Study Book Insurance I

Study Book for the Insurance IndustryVolume 1 – Basic principles

A project of the East European Committee of the GDV

The study book consists of the volumes

Volume II – Basic PrinciplesVolume II – Classes of insurance

Published by the Berufsbildungswerk der Deutschen Versicherungswirtschaft(BWV) e.V., in Munich on behalf of the East European Committee of the GDV(GDV e.V.), Berlin

Responsible editors

Dirk CzayaPetra FleckKatharina HöhnMichael Theilmeier

Authors of this volume

Georg ErdmannGerhard MayrEsther Grafwallner

© 2010 Berufsbildungswerk der Deutschen Versicherungswirtschaft (BWV) e.V.

This book including its parts is protected by copyright.Every use that is not expressly allowed by copyright law requires the previouspermission of the publisher.

Satz hgk:fotosatz Weingarten/Baden

2

Foreward

This study book was initiated as a project of the German Insurance Association(GDV). The authors, who have written the chapters on a voluntary basis, are expertsfrom the German insurance industry. The GDV makes this study book available topartner associations, supervisory authorities as well as other institutions in coun-tries where there is an interest.

The purpose of the study book is to enable the staff of insurance companies toacquire a basic knowledge of insurance interrelationships. Complex facts are alsopresented for new entrants into the industry. This book addresses staff who areinternally employed as well as those with customer contact.

The facts are based on European law and describe the implementation into Germaninsurance law in an exemplary fashion.

The study book, which is available in a German and English version, is divided intothe two parts:

Volume II Basic PrinciplesVolume II Classes of insurance

We hope that all readers obtain many insights as they read and with them muchsuccess in transferring these to the workplace. We are grateful to all the authors fortheir voluntary contribution to this work.

Munich and Berlin in August 2010

Foreward 3

Contents

1 Basic principles of the insurance industry ...................................................... 5

1.1 Risk management ............................................................................................... 61.2 Financial coverage of the risk ............................................................................ 121.3 Classification of individual and social insurance ............................................. 161.4 Importance of private insurance ....................................................................... 221.5 Cost accounting .................................................................................................. 26

2 Organization of the insurance industry ........................................................... 30

2.1 Legal forms of insurance companies................................................................ 312.2 Co-operation and concentration in the insurance industry ............................ 352.3 Separation of insurance classes........................................................................ 382.4 Structure of the organization............................................................................. 392.5 Organization of workflow................................................................................... 442.6 Methods of distribution in the insurance industry .......................................... 45

3 Legal basis of the insurance contract .............................................................. 52

Overview of the new German Insurance Contract Law................................... 533.1 Introduction......................................................................................................... 543.2 Legal sources ...................................................................................................... 553.3 Insurance conditions .......................................................................................... 573.4 Persons involved ................................................................................................ 583.5 Conclusion of the insurance contract ............................................................... 623.6 Commencement, duration and termination of the insurance contract.......... 713.7 Duty to pay the premium ................................................................................... 813.8 Obligations .......................................................................................................... 853.9 The insurer’s duties ............................................................................................ 893.10 Possibilities for the policyholder’s complaints and asserting his will............ 92

4 Insurance practice and statistics ...................................................................... 94

4.1 Insurance risk ...................................................................................................... 954.2 Basic principles of the premium calculation .................................................... 974.3 Emergence and distribution of surpluses......................................................... 994.4 Insurance accounting ......................................................................................... 1044.5 Insurance mathematics and actuarial science ................................................. 1124.6 Fundamentals of claims handling ..................................................................... 116

5 Coinsurance and reinsurance............................................................................ 117

5.1 Functions ............................................................................................................. 1185.2 Coinsurance ........................................................................................................ 1185.3 Reinsurance......................................................................................................... 120

6 Cost accounting and results accounts............................................................. 131

6.1 Tasks and terms .................................................................................................. 1326.2 Contribution margin accounting ....................................................................... 142

7 Controlling .......................................................................................................... 148

7.1 Nature of controlling .......................................................................................... 1497.2 Strategic and operative controlling................................................................... 1507.3 Controlling instruments ..................................................................................... 151

4 Contents

1Basic principlesof the insurance industry

byDr.Georg Erdmann

1.1 Risk management

Herr Otto Müller is the proprietor of a carpenter’s shop. He is thinking about whatrisks threaten his business, his private home and himself. Basically, every entrepre-neur and every private person must think about these problems. It must be the aimto minimize such risks and if necessary to pay a premium to transfer them.

The planning, execution and control of security measures of all kinds is called riskmanagement. The choice of these words indicates that these risks must be control-led. It is necessary to recognize and then control them.

For private households risk management is simply part of housekeeping. In the caseof companies the responsibility rests either with the management or in special de-partments. It is important that the whole business and all the staff should be securityconscious. The starting point of all risk management considerations are the risksand their consequences if they occur. It is necessary to analyze each risk separatelyand consider if it can be controlled.

1.1.1 Security, risk, insecurity

Perils threaten security. In normal speech “peril” means the possibility that some-thing economically unfavourable will occur. Instead of the word “peril” the term“risk” is often used in the same sense. They are semantically basically the same. Inthe science, however, three terms are used

� Security (“We know what will happen in the future.”),

� Risk (“We can measure the occurrence of future situations with probabilities.”),

� Insecurity (“We do not know what will happen in the future.”) or (“We cannotmeasure the occurrence of future situations with probabilities.”).

There are many different perils. They can lead to damage to belongings, strikepeople down by illness and death, or lead to considerable claims for damages in theevent of carelessness.

6 Dr. Georg Erdmann

Perils threaten:

People Property Pecuniary

by damage, destruction, loss,e. g. by

Unexpected financialexpenses for

� sickness� accident� death� disability

� fire� burglary� machinery breakdown� tapwater

� indemnification� legal expenses� continuation of wages

after a fire

For private persons and households, on the one hand, and companies, on the other,there are different risks. Companies are also exposed to the danger of property andpecuniary losses. More especially they are threatened by the so-called entrepreneu-rial risk, which includes the possibility that losses arise from the economic environ-ment, from fluctuations in economic activity, from changes in the market and vari-ations in customer behaviour.

Basic principles of the insurance industry 7

entrepreneurial risk

uninsured

pecuniary loss

property damage

Moral hazards Physical hazards

are based directly on human behaviour– arson– carelessness when welding– dangerous driving

are generally not influenced by humanbehaviour– lightning– natural disasters

They are different depending on how they arise

1.1.2 Losses

The occurrence of a threatening event leads to a loss. Loss means, therefore, theascertainment or realization of the threatened peril.

Material damage Intangible damage

is immediate financial loss for theinjured party– because of loss of assets– because of expenses incurred

affects the wealth directly because of– pain after an accident– loss of a close relative

Property damage can affect the wealth of the aggrieved party in two ways:

8 Dr. Georg Erdmann

Bodily injury Property damage Pure financial loss

Injury or death of aperson

Loss, damage ordestruction of an object

Reduction in the wealth itself(bad advice by a lawyer ornotary, which leads to financialloss)

Material damage or financial losses can occur with a person or an object or with thewealth as such. Accordingly, a distinction is made between bodily injury, propertydamage and financial loss.

1.1.3 Analysis and control of risks

Loss prevention is an important task because of the many threatening risks and thelosses associated with their occurrence. A precondition for all security measures isthe timely recognition of risks (perils). The function of familiar street signs as dangersignals serves this purpose, for example. They warn of the need to be prepared forthe looming peril.

Risk avoidance is part of the security policy of the state to protect its citizens. Thereare many legal rules to this effect: traffic laws, fire protection, commercial andhealth police regulations.

But also every private person and every company is concerned to take measuresagainst threatening perils. As risk management such measures are of particularimportance in businesses, because technology, industrialization and scientific prog-ress create new sources of danger all the time.

The analysis and handling of risk is generally called risk management. This ap-proach consists of several stages. The process of risk management consists of threedifferent steps:

1) Risk analysis and evaluation

2) Handling of risk

3) Risk control

Unplanned expenses Loss of sources of income

– replacement of household goods– motor vehicle repair– doctor and hospital expenses

– death of the breadwinner– disability– unemployment

Re 1) Risk analysis and evaluation

In the beginning there is always a risk analysis. The carpenter has to examine whichperils threaten his business, his household as well as himself and his family mem-bers. This risk analysis process is composed of three different areas.


Risk analysis process

Risk recognition Quantification of risks Root cause analysis

It is only possible to get a grip on risks and deal with them if they and their causeshave been recognized. Consequently, the carpenter has to examine systematicallywhich events threaten his business. The following events are conceivable:

– A fire destroys the building and the complete plant and equipment including sto-res of wood.

– Valuable furniture is stolen

– A storm strips off the roof and rain makes the wooden products unusable.

– A valuable machine needed for the production is suddenly no longer available.

– An important customer becomes bankrupt so that bills are not paid.

Not only the detection of possible perils is part of risk analysis but also the valuationof the whole business. This is called the quantification of risks.

There are two ways of achieving this.

The carpenter will first of all inquire about the frequency of occurrence of particularevents. Have there been many fires in this business? How frequently have importantmachines broken down? Has the workshop been plagued by thieves?

Furthermore, it is also very important to know what damage the individual risks cancause if they occur. From this point of view they can be divided into three differentdanger classes:

– Catastrophic perils such as, for example, the complete destruction of the businessby fire

– Perils that threaten the existence of the business, such as, for example, the break-down of a machine or the failure of an important customer

– Perils that do not threaten the continuation of the business, such as, for example,the breakage of glass as a result of a storm

The measures to establish the level of the resulting damage are the reinstatementcosts as well as the loss of profits for the business. Besides the recognition andquantification of the risks, within the framework of an analysis it is necessary toestablish their causes.

Risks can have their origins in the business itself, because, for example, there is alack of organization, the staff lacks risk awareness or the fire protection installationis inadequate. But risks can also have their origins outside the business, as forexample, natural forces or the insolvency of important customers.

Re 2) Dealing with risk

The most important task of risk management is to deal with the risks after they havebeen analyzed. To this end appropriate wide-ranging measures must be decided on,carried out and controlled. Dealing with risks is thus divided into three areas.

10 Dr. Georg Erdmann

Dealing with risk

Alternative courses of action Decision Execution

After the proprietor of the carpenter’s shop has achieved a clear overview of thesituation by means of a risk analysis, with a risk management approach he canchoose between different courses of action. The master carpenter decides on thefollowing possibilities:– Risk retention– Risk avoidance or containment– Financial transfer of the risk

Entrepreneurs and private persons can retain the threatening risks themselves with-out taking any measures regarding their avoidance, containment or financial trans-fer. They assume that they will not be subject to the perils or that their occurrencewill not destroy their financial existence. Such a decision is very rare, becauseeveryone knows that businesses and all personal belongings can be completelydestroyed by fire or natural catastrophes.

