourselves with the law of large numbers.
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 tends to approach the actual
loss. Although the law of large numbers is a
simple concept, it can only operate efficiently
if 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 better prediction of future losses. This is
important to insurers because they must charge
a premium (based on predicted future losses)
that will be adequate for paying losses for the
period of insurance.
1.4. WHAT IS 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 organization, seeks to provide
protection against financial loss caused by
fortuitous events.
Insurance Defined
Insurance can therefore be defined as:
An economic institution based on the
principal of mutuality, formed for the purpose of
establishing a common fund, the need for which
arises from chance occurrences of nature,
whose probability can be fairly estimated.
The insurance service, therefore, involves
payment of contracted benefits or
compensation to the insured or a third party
against unforeseen losses.
Essential Features of Insurance
The essential features of insurance, therefore,
are:
i. It is an economic institution.
ii. It is based on the principle of mutuality
or cooperation.
CHAPTER 1 - INTRODUCTION TO INSURANCE
5. 5
iii. Its objective is to accumulate funds to
pay for claims that arise as a result of
the operation of specific risks.
iv. Only certain risks can be insured
against, namely those whose
occurrence can be confidently
estimated with a certain degree of
accuracy.
1.5. FUNCTIONS OF INSURANCE
In this section we will look at the various
functions of insurance.
1.5.1. Primary Function
The primary function of insurance is the
equitable distribution of the financial losses
of the few who are insured among the many
insured. This immediately leads to the
secondary functions stated below.
1.5.2. Secondary Functions
• Stabilization of Costs
Through the purchase of insurance,
business enterprises avoid the necessity
of having to freeze capital to provide for
financial protection against losses. This
provides a means of stabilizing the costs
involved in managing risks.
• Stimulation of Business
Enterprise
The risk 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 owners were not able to transfer
their risks through insurance.
• Provision of Security for
Expansion of Business
Insurance helps to remove the fears
and worries of losses of individuals
and business executives. This removal
of fears and worries helps to establish
confidence and enables the forward-
planning of economic activities.
• Reduction of Losses
Insurers help to reduce losses (both
in frequency and security) through
their actions and recommendations in
rating, survey, inspection services and
salvage.
• Provision of a Means of Saving
Insurance functions as a means of
saving, primarily through the use of
endowment insurance.
An 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 of Capital for
Investment
Insurers accumulate large funds which
they hold as custodians and out of which
claims and losses are met. These funds
are usually invested (to earn interest)
in the public and private sectors. Such
investments help considerably in the
overall development of the economy.
CHAPTER 1 - INTRODUCTION TO INSURANCE
6. 6
• Provision of Employment for
Many
The insurance industry in Malaysia
has created various categories of
employment opportunities. Following
are the statistics for 2007:
No. of Personnel
Employed
20,600
1,162
1,844
78,587
39,165
Market Structure
1.Insurers
2.Insurance Brokers
3.Adjusters
4.Registered Life Agents
5.Registered General Agents
While the nature of jobs for brokers and adjusters
are independent and more of specialized
roles, the various job functions 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 inter-dependent.
1.6. CLASSES OF INSURANCE
The pooling of risk is the fundamental principle
underlying the insurance business and it is
useful to classify insurance business broadly
into Life Insurance and General Insurance.
What is Life 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, dependent on a human
life.
As we progress through the book, you may note
that the above definition is not precise in relation
to with profit policies, for there is no agreed sum
of money at the outset.
Life insurance contracts can be arranged to
provide cover against the following forms of
risks:
• Premature death
• Loss of a continuous stream of income
during retirement (i.e. during old age)
• Sickness or disability
What is General Insurance?
General insurance business can be taken to be
all other forms of insurance business (including
thereinsuranceofliabilitiesunderapolicyinrespect
thereof) which is not life insurance business as
defined in the Insurance Act 1996.
Risks Covered by General Insurance
General insurance contracts, to mention a few,
can be arranged to provide cover against the
following forms of risk to the insured and/or third
parties in respect of
• loss or damage to property, e.g. to
motor vehicles, ships, buildings,
stocks-in-trade;
• legal liability caused by products or
goods sold, or the process carried
out;
• death or injury to a person by an
accident.
More about the basis underlying the conduct of
the Life Insurance and the General Insurance
classes of business is provided in Part B and
Part C of this book.
CHAPTER 1 - INTRODUCTION TO INSURANCE
7. 7
1.7. HISTORICAL ASPECTS
OF INSURANCE
This section will provide a brief introduction to
the historical aspects of insurance.
The earliest beginnings of insurance were in
the field of marine insurance. Men engaged
in trade by sea attempted to minimize their
losses which resulted from the perils of the
sea, by spreading the losses amongst all who
were similarly engaged. In the normal course
of events, many ships arrived safely in port and
only a few suffered losses. The many who were
successful thus contributed to overcome the
suffering of those who were unsuccessful. In
other words, the misfortune of the unfortunate
few was borne by the many.
This was achieved by the payment of a premium
into a common fund. So much benefit followed
this action that traders adopted the idea in
many countries and gradually there came into
existence groups of men who specialized in
managing the fund and who studied the rates
of loss which occurred in different types of
maritime adventure. This was the beginning of
marine insurance.
At a much later date came life insurance and
other modern forms of insurance, all of which
worked on the principle of spreading the
losses of the few over the fund created by the
contribution of the many.
Initially life insurance policies were sold as short-
term policies, cover being renewed at the option
of the insurer at the end of the period. Such an
approach had disadvantages and perhaps,
was the only possible one that could be adopted
when there were no mortality tables.
The year 1706 marked the emergence of the
Amicable Society for a Perpetual Assurance,
which adopted a scheme under which each
member was required to contribute a fixed
sum annually. The accumulated contributions
were divided at the end of the year among
the dependents of the members who had died
during the year.
Membership was open to persons between
the ages of 12 and 45 and members’
contributions were uniformly fixed at £5 per
annum (which was increased to £6.20 later on).
In the early years of its operation the company
did not guarantee a definite sum assured but
after 1757 a minimum sum assured at death
was laid down. A variable premium based on
age was fixed only in 1807.
An important landmark in the development of life
insurance related to the use of the Mortality
Table in conjunction with compound interest
rates, when in 1762 The Equitable Assurance
for the first time fixed premium rates based
on modern lines, adopting the level premium
system.
1.7.1. Insurance in Malaysia
The beginning of insurance in Malaysia can be
traced to the colonial period between the 18th and
19th centuries when British trading firms or agency
housesestablishedinthiscountryactedasagencies
for the UK-based insurance companies, among
which were Harrison & Crossfield, Boustead, and
Sime Darby.
The insurance industry in Malaysia had been
largely patterned on the British system whose
influence still continues to be felt. Even as late
as 1955, it was reported that foreign insurance
domination of the local insurance market was as
much as 95% of the total business transacted.
After independence in 1957, however, concerted
efforts were made to introduce domestic
insurance companies. The early 1960s
witnessed the growth of a few life insurance
companies which wound up soon after because
of their unsound operations and inadequate
technical background.
CHAPTER 1 - INTRODUCTION TO INSURANCE
8. 8
Control of Insurance Business
These unhealthy features culminated in
the Government’s intervention through the
enactment of the Insurance Act 1963 to regulate
the insurance industry. This 1963 Act has since
been replaced by the Insurance Act 1996.
Since January 1997, the Insurance Act 1996
has become the principal legislation governing
the conduct of insurance business in Malaysia
1.8. THE ROLE OF AN INSURANCE AGENT
The roles of an insurance agent are:
• to bring financial relief to aggrieved
dependents of insured people who
may meet with untimely death;
• to bring financial relief in the event
of property loss;
• to inculcate the discipline of saving
amongst the working population;
• to provide other forms of
insurance-related services to the
public.
To be an effective agent, one should be able to
recognize the insuring needs of one’s clients.
Clients should be advised of the right type of
products so that they meet their insuring needs
and the policies do not lapse. Insurance agents
are expected to provide, in a sense, the best
possible advice to their clients.
It is greatly hoped that the reader will persevere
through the rest of this book and acquire the
technical and sales-related knowledge to
achieve success in his or her career.
CHAPTER 1 - INTRODUCTION TO INSURANCE
9. 9
SELF - ASSESSMENT QUESTIONS
CHAPTER 1
1. Which of the following statements is NOT true about the law of large numbers?
a. The loss exposures must be independent.
b. There must be a large number of similar loss exposures.
c. There must be a random or chance occurrence of losses.
d. There must be a large number of insureds experiencing the same loss at the
same time out of the same event.
2. Which of the following is NOT an essential feature of insurance?
a. All risks can be insured.
b. It is an economic institution.
c. It is based on the principle of mutuality.
d. It is an accumulation of funds to pay for claims resulting from a specific
risk.
3. Which of the following is NOT a risk covered by insurance?
a. loss of life due to a motor accident.
b. loss or damage arising from a motor vehicle accident.
c. liability to third parties arising from the sale of products.
d. financial loss due to a drop in the market price of a company’s shares.
4. The secondary functions of insurance will include all of the following, EXCEPT
a. risk transfer mechanism.
b. means of savings.
c. cost stabilization.
d. reducing losses.
CHAPTER 1 - INTRODUCTION TO INSURANCE
10. 10
CHAPTER 1 - INTRODUCTION TO INSURANCE
5. Life insurance contracts can be arranged to provide cover against the following
forms of risk:
I. bank loans.
II. premature death.
III. sickness or disability.
IV. continuous stream of income during retirement (i.e. old age).
a. I and II.
b. I, II and IV.
c. III and IV.
d. All of the above.
6. Amongst many other risks, general insurance contracts will cover the following,
EXCEPT:
a. property.
b. accident.
c. natural death.
d. legal liability.
7. Insurance, as an organization, seeks to provide protection against ___________
caused by fortuitous events.
a. emotional losses.
b. sentimental losses.
c. financial losses.
d. non-financial losses.
8. Which ONE of the following facts is NOT true about both life and general
insurance?
a. Life insurance policies are subject to the principle indemnity whereas general
insurance policies are not.
b. General insurance policies are subject to the principle of indemnity whereas life
insurance policies are not.
c. Life insurance policies and general insurance policies will both pay when a person
suffers permanent disablement due to an accident.
d. Life assurance is a long-term contract whereas general insurance is a yearly
renewable contract.
11. CHAPTER 1 - INTRODUCTION TO INSURANCE
11
9. The operation of the principle of the law of large numbers will ensure
a. better prediction of future losses.
b. better understanding of the market.
c. better understanding of the customers.
d. better cash flow for the insurer.
10. The essential features of insurance are:
I. It is economic institution.
II. It is based on the principle of mutuality or co-operation.
III. Its objective is to accumulate funds to pay for claims that arise as a result of the
operation of specific risks.
IV. Only certain risks can be insured against, namely those, whose occurrence can be
confidently estimated with a certain degree of accuracy.
a. I and II.
b. II and IV.
c. II, III and IV.
d. All of the above.
YOU WILL FIND THE ANSWERS AT THE BACK OF THE BOOK.
12. CHAPTER 2 - NATURE OF RISK AND RISK MANAGEMENT
12
Overview
2.1. Concepts of Risk
2.2. Related Concepts
2.3. Basic Categories of Risk
2.4. Methods of Handling Risks
2.5. Risk Management
2.6. Characteristics of Insurable Risk
OVERVIEW
This chapter focuses on risk and a detailed
discussion of the following is provided:
• Characteristics of Risk
• Concepts Related to Risk
• The Measurement of Risk
• The Management of Risk
• The Characteristics of Insurable Risks
2.1. CONCEPTS OF RISK
We live in a world in which we are continually
exposed to perils. A peril is usually a cause of
loss. Typical perils include fire, collision, flood,
sickness and premature death. When perils
occur, property may be destroyed or lost and
people injured or killed. Any loss of property or
lives will invariably lead to financial losses.
Figure 2.1. Examples of Perils and their
Consequent Losses
13. CHAPTER 2 - NATURE OF RISK AND RISK MANAGEMENT
Although we are continually exposed to
perils, we are uncertain as to when such loss-
producing events will occur. In other words, we
are uncertain about the losses we may suffer in
the future. An uncertainty regarding loss is often
termed as “risk”. Since risk exists whenever the
future is unknown, it can be said to be present
everywhere and in all circumstances. It is
present in human lives and in industry.
Measurement of Risk
Even though we are uncertain about a future
loss, it is possible to determine the chance of
loss using a branch of mathematics known as
the probability theory. The term “probability”
refers to an area of study which measures the
chance of occurrence of particular events. The
study of chance, events or probability can be
approached along three possible lines: A priori,
empirical and judgmental.
Application of A Priori Probability
A priori probability is determined when the total
numbers of possible events are known. For
example, the probability of getting a five on a
roll of dice is 1/6 or 0.1666. The priori concept
has limited practical application in the study of
risk and insurance because situations where
the possible outcomes have an equal chance of
occurrence are very rare.
Application of Empirical Probability
Empirical probability is determined on the basis
of historical data. For example, a transport
company which operates a fleet of 1000
vehicles and experiences an average of 50
accidents over the previous year has a 50/1000
or 0.05 probability of an accident occurring the
next year. The underlying concept that makes it
possible for empirical probability to be measured
accurately is the law of large numbers. (See
1.3.)
Application of Judgmental Probability
Judgmental probability is determined based
on the judgment of the person predicting the
outcomes. Judgmental probability is used when
there is a lack of historical data or credible
statistics. For example, judgmental probability
is used in insurance of nuclear plants because
of a lack credible statistics.
In practice, actual outcomes differ from
expected outcomes
In practice, an insurance company, depending
on the availability and credibility of data, uses the
empirical or judgmental probability techniques
to predict future losses. In any events, either
technique provides an estimation of the future
loss. This implies that actual outcomes may
not be the same as the expected outcomes.
For example, an insurance company which has
predicted that 30 of its insured cars may be
destroyed next year faces the possibility that the
number of cars actually destroyed may be 20,
40 and 50 or even 100. Such random variations
from predicted outcomes arise because the
requirements of the law of large numbers are
seldom met in practice.
Other Possible Definitions of Risk
Even though an insurance company has a
large number of similar loss exposures and
therefore is able to predict an expected loss, it
is nevertheless subject to uncertainly because
the actual loss may not be the same as the
predicted loss. And when uncertainly exists, risk
remains. In this respect, we can take another
step further by defining risk as the variation in
outcomes in a given situation. In addition to the
two definitions given, the term “risk” has also
been loosely referred to as
• the possibility of loss;
• the exposure to danger;
• the subject matter of insurance.
13
14. CHAPTER 2 - NATURE OF RISK AND RISK MANAGEMENT
In conclusion, it can be said that risk has
several meanings and the meaning of risk will
therefore depend on the context in which it is
being used.
2.2. RELATED CONCEPTS
Before we consider the other aspects of risk, it
is important to distinguish risk from the following
concepts:
• Loss : a reduction or disappearance
of economic value.
• Peril : a cause of loss.
• Hazard: a condition that increases
the chance of loss.
There are two major types of hazards.
Physical Hazard Defined
Physical hazard is a physical characteristic that
increases the outcome of a loss. Examples
of physical hazards include the wooden
construction of building and the poor mechanical
condition of a motor car.
Moral Hazard Defined
Moral hazard is a character defect in an
individual that increase the outcome of a loss.
Examples of moral hazards include dishonesty,
carelessness and unreasonableness.
2.3. BASIC CATEGORIES OF RISK
Risk can be classified into two major
categories:
• Fundamental and particular risks;
• Pure and speculative risks.
2.3.1. Fundamental and Particular Risks
Fundamental Risks Defined
A fundamental risk affects the entire economy
or large numbers of persons / groups within
the economy. Examples include the risk of
property damage from earthquake, flood and
typhoon (forces of nature), the risk of damage
to property, the loss of lives arising out of war,
and the risk of mass unemployment.
Particular Risks Defined
A particular risk affects individuals and not the
entire community or country. Examples include
the risk of damage to property from fire and
the risk of death or injury resulting from road
accidents
Whose Responsibility?
Because of their difference in effects, particular
risks are the responsibility of individuals whereas
fundamental risks are the responsibility of the
government and society as a whole.
2.3.2. Pure and Speculative Risks
Pure Risks Defined
Pure risk exists when there is the possibility of
either loss or no loss. Examples include the risk
of damage to property resulting from fire and
the risk of premature death.
Speculative Risks Defined
Speculative risk exists when there is the
possibility of profit, loss or no loss. Examples
include investment in the stock market or real
estate, venturing into business, and betting in
a horse race.
14
15. CHAPTER 2 - NATURE OF RISK AND RISK MANAGEMENT
Figure 2.2. The Main Characteristics of Pure and
Speculative Risks
Other Characteristics of Pure Risks
In addition to the difference in outcome, pure
risks are more predictable because it is easier
to apply the law of large numbers to such risks.
This also implies that pure risks can generally
be handled by insurance techniques, while
speculative risks are rarely insured.
2.4. METHODS OF HANDLING RISKS
In this section we will look at the methods of
handling pure risks. Basically there are four
methods of handling risks:
• Risk avoidance
• Loss control
• Risk retention
• Risk transfer
2.4.1. Risk Avoidance
Risk avoidance involves avoiding the property,
person or activity, which produces the risk.
Examples:
i. A manufacturer who is worried about a
product liability lawsuit arising from
one of his products can avoid it by not
manufacturing that product.
ii. An individual who is worried about
health problems arising from lung
cancer can avoid them by not smoking.
2.4.2. Loss Control
Loss control aims to reduce the total amount of
loss. The total amount of loss is influenced by
the frequency and severity of loss.
Frequency of loss is the number of times a loss-
producing event will occur over a given period
of time.
Severity of loss is the cost or amount of loss,
in money terms, arising from loss- producing
events.
Loss control measures handle risks by:
• Loss Prevention
Loss prevention refers to reducing the
frequency of loss, say for example, by
the use of fire resistant material in the
construction of a building to help prevent
fire losses.
• Loss Minimization
Loss minimization refers to reducing
the severity or amount of loss, say
for example, by the installation of an
automatic fire sprinkler system to help
reduce the amount of fire losses when
a fire occurs.
15
Pure Risk
Speculative Risk
Loss
No Loss
Loss
Break-even
Gain
16. CHAPTER 2 - NATURE OF RISK AND RISK MANAGEMENT
2.4.3. Risk Retention
Risk retention involves the retaining of risks by
an individual or organization. When risks are
retained, the losses incurred are borne by the
party retaining the risks. Risk retention may
be planned or unplanned. When risk retention
is planned, risks are retained deliberately.
Unplanned risk retention involves the retaining
of risks unknowingly.
2.4.4. Risk Transfer
Risk transfer involves the transferring of risks
to an organization or individual. When a risk
is transferred, the loss will be paid for by the
organization or individual to whom the risk is
transferred. There are two ways of transferring
risks.
• Insurance Contract
Example: A house owner can transfer
the loss incurred when his house is
destroyed by fire by entering into a fire
insurance contract.