Security and protection measures are possible alternatives by which the occurrenceof particular perils should be avoided or the degree of loss reduced. Since humanexistence and the economy necessarily involve perils, there is no general risk exclu-sion. Rather, risk avoidance can only be considered for limited areas.

Preventive measures to avoid risk can only apply to the time before the loss occursas well as its subsequent containment. The laying off of risk by means of relevantagreements with the contractual partner, splitting and spreading risk are also part ofrisk avoidance.

Risk avoidance Risk containment

by means of preventive measures

Risks cannotbe generallyexcluded

For limited areas it ispossible to– transfer risk by

excluding liabilitycontractually

– Split a risk bysub-contracting

– Spread riskby distributingthe assets overseveral types ofinvestment

Against the occurrenceof the risk (realizationof the peril)– Alarm system– Accident prevention

equipment– Inspection of

technical plant– early detection

measures

To contain the loss(minimization)– Company fire

brigade– Emergency

powergenerator

– Detection andrescue sytemsfor trafficaccidents

– Fire walls


Since risks cannot be entirely avoided and can only be reduced to a certain degree,financial safeguarding by means of a series of early measures within the frameworkof risk management is very important. The decisions with respect to these mattersvery often consist of a combination of measures. Thus a business will, for example,take the necessary safety measures against fire, burglary and accident, but alsocarry part itself in order to save premium if necessary and to this end set up thereserves needed, so that when a loss occurs it can be paid.

Re 3) Risk control

Subsequent to the stages of risk recognition and dealing with risk within the frame-work of risk control it is necessary to establish whether the desired targets could beattained with risk management, in order to receive suggestions for improvement forfurther risk management procedures.

1 Peril = Possibility of the occurrence of the loss

2 Nature of the threat

Persons Property Pecuniary

3 Reason for occurrence

Subjective preconditions Physical preconditions

1 Loss = realization of a threatened peril

2 Types

Persons Property Purely financial

3 Results– unplanned expenses– loss of income

1 Need for security measures2 Carrier: state, private persons, enterprises3 Risk management route:

Dangers– Recognition– Avoidance– Reduction– Financial transfer (precaution)

4 Combination of different measures depending on the particular situation

Summary

1.2 Financial coverage of the risk

Despite all safety measures the realization of perils and thus the occurrence of los-ses cannot be avoided. For this reason private households and economic enterpri-ses are forced to take precautions to mitigate the economic effects by means ofcomplete or partial compensation.

There are different types of protection which can be employed by private house-holds and economic enterprises. They differ according to their carriers and precon-ditions.


Possibilities for financial precaution

– state benefit– individual self help– insurance

1.2.1 State benefits

State benefits can be claimed under certain circumstances in most countries.

The cases are very limited, however, because in a mixed economy the emphasis ison each individual taking responsibility for making his or her own provision. Only inexceptional circumstances should tax funds be employed for such purposes. Yet inthe event of catastrophes there is often a national programme to help the victims.Incidentally, for social political purposes the state makes use of insurance, especial-ly social insurance.

For individuals, private households and economic enterprises the following statebenefits are also of significance:

Subsidies Provision Social welfare

Measures to support theenterprise in the form oflost allowances, credits,pledges and guarantees

Claims of a particulargroup (especially civilservants, soldiers, warvictims) because of thefiduciary duty of theiremployers

State support for those ina situation of need, whichprevents them leading adecent life and which theycannot change by their ownmeans and efforts

The provision of these state benefits generally differs from country to country. Sofor example, the social state in Germany is much more developed than in GreatBritain. The provision of state benefits is provided as a rule on the basis of certainobjective criteria to those who fulfil them.

1.2.2 Individual self help

The simplest means of individual protection for private persons and households issaving. By consuming less, money is collected which is available for future financialneeds. However, savings can never replace insurance protection against the occur-rence of uncertain events. Savings accumulate gradually and are not freely avail-able, whilst at any time there could be a need for money to pay for losses.

Also enterprises are not in a position by building up reserves to have adequatesums available to pay for the economic effects of losses. Such a procedure is eco-nomically unsuitable, because such risks are incalculable in the individual case. Fur-thermore, resources which might not be needed would be tied up inefficiently.

Nevertheless, savings and reserves are also a necessary form of protection in addi-tion to taking out insurance. Not all private and business risks can, namely, be co-vered by insurance. The entrepreneurial risk is in any case only to a limited extentinsurable. There is no insurance cover, for example, for the replacement and rene-wal of objects subject to wear and tear, such as machines, clothing or motor vehic-les.

Savings must also be available if a policyholder quite consciously does not comple-tely insure against all possible losses. Whoever agrees to a deductible in motor orhealth insurance achieves a lower premium by doing so, but in the event of an insu-red loss he must pay the amount that is not covered himself.

1.2.3 Insurance of risks

A very suitable and thus very widespread way of financial protection against contin-gent need, which becomes reality if the threatened peril happens, is insurance. Itprovides benefits in accordance with the insurance classes if particular events suchas fire, burglary, storm, hail, sicknesss, unemployment or death occur. The extent ofthe insurance protection depends on the particular legal requirements or by con-tractual agreement in the individual case.

The means to pay for the insurance benefits are provided by the insured by meansof premiums or contributions. All expenses have, therefore, to be covered by theappropriate contributions. This financial procedure is called the insurance principle.

Insurance differs from saving or the building up of reserves in that its benefits arenot limited to the saved resources of the individual insured. Rather, risks are spreadover a large number of insureds.

Insurance is different from savings protection in that it is not limited to a narrowcircle of people who have a right to protection, and it offers not only to basic protec-tion, but also complete indemnity. Insurance differs from social welfare in that theclaimant’s need for help is not a precondition and it offers complete compensationfor the economic results of losses.

Insurance offers complete insurance protection right from the beginning withouthaving to save the money that would be needed to pay for a claim. By paying hispremium the insured achieves a legal right to the complete insurance benefit thathas been agreed.


Insurance can take two forms:

– Individual insurance is an economic branch and is based on the principle of bene-fit and benefit in return. (Principle of equivalence)

– Social insurance is a part of the state’s social policy and has the purpose of socialequilibrium by means of the contributions. (Principle of solidarity)


Financial protection

Forms Need check Financing

SavingProtectionSocial welfareInsurance

NoNoYesNo

Saving moneyTax revenueTax revenueContributions of the insured

1.2.4 Term of insurance

Insurance is characterized by the following features:

1. Covering a need for money

2. Uncertainty, but the need can be estimated

3. Spreading economic risk over many entities

Re 1. Covering a need for money

It is the task of insurance to place at disposal the means to cover a possible needfor money. This need is triggered by the occurrence of a threatened peril and thenecessity to compensate for the economic results.

The need that arises must be a financial need. That is, it must be quantifiable in mo-netary terms. This is always the case when there are economic losses such as thedestruction of assets by fire. Consequently, objects are not insurable for whose va-luation there are no objective criteria, such as a family photograph or the letters of adeceased relative.

The level of need which should be covered by insurance can be calculated in diffe-rent ways. In this way a distinction is made between concrete and abstract need.

Concrete need Abstract need

This depends basically on the size ofthe loss that occurs (stolen items, carrepair costs, burnt down building).

It is decided by the policyholder himself,in that he fixes the sum insured for lifeinsurance or daily benefits in the accidentor health insurance.

Re 2. Uncertainty, but the need can be estimated

The monetary need must be uncertain. The occurrence and extent of the insuredevent must not, therefore, be known. It must occur fortuitously. Admittedly, every-one is exposed to perils: it is nevertheless uncertain when and to what extent theyactually occur.

An event is fortuitous,

– if it is not known whether it will occur at all: e.g. a hailstorm or an accident,

– if it is known that it will certainly occur, but the timing is uncertain, such as thedeath of a person in life insurance.

An insurance company can offer cover for perils only if the need for financial com-pensation can be estimated. Consequently, certain statistical documents are neededfor the premium calculation.

Re 3. Spread of risks

Insurance is based on the assumption that the perils threaten all persons, house-holds and economic enterprises, but that only a few of them will be actually affec-ted. For this reason we speak of spreading risks in the community of policyholders.The insurer takes responsibility for the individual risks in return for a premium,whereby the total premium income must be sufficient to pay for the losses that oc-cur and cover the expenses.

Furthermore, risks can be spread over time, for example, by setting up reserves forthe need to pay claims in the case of annually fluctuating claims experience, such asin the hail or storm insurance.


Many persons threatened by perils(policyholders)

Premiums

Insurance business

Paying out the insurance benefits to the policyholder or injured third parties

There must be a balance between the premiums of the policyholder, on the onehand, and the claims benefits and expenses [of the insurer], on the other. This needfor a balance is called the principle of insurance equivalence.

Premiums Claims benefits

Expenses

To achieve a spread of risks insurance companies use the statistical experience ratewhich is commensurate to the loss occurrence according to the values resultingfrom the probability calculation. Using further insurance techniques other methodsare used to spread risk, such as safety loadings in the premium calculation, coinsur-ance or reinsurance. The provision of insurance protection is an entrepreneurial ser-vice. From a legal point of view insurance is a promise of a benefit for the contin-gency that an insured peril occurs.

Because this kind of service appears particularly complicated and intangible onaccount of the mathematical preconditions and the need for a precise legal delimi-tation of the extent of cover, it is particularly important that insurance companiesand their staff perform their tasks in a consumer friendly way. The circle of personsinsured by an insurance company should not be called a risk-bearing community asoften used to be the case in the past. They are customers of the insurance company,who must be treated as individually as possible.


Ways of providing financial protection Insurance features

Saving:Limited amount of money to pay forlosses

Cover of the need for money

– concrete need – abstract needSocial welfare:Basic provision for emergencies

Provision:Number of candidates limited by law

Uncertainly about the assessmentof the need– Fortuity– Statistical documents

Insurance:Economic effects of losses made upfrom premiums

Spreading of risk over many entitiesCoverage of the insurance benefits andexpenses by means of premiums

Summary

1.3 Classification of individual and the social insurance

1.3.1 Demarcation of individual and the social insurance

In most countries insurance is divided into the two large fields of individual and so-cial insurance. There are considerable differences between the two areas. Consider-ing the range, social insurance in Germany provides only basic provision. Further-more, its purpose is restricted to the insurance of risks connected with theworkplace. For this reason statutory accident insurance covers only accidents at andon the way to work, not accidents which occur in leisure time, while engaged insport or at home.