• Non Insurance Contract
Example: A supermarket can transfer
potential liability arising from the sale of
a defective product by entering into an
agreement whereby the manufacturer
agrees to compensate the supermarket
from any liability arising from the
defective product.
Figure 2.3. The Risk Management Process
Identification
Evaluation
Selection
Avoidance
Loss Control
Transfer
Retention
Implementation
Control
16
2.5. RISK MANAGEMENT
Earlier we learnt that risk is ever present in our
lives and that pure risks lead to financial losses.
In this section, we will look into how risks
are managed through a process called Risk
Management.
Risk management may be defined as a
systematic approach to dealing with risks that
threaten the assets and earnings of a business
or enterprise.
The risk management process involves the
following steps:
• identifying loss exposures
• evaluating potential losses
• selecting techniques of risk
handling
• implementing the risk management
programme
• controlling the risk management
programme.
The process is represented schematically in
Figure 2.3.
17. CHAPTER 2 - NATURE OF RISK AND RISK MANAGEMENT
17
2.5.4. Implementing the Risk Management
Programme
After the selection of the most appropriate
technique or combination of techniques, the
next step is to implement the risk management
programme.
2.5.5. Controlling the Risk Management
Programme
Once implemented, a risk management
programme needs to be monitored to ensure
that it is achieving the results expected and to
make changes to the programme, if necessary.
2.6. CHARACTERISTICS OF INSURABLE
RISK
Not all risks are capable of being insured.
Risks that are insurable must fulfil certain
characteristics. The main characteristics are as
follows:
2.6.1. Financial Value
Insurance is concerned with situations where
monetary compensation can be given following
a loss. Therefore, insurable risks should involve
losses that are capable of being financially
measured. The following are some examples of
such risks:
2.5.1. Identifying Loss Exposures
The first step in risk management is to identify
all pure loss exposures including
• physical damage to property;
• business interruption losses;
• liability lawsuits;
• losses arising from fraud, criminal
acts and dishonesty of employees;
• losses arising from the death or
disability of key employees.
Loss exposures can be identified from various
sources including questionnaires, financial
statements, flow charts and personal inspection
of facilities.
2.5.2. Evaluating Potential Losses
After identifying potential losses, the next
step is to evaluate the potential losses of the
firm. Evaluation involves the estimation of
the frequency and severity of loss exposures
and ranking them according to their relative
importance. Loss exposures with high loss
potential will be given priority in the risk
management programme.
2.5.3. Selecting Risk Handling Techniques
Riskhandlingtechniquesincluderiskavoidance,
loss control, risk retention and risk transfer.
The selection of a risk handling technique may
be based on financial or non-financial criteria.
Selection based on financial criteria will consider
how the choice will affect the organization’s
profitability or rate of return. Non-financial
considerations will include humanitarian aspects
and legal requirements.
Risks Financial Measurement
i. Damage to Property Cost of Repairs
ii. Injury to Others Court Awards
iii. Death of a Life Assured The ability to pay the premium in
relation to the sum assured and his
financial standing
18. CHAPTER 2 - NATURE OF RISK AND RISK MANAGEMENT
18
2.6.2. Large Number of Similar Risks
There must be a large number of similar risks
before any one of the risks is capable of being
insured. There are two reasons for this:
• To enable the insurer to predict
losses more accurately.
• If there are only few risks, the
principle of losses of a few to be
borne by many cannot be applied.
2.6.3. Pure Risks Only
Insurance is concerned only with pure risks
because in a pure risk situation, one will suffer a
loss or incur no loss, thus there is no possibility
of profiting from a pure risk. Speculative risks
hold out the prospect of loss, break-even or
profit, and thus are rarely insured. An insured in
such a situation would be less inclined to put in
efforts to bring about a gain because the insurer
will indemnify any loss.
2.6.4. No Catastrophic Losses
For a risk to be insurable, the loss should not
be so catastrophic in nature as to render it too
heavy to be borne by an insurer. A catastrophic
loss arises when a very large number of risks
incur losses at the same time or when one risk
results in a huge loss. Examples of catastrophic
losses include losses arising from wars and
earthquakes.
2.6.5. Fortuitous Losses
Another characteristic of insurable risk is that the
loss must be fortuitous. A fortuitous loss is one
that is accidental and unintentional. Insurance
cannot function properly and efficiently if losses
are intentionally or fraudulently brought about
by the insured.
2.6.6. Insurable Interest
Generally, a person who wishes to effect
insurance must have insurable interest in the
property, rights, interest, life, limb or potential
liability to be insured. The existence of insurable
interest in contracts of insurance is one of the
main factors that differentiate insurance from
gambling. (Insurable interest will be dealt with
further in Chapter 3.)
2.6.7. Legal and Not Against Public Policy
The object of insurance must be legal and
not against public policy. A ship engaged in
smuggling or a wager on a life is not an insurable
risk because such a risk is of an illegal nature.
Fines and penalties imposed by law are not
insurable because it is against public policy to
provide insurance for such events.
2.6.8. Reasonable Premium
The final characteristic of an insurable risk is
that the premium must be reasonable in relation
to the potential loss. A risk that has a very high
probability of loss or near certainty would involve
a premium that may be unreasonable from the
prospective insured’s point of view. On the other
hand, the insurance premium required to cover
the risk of fire on a ballpoint pen worth a few
cents may be quite unreasonable in relation to
the potential loss in view of the insurer’s claim
handling expenses.
19. CHAPTER 2 - NATURE OF RISK AND RISK MANAGEMENT
SELF - ASSESSMENT QUESTIONS
CHAPTER 2
1. Which of the following is NOT a characteristic of an insurable risk?
a. It should not be against public policy.
b. It must be accidental in nature.
c. It must be a speculative risk.
d. It must be a pure risk.
2. Which of the following is the least effective approach to risk management?
a. avoiding the risk.
b. transferring the risk.
c. retaining the risk.
d. ignoring the risk.
3. Which of the following is NOT a loss prevention and loss reduction technique in fire
insurance?
a. training employees in fire prevention.
b. disposal of waste material in a proper manner and good housekeeping.
c. use of non-combustible material in building construction.
d. installation of a burglar alarm system.
4. Which of the following is NOT a loss prevention and loss reduction technique in life
and health insurance?
a. training employees in first aid.
b. avoiding cigarette smoking.
c. insuring a life for an amount in line with his financial standing in life.
d. installing grills in windows of the house in which the life assured is living.
5. Which of the following is NOT a pure risk?
a. Fire.
b. Flood.
c. Theft.
d. Operating a supermarket.
19
20. CHAPTER 2 - NATURE OF RISK AND RISK MANAGEMENT
6. Which of the following descriptions is incorrect?
a. Peril is the prime cause of a loss.
b. Hazards will influence the outcome of losses.
c. An uncertainly regarding loss is often termed as risk.
d. Moral hazard can be determined by the physical characteristics of a risk.
7. When a person stops playing football because he does not want get hurt, the risk
control method used is known as
a. loss prevention.
b. risk avoidance.
c. risk transfer.
d. risk retention.
8. The best description of a pure risk would be
a. break even, gain or loss.
b. break even or loss.
c. gain or loss.
d. loss.
9. Which of the following determines the total amount of loss under the loss control
method of handling pure risk?
I. frequency.
II. severity of loss.
III. physical hazard.
IV. moral hazard.
a. I and II.
b. II and III.
c. III and IV.
d. All of the above.
20
21. CHAPTER 2 - NATURE OF RISK AND RISK MANAGEMENT
10. The best definition of insurable interest would be
a. any form of relationship a proposer has with the subject matter of
insurance.
b. any future relationship that can come about between the proposer and
subject matter of insurance.
c. an interest that is created by having the prospect of inheriting the subject
matter of insurance.
d. the legal right to insure arising from the legitimate financial interest,which
an insured has in a subject matter of insurance.
YOU WILL FIND THE ANSWERS AT THE BACK OF THE BOOK.
21
22. CHAPTER 3 -
THE BASIC PRINCIPLES OF INSURANCE AND AN INTRODUCTION TO TAKAFUL
22
Overview
3.1. Principles of Insurance
3.2. Takaful
3.3. Shariah Supervisory Council
3.4. Takaful and Insurance
3.5. Principles of Takaful Operation
3.6. Aspects of Takaful Operation
3.7. Types of Takaful Business
OVERVIEW
The following basic principles of insurance are
covered in this chapter:-
• Insurable Interest
• Utmost Good Faith
• Indemnity
• Subrogation
• Contribution
• Proximate Cause
This chapter also provides an introduction to
takaful:
• An Introduction to Takaful
• The Shariah Supervisory Council
• Takaful and Insurance
• Principles of Takaful Operation
• Aspects of Takaful Operation
• Types of Takaful Business
3.1. PRINCIPLES OF INSURANCE
Insurance contracts are not only subject to the
general principles of the law of contract but
also certain special legal principles that are
embodied in insurance contracts.
Special Legal Principles Embodied in
Insurance Contracts
• Insurable Interest,
• Utmost Good Faith,
• Indemnity,
• Subrogation,
23. CHAPTER 3 -
THE BASIC PRINCIPLES OF INSURANCE AND AN INTRODUCTION TO TAKAFUL
Table 3.1. Subject Matter of Insurance
• Contribution, and
• Proximate Cause
3.1.1. Insurable Interest
Insurance must be supported by insurable
interest
Insurance is quite different from gambling. One
of the major differences between insurance and
gambling is that unlike the latter, insurance must
be supported by insurable interest.
Before looking at the concept of insurable
interest, it is important for readers to be familiar
with two related concepts, namely:
• Subject matter of insurance, and
• Subject matter of the insurance
contract.
3.1.1.1. Subject Matter of Insurance
In the insurance business, the subject matter of
insurance may be any property, potential legal
liability, rights, life or limbs insured under a policy.
The types of subject matter of insurance are as
varied as the types of insurance available. Some
examples of the subject matter of insurance
under the various types of insurance can be
found in Table 3.1 below.
3.1.1.2. Subject Matter of the Insurance
Contract
The subject matter of insurance should not
be confused with the subject matter of the
insurance contract, which is the financial
interest of an insured in the subject matter of
insurance. To distinguish between the two,
consider a person who has insured his house
valued at RM100,000 against fire or his own life
for RM100,000 against death. In this case, the
house or life is the subject matter of insurance
and the insured’s financial interest in the house
valued at RM 100,000 or his life is the subject
matter of the insurance contract.
3.1.1.3. What is Insurable Interest?
Insurable Interest Explained
Insurable interest is the legal right to insure
arising from the legitimate financial interest which
an insured has in a subject matter of insurance.
The phrase “legitimate financial interest” refers
to a financial interest which is recognized at
law. Thus, when a person’s financial interest
in a subject matter of insurance is not legally
recognized, he lacks the necessary insurable
interest to effect a valid insurance. It is for this
reason that a thief cannot effect a valid insurance
on the goods stolen by him nor can a person
effect a valid insurance on the life of another if he
has no financial relationship recognized by law to
that life as this would be considered wagering.
3.1.1.4. When Must Insurable Interest Exist?
For general insurance contracts, insurable
interest must exist at the beginning and
at the time of loss. Marine insurance is an
exception.
As a general rule, a person who effects a general
insurance contract must have insurable interest
at the time he enters into it and at the time of
23
24. CHAPTER 3 -
THE BASIC PRINCIPLES OF INSURANCE AND AN INTRODUCTION TO TAKAFUL
loss. Otherwise, the insurance effected is void.
However, this general rule does not apply to
marine insurance. In this class of insurance, the
insured needs only to have insurable interest at
the time a loss occurs to be able to enter into a
valid contract. For example, an importer of goods
will be able to validly arrange for insurance on the
goods he expects to import so long as he later
acquires insurable interest, that is by becoming
the owner before an insured peril happens. On
the other hand, a person cannot validly arrange
for motor insurance on a car which he anticipates
to own in the future.
Forlifeinsurancecontracts,insurableinterest
must exist at the beginning only.
In contrast, the application of insurable interest
to life insurance is quite straightforward. The
insured needs only to have insurable interest at
the time of effecting the life insurance contract.
Subsection 152(1) of the Insurance Act 1996
also makes provision for this.
Who Has Insurable Interest?
In property insurance, an owner, trustee, agent,
mortgagee or hirer has insurable interest in the
property owned, held in trust, held in commission,
mortgaged and hired respectively. On the other
hand, liability insurance can be effected by
anyone who has potential legal liability and legal
costs and expenses associated with it. With
respect to life and personal accident insurance,
a person has unlimited insurable interest in his
own life and limbs. Subsection 152(2) of the
Insurance Act 1996 provides that a person shall
be deemed to have insurable interest in relation
to another person who is
a. his spouse, child or ward being under
the age of majority at the time the
insurance is effected;
b. his employee; or
c. a person on whom he is at the time
the insurance is effected, wholly or
partly, dependent.
3.1.2. Assignment
Generally speaking, an assignment is the transfer
of rights and liabilities by one person to another.
In insurance, the transfer of all rights and liabilities
of the insured to a new insured is referred to as
an assignment of policy. An assignee, the person
who takes over the assigned rights, will have no
better rights than those enjoyed by the assignor.
Thus, if the insurer is able to repudiate liability
on any grounds against the assignor, the same
grounds may be used against the assignee.
3.1.2.1. Prior Consent
Prior consent of the insurer is needed for an
assignment to be valid.
Insurance contracts are generally referred to as
personalcontractsbecausetheinsurer’sdecision
to enter the contract depends very much on the
qualities of the insured. Thus, when an insurer
enters into a contract with a particular insured
that insured cannot assign his right in the policy
to another less prior consent of the insurer has
been obtained.
For example, the vendor of a house cannot
assign his fire policy to the purchaser unless the
insurer concerned agrees to the substitution of
the vendor to the purchaser as the new insured.
Legally, when an insurer gives consent to the
substitution of the insured by a new insured, a
new contract is created between the insurer and
the assignee of the original policy. This alteration
is termed “novation”.
3.1.2.2. Exception to the Rule
Although prior written consent of the insurer
is generally required before the assignment
of policies can be effected, there are three
exceptions to this rule.
24
25. CHAPTER 3 -
THE BASIC PRINCIPLES OF INSURANCE AND AN INTRODUCTION TO TAKAFUL
25
• Marine policies
They are freely assignable by statutory
provision in the Marine Insurance Act
1906. In practice, only cargo policies
are freely assignable while hull policies
usually contain a clause which prohibits
the assignment of policies without the
insurer’s consent.
Cargo policies are freely assignable
because they are important documents
of overseas trade and provide collateral
security to the banks which finance the
overseas trade.
• Life policies
Life policies are assignable by statutory
provisionunderthePoliciesofAssurance
Act 1867, subject to the conditions
outlined in section 23.3. of Chapter 23.
• Transfer by will or operation of law
Certain policies, for example fire policies
provide for the automatic assignment of
a policy if the transfer of interest in the
subject matter of insurance is made by
a will or operation of law.
Assignment of Claim Amount.
In insurance, the term “assignment” is also
used in the context of the assignment of policy
proceeds. An assignment of policy proceeds
arises when the insured instructs his insurer
to pay the policy proceeds to a third party.
For example, there is an assignment of policy
proceeds when an insured instructs his fire
insurer to pay the amount of indemnity (for the
damage of his house) to which he is entitled to
the repairer. In life insurance, assignment of the
policy proceeds occurs when the policyowner
names a beneficiary to receive the death benefit
under his policy. In such an assignment, the
insured remains a party to the insurance contract
and continues to assume liabilities under it even
after the assignment of policy proceeds. All
policy proceeds are freely assignable unless the
contract provides otherwise.
Part XIII of the Insurance Act 1996 deals with
the payment of policy monies under a life policy,
including a life policy under section 23 of the
Civil Law Act 1956, and a personal accident
policy, effected by the policyowner upon his
own life providing for payment of policy monies
on his death. Section 163 of Part XIII provides
that a policyowner who has attained the age of
eighteen (18) years may nominate a person to
receive the policy monies upon his death under
the policy by notifying the insurer in writing the
following details of the nominee:
a. Name,
b. Date of birth,
c. Identity card number or birth
certificate number, and
d. Address.
Such nomination shall be witnessed by a person
of sound mind who has attained the age of 18
years and who is not a nominee named under
the policy.
3.1.3. The Principle Of Utmost Good Faith
3.1.3.1. Ordinary Commercial Contracts
In most commercial contracts, there is no
need for the parties to disclose information not
requested. Each party is expected to make the
best bargain for himself so long as he does not
mislead the others. The legal principle governing
such contracts is caveat emptor (let the buyer
beware).
26. CHAPTER 3 -
THE BASIC PRINCIPLES OF INSURANCE AND AN INTRODUCTION TO TAKAFUL
26
Subsection 150(2) continues that the duty of
disclosure does not require the disclosure of a
matter that
a. diminishes the risk to the insurer;
b. is of common knowledge;
c. the insurer knows or in the ordinary
course of his business ought to know; or
d. in respect of which the insurer has
waived any requirement for disclosure.
Subsection 150(3) further states that “Where a
proposer fails to answer or gives an incomplete
or irrelevant answer to a question contained
in the proposal form or asked by the insurer
and the matter was not pursued further by the
insurer, compliance with the duty of disclosure
in respect of the matter shall be deemed to have
been waived by the insurer”.
(Read also Chapter 7 Section 7.6.2. concerning
knowledge of, and statement, by an insurance
agent.)
3.1.3.4. Material Fact
Material facts are to be disclosed by the
insured.
A material fact is a fact which will influence a
prudent underwriter in deciding the acceptance
of the risk or the premium to be charged. The
materiality of a fact depends on the nature of the
proposed insurance. For example, the alcohol
consumption of a proposer may be a material fact
to either a motor or a personal accident insurer
but the same fact is not material to a marine cargo
insurer. The materiality of a fact also depends
on the circumstances surrounding a proposed
risk. Thus, a fact relating to alcoholism may not
be material in a motor insurance proposal if the
proposer is always chauffeured.
3.1.3.2. Insurance Contracts
The insured has to disclose all important
facts regarding the risk to be insured.
Different considerations apply to a contract
of insurance. When an insurer is assessing a
proposal he cannot examine all the material
aspects of the proposed insurance. On the
other hand, the proposer knows or should
know everything about the risk proposed. This
situation places the insurer at a disadvantage.
He is not able to make a complete assessment
of the risk unless the proposer is willing
to disclose information material to the risk
proposed. To remedy this inequitable situation,
the law imposes the duty of utmost good faith
on the parties to an insurance contract. Since
the insured knows more about the risk, the duty
of disclosure tends to be more onerous on the
insured than on the insurer.
This duty can be defined as the positive duty to
disclose fully and accurately all material facts
relating to the proposed risk that a proposer
knows or is reasonably expected to know,
whether asked or not.
3.1.3.3. Duty of Utmost Good Faith
Section 150 of the Insurance Act 1996 makes
emphasis on the duty of Utmost Good Faith, i.e.
the duty of disclosure, particularly on the part of
the proposer.