Individual insurance provides insurance protection in all the areas not covered bysocial insurance. In addition, it is possible in some cases to avoid contributing tosocial insurance by taking out a private insurance policy – for example, for studentscovered by statutory health insurance. Furthermore, individual insurance comple-ments the benefits provided by social insurance and supplements them by:

– Additional benefits to those of statutory health insurance

– Life insurance to augment the statutory pension

– Private accident insurance

– Private long-term care insurance.

The interaction of individual and social insurance is especially clear with respect toprovision for old age. According to the so-called three pillar concept, their founda-tion is statutory pension insurance, company pension schemes and private life in-surance. Life insurance in particular serves the purpose of extending and increasingthe basic cover provided by statutory pension insurance.


Feature Social insurance Individual insurance

Creation ofthe insurancerelationship

According to lawCompulsory insurancefor occupations with a dutyto insure

Agreement by taking outan insurance policy

Insured risks Sickness, workplaceaccident, disability,provision for widows andorphans, unemployment,long-term care(risks of the person)

All insurable perils(natural and legal persons)

Legal form Social insurance carriersas institutions or publiccorporations with autonomy(participation of the insureds)

Private and public statutoryinsurance companies

Premium rating Depending on the incomeof the insured(principle of solidarity)

According to riskand benefit(principle of equivalence)

Benefits Legally uniformlydetermined

Freely negotiable

Summary

1.3.2 Individual insurance

Individual insurance is understood as being the insurance sold by private insurancecompanies. And so instead of the word “individual insurance” the expression “pri-vate insurance” is often used. In the field of individual insurance contracts are takenout on an individual basis according to the needs of the individual case. The premi-ums are calculated by the companies on economic principles and are appropriatefor the risk as well as the benefit offered.

Private persons, households and companies seek protection within the frameworkof individual insurance against the economic effects of the most varied types of loss.This insurance cover is offered by many classes of insurance which are based onlegal and insurance techniques.

1.3.2.1 Classes of insurance

The word “Versicherungssparte” (class of insurance) can be explained by compar-ing insurance protection to a tree, in which the individual branches indicate theinsurance classes. Instead of “Sparte” the word “Branch” is also used, although thisexpression should be reserved for the term “Wirtschaftssparte” (economic class).

It is difficult to get an overview of all the individual classes of insurance. Their num-ber is large. Nevertheless, they are not all equally important. Some branches pro-duce only a small premium income and are only sold by a few companies.

Breakdown of the gross premiums according to class of insurance 2007

Class of insurance Gross premium in € 1,000m

Life insurance 83.4Private health insurance 31.5Motor insurance 20.1General liability insurance 6.8Personal Accident 6.4Buildings insurance 4.7Legal expenses insurance 3.2Contents insurance 2.6Transport insurance 1.7

Source: German Insurance Association (Publisher): Year Book 2009 – The German insuranceindustry Page 51

Within a class of insurance, broadly similar risks are bundled together that are in-sured against the same perils. This aggregation makes it possible to calculate a fairrisk premium due to statistical documentation and to create unified policy terms andconditions for each class of insurance, in which the extent of the insurance cover aswell as the rights and duties of the contractual partners are regulated.


Insurance of buildings and goods and chattels against the peril of fire = fire insur-ance

Insurance of persons against expenses in the event of sickness = health insurance

Insurance of persons against liability for indemnification = liability insurance

Insurance of contents against fire, burglary, robbery, vandalism, tap water, stormand hail perils = contents insurance

Insurance branches are further sub-divided into types of insurance according to theinsured risks. In these cases they are subdivisions of an insurance branch. Severalinsurance types create a branch of insurance.


Insurance branch Insurance type

Motor insurance Motor liability insuranceMotor hull insuranceMotor accident insurance

Liability insurance Personal liability insurancePublic liability insuranceProfessional indemnityLiability for financial loss

Fire insurance Simple fire insuranceAgricultural fire insuranceIndustrial fire insurance

There are insurance companies which sell several branches together: for example,the classes property and liability, accident and motor insurance. They are known asmultiline or composite insurers. Among them one has to distinguish between mo-noline or special insurers, which have restricted themselves to the sale of one classof insurance. This specialization can be for strategic reasons (e.g. transport insur-ance) or be due to a supervisory requirement (e.g. life and health insurance).

1.3.2.2 How individual classes of insurance can be classified

The individual classes of insurance can be subdivided according to different criteria.They can be classified according to the type of insurance benefit, the insured objectand the need covered.

Subdivision according to insurance benefit

Indemnity insurance Fixed benefit insurance

Insurance benefit:Compensation for loss.The insurer has to replace the actualloss, insofar as it is covered by the suminsured.Case of actual demand covered.

Insurance benefit:Payment of the agreed sum insured.There are no objective measures forthe insurance value.

Case of abstract demand covered.

Example of indemnity insurance:

The policyholder insures an object worth € 50,000 for € 100,000. In the case of a to-tal loss the insurer indemnifies only the actual loss of € 50,000. If the policyholderinsures an object worth € 100,000 for only € 80,000, the indemnity is limited to thesum insured, because he has only paid the premium for the lower sum.

Example for fixed benefit insurance:

The policyholder chooses a sum insured of €100,000 for the sum insured. There areno restrictions if there is a claim.


Classification according to the insured object

Insurances of the person Non-life insurance Financial insurance

The risk consists of anactual person. Financialloss is indemnified.

Individually indicatedobjects (buildings orgoods and chattels) areinsured in the insurancepolicy. Single or severalperils can be insured.

The insurance relates tothe wealth as a whole,not to single objects.Reduction of wealth isinsured (e. g. because ofexpenses due to a courtcase or the liabilityclaims of third parties).

– Life insurance– Health insurance– Accident insurance

– Property insurance– Storm insurance– Household insurance

– Liability insurance– Legal expenses

insurance– Credit insurance

1.3.2.3 Summary of the insurance classes of private insurance

Dividing insurance protection into insurance classes may cause gaps in cover forthe policyholder, which can be avoided by combined insurances. At the same timethey serve the purpose of simplifying the work, because only the acceptance of aproposal and the issue of a policy are necessary. We must distinguish between com-bined insurance and insurance package policies.

Combined insurance Insurance package policies

Coverage of a majority of perils on thebasis of one set of policy conditions inan insurance contract. A new class ofinsurance is created by this combination.There is one premium rate. The policycan only be cancelled as a whole.

Consolidation of several insurancecontracts on the basis of separategeneral policy conditions for each ofthem. For each class of insurance thereis a specific premium. The individualinsurance policy can be cancelledindependently of the other covers.

Examples:Comprehensive household insuranceComprehensive building insurance

Examples:Family insurance as a bundle ofhousehold, personal liability andaccident insurance

1.3.3 Social insurance system

Besides private insurance in many countries, there is also a statutory social insur-ance system, which is either financed out of contributions or tax. In what followssuch a social insurance system will be explained using as an example the FederalRepublic of Germany.

In contrast to private insurance, social insurance is a part of social security in theFederal Republic of Germany. In this way the state pursues it socio-political aims.Consequently, alongside the insurance principle social insurance includes elementsthat have nothing to do with insurance, such as, for example, statutory grants. As amatter of principle social insurance has its roots in the contract of employment. Theinsurance relationship occurs as a rule because of the law or because of certainlabour law or occupational features.

The individual branches of social insurance are regulated in a relatively complicatedway by a large number of legal provisions. They can be distinguished by five im-portant features, however:– compulsion– labour protection– principle of solidarity– non-cash benefit– propagated by the social insurance carrier

Compulsion

For those in employment social insurance is usually compulsory. The start of the in-surance relationship and the extent of insurance protection are legally prescribed(compulsory character). This regulation serves the purpose of protecting the insuredand the social balancing process.

There is, for example, voluntary insurance for persons who are not compulsorilyinsured within the statutory health insurance, because they have exceeded theincome limit.


System of insurance classes

Indemnity insuranceActual need for coverIndemnity

Fixed benefit insuranceAbstract need for coverSum insured agreed

BodilyinjuryMedicalexpenses

Propertydamage– Fire

Financialloss– Liability

Amount

– Life insurance sum

Recurringbenefits– Daily benefits

Summary of insurance classesSingle proposal and one insurance policy

Combined (linked) insurance Insurance package policies

One insurance contractOne insurance class

Several insurance contractsSeveral insurance classes

Labour protection

Social insurance is restricted to covering certain risks of the person in connectionwith work, such as health, accident at work, disability, unemployment and long termcare.

Contributions

The insurance benefits are paid for in the first instance by the contributions of thoseinsured and their employers, in part also by the employer alone. The insurance prin-ciple is broken by means of state allowances. The contributions are not levied inaccordance with the principle of equivalence, but according to the principle of soli-darity in line with the income of the insured, so that a redistribution takes place.Social pension insurance is based on the solidarity of the generations (generationcontract). The generation in work pays contributions in the expectation that the fol-lowing generation will take over the same duty to guarantee the pensions.

Benefits

The purpose of social insurance benefits is in the first instance the recovery/restora-tion and the commitment of the labour force. In the forefront is the principle of pay-ment in kind in the form of health insurance or the provision of therapy in the acci-dent and pension insurance. In contrast, private insurance provides its benefitsmainly in the form of money payments.

Social insurance carriers

Social insurance is conducted by special social insurance carriers on a legal basis.It is subject to the principle of self administration, which is carried out in the com-mittees appointed for that purpose, which are comprised of those insured and theemployers. Legal action can be taken in the social courts against decisions of thesocial insurance carriers.

1.4 Importance of private insurance

Insurance fulfils important economic tasks. Microeconomically it safeguards theexistence of private households and companies. Macroeconomically it providesthem with the unhampered continuation of the economic process.

1.4.1 Microeconomic importance

Private households and companies take out insurance policies, because they expectthat insurance protection will bring them advantages and thus economic utility. Theinsurance protection constitutes an economic good that has a value as a marketbenefit. It is a necessary safeguard, which transfers to the insurer the risk of nega-tive effects on current sources of income and investments.


Insurance offers the possibility of independent provision, for which savings andreserves would be inadequate. Furthermore, insurance protection is generally chea-per than always having to have resources available to cope with particular events.

With respect to the microeconomic importance of insurance, considerations of cus-tomer orientation must govern the form and development that the contractual rela-tionship takes.

Risk transfer

By taking out insurance, private households and companies transfer particular, pre-cisely defined risks to the insurer. In the first instance, the importance thus lies in thereduction or removal of dangerous situations and the generation of security.

For companies the risks thus become calculable and the premium is factored intothe calculation of their products. The delimitation of the perils by this means en-ables companies to concentrate on those risks that are not covered, such as thedistribution risk.

Equalization of risk

If an insured peril occurs, the economic consequences of a loss of wealth are ma-terially compensated for. Private households and companies are put in the sameposition as if the insured claim had not occurred.

Example:

Property insurance makes the money available to rebuild a burnt down building aswell as to repurchase damaged or missing objects. Liability insurance frees the po-licyholder from his duty to provide compensation.

Financing

Private households and companies must offer collateral when they take up a credit.Objects used to provide security for financing, such as buildings or vehicles, canonly serve this purpose if they are adequately insured. It is thus insurance that en-ables foreign capital to be taken up. In this connection a life insurance policy alsoconstitutes an important collateral for a personal loan.

A prerequisite for the financing of companies is that creditworthiness only existsif the usual volume of insurance protection is available. In this way creditors andshareholders can be offered increased security.

1.4.2 Macroeconomic importance

In the macroeconomic system insurance has an important position alongside pro-ductive industry and trade. Insurance is a service, the effects of whose benefits arenot restricted to private households and enterprises, but are also of importance forthe whole economy.


Economic process

Insurance ensures that a loss is usually confined to the area of the policyholder anddoes not affect other persons or businesses. The primary loss is thus localized andthe consequential damage for other economic entities is avoided. To this extent in-surance prevents an interruption of the economic process. An uninsured loss in anindustrial enterprise would have a deleterious effect on creditors, suppliers and cus-tomers. Continued employment is not only guaranteed in the company directlyaffected, but also within its sphere of activity.


Creditors

Suppliers Customers

Employees

Fire in an industrial enterprise

Due to the concentration of the loss on the insured business insurance reduces thesusceptibility of the whole economy to negative effects and enables the uninterrup-ted continuation of management in an economic sense.

Discharge of the state

Insurance absolves the state and thus the public from the need for tax relief if a lossoccurs. For this reason public authorities have an interest in a functioning insuranceindustry. They would otherwise have to take frequent action to prevent interruptionof the economic process and to relieve the labour market. Thus the state assists theinsurance industry by means of tax relief for insurance premiums and the introduc-tion of compulsory insurance for certain risks. The aim of these measures is to pro-tect the general public from unforeseen burdens.

Reservoir for capital

The insurance industry creates a reservoir for capital that is filled by the policyhol-ders’ premiums. Since the premiums are paid in advance and in the case of life in-surance saving and insuring are bound up with each other, insurance companieshave considerable sums to invest. They flow especially into promissory note bonds,commercial papers, credits on real estate and property. With these funds particu-larly housing construction, industry and the state is financed. In this way insurancecompanies contribute to the promotion of the economy and to the increase of thenational income.

Promotion of technical development

The insurance industry encourages technical development and the adoption of newmethods of production. It takes over the associated risks and in this way supportsthe willingness of the economy to invest. Certain technical facilities such as energyplants as well as modern road and air traffic could not be realized without suitableinsurance protection.

Social function

Finally, the protection of injured third parties by liability insurance is of great socialimportance. There is a close connection between this and the promotion of techni-cal progress. In many cases traffic victims and other injured parties could not asserttheir claims for compensation against the injuring party if the latter were not in-sured. Consequently, liability insurance serves to protect the tortfeasor by freeinghim from the claims of third parties, as well as the injured party, who otherwisewould often not be indemnified. Motor liability is an important example of this,which every owner of a motor vehicle is legally bound to take out.


Capital investments of insurance companies

Promotion of

Housing construction Industry State

Economic result:– Promotion of investments– Creation of employment– Demand for goods and services– Increase of the national income

Microeconomic importance

of insurance

Macroeconomic importance

of insurance

– Assumption of risks– Payment of claims– Facilitation of financing– Enabling the concentration on

risks that are not covered

– Continuation of the economic process– Freeing the state from providing benefits– Financing of the public purse and the

economy– Promotion of technical progress– Protection of injured third parties

Summary

1.5 Cost accounting

1.5.1 Purpose of cost accounting

The purpose of cost accounting is to record systematically, control and consolidateinto information the money and the flow of money of an insurance company that isengendered by the company value chain. Cost accounting thus achieves internaland external tasks.

External cost accounting tasks– Reporting to creditors and shareholders about business success, liquidity and cre-

ditworthiness– Reporting to the public and the state about the safeguarding of jobs and the eco-

nomic policy– Basis of assessment for tax purposes

Internal cost accounting tasks– Documentation of the course of the business– Controlling the cost effectiveness– Control of the financial equilibrium– Basis for operational decisions

1.5.2 Organization of cost accounting

Depending on the different task priorities there has developed a number of organi-zational possibilities– Financial accounting and the balance sheet– Cost and activity accounting– Budgeting– Operational statistics and comparative calculations


Areas

Primarytask

Operand

Cost

accounting

Financial

accounting

Cost

accountingBudgeting

Operational

statistics

Documentation Allocation Allocation Sundry

Wealth/CapitalExpenses/Earnings

Costs OperatingPerformance

IncomeOutgoings

Sundry

The four branches of cost accounting differ fundamentally from each other withregard to contents, but they are associated with each other, they complement eachother and they are in part constructed on each other.

Bookkeeping

Bookkeeping creates the prerequisites for the compilation of individual bills andtogether with these the accounting system of the insurance company. It is the plan-ned, systematically ordered, complete record of the business transactions in an in-surance company over a specific period of time. By means of this complete, orderlyand planned registration and chronicle of all business transactions the company canat any time establish, e.g.:

– how the assets and/or the debts have changed

– whether the company has made a profit or a loss

Further important tasks of the bookkeeping are:

– Basis of information for the branches of the cost accounting system (statistics,cost-benefit accounting and budgeting) and thus for the company decisions

– Basis of taxation by means of the basis of calculation profit and assets

– Methods of information for third party stakeholders (e.g. policyholders, sharehol-ders, creditors, supervisory authorities) by means of financial accounting

– Proof in the case of legal disputes with representatives, the tax authority, courts,banks

Bookkeeping is based on a great number of different rules (among other things,laws and regulations) and among other things recommendations and customaryusages. The most important principles are the basics of orderly bookkeeping, whichare partly the source and partly the result of the legal regulations.

Cost accounting and results accounts

One of the most important functions of the cost accounting and results accounts isthe supervision of the economic efficiency of the business value chain. In this con-nection among other things the costs incurred in the production of the insuranceprotection are allocated according to type, the place of production and the costcentre. This information is among other things the basis for pricing and thus also forthe calculation of the insurance premium. The cost accounting and results accountsis a purely internal business concern.

Budgeting, controlling and auditing

As preview accounting, budgeting has a future orientation. It is based on the data ofthe other three branches of the business accountancy system. Within a completeplan partial plans are compiled (finance, turnover, advertizing plan, etc.). The budgetis a control and management instrument for the company’s management, becausetargets are given in the process of making business decisions which can be com-pared to the actual results. (Target performance comparison).

Closely connected with the budget is controlling. In contrast to the branches alreadymentioned in connection with business accountancy, in the case of controlling, as


with auditing, it is a component part of the company’s system of supervision. Thismeans that although controlling is dependent on information from business ac-countancy, it itself should nevertheless be interpreted as a service function for themanagement. The company management, but also sections of the company, shouldbe supplied with information which enables them to manage the company and itsdivisions in a future-oriented way. In addition, there is the important task of co-ordi-nating subtasks in the complex company system.

Auditing should further be distinguished from controlling insofar as it constitutesthe management of all business activities, processes and structures that is indepen-dent of the systems and processes. Among other things, compliance and economicefficiency must be controlled.

Statistics

– In order to be able to charge premiums that match the risk and to regulate allclaims that must be indemnified, insurance companies need in motor insurance,for example, information about claims frequency and the average level of claimsfor the various types of vehicle.

– In order to protect market share insurance companies need among other thingsinformation about the product wishes of households and companies, the pre-mium development of the individual classes of insurance, the disposable incomeof the respective groups of households and the rate of inflation for the mostvaried range of goods and services.

– To achieve adequate personnel planning insurance companies need, for example,information about the average age and income, in all cases broken down amongother things according to staff with company internal duties and those with custo-mer contact, gender, possibilities of employment with office work and staff qua-lifications.

1.5.3 Technical terms of the cost accounting system

Certain technical terms have developed in connection with the individual sections ofbusiness accounting, in order to express various economic circumstances – pay-ment and benefit processes. Broadly, these are the following contrasting pairs:

– receipt / disbursement

– income / outgo

– profit / expenditure

– benefit / costs

In daily usage not much care is taken to differentiate precisely between these con-trasting pairs. An exact separation of the individual pairs of terms is advisable, how-ever, because a precise distinction of terms makes it easier to talk about businesseconomics.

Every entry for means of payment or liquid funds is called income. (Examples couldbe premium income, as well as paid up owner’s equity or borrowed capital, interestearnings or tax rebates). Every movement out of means of payment or liquid funds


is known as a disbursement. (Examples could be claims payments, payments forworking capital, dividends, tax payments).

Income, in contrast, means – irrespective of the actual cash flow – the equivalent inmonetary terms for goods and services sold.

An outgo, in contrast, means – irrespective of the actual cash flow – the equivalentin monetary terms for the addition to the factors of production (goods and services).It makes no difference in this respect as to whether the factors of production arepaid or consumed in the accounting period.

The profit for a period is the value of net income for all consumed goods and ser-vices. The expenditure for a period is the value of net income for all consumedgoods and services.

By benefit is meant the gross added value obtained in an accounting period insofaras it can be traced back only to one of the activities relevant to the business target.

By costs are meant the quantified use of factors of production which are needed forthe production and sale of the business’s products and for the maintenance of itsbusiness capability in order to achieve these aims.


2Organizationof the insurance industry

byDr.Gerhard Mayr

2.1 Legal forms of insurance companies

2.1.1 Overview

Legally every company that carries out insurance business is an insurance company(IC). The legal form is regulated by the national legislator. In Germany the legalforms that are currently approved are:

– Stock company (including the European Company – SE)

– Mutual insurance company

– Insurance company under public law

In other countries individuals, too, can quite easily be insurers, as is the case withthe names of Lloyd’s in Great Britain.

Insurance companies need the approval of the supervisory authority before theystart business. (In Germany this is controlled by the Insurance Supervisory Law –VAG). In Germany the business plan must be handed in with the submission for ap-proval. It must clarify the purpose and the organization of the enterprise, the areacovered by the intended business operations, as well as the conditions by which thefuture obligations of the company should be permanently met. Among other things,the constitution of the company, the classes of insurance to be sold, company pol-icies, contracts for the outsourcing of functions, proof of required capital (guaranteefunds) and a business case for the first three business years must be submitted.