Subsection 150(1) states that “Before a contract
of insurance is entered into, a proposer shall
disclose to the insurer a matter that
a. he knows to be relevant to the
decision of the insurer on whether to
accept the risk or not and the rates
and terms to be applied; or
b. a reasonable person in the
circumstances could be expected to
know to be relevant.”
27. CHAPTER 3 -
THE BASIC PRINCIPLES OF INSURANCE AND AN INTRODUCTION TO TAKAFUL
Figure 3.1. Breaches of Utmost Good Faith
Non Disclosure Misrepresentation
Breach of Utmost Good Faith
Voidable Contract
27
3.1.3.5. Duration of Duty to Disclose
At common law, the proposer is required to
disclose material facts during negotiation. The
duty to disclose material facts lasts until the
insurance contract is effected.
In general insurance contracts, the duty to
disclose is frequently extended beyond the
inception of the contract. This is usually effected
by a policy condition or continuing warranty
requiring the insured to notify the insurer of any
material changes to the risk during the currency of
the policy. During renewal the duty of disclosure
is revived simply because a renewal of policy
constitutes a new contract.
Utmost good faith is breached when a proposer
who knows or is reasonably expected to know
a material fact
• fails to disclose the material fact, or
• misrepresents the material fact.
When an insured fails to disclose a material fact,
the breach of utmost good faith is termed either
as a “non-disclosure” or “concealment”, i.e. a
fraudulent non-disclosure. If he misrepresents
a material fact, the breach is termed either as
an “innocent misrepresentation” or “fraudulent
misrepresentation”. When a breach of utmost
good faith takes place the insurance contract
becomes voidable irrespective of whether
the breach has been committed innocently
or fraudulently. However, concealment and
fraudulent misrepresentation may further entitle
the insurer to sue for damages.
3.1.4. Indemnity
The Principle of Indemnity Explained
Insurance contracts promise “to make good the
insured loss or damage”. This promise is subject
to the principle of indemnity. The principle of
indemnity requires the insurer to restore the
insured to the same financial position as he had
enjoyed immediately before the loss. The object
of the principle is to ensure that the insured, after
being indemnified, shall not be better off than
before the loss. The effect of the principle is that
the insured cannot receive more than his loss
although he may receive less than his loss as a
result of policy limitations including inadequate
sum insured, application of average, excess
and limits.
3.1.4.1. Contracts of Indemnity
General insurance contracts are contracts
of indemnity.
General insurance contracts consist of
contracts of insurance where insurable interest
is measurable, for example property, pecuniary,
andliabilityinsurancecontracts.Whereinsurable
interest is unlimited as in the case of a personal
accident insurance contract on one’s own life,
limbs or other physical attributes, indemnity is
not possible.
Personal accident and life insurance
contracts are not strictly contracts of
indemnity.
Assuch, personal accident policies are generally
not considered contracts of indemnity. For the
same reasons, life insurance contracts are not
considered to be contracts of indemnity.
28. CHAPTER 3 -
THE BASIC PRINCIPLES OF INSURANCE AND AN INTRODUCTION TO TAKAFUL
28
3.1.4.2. Measure of Indemnity and Methods
of Indemnity
Themeasureofindemnitydependsonthenature
of insurance. Generally, indemnity in property
insurance is based on either replacement
cost less depreciation, or the market value,
while in liability insurance it is measured by
the amount of court award or negotiated out
of court settlement plus approved costs and
expenses. Indemnity in pecuniary insurance
is measured by the amount of financial loss
suffered by the insured, for example in a fidelity
guarantee insurance, indemnity is measured by
the amount of financial loss suffered as a result
of an employee’s dishonesty.
The methods of indemnity include payment by
cash, repair, replacement or reinstatement.
3.1.5. The Principle Of Subrogation
The principle of subrogation provides that an
insurer who has indemnified an insured for a loss
may exercise the insured’s rights to claim from
the third party in respect of the loss. The principle
of subrogation has been developed to prevent
the insured from getting more indemnity when
he has two or more avenues to recover his loss.
For example, when an insured object valued at
RMl,000 has been destroyed by a negligent third
party the insured may have two parties, in the
absence of subrogation, to recover his loss, that
is from the insurer and the negligent third party.
If the insured recovers his loss from both parties
he would be able to recover a total of RM2,000.
To prevent the insured from making a profit out
of his loss, the insurer who has indemnified
the insured would exercise the insured’s rights
under the principle of subrogation and attempt
to recover from the negligent third party the
amount paid to the insured. Subrogation is
considered as a corollary of indemnity, that is
it is a natural consequence of indemnity. Since
subrogation arises when indemnity arises, it is
not applicable to non-indemnity contracts.
3.1.5.1. How does Subrogation Arise?
Subrogation may arise in the following ways:
• Subrogation arising out of tort
When a tort, for example an act of
negligence committed by a third party
damages or destroys a property insured
under a policy, the insured would have a
right to be indemnified under the policy,
as well as a right to recover the loss from
the negligent third party. If the insured
decides to recover his loss under his
policy, the insurer will have subrogation
right against the third party. Under these
circumstances, subrogation is said to
arise out of tort.
• Subrogation arising out of contract
Alternatively, the insured may have
incurred a loss which is not only covered
under a policy, for example a money
policy, but is also covered under a
contract entered between the insured
and a third party, that is the security
company carrying the money. The
insured therefore may be able to recover
his loss from either the insurer or the
security company. If the insured decides
to recover his loss from the insurer, the
insurer may exercise the right of the
insured to recover under the contract
Table 3.2. Classes of Insurance and Methods of
Indemnity
29. CHAPTER 3 -
THE BASIC PRINCIPLES OF INSURANCE AND AN INTRODUCTION TO TAKAFUL
with the third party security company.
Under these circumstances, subrogation
is said to arise out of contract.
• Subrogation arising out of statute
Occasionally a statute may grant a
person a right to recover a loss from a
third party. For example, the Innkeepers
Act 1952 provides that a hotel guest may
recover from the hotel owner the value
of the goods lost while in the custody of
the hotel. Assume that several valuables
belonging to a hotel guest have been
lost while in the custody of the hotel.
The valuables lost are covered under
an all risks policy owned by the hotel
guest. If the insured decides to recover
his loss from his insurer, his insurer may
exercise the insured’s right under the
statute against the hotel. Under these
circumstances, subrogation is said to
arise out of statute.
• Subrogation arising out of the
subject matter
When an insured property is totally
destroyed, the insurer will usually make
a total loss payment to an insured. After
the insurer has made the payment, he is
entitled to exercise the insured’s right in
whatever remains of the subject matter
of insurance, that is the salvage. When
the insurer takes over the salvage he is
said to be exercising subrogation arising
from the subject matter of insurance.
3.1.5.2. Modification of the Principle of
Subrogation
Subrogation can be exercised by the insurer
even before the insured is indemnified.
Inmostclassesofgeneralinsurance,theprinciple
of subrogation has been modified by a policy
condition which allows the insurer to exercise
subrogation before or after indemnity has been
made. In other words, the insurer can exercise
subrogation even before they have indemnified
the insured.
3.1.6. The Principle Of Contribution
When a loss is covered by two or more policies,
the principle of contribution provides that an
insurer who has indemnified an insured may
call upon other insurers liable for the same loss
to contribute proportionately to the cost of the
indemnity payment. Contribution is the other
corollary of indemnity, which has been developed
to prevent the insured who has two or more
policies covering the same loss from being more
than indemnified.
3.1.6.1. Essentials of Contribution
For contribution to apply, the following conditions
have to be fulfilled:
• two or more policies of indemnity
must be in force;
• the policies must cover a common
interest;
• the policies must cover a common
peril which gives rise to the loss;
• the loss must involve a common
subject matter covered by the policies.
29
Loss Caused by Third
Party to Insured
YES
NO Insured Claims
from Insurer
Insurer Acquires
Subrogation
Matter is Settled
Insured Cannot Claim
from Insurer
Insured Claims
from Third Party
Matter is Settled
30. CHAPTER 3 -
THE BASIC PRINCIPLES OF INSURANCE AND AN INTRODUCTION TO TAKAFUL
3.1.6.2. Modifications of the Principle of
Contribution
The application of the principle of contribution
can also be modified by a policy condition. In
most classes of general insurance the policy
condition usually provides that when contribution
exists, the insurer would pay the proportion of
the loss for which he is liable.
3.1.7. The Principle Of Proximate Cause
3.1.7.1. Importance of the Principle of
Proximate Cause
Onus of proof of loss rests on the insured.
Which among the many causes of losses
can be taken to be the dominant cause of
loss? This cause is the proximate cause.
When a loss occurs, the onus is on the insured
to prove that the loss in respect of which a claim
is made has been caused by an insured peril. If
the loss is the result of one cause, it will not be
difficult to decide on the question of liability.
The insurer is not liable for an uninsured or
excluded peril.
An insurer is liable for a loss caused by an
insured peril. On the other hand, the insurer
will not be liable for a loss caused by either an
uninsured peril or excluded peril. A loss may be
the result of two or more causes occurring at
the same time or one after the other. A problem
arises when the two or more causes involved
are both insured perils and excluded perils.
In such a situation, it becomes difficult for an
insured to establish the actual cause of loss.
To resolve this difficulty, the law developed the
doctrine of proximate cause based on the Latin
maxim causa proxima non remota spectatur
which means that the proximate cause and not
the remote must be looked at. Thus, when a
loss is the result of many causes the proximate
cause, that is the dominant or effective cause,
30
Figure 3.2. The Insurer’s Liability under Concurrent Causes
31. CHAPTER 3 -
THE BASIC PRINCIPLES OF INSURANCE AND AN INTRODUCTION TO TAKAFUL
must be identified and attributed as the cause
of the loss.