2.1.2 Joint-stock company

The joint-stock company (Plc) is a company with its own legal personality, whoseauthorized capital is split into shares. Its carriers are the shareholders as owners andsuppliers of the owners’ equity. The company’s creditors are responsible for the lia-bilities of the company only to the extent of the company’s assets. In Germany theGerman Stock Companies Act stipulates the legal norms.

Foundation

1. The foundation by one or several persons who take over the shares by means ofoutstanding capital contributions

2. Minimum face value of the authorized capital of € 50,000. In the case of insurancecompanies the regulation of capital resources, which can require higheramounts, must be considered.

3. Shares are either par value shares (at least € 1) or a share without a par value(same share of the authorized capital).

4. Articles of association certified by a notary (constitution)

After the supervisory authority has granted the license, this is registered in the com-mercial register. With the registration the joint stock company receives its legal ca-pacity.

Organization of the insurance industry 31

Important rights of shareholders

– Voting rights in the Annual General Meeting according to the face value of theshares or in the case of shares without par value according to their number,

– Profit sharing rights (dividends),

– Subscription right on the issue of new (young) shares, so that the shareholder– can secure the current proportion of voting rights by taking up the subscription

right– receives compensation for the sale of the subscription right, that a “watering

down” of the share price occurs by the average price after the increase in capi-tal, because in general the issue price of new shares is lower than the stockexchange price of the old shares before the increase in capital.

Institutions of the PLC

a) Annual General Meeting (AGM)

Shareholders’ meeting, use of the voting right

Important functions:

– Appointment of the shareholders’ representatives on the supervisory board

– Resolution regarding the use of the balance sheet profit

– Release of the members of the board and the supervisory board

– Changes to the articles of association

– Measures to increase and reduce capital

b) Supervisory board (SB)

Controlling body of the supervisory board, appointed every four years

Composition:

– up to 2,000 employees: two thirds shareholders’ representatives, one third em-ployees’ representatives (the number must be divisible by three; the number isdetermined by the level of authorized capital)

– more than 2,000 employees: half shareholders’ representatives, half employees’representatives (equal rights)

Important tasks:

– Control of the management

– Appointment and dismissal of the board

– Checking the annual financial statement, of the management report and theboard’s recommendation about the disposal of the balance sheet profit

– Report for annual general meeting

– Calling of an extraordinary annual general meeting

32 Dr. Gerhard Mayr

c) Board of management

Management of the company on own authority

Important tasks:– Report to the supervisory board about the course of business and the situation of

the company– Compilation of the annual financial statement and the draft for the auditor of the

annual accounts– Calling of the annual general meeting and recommendation about the disposal of

the balance sheet profit– Insurance stock company: Announcement to the supervisory authority in the

event of insolvency or if liabilities exceed assets

2.1.3 European Company (Societas Europaea – SE)

The European company is a legal form for a stock company in the European Union.Since 2004 this has enabled the EU to found companies according to broadly unifiedlegal principles (Regulation 2157/2001 concerning the Statute of the European Com-pany (SE) of 8.10.2001).

Subject to the EU-provision an SE founded in accordance with the law of the SE’sstate of domicile will be treated as a stock company in each member state.

Nature of the European Company:– Own legal personality– Limited liability company– The capital is split into shares– Domicile in an EU state, transfer of domicile into another EU state possible at any

time.– Shareholders exercise their rights of ownership in the annual general meeting– The management can be carried out in two ways:

(1) Board manages the business and is controlled by the supervisory authority(dual system – as is usual in Central Europe)

(2) An administrative organization (Board of Directors) that consists of threeboards including an executive director (mono system – usual in Anglo-Saxoncountries)

– Shares are transferable in accordance with the respective national regulations.Listing is not absolutely necessary.

2.1.4 Mutual insurance company

A mutual insurance company is an association vested with legal capacity, whichpursues the insurance of its members according to the principle of mutuality. Itreceives the legal capacity with the approval of the supervisory authority. It is – likea stock company – registered in the commercial register. The company name has tocontain the addition “a.G.” The assets of the association are liable only for the asso-ciation’s commitments. The members are not liable with their assets.


The membership is acquired by the establishment of an insurance relationship withthe mutual, so that the beginning of the membership coincides with the beginningof the insurance. As consideration the policyholders have to pay provisional pre-miums or an apportionment later.

34 Dr. Gerhard Mayr

Premiums

provisional premiums apportionment

with without with without

obligation to pay an additional premium highest premium

The provisional premium is required for the estimated future need. If the provisionalpremiums are insufficient, in accordance with the articles of association additionalpremiums are required or the insurance benefits are reduced. The obligation to payadditional premiums can, however, also be excluded by the articles of association.This is meanwhile the rule for mutual insurance companies. Then in effect there isno difference from the fixed premium of an insurance stock company.

The apportionment is not payable in advance but afterwards when the need arises,such as on the death of a member if there is a funeral expenses fund. The articles ofassociation fix a limit for the apportionment. Such an apportionment process is onlyfound in smaller mutual insurance companies.

Foundation

A defined number of founders is not prescribed. Foundation is possible with twopeople. A reserve fund must created for the financing, the level of which depends onthe regulation for capital resources.

Company functions

a) Highest RepresentationThis is broadly equivalent to the annual general meeting of a stock company and isthe gathering of members or the representatives of the members.

b) Supervisory BoardThis consists of at least three persons. The articles of association can fix a highernumber, which must be dividable by three (21 at most). Two thirds of the super-visory board is elected by the Highest Representatives and one third by the em-ployees.

c) Board of ManagementThis consists of at least two persons. The same regulations apply as for a stock com-pany.

2.1.5 Insurance companies under public law

State law applies to insurance companies under public law, which is also decisivefor the supervision of services. The state supervision of insurance companies is re-sponsible for supervisory control . They are mainly public law institutions for whichthe liability is guaranteed by public bodies. They were founded, for example, bystates, territories, local associations and regional banks. Nowadays most insurancecompanies under public law sell all classes of insurance. However, the business isrestricted to a particular region or state (regional principle), so that they cannot com-pete with each other.

Bodies

The large insurance companies under public law have a board of management,which runs the business and represents the insurance company externally and aboard of directors which mainly exercises rights of control.

2.2 Co-operation und concentration in the

insurance industry

2.2.1 Co-operation

There is co-operation when economically independent companies commit themsel-ves contractually to work together.

Example:

An insurance company, a bank, an investment company and a building society worktogether in order to offer the customers all financial services from one source.

Aims:

– Completion of product range (“Everything from one source“)

– Better utilization of the sales capacity

– Protection from competition

– Policyholder’s capital stays with the co-operating companies

– Access to new customer groups

– Improvement of the insurance image

– Extensive information about customers

Problems:

– Overtaxing the sales personnel

– Agents’ commission must be factored into bank products

– Bancassurance concepts do not always offer customers the cheapest products


– Overlapping products

– Different size and strengths of the contractual partners can to lead to dependencyrelationships

– Conflicts of interest between the contractual partners (e.g. in the targets or accord-ing to customers – “good” bank customer – but “bad” insurance policyholder)

2.2.2 Concentration

2.2.2.1 Cartel

The cartel is a contractual horizontal agreement of companies that remain legallyseparate but give up a part of their economic independence.

The aim is that the market should be influenced by cartel contracts. The cartel mem-bers want to limit the competition in their commercial sector in order to be able toincrease their profit. Cartels contradict the economic and social political goals of oureconomic system and are thus – a few exceptions aside – forbidden.

Example:

The industrial fire insurers decide to calculate a common risk premium (calculationcartel).

On breach of the cartel contract a contractual penalty is agreed.

Calculation cartels are strictly forbidden. Also a non-binding recommendation forthe risk premium (net premium) is not allowed by the association.

The European Union has also taken up this matter and certain gentleman’s agree-ments between insurance companies are excluded from the cartel prohibition.These exceptions are regulated in the Group Exception Regulation for InsuranceCompanies. The regulation that currently applies was last extended to and runs outin March 2010. Exemptions from prohibition are among others non-binding examp-les of general insurance conditions, the exchange of statistics about risk coverageand the setting up of insurance collectives (so-called pools – see 5.3.4 in this re-spect). In this respect the EU is of the opinion that co-operation in these areas im-proves efficiency for the insurance companies, from which consumers also benefit.

2.2.2.2 Consortium

The consortium is the horizontal agreement of companies in order to carry out cer-tain tasks that are usually of limited duration.

Example:

Various insurance companies share a risk (coinsurance)

2.2.2.3 Affiliated companies

Affiliated companies are formed primarily because of capital and personal connec-tions as well as by means of company contracts.

36 Dr. Gerhard Mayr

a) Concern

The concern is a horizontal, vertical or unconnected union of companies that remainlegally independent but whose economic independence has been given up becauseof a unified management.

In the insurance industry the separation of lines of business leads to the creation ofconcerns. If all classes of insurance are to be offered, then separate companies mustbe founded for life, health and composite insurance respectively (previously legalexpenses insurers were also separate).

Horizontal concernCompany unions at the same production and service level: e.g. an insurance con-cern with general, life, health and legal expenses insurance.

Vertical concernCompany unions with successive production and service levels: e.g. reinsuranceand direct insurance companies.

Unconnected concernUnions which straddle branches: e.g. insurance – banks – motor manufacturers

Subordination concernA company controls one or more companies by means of capital or voting majority.The controlling company is often a holding. It is usually a purely financing and ad-ministrative company without insurance business.


Controlling company

Insurance company

or

Holding company

Company Company Company forfor life for health general and

insurance insurance accident insurance(composite insurer)

Group of companies which are legally separate entities, but under unified controlwithout a parent companyThe companies are combined by one management without any of them being de-pendent on the others.

b) United companies

United companies (trusts) are a union of companies which have given up their legaland economic independence.

2.2.2.4 Goals and problems of concentration

Goals

– Use of synergy effects (purchasing, production, marketing)

– Increase of share value and higher dividends (shareholder value)

– Lowering the premium

– Greater security

– Strengthening the market power or weakening the competitors

– European or worldwide activities

– Customized financial concepts

Problems

– Curtailment of the competition

– Curtailment of supply

– Exploitation of power (e.g. by means of collective agreements, legislation)

– Staff reduction

– Conglomerates that are difficult to manage

– Loss of identity of the individual insurance company

2.3 Separation of insurance classes

For the protection of policyholders insurance companies are not allowed to sell allclasses of insurance. According to German supervisory law the division into classesof insurance applies to life and substitutive health insurance.

Reasons

Life insurance is characterized by the accrual of savings premiums in the mathema-tical reserve and in profit sharing schemes. If it were sold with non-life insurance,which is subject to great fluctuations, there would be the danger that losses fromthe non-life insurance would be made up from the life insurance surplus. In the caseof health insurance the ageing reserve in particular, which contains all the risk pre-miums for old age, should be protected from non-life losses.

For legal expenses insurance there is the special case that the claims handling mustbe transferred to another company (claims handling company). The transfer countsas functional outsourcing. In this way a conflict of interest should be avoided. If theclaimant’s legal expenses insurance and the liability of the defendant were with thesame company, the legal expenses insurer would have to deal with a claim againstitself. By means of the transfer of the benefit to an independent claims handlingcompany this conflict is avoided.

38 Dr. Gerhard Mayr

2.4 Structure of the organization

The structure of the organization constitutes a company’s hierarchical framework.While the structure of the organization establishes the basic framework (which taskswill be tackled by which people and which material resources), workflow manage-ment regulates the work and information processes within the framework. The com-pany is organized on the basis of the structure of the organization. To this end thecompany’s global task is broken down into sub-tasks and the company as a whole isdivided into business areas (section). The business sections are allocated to thetasks that have to be completed. In doing so the relationships between the indivi-dual areas have to be exactly regulated.

Paradigm models are broken down into functions according to the following factors:

– according to products or product groups (e.g. property, liability, accident, motorinsurance)

– according to economic functions (e.g. acquisition, production, sales, financingand administration)

– according to region (e.g. according to business areas or home/abroad)

– according to customer groups

The structure of insurance company organization is not in practice derived fromthese paradigm models. In practice, blends of functional related factors (acquisition,financing, administration) are found.

2.4.1 Product related structure

The insurance business is, for example, divided into the following business areas:

– Management

– Underwriting area (with respective proposal, contract and claims processing)

– Financial area (financing, investments)

– Administration (e.g. personnel, administration, legal department)

The underwriting areas are basically constructed on a product related basis (life,health and composite area), and composite is usually further divided into classes ofinsurance.

The processing of insurance business by classes is traditionally done according tospecialization, for each of which there is a management that is responsible for fun-damental questions, the organization of the insurance protection according to priceand coverage for the particular class, as well as the monitoring of the daily business.Below this level is contract and business processing. The processing of proposals(new business) and portfolio administration belong to contract processing. This isreferred to as the processing of new and renewal business. These are often com-bined as business departments with corresponding claims departments, which inthe insurance of the person are called benefits departments.


2.4.2 Functionally oriented construction

The insurance company’s mission is divided into functions, e.g.

– Management

– Acquisition

– Sales

– Production

– Administration

– Financing

Management includes planning, organization and control. It combines the businessproduction factors. It makes the decisions about company policy, especially the spe-cification and implementation of the company goals.

Acquisition includes particularly the basic materials, the personnel and further ser-vices.

Sales are vitally important for an insurance company. Branch offices and the salesforce are usually part of the sales or distribution.

Production is usually broken down into proposal, contract and production proces-sing. There are other sub-functions besides these, such as underwriting, reinsur-ance and coinsurance.

Administration includes activities that are not directly connected to the productionof insurance protection, such as personnel administration, the administration ofworking capital, IT. It is a continuation of the supply function.

Financing should safeguard the performance in particular – even when there areunexpected losses.

40 Dr. Gerhard Mayr

Specialist department for a class of business

(e. g. motor insurance)

Management– Fundamental questions– Co-ordination– Collective bargaining policy

Business Claim

Initial processing(Proposal processing)

Renewal processing(Portfolio administration)

From time to time alsofor several combinedclasses of business

2.4.3 Structure based on customer groups

The customer group orientation should achieve a better matching of the insurancecoverage for the individual customer groups as well as customized in-house sup-port. The customer is offered a range of insurances which meet his needs. The trendis away from simply offering products to solving problems. The structure of the or-ganization and also the processes have to focus on the solution of problems. Thespecific risk situation of each individual customer group should be considered bothby the sales force in counselling as well as by in-house staff in dealing with policies.


Structure of organization according to functions

Type Acquisition andadministration

Sales Production Financing

Breakdownaccording tofunctions orareas

Basic materials Internal support Initialprocessing

Personnel Sales force Renewalprocessing

Investments

Claimshandling

Structure based on customer groups

Private customers Corporate customers

Private households– simple– wealthy

Industry Other commercial Independentprofessions

Private customers, e.g.

– young people

– young families

– single households

– wealthy households

– older people

Independent professions, e.g.

– doctors

– lawyers / notaries

– tax advisers / auditors

– artists

Advantages of customer group organizations

– Insurance selection customized to the need of the customer group

– Quick adjustment of the insurance selection to the changed customer need

– “Package solutions” – sell few single insurance policies

– Cut out the competition

– Stronger identification with the customers

– Insurance calculated according to the customer groups

– One voice to the customer for the complete product range

– Short communication path

– Better use of qualifications, especially for younger members of staff

Problems

– Difficult to implement, especially with the sales force (agency contracts still inforce)

– High costs and friction losses when restructuring

– Errors in the contract and claims processing

– Staff difficult to replace: long training period

– Overlapping customer groups

– For small insurance companies scarcely possible (Contract portfolio, number ofcustomer groups)

– Unclear delineation of insurance classes

2.4.4 Centralization and decentralization

Centralization means the concentration of administrative work of an insurancecompany in the head office. Decentralization means the general transfer of thiswork to the branches.

Reasons for decentralization

– Close to the customer

– Close to the sales force

– Flexibility because close to the market and quick decisions

– Consideration of regional differences

– The head office is relieved of administrative tasks

– Local presence (image advertizing)

Reasons for centralization

– Less co-ordination of work and controlling

– Better control of the underwriting and claims handling policy

– Fewer problems if staff are not available

– Better distribution of work and specialization

– Duplication of work avoided

42 Dr. Gerhard Mayr

– Cost reduction because of elimination of personnel and material costs

– The branches become less important because of complete processing by thesales force

2.4.5 Overview of call centres

With a call centre the customer comes into direct contact with a competent businesspartner. Call centres are telephone service departments in which incoming calls aredistributed over an automatic call distribution system to the staff of the centre.

The automatic call distribution system provides a well-balanced utilization of staff.Incoming calls are accepted within a few seconds. At peak times the calls can beswitched to other clerks (e.g. those responsible for correspondence) or to externalstaff. The staff in the call centre as well as being very resilient must also have asound knowledge of the products. During the discussion the employee can call upall the relevant data about the customer onto the screen and update it during thecall. In the call centre up to 80% of all incoming calls can be completely processed –from the acceptance of proposals to policy changes and claims handling as wellas tariff information, product information or complaints. In this connection the callcentre is often called „first level processing“. If the question cannot be completelyanswered the call is forwarded to the specialist departments (so-called “secondlevel”). For the processing of documents it can also make sense to divide theprocessing into first level (routine questions) and second level (complex technicaldetail).

The call centre can not only be used for inbound questions, i.e. for questions fromoutside for the insurance company, but also for outbound questions, for telemarke-ting. In telemarketing the telephone system dials the numbers of selected custo-mers. If the customer can be reached, his contract details appear on the screen. Theemployee in the call centre can then give the sales talk – supported by this data. Thecall centre call (outbound) can also be used to maintain the business portfolio. Themaintenance of the business portfolio can be carried out prophylactically (e.g. if atariff is increased) as well as for actively winning back customers

Advantages of the call centre

– Always accessible– Quick assistance in the event of a claim or for contractual questions– No transfer (several times) to special departments– Complete processing– Easy to deal with complaints– Use for advertizing campaigns (“outbound”) – the customer is approached by

telephone– “Comfort call” in the face of surrender or to pre-empt it.

Disadvantages of the call centre

– Complexity of the material makes it necessary to have highly qualified staff– Overlaps with the service activities of intermediaries– Under certain circumstances double work with doubled costs


2.5 Organization of workflow

The organization of workflow in an insurance company includes the design of the in-dividual work processes in order to complete tasks, their assignment to particularresponsible persons and the rules for the combination of the individual work pro-cesses for the overall performance. Within the structural framework of the organiza-tion the processes are ordered realistically in space and time. The work places andwork processes created in this way are linked with each other. Workflow manage-ment is thus based on an analysis of the processes and the ensuing process synthe-sis.

Examples of processes in the insurance company

– Proposal process (from the process in the sales force until the policy is dispat-ched)

– Claims regulation process (from the first claims report until the final regulation)

– Process of the in-force business (from policy alteration to sending the new policy)

2.5.1 Examples of the claims handling process

The work can also be done at the first and second level in the claims regulation pro-cess. While at the first level mass claims up to a certain level are processed, highclaims or bodily injury claims are taken care of at the second level. In this connec-tion, so-called workshop management plays an ever greater role in motor insur-ance. When a claim is reported, the insurer tries to send the customer or the injuredparty to a workshop that is contractually bound to the insurance company in orderto reduce claims costs (A price discount can be agreed with the workshop in returnfor a large total volume of repairs).

2.5.2 Outsourcing

Outsourcing is the removal of services or parts of the administration and productionto subsidiaries or to other companies.

In the insurance industry the following can be outsourced:

– Distribution

– Claims handling (e.g. for major claims and for bodily injury)

– IT

– Investment administration

– Administrative areas (e.g. security, cleaning, cantine)

– Accounting

– Personnel

44 Dr. Gerhard Mayr

Advantages

– Lower wages and salaries (other collective agreements)

– Less protection against dismissal

– Lower social benefits

– Flexible reaction to variations in production

– Increased awareness of costs and earnings awareness

– Winning of third party contracts

– Tax advantages (e.g. with regard to Value Added Tax; Profit Tax)

– Better internal control

2.6 Methods of distribution in the insurance industry

2.6.1 Overview

Insurance companies bring their insurance products to the customers. Sales or dis-tribution of insurance protection means, therefore, in the first instance the bridgingof the gap between the insurer and customer.

The sales or distribution of insurance protection is not a one off activity, but theissue of an insurance policy means a long-term relationship with the customer,which must be fostered accordingly (so-called portfolio servicing).

As a rule insurance contracts are concluded by means of a sales organization (e.g.an intermediary or broker). The expression for this is indirect distribution. In con-trast, in the case of direct distribution direct relationships are established betweenthe customer and the insurer. In this case the customer turns directly to the insur-ance company in order to obtain insurance protection.

2.6.2 Indirect distribution by sales organizations

2.6.2.1 Company sales organizations

Company sales organizations are part of the insurance distribution. These are usu-ally employees in the sales force.