Points to remember:
Insured perils are perils which are expressly
covered by a policy.
Uninsured perils are perils not mentioned in the
policy and therefore not covered by the policy
unless they occur as a result of an insured peril.
Examples of uninsured perils in a fire policy are
smoke and water damage.
Excluded perils are perils which have been
expressly excluded from the policy.
3.1.7.2. Application of the Doctrine of
Proximate Cause
3.1.7.2.1. Concurrent Causes
When two or more perils including one that is
insured occur concurrently and the ensuing
loss can be separated according to their effects,
the insurer will be liable for the loss caused by
the insured peril. However, if the loss cannot
be separated the insurer will be liable for the
full amount provided there is no excluded peril
involved.
When an excluded peril is one of the concurrent
causes, the insurer is liable for the loss caused
by the insured peril only if the loss can be
separated. If the loss cannot be separated the
insurer will not be liable for the loss.
Figure 3.3 illustrates the points covered above.
3.1.7.2.2. Chain of Events
When there is an unbroken chain of events, the
insurer will be liable for the loss insured under the
policy from the insured peril onwards provided
no excluded peril precedes an insured peril.
Let us look at some examples which explain the
principles involved.
1. Examples of cases where no excluded
peril is involved:
a. A building is insured under a fire
insurance policy. The building catches
fire due to an electrical short circuit.
The local fire brigade is called and
the fire is put out within one hour
but the building and contents are
badly damaged by the fire and water
from the firefighters’ hoses.
While the electrical short circuit is
an uninsured peril, it is the proximate
cause of the loss. The insurer is
liable for any loss caused directly by
the fire and also for the losses resulting
from the water from the firefighters’
hoses because such loss is considered
a direct result of the fire.
b. While crossing a road, a life assured
is knocked down by a vehicle and
dies. The accidental collision resulting
in the death is the proximate cause
of the loss and the insurer is liable.
2. Examples of cases where an excluded
peril is involved:
a. A shop and its contents are insured
under a fire policy. A tank of acetylene
gas used for welding explodes and
causes fire to a motor repair shop.
The explosion of gas used for
commercial purposes is an excluded
peril. If the explosion (an excluded
peril) occurs before the fire (an
insured peril), the insurer will not
be liable for any loss caused by the
fire. However, if the explosion
happens after the fire, the insurer
will be liable for the fire loss before
the occurrence of the explosion.
b. A life assured is greatly depressed
and throws himself over the balcony
of a ten-storeyed building, resulting
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32. CHAPTER 3 -
THE BASIC PRINCIPLES OF INSURANCE AND AN INTRODUCTION TO TAKAFUL
in his death. His death occurs within
one year of taking out a whole life
assurance policy. As a result of the
exclusion of the suicide clause in the
policy, the insurer is not liable for
the death by suicide.
Broken Chain of Events
When there is a broken chain of events, the
proximate cause of loss is the one immediately
following the last interruption.
Example 1:
An insured has a personal accident policy. While
crossing a river he accidentally falls into it. He
then suffers a heart attack and subsequently
drowns. In this case, the drowning and not the
heart attack is the proximate cause because
there is a break in the chain of events between
the drowning and the heart attack. The insurer
is liable to pay the benefits under the personal
accident policy.
Example 2:
An insured is involved in an accident and
hospitalized but subsequently dies of a disease
unrelated to the accident. In this event the
insurer will only be liable to pay the weekly
hospital benefits arising out of the accident.
No death benefits will be payable under the
personal accident policy because the death is
caused by an excluded peril, that is a disease.
3.2. TAKAFUL
In this section we will discuss takaful, an
alternative to conventional insurance. Although
the objective of providing protection may be
similar, the actual workings of takaful differ from
conventional insurance.
3.2.1. Overview Of Takaful
All human beings are exposed to the possibility
of meeting with mishaps and disasters that
result in misfortune and suffering such as
death, destruction of property, loss of business
or wealth, etc.
Islamic teachings encourage peace,
brotherhood, and economic security of
humankind. Islam teaches us to help each
other regardless of religion. When one is facing
a misfortune others should come to help so as
to minimize the financial losses or emotional
distress. This also reflects the inherent nature
of mankind to find a solution collectively.
The same basis is used in insurance where
contribution from many help mitigate the
losses of the unfortunate few. This insurance
concept is generally accepted by Muslim jurists
and does not contradict with the Shariah or
Islamic religious laws. In essence, insurance is
synonymous to a system of mutual help.
What is Takaful?
Takaful is an alternative to the contemporary
insurance contract.Takaful is a form of insurance
based on the principle of mutual assistance.
Takaful is a noun stemming from the Arabic
verb kafala meaning to protect or to guarantee.
Essentially takaful means mutual help among
a group to support the needy within the group
through a fund contributed by group members.
The concept of takaful already existed during
the time of the Prophet when Muslims
contributed to a fund under the system of aqila
for the purpose of helping members of their
own community who were liable to pay “blood
money (diyat)” in a situation where a person
is murdered unintentionally or to pay ransom to
release war prisoners.
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33. CHAPTER 3 -
THE BASIC PRINCIPLES OF INSURANCE AND AN INTRODUCTION TO TAKAFUL
Essential Elements in Takaful
Within Islamic beliefs, the following are the
underlying concepts that drive the acceptance
of the takaful system:
• Piety or individual purification:
People are accountable to Allah and
their success in the hereafter
depends on their performance in this
life on earth.
• Brotherhood via ta’awun or mutual
assistance: Policyholders cooperate
among themselves for their common
good.
• Charity through tabarru’ or donation:
Every policyholder pays his contribution
to help those that need assistance.
• Mutual guarantee.
• Self-sustaining operations as
opposed to profit maximization:
Losses are divided and gains are
spread according to an agreed
takaful model.
The basis of mutual help in takaful is grounded
on the Islamic values of
1. sincere intention (niat) to help and
support the needy by the group
members as well as the manager of
the fund; and
2. compliance to Shariah principles
whereby business is conducted openly
in accordance with utmost good
faith, honesty, full disclosure,
truthfulness and fairness in all
dealings as well as avoidance of unlawful
elements.
3.2.2. The Formation Of Takaful Companies
In Malaysia
Malaysia is a model of an Islamic country that
is serious in implementing an Islamic economy
parallel with the conventional economy. The
introduction of Islamic financial products in
Malaysia dates back to the 1980’s with the
introduction of the first Islamic bank in the
country, Bank Islam Malaysia Berhad. The
successful introduction of Islamic banking
products paved the way for other Islamic
products in the market. The formation of
takaful companies is part of the aspiration
of the Malaysian government to establish an
Islamic financial system in Malaysia. Takaful
companies play a major role in providing
insurance based on a system of operation that
is in accordance with Islamic law or Shariah.
The Takaful Act 1984, passed by Parliament
on 15 November 1984, was enacted to
regulate the operations of takaful in Malaysia
in compliance with Shariah principles. The first
takaful company in Malaysia, Syarikat Takaful
Malaysia Berhad, started its operations in
1984.
Takaful operations have been regulated and
supervised by Bank Negara Malaysia (BNM)
since 1988 with the appointment of the BNM
Governor as the Director General of Takaful.
3.2.3. Takaful Act 1984
The Takaful Act 1984 is the source of Takaful
legislation in Malaysia. The Insurance Act 1963
forms the basis of the Takaful Act 1984.
The Takaful Act 1984 is divided into four parts:
Part I: This provides for the interpretation,
classification and references to takaful
business. Takaful business is divided into two
broad categories, general takaful and family
takaful. Those who enter the plans are called
takaful participants. Any employee retirement
scheme which pays benefit at retirement, death
or disability shall not be treated as takaful
business.
Part II: This provides the mode and conduct
of takaful business such as restriction on
the usage of the word ‘takaful’, conditions of
registration, restrictions on takaful operators, the
33
34. CHAPTER 3 -
THE BASIC PRINCIPLES OF INSURANCE AND AN INTRODUCTION TO TAKAFUL
3.4. TAKAFUL AND INSURANCE
Insurance as a concept does not contradict
the practices and requirements of Shariah.
However, Muslim jurists generally view that
conventional insurance, which is based on
exchange transaction, does not conform to the
rules and requirements of Shariah because of
involvement in the following elements either
in its buy-and-sell agreement, operations or
investments:
1. Al-Gharar – uncertainty in the
contract of insurance.
2. Al-Maisir – gambling as the
consequence of the presence of
uncertainty.
3. Al-Riba – the existence of interest or
usury in its investment activities.
The takaful system, on the other hand, is
based on mutual cooperation among members,
where members contribute to a certain agreed
fund for the purpose of sharing responsibility,
assurance, protection and assistance between
group members or takaful participants. It is a
pact among a group of persons who agree to
jointly indemnify the loss or damage that may
inflict upon any of them, out of the collected
fund.
3.5. PRINCIPLES OF TAKAFUL
OPERATION
Takaful operation incorporates the concept
of takaful that applies the concept of
tabarru’ and the principle of mudharabah.
3.5.1. The Concept Of Takaful
Takaful is a method of joint guarantee among
a group of people in a scheme to share the
burden of unexpected financial losses that
establishment and maintenance of takaful funds
and allocation of surplus, the establishment and
maintenance of a takaful guarantee scheme
fund, requirements relating to takaful, and other
miscellaneous requirements on the conduct of
takaful business.
Part Ill: This part specifies the powers vested
in Bank Negara and the appointment of the
Governor as the Director General of Takaful
in regulating takaful business, the powers of
investigation of Bank Negara and provisions
for the winding-up and transfer of business of a
takaful operator.
Part IV: This provides for the administration
and enforcement of matters such as indemnity,
submission of annual reports and statistical
returns, offences and prosecution of offences.
3.3. THE SHARIAH SUPERVISORY
COUNCIL
One of the important features of the Takaful Act
1984 and which is not provided in conventional
insurance is a provision in the Articles of
Association of takaful operators for the
establishment of a Shariah Supervisory Council
or Shariah Supervisory Board.
The function of the Council is to advise the
takaful company on its operations in order to
ensure that it is not involved in any element
which is not approved by Shariah. Members
of the Council are Muslim jurists who are well
versed in Shariah matters.
The Council is not directly involved in the
management of the takaful company but only
decides whether the company’s activities
comply with Shariah. The auditor of the
company must ensure the decisions of the
Council are followed. Decisions of the Council
must always be according to ruling by shura or
mutual consultation and agreement, and not be
based on decision by majority.
34
35. CHAPTER 3 -
THE BASIC PRINCIPLES OF INSURANCE AND AN INTRODUCTION TO TAKAFUL
2. Takaful business is not a contractual
transfer of risk. The takaful company
does not assume the risk. It is the
group of members or participants of
takaful plans who agree to jointly
guarantee against loss or damage
that may fall upon any of them.
3. The takaful operator acts as asset
manager and profit distributor on
behalf of all the participants. In a
takaful business venture, profit-sharing
follows the principle of mudharabah.
The distribution of the profit follows
a pre-agreed ratio.
4. Participants of takaful plans make
donations (tabarru’) or installments
that will be accumulated in the
Takaful Fund. This fund may be
invested in areas acceptable to
Shariah. Payments of all takaful
benefits will be paid by the fund.
5. In order to fulfill the obligations of
mutual help in the concept of
takaful, participants make an aqad
(agreement) at the outset to pay part
or the whole of the takaful contributions
as tabarru’. The agreement shall be
an aqad of helping and cooperating
and not an aqad of buying and selling.
Nevertheless, the tabarru’ proportion
defines the participant’s share of the
risk, computed using the same
actuarial principles as in conventional
insurance.
The Takaful Act 1984 divides takaful into two
broad business categories, family takaful and
general takaful.
3.7. TYPES OF TAKAFUL BUSINESS
Takaful businesses carried on by Malaysian
takaful operators are broadly divided into family
takaful business (life insurance) and general
takaful business (general insurance).
may fall upon any of them. It is a scheme that
upholds the principles of shared responsibility,
mutual help and co-operation.
3.5.2. The Concept Of Tabarru’
Tabarru’ means donation, gift or contribution. By
definition, tabarru’ is the agreement (aqad) by a
participant to hand over as donation, a certain
proportion of the takaful contribution that he
agrees or undertakes to pay, thus enabling him
to fulfill his obligation of mutual help and joint
guarantee should any of his fellow participants
suffer a defined loss. The concept of tabarru’
eliminates the element of uncertainty in the
takaful contract.
3.5.3. The Principle Of Mudharabah
Mudharabah(trusteeprofit-sharing)isdefinedas
a contractual agreement between the provider
of capital and the entrepreneur for the purpose
of business venture whereby both parties agree
on a profit-sharing arrangement.
The principle of mudharabah when applied to
the takaful contract defines the takaful company
as the entrepreneur who undertakes business
activities. The participants entrust funds to
the takaful company by means of takaful
contributions. The takaful contract specifies
the proportion of profit (surplus) to be shared
between the participants and the takaful
company.
3.6. ASPECTS OF TAKAFUL OPERATION
The important aspects of takaful operation are
as follows:
1. The takaful operator provides
various takaful plans to cover risks,
namely business risks and pure risks,
which are allowable by Shariah.
Those who enter the plans are called
takaful participants.
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36. CHAPTER 3 -
THE BASIC PRINCIPLES OF INSURANCE AND AN INTRODUCTION TO TAKAFUL
3.7.1. Family Takaful Business
A family takaful plan is a combination of
long-term investment and a mutual financial
assistance scheme.
The objectives of the plan are:
1. to save regularly over a fixed period
of time;
2. to earn investment returns in
accordance with Islamic principles; and
3. to obtain coverage in the event of
death prior to maturity of the plan
from a mutual aid scheme.
Each contribution paid by the participant is
divided and credited into two separate accounts,
namely:
• The Participants’ Special Account
(PSA)
A certain proportion of the contribution
is credited into the PSA on the basis of
tabarru’. The amount depends on the
age of the participant and the cover
period.
• The Participants’ Account (PA)
The balance goes into the PA which
is meant for savings and investments
only.
Examples of covers available under the
family takaful business are:
• Individual family takaful plans;
• Takaful mortgage plans;
• Takaful plans for education;
• Group takaful plans; and
• Health/Medical takaful.
3.7.2. General Takaful Business
The general takaful scheme is purely for mutual
financial help on a short-term basis, usually 12
months, to compensate its participants for any
material loss, damage or destruction that any of
them might suffer arising from a misfortune that
might inflict upon their properties or belongings.
The contribution that a participant pays into the
general takaful fund is wholly on the basis of
tabarru’.
If at the end of the period of takaful there is a
net surplus in the general takaful fund, it shall
be shared between the participant and the
operator in accordance with the principle of al-
Mudharabah, provided that the participant has
not incurred any claim and/or not received any
benefits under the general takaful certificate.
The various types of general takaful schemes
provided by takaful operators include:
• Fire Takaful Scheme;
• Motor Takaful Scheme;
• Accident/Miscellaneous Takaful
Scheme;
• Marine Takaful Scheme; and
• Engineering Takaful Scheme.
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37. CHAPTER 3 -
THE BASIC PRINCIPLES OF INSURANCE AND AN INTRODUCTION TO TAKAFUL
SELF - ASSESSMENT QUESTIONS
CHAPTER 3
1. Lack of insurable interest will
a. render the contract void.
b. have no effect on the policy contract.
c. render the contract unenforceable to certain extent.
d. operate only when loss is caused by an insured peril.
2. In marine cargo insurance, insurable interest must exist
a. at the time of loss.
b. before the ship sails.
c. at the time of effecting the insurance contract.
d. at the inception of the contract and at the time of loss.
3. In life insurance, insurable interest must exist
a. at the time of loss.
b. during the currency of the policy.
c. at the time of effecting the insurance contract.
d. at the inception of the contract and at the time of loss.
4. In case of breach of utmost good faith, the aggrieved party can
a. void the contract.
b. sue for damages.
c. waive the breach.
d. do any one of the above.
5. Indemnity can be provided in the following ways:
a. cash payment or repair only.
b. cash payment or replacement only.
c. cash payment, repair or replacement only.
d. cash payment, replacement, repair or reinstatement.
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38. CHAPTER 3 -
THE BASIC PRINCIPLES OF INSURANCE AND AN INTRODUCTION TO TAKAFUL
6. The contribution condition requires the insured to claim from each underwriter
involved
a. proportionally.
b. in instaments.
c. periodically.
d. annually.
7. Perils covered in the policy are known as
a. insured perils.
b. excluded perils.
c. uninsured perils.
d. exception perils.
8. Which of the following does NOT constitute a breach of Utmost Good Faith?
a. non-disclosure of material facts.
b. deliberate concealment of facts.
c. fraudulent misrepresentation.
d. claim for an insured item.
9. Which of the following is NOT an essential condition for the operation of
contribution?
a. The policies must cover a common interest.
b. The policies must involve a common subject matter.
c. There must be 2 or more policies covering different insureds.
d. The policies must cover a common peril that gave rise to the loss.
10. The legislation in Malaysia that regulates Islamic insurance is the
a. Takaful Act 1984.
b. Insurance Act 1996.
c. Central Back of Malaysia Ordinance 1958.
d. Muslim (Titles and Construction) Ordinance 1952.
YOU WILL FIND THE ANSWERS AT THE BACK OF THE BOOK.
38
39. CHAPTER 4 - THE INSURANCE MARKET
OVERVIEW
This chapter will cover:
• The Main Components of the
Insurance Market
• Other Components of the Insurance
Market
• Organization Structure of Insurance
Companies
• Centralization of Insurance Companies
as Compared to Decentralization
• Insurance Supervisory Authority and
Mandatory Associations
• Insurance Mediation Bureaus
• Other Associations
• Market Services
• Insurance Educational Institutions
4.1. THE INSURANCE MARKET
The term “market” is used for describing the
facilities for buying and selling a product. An
insurance market therefore refers to the facilities
for buying and selling insurance. Insurance, in
a broad sense, may include private insurance,
government compensatory schemes and takaful
business. In this chapter, the term insurance
shall, for practical purposes, be confined to the
market for private insurance.
Overview
4.1. The Insurance Market
4.2. Other Market Components
4.3. Organization Structure
4.4. Centralization Versus
Decentralization
4.5. Insurance Supervisory Authority
and Mandatory Associations
4.6. Insurance Mediation Bureaus
4.7. Other Associations
4.8. Market Services
4.9. Insurance Educational
Institutions
39
40. CHAPTER 4 - THE INSURANCE MARKET
4.1.1. Main Components
Like any other market, the market for private
insurance comprises the following main
components:
• Buyers
• Sellers
• Intermediaries
4.1.1.1. Buyers
The buyers of private insurance include
individual persons, associations, societies,
small business enterprises, large national
and multinational corporations, and public
enterprises.