Features

– Employment contract that is dependent on the insurance company

– Not self-employed

– No entrepreneurial risk

– Bound by instructions

– Salary (plus commission and expenses)

– Collective agreement

– Right to holiday

– Obligation to contribute to social insurance


Main tasks

– Winning and training of insurance representatives

– Support of difficult insurance classes

– Carrying out special tasks

– In some insurance companies normal customer contact (prospecting, sales clo-sure, portfolio support as well as help in claims handling)

2.6.2.2 Means of distribution that are linked to the company (insurance agents)

By this means of distribution is meant a self-employed businessman (insuranceagent) who is tied to the insurance company by means of a contract of representa-tion or an agency agreement. He is permanently entrusted with the task of arrangingor concluding insurance contracts.

The typical insurance agent acts on behalf of an insurance company or for a con-cern. He is, therefore, known as a tied agent or tied representative. From a legal per-spective the name representative of a concern or of various companies is more cor-rect, since he represents several companies with which he has contracts, because ofthe various classes of insurance.

Features

– Legally recognized businessman

– Free to arrange his own activities

– Free to determine his own working hours

– Book-keeping

– Commission (no salary)

– Registered at the trade licensing office

– Free from the duty to pay social insurance

– Submission of income tax and trade tax on the basis of self-employed commercialactivity

– Compensation entitlement

Principle tasks

– Making customers aware of the need for insurance

– Arranging insurance contracts

– Servicing policyholders

– Assisting in claims handling

2.6.2.3 External sales organizations

Insurance brokers

The insurance broker is a self-employed businessman who arranges contracts forother people without being contractually tied to this task. The insurance broker hashis own contract with the customer (so-called broker contract) and in contrast to theinsurance agent does not have a fixed relationship to the insurance company. Hehas a duty to the customer and not the insurer. This leads to a special kind of liability

46 Dr. Gerhard Mayr

towards the customer. The payment is in the form of commission, which is part ofthe insurance premium and is paid by the insurance company to the broker.

Advantages from the point of view of the insurance company

– No expenses for setting up a sales force– No claim for compensation– Brokers are knowledgeable– Brokers often take work off the insurance company– Brokers often bring large contracts

Disadvantages from the insurance company’s point of view

– The insurance company scarcely has contact with the policyholder– The contracts are often not long-term– The broker represents the policyholder’s interests– Commission and premium pressure– “Competition” between the brokers and own agents

Independent sales organization

The independent sales organization usually has several hierarchical levels. At thelowest level the placing of insurance (“sales”) – often by part-time staff – is the mainactivity. If the sales results are good, the sales persons can be promoted to higher le-vels. Besides the placing of insurance there is organizational activity, i.e. the findingand training of new intermediaries. A member of staff who has been promoted par-ticipates in the turnover of the intermediaries below him (third party turnover). Thehigher the member of staff rises, the less sales work he does and the more the ad-ministrative work increases. Remuneration and career progress follow exclusivelythe performance principle.


No direct contribution to turnover,many members of staff

Large contribution to turnover,no members of staff

6

5

4

3

2

1

A

Independent sales organizations try to sell their products with as many members ofstaff as possible, who are organized in a pyramid structure. At the lowest level A thesales persons have to sell as many insurance policies as possible in order to moveon to Level 1 and to earn from the turnover of the members of staff of Level A. At Le-vel A only the own turnover is evaluated. From Level 1 onwards not only the ownbut also the turnover of others is quantified as part of the total turnover, and withthis the possibility of moving higher up the hierarchy.

Opportunities

– Highly motivated sales personnel

– Good possibilities to earn well if good at selling

– Good opportunities for promotion and earnings

– Targeted customer approach (e.g. by analyzing the wealth and insurance rela-tionships)

– Financial service offers that are customized for customer groups

– Comprehensive counselling (everything from one source)

Risks

– Sometimes poor counselling because of inadequate knowledge

– Aggressive selling

– Strong (also psychological) sales pressure

– High cancellation rates

– High staff fluctuation

– Low earnings at the lowest hierarchical level

– Low follow up service for policyholders, because there is no fixed portfolio

– Often expensive financial and insurance products

– Often intensified sale of products with higher commission (that are not needed)

Other external sales organizations

– Co-operation with banks

– Annex distribution (sales over third parties, whose core business has nothing todo with insurance distribution) e.g.:

– Mail-order companies

– Motor traders and manufacturers

– Automobile clubs

– Credit card sellers

– Tour operators

– Food store chains

They offer specific insurance policies, which in certain circumstances are connectedwith their product. Thus insurance protection is offered to the supporting productonly in limited areas which often overlap with already existing insurances (e.g. cre-dit cards, travel insurance policies). If these providers succeed, however, in develop-ing an independent distribution channel, there can be real competition to the tradi-tional sales channels (e.g. ADAC, which offers all forms of motor insurance).

48 Dr. Gerhard Mayr

2.6.3 Direct marketing

In the case of direct marketing selling is done directly by the head office withoutinvolving sales organizations. The contact between the customer and the insurancecompany takes place exclusively by letter, telephone or other electronic media.

In the case of direct marketing it is the customer who takes the initiative. He mustknow which insurance policies and which sums insured he needs and which insur-ance can best meet this need.

Advantages

– No commission, and consequently lower costs and cheaper premium

– No agent visit (customer can decide himself)

– No unnecessary insurance policies or policies with too high a sum insured

– Lower cancellation rate

– New customer groups are reached

– Shorter work processes

– Professional counselling by the head office if desired (e.g. telephone, letter, Inter-net)

Disadvantages

– No arousing of needs by the sales force

– No personal counselling / contact

– Low insurance penetration, because the need for insurance protection is suppres-sed

– Poor support / missing adjustment of the insurance contracts

– Missing assistance in claims handling

– Business is difficult to direct

– Only simple products

– Relatively expensive direct advertizing (low success rate)

– To some extent aggressive underwriting (e.g. in motor insurance)

– To some extent high complaint rate

2.6.4 Insurance consultants

Insurance consultants advise and support the self-employed, companies, privateclients and public authorities about all forms of individual insurance and are, there-fore, committed to a form of counselling that is oriented to the personal need thathas been ascertained. They produce risk analyses for their clients, advise aboutinsurance cover, which is customized to the needs of the particular client, and theynegotiate about this with possible insurers. They represent their clients before theinsurers if there are claims. They continuously check that the insurance covers inforce are updated.

In so doing they play an advisory and professional role, the placing or the sale ofinsurances being forbidden for them. On request the client receives the names and


addresses of relevant insurers. One of the main tasks is to achieve the cheapest andmost suitable insurance cover for the client. Insurance counsellors must be neutraland independent: i.e. they must not work on behalf of an insurance company, butgenerally receive their fee from their client according to an agreed hourly or dailyrate.

The direct instruction and also the direct payment by the client avoids some of thepossible adverse affects of one party representing the client’s interests.

The profession of insurance counsellor is one of the legal advisory professions andcan only be performed if the responsible Chamber of Industry and Commerce hasgranted authority. The professional title “insurance adviser” is legally protected.

2.6.5 Legal aspects of insurance sales and marketing

The European Union Directive on Insurance Selling (Directive 2002/92/EG of the Eu-ropean Parliament and Council of December 9th 2002 concerning insurance selling)was published on January 15th 2003 in the official gazette of the EU. The directivewas needed, on the one hand, to facilitate freedom of services in the field of insur-ance sales and, on the other, to comply with consumer protection requirements.

The following important points are regulated in the Directive:

– Recording of the intermediary in a register that is accessible to the public

– The duties of the intermediary to provide information

– Counselling and documentation duties (Counselling report)

– Creation of an arbitration post

– Safeguarding of customer monies

In the course of implementing the EU-Directive on Insurance Selling new rules wereintroduced with effect from May 22nd 2007 in Germany, among other things in thetrade regulations as well as in insurance contract law. These clearly define the typesof intermediary. Thus henceforth insurance intermediaries are either insuranceagents or insurance brokers.

Since May 22nd 2007 permission has had to be obtained in order for an interme-diary to sell insurance, and the Chamber of Industry and Commerce is responsiblefor granting this. This is contingent on certain requirements.

Thus the intermediary has to be personally reliable, i.e. he cannot have been legallyconvicted in the last 5 years prior to submission of the application. Furthermore, hisfinancial affairs must be in order, which is usually the case if no insolvency proceed-ings have begun or they have been rejected owing to a lack of substance and he hasnot made an affidavit before the district court – a court which executes civiljudgments. He must continue to show that he possesses a professional indemnitypolicy with a certain minimum cover. Finally, proof of professional competence isneeded. This professional expertise can be proved by a professional examination ofthe Chamber of Industry and Commerce that has been passed. A large number ofother legally controlled qualifications are also recognized as being adequate proofof competence.

50 Dr. Gerhard Mayr

Furthermore, an intermediary register has been set up, in which every intermediaryhas to be entered. The entry application must be made for the intermediary at theChamber of Industry and Commerce that is responsible.

The insurance agent represents the interests of the insurer. For insurance agentsthere is fundamentally the duty to provide counselling as needed. They must, how-ever, only refer to the insurers and their products with which they have a contract.The customers must be told who these insurers are. During their first meeting theintermediary has to give the customer the so-called “first information” in writing,from which can be seen:

– the name and business address of the intermediary

– the intermediary’s registration number

– the intermediary’s status (broker or agent)

– the mediation offices in case of disputes

During the counselling the wishes and needs (better: the objectively existing need)of the customer is established. The advice to the customer should match the com-plexity of the insurance product, the person and the customer situation. As definedin law the level of the insurance premium should also be a measure of the counsel-ling requirements. Reasons must given for the advice the customer receives, so thatthe customer can also understand later why he chose a particular insurance pro-duct.

The basic facts of the counselling must be recorded in the counselling documen-tation, which the customer must receive at the latest before the contract in writtenform has been concluded. The customer can dispense with counselling and docu-mentation of the counselling, but he must do this in a separate written statementwhich contains a warning that such a waiver could be disadvantageous for him inpursuing and achieving claims for damages against the intermediary.

The new legal regulation stipulates that the agent and broker are personally liablefor wrong advice and for inadequate compliance with the requirements describedabove. The tied agent as well as the agent that represents several companies can letthemselves be contracted out by an insurer. In this case the insurer takes over theliability against which professional indemnity insurance would otherwise have to betaken out.

Sources

Farny, Dieter: Versicherungsbetriebslehre. 4th edition. Karlsruhe: VVW, 2006

Schulenburg, J.-Matthias Graf von der: Versicherungsökonomik – Ein Leitfaden fürStudium und Praxis. Karlsruhe: VVW, 2005


3Legal basisof the insurance contract

byEsther Grafwallner

Overview of the new German Insurance Contract Law

By Professor Helmut Schirmer

On January 1st 2008 a new Insurance Contract Law (VVG) came into force in Ger-many that replaced the old one of 1908. The preparation for this new codificationhad begun in the middle of 2000. The guidelines of the EU directive for intermedi-aries have been included.