4.1.1.2. Sellers
The sellers of private insurance are the
insurance companies. In 2007, there were 41
directinsurersandsevenprofessionalreinsurers
carrying on insurance business in Malaysia.
Insurers carrying on life business only are the life
insurers; those carrying on general business are
the general insurers, and those carrying on both
life and general businesses are the composite
insurers. Of the 41 direct insurers, there were
six life insurers, 25 general insurers and 10
composite insurers. Of the seven professional
reinsurers, five were registered to transact
general reinsurance business, one registered
for life only, and one for both general and life
reinsurance business in Malaysia.
In addition to classification by type of insurance
business transacted, insurance sellers can be
classified according to their legal forms. In this
respect, there are 48 proprietary companies
(including the seven professional reinsurance
companies) carrying on insurance business in
Malaysia.
A proprietary company is a limited liability
company with a subscribed or guaranteed
capital. Any profits made by the operations of
such a company belong to its shareholders
who are the ‘proprietors’ of the company.
The insurance business in Malaysia may
be transacted by a domestically Malaysian-
incorporated company or a foreign-
incorporated company that had an established
place of business at the time the InsuranceAct
1963 was implemented. Of the 48 proprietary
insurers and professional reinsurers operating
in Malaysia, 42 were Malaysian-incorporated
and six were foreign-incorporated.
With the enactment of the Insurance Act 1996
which came into force on 1 January 1997
(repealing the Insurance Act 1963), section 9 of
the Act provides that no person, unless he is
licensed under the Act (by the Finance Minister)
shall carry on insurance business. In addition,
section 14 of the Act provides that no person
shall apply for a licence to carry on insurance
business unless it is a public company.
If the insurance company is a private company,
it shall convert itself into a public company in
accordance with the Companies Act 1965 within
twelve months from 1 January 1997.
If the insurance company is a foreign insurer
other than a professional reinsurer, it shall
transfer its property, business and liabilities
to a public company incorporated under the
Companies Act 1965, in so far as they relate to
its insurance business in Malaysia, on or before
30 June 1998.
If the insurance company is a cooperative
society, it shall transfer its property, business
and liabilities to a public company incorporated
under the Companies Act 1965, in so far as they
relate to its insurance business, within twelve
months from 1 January 1997. Before January
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41. CHAPTER 4 - THE INSURANCE MARKET
1998, there was one co-operative society
carrying on insurance business in Malaysia. It
transferred its business to a public company in
1998.
A cooperative society is owned by the
policyholders and profits earned may be shared
by policyholders in the form of lower premium
or policy bonus. Frequently, profits earned may
be used in building up surplus to strengthen the
financial position of the insurer.
A cooperative which is incorporated as a
company is referred to as a mutual company.
Mutual companies are owned by policyholders
and profits are shared among policyholders or
used to build up surplus. Mutual companies are
common in the United Kingdom and the United
States of America.
4.1.1.3. Intermediaries
The intermediaries or middlemen in the
insurance market are composed of insurance
agents and brokers. The intermediaries’ main
function is to match the needs of buyers with
the insurance product offered by sellers.
Section 184 of the Insurance Act 1996 provides
that no person shall act on behalf of a person
not licensed under the Act to carry on insurance
business in Malaysia unless approved in writing
by Bank Negara Malaysia. Penalties for such
breach include imprisonment for three years or
a fine of RM3 million or both.
Section 184 of the Act provides that no person
shall invite any person to make an offer or
proposal to enter into an insurance contract
without disclosing
• the name of the insurer,
• his relationship with the insurer, and
• the premium charged by the insurer.
Section 186 further provides that no person shall
arrange a group policy for persons in relation
to whom he has no insurable interest without
disclosing to each person
• the name of the insurer,
• his relationship with the insurer,
• the condition of the group policy,
including the remuneration payable
to him, and
• the premium charged by the insurer.
Penalty for breach of section 186 is RM 1
million.
4.1.2. Insurance Agents
Section 2 of the Insurance Act 1996 defines an
insurance agent to mean a person who does all
or any of the following:
a. solicits or obtains a proposal for
insurance on behalf of an insurer;
b. offers or assumes to act on behalf of
an insurer in negotiating a policy; or
c. does any other act on behalf of an
insurer in relation to the issuance,
renewal or continuance of a policy.
Depending on the terms of the agency
agreement, an insurance agent may be
authorized to solicit insurance business, collect
premiums, and issue cover notes on behalf
of the insurer and is remunerated through the
payment of commission.
Since Persatuan Insurance Am Malaysia’s
(PIAM) Inter-Company Agreement on Agencies
came into effect in 1988 (now incorporated
into the Inter-Company Agreement on General
Insurance Business 1992), a general insurance
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42. CHAPTER 4 - THE INSURANCE MARKET
agent, whether individual or person or persons
corporate or incorporate, is required to pass
or be exempted from a qualifying examination
conducted by The Malaysian Insurance Institute
(MII) and be registered and licensed by PIAM
before dealing or engaging in any general
insurance business. In addition, a general
insurance agent may not at any time represent
more than two general insurance companies.
In the case of life insurance agents, they
must pass or be exempted from a qualifying
examination conducted by The Malaysian
Insurance Institute and be registered and
licensed by the Life Insurance Association of
Malaysia before dealing or engaging in any life
insurance business. It is also industry practice
that a life insurance agent may not represent
more than one life insurance company.
4.1.3. Insurance Brokers
The term “insurance broker” is defined under
section 2 of the Insurance Act 1996 to mean
a person who, as an independent contractor,
carries on insurance broking business and the
term includes a reinsurance broker.All insurance
brokers must be licensed under the Act by Bank
Negara Malaysia. In addition, section 14 of the
Act provides that no person shall apply for a
license to carry on insurance broking business
unless it is a company.
An insurance broker is an ‘agent’ who normally
acts on behalf on the insured and is normally
not tied to any one insurer. His job is to advise
his clients on the most suitable covers at the
most economic cost. Insurance brokers are
deemed to be knowledgeable in insurance
and they therefore are expected to possess in-
depth knowledge of the covers available and
the rates charged. In addition to advising clients
and placing business on their behalf, insurance
brokers may also help in presenting claims and
getting them settled. They are remunerated
through the payment of brokerage, which
is usually a percentage of the premium. All
insurance brokers operating in Malaysia must
be licensed by Bank Negara Malaysia.
4.1.4. Insurance Professionals
Underwriter
This term underwriter originated in Lloyd’s
Coffee House when merchants signed their
names at the foot of a slip to signify acceptance
of a part of a maritime risk. The term is used
to refer to an insurer or an individual skilled in
the process of selecting risks for an insurance
company.
Loss Adjuster
The term loss adjuster is interpreted under
section 2 of the Insurance Act 1996 to mean a
person who carries on the adjusting business
of investigating the cause and circumstances
of a loss and ascertaining the quantum of the
loss either for the insurer or the policyowner or
both. A loss adjuster is an independent party
appointed, usually by an insurer, when a loss
occurs.
Upon investigating the cause and extent of
the loss, a loss adjuster makes a report of
his findings and recommendations to the
principal, usually an insurer, who would then
decide whether the loss is covered and if so,
the amount of indemnity or compensation to be
paid. A loss adjuster is normally paid on a fee
or a time basis by the principal who engaged
him. All loss adjusters must be licensed under
the Insurance Act by Bank Negara Malaysia. In
addition, section 14 of the 1996 Act states that
‘No person shall apply for a license to carry on
adjusting business unless it is a company’.
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43. CHAPTER 4 - THE INSURANCE MARKET
Loss Assessor
A loss assessor is generally employed by the
insured to assess the extent of the damage
or loss settlement, and frequently assists the
insured in the preparation and negotiation of
the claim.
Marine and Cargo Surveyor
A marine and cargo surveyor is a specialist
appointed by insurers to survey ships and cargo
that have been damaged and to report on the
cause and extent of loss.
Actuary
An actuary is a business professional who deals
with the financial impact of risk and uncertainty.
He applies probability and other statistical
theories to insurance. His work covers rates,
reserves, dividends and other valuation, and he
also conducts statistical studies, makes reports
and advises on solvency.
An actuary is also skilled in the analysis,
evaluation and management of statistical
information. He evaluates insurance firms’
reserves, determines rates and rating methods,
and determines other business and financial
risks.
Risk Surveyor
Where a risk insured is substantial in amount,
insurance companies would normally engage
the services of a risk surveyor to become
its ‘eyes and ears’ in evaluating the risk. The
risk surveyor will prepare a survey report
detailing all the necessary information needed
by the underwriter in evaluating the risk. Risk
surveyors are normally employed by insurance
companies.
4.2. OTHER MARKET COMPONENTS
4.2.1. Reinsurers
Insurers frequently reinsure or cede part of each
risk underwritten by them so that the burden
of paying claims, particularly those involving
large amounts, will be shared by the reinsurers.
Reinsurance, therefore, is the insurance which
insurers purchase to cover risks underwritten
by them just as individuals purchase insurance
to cover risks they assume. An insurer can
purchase reinsurance from the following:
• professional reinsurance companies,
i.e. reinsurance companies that do
not accept business direct from the
general public, e.g. Malaysian
Reinsurance Berhad (Malaysian Re);
• direct insurers who underwrite
reinsurance business together with
direct business.
4.2.2. Service Specialists
Service specialists provide support services to
insureds and insurers. They include doctors,
hospitals, engineers, marine and cargo
surveyors, loss adjustors, investigators and
assessors.
Doctors
Where a medical examination is required before
a risk is accepted, it is usual for the insurer to
arrange for the life proposed to see a doctor
from the insurer’s panel of examiners.
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