The aim of the new law is to strengthen the rights of the policyholder, to increase thetransparency of insurance products for the policyholder and to incorporate courtverdicts into the earlier insurance contract law and to develop it further. The duty tocounsel the policyholder as developed by jurisprudence is henceforth subject to law,the commensurate duties of intermediaries are based on the intermediary directive. Violation of the policyholder’s duties to conform (obligations) has received a newsystem. The consequences of a breach – total or partial loss of insurance coverage –fundamentally make causality a precondition. The only exception is fraudulentintent by the policyholder. A distinction has to be made between the degrees of re-sponsibility. If the policyholder is merely slightly negligent, the insurance coverageremains unaffected. In the case of gross negligence, there is contribution. Contribu-tion means that the insurance cover can be limited depending on the degree of thepolicyholder’s responsibility. Only in the case of policyholder intention, however,may the insurer not need to pay the benefit. This system is supported by the insu-rer’s numerous informational duties, by means of which the policyholder shouldknow of the negative consequences of not complying with the obligations. (Duty towarn).

Many of the insurer’s duties to inform have the aim of drawing the policyholder’sattention to the content of the future insurance cover even before making a contrac-tual declaration. A general right of revocation extends the policyholder’s freedom ofdecision.

For large risks as defined by EU directives, however, freedom of contract remainsbroadly as before. Agreements that do not conform to the new insurance contractlaw (VVG) remain fundamentally valid.

Legal basis of the insurance contract 53

3.1 Introduction

The contracts taken out between insurance companies and their customers are cal-led insurance contracts. Their contractual partners are called insurers and policyhol-ders.

54 Esther Grafwallner

insurer insurance policy policyholder

An important feature of an insurance contract is that the insurer safeguards againstan unforeseeable event. In other words, in return for a fee it takes over the risk thata peril might occur. For carrying this risk and the promise of a benefit that is boundup with it, the policyholder owes the insurer financial consideration, the premium.

insurer carrying of risk policyholder

payment of premium

The insurer and the policyholder have the freedom to agree whether an insurancecontract should be concluded and what its contents should be. This freedom of con-tract is limited in various ways:

3.1.1 Compulsory insurances

Basically, everyone can decide for himself whether he wants to insure certain risksof his life. However, it can be in the public interest that this freedom is restricted bythe regulation of a compulsory policy of insurance. A motor vehicle, for example, isconsidered a potential source of danger, but the driver may not be able to pay easilyin case of a claim for damages. Consequently, the legislator has decided in this caseto introduce compulsory liability insurance. There are other such compulsory insur-ances in many other areas, such as, for doctors or lawyers, for example.

3.1.2 Obligation to enter into a contract

Insurers as well as policyholders are generally free to decide whether and withwhom they want to take out an insurance policy. In some areas of insurance thisfreedom is abolished by the obligation to enter into a contract. This means that theinsurer is compelled to accept a proposer’s application (e.g. in motor insurance, § 5II Compulsory Insurance Law for Motor Vehicle Drivers (PfIVG)).

3.1.3 Laws and regulations

In order to protect the policyholder as the weaker party from discrimination, free-dom of contract is limited in various laws and regulations, which at the same timeconstitute the legal sources of the insurance contract.

3.2 Legal sources

3.2.1 Insurance Contract Law (Versicherungsvertragsgesetz VVG)

The most important basis is the VVG, first passed on May 30th 1908 and which on Ja-nuary 1st 2008 was thoroughly reformed. Important contents of the reform are theintroduction of many advisory, explanatory and informational duties of the in-surer as well as extensive consumer protection, which has been very largely harmo-nized.

The VVG is a special law for insurance contracts and therefore overrides or supple-ments the general regulations about the form of contracts as they are particularlyfound in the Code of Civil Law (BGB). Only if there is no regulation under the VVGregarding a specific matter, are the more general regulations of the BGB used.

The basic principle of freedom of contract applies to the insurance contract. For thisreason the contractual parties can depart from individual standards of the VVG, un-less the legislator wants to safeguard particular rules or minimum contents for oneparty or even both parties. Thus a distinction should be made between


Non mandatory norms Half mandatory norms Mandatory norms

It is possible to departfrom these norms,either to the advantageor the disadvantage ofthe policyholder.

It is only possible todepart from these normsto the advantage of thepolicyholder.

It is not permittedto depart from thesenorms.

In the VVG they are notspecifically identified.

In the VVG they arespecifically identified, as arule at the end of a sectionand combined with theinformation that theycannot be departed fromto the disadvantage of thepolicyholder.

They are alsospecifically identifiedin the VVG.

3.2.2 VVG Regulation regarding the duty to provide information

(VVG-Informationspflichtenverordnung VVG-InfoV)

The Insurance Contract Act (VVG) is supplemented by some ancillary laws and re-gulations. In practice the most relevant of these is the VVG-InfoV. It has its basis ofauthorization in § 7 Abs. 2 VVG and regulates in detail the content of the insurer’sduty to provide information before the conclusion of the insurance contract and forits duration.

3.2.3 Insurance Supervisory Law (Versicherungsaufsichtsgesetz VAG)

The VAG regulates in the first instance the relationship between insurance compa-nies and the Insurance Supervisory Authority (so-called Federal Financial Super-visory Authority – BaFin, for short) and is thus public law, whereas the InsuranceContract Act (VVG) regulates the private legal relationships between insurance com-panies and policyholders.

The VAG sets certain minimal requirements for insurance companies and ensurestheir compliance by giving BaFin various possibilities of intervening in the event ofviolations. The background to this is that the public has a great interest in the finan-cial stability and legality of insurance companies, in order to make sure that theysurvive and remain effective.

3.2.4 Code of Civil Law (Bürgerliches Gesetzbuch BGB)

The BGB applies to all contracts regulated by private law and thus basically also tothe insurance contract. Being general law, the BGB is not used, however, if specialregulations of the Insurance Contract Act (VVG) apply. Especially relevant for theinsurance contract are the regulations about forming contractual obligations bymeans of the general terms and conditions (§§ 305 ff BGB).

The General Insurance Conditions (Allgemeine Versicherungsbedingungen AVB) area special form of the general terms and conditions. The VVG regulates how they areto be incorporated into the insurance contract, so that the regulations of the BGB arenot relevant in this respect. The possible contents are also regulated as far as pos-sible in the VVG. There are regulations in the VVG which can be departed from (nonmandatory norms), but the insurer is, nevertheless, not completely free in terms ofits AVB. So, for example, very important principles of the VVG have to be respected.In this case a single regulation of the AVB can be invalid because of § 307 BGB(“Control of contents”), even though the VVG permits a deviation.


Example:

X-AG has a clause in its AVB which contains the following:

“If the policyholder causes the loss intentionally or recklessly, the insurer is notobliged to pay the benefit.”

In accordance with § 81 VVG the insurer can reduce its benefit in proportion to thepolicyholder’s degree of blame if the policyholder brought about the insured claimintentionally or recklessly. According to § 87 VVG it is possible to deviate from § 81VVG either to the advantage or the disadvantage of the policyholder, and in the pastthe insurer was released from paying the benefit if the policyholder had acted reck-lessly (the so-called “all or nothing principle”). The newly introduced “more or lessprinciple” of the VVG reform, however, does not release the insurer from paying thebenefit for gross negligent (reckless) behaviour, but only permits a reduction ofbenefit. This is such a basic principle of the VVG that it cannot be completely under-mined. The X-AG clause is, therefore, invalid according to § 307 BGB.

3.2.5 General Anti-discrimination Law

(Allgemeines Gleichbehandlungsgesetz AGG)

The intention of the AGG is to prevent or eliminate discrimination for reasons ofrace or ethnic origin, religion or philosophy, a handicap, age or sexual identity (§1AGG). This law also applies according to §19 Para. 1 No. 2 AGG to insurance con-tracts and limits insurance companies’ freedom of contract, because they are notallowed to reject lightly a contract because of one of the above mentioned reasons.

§ 20 AGG regulates the cases in which under certain circumstances different treat-ments are possible because of one of the above named features, without being dis-criminatory. Thus, for example, a different treatment is possible because of genderif there are reasonable grounds for this (e.g. the greater risk of men to suffer a heartattack can be included in the premium calculation). Expenses in connection withpregnancy and motherhood may not – again as an exception in this respect – lead todifferent premiums or benefits.

3.3 Insurance conditions

The General Insurance Conditions (AVB) are preformulated contractual conditionsfor many contracts, which must comply with the regulations contained in §§ 305 ffBGB.

Since the conclusion of insurance contracts is high volume business for many clas-ses of insurance (e.g. in motor insurance), the use of the AVB is the common prac-tice. For special risks, however, it is quite possible either to depart from individualconditions of the AVB by means of special agreements or even to make completelyseparate agreements. Whether and to what conditions an insurer departs from itsAVB is a question of its risk assessment policy, the so-called underwriting.


Until the introduction of the Third EG-Directive into German law in July 1994 the su-pervisory authority had to approve the AVB for each class of insurance before theycould be used. This led to very similar AVB in each class. Today insurance compa-nies can develop their own AVB which can differ for different target groups or pro-ducts even within one company.

The minimum content of the AVB is explicitly itemized in §10 Insurance Super-visory Law (VAG). The unique feature of insurance contracts is that the AVB not onlyregulate the basic conditions of a contract, as for instance payment conditions, butalso define the content of the contract itself, the promised benefit.

For this reason the minimum content includes especially the regulations

� for which events the insurer is obliged to provide a benefit and

� in which case this benefit is excluded, nullified or restricted due to particularreasons.

Other subject matters relate to the wording of the basic conditions, such as the ma-turity date of the benefit, payment conditions and courts of jurisdiction. In the caseof compulsory insurances, such as motor third party liability, further minimal con-tents can be prescribed in the relevant special laws.

3.4 Persons involved

The insurance contract is concluded between the insurer and the policyholder.These two parties are the contractual partners. Apart from the contractual partners,other persons can also participate in the insurance contract. That will not make themcontractual partners, however.

3.4.1 Insured person

The insured person is the one for whose benefit the insurance contract has beentaken out. Insofar as the policyholder and the insured person are not the same per-son, it is an insurance for the account of a third party. This is specifically regulated in§ 43 ff Insurance Contract Act (VVG).

Example 1:

A Plc, which has been paid to store the goods of third parties, takes out an insurancepolicy against fire and natural perils for these goods. If there is a claim, the custo-mers are entitled to the settlement.

Example 2:

The tour operator takes out travel cancellation insurance for the benefit of his travelcustomers.

Example 3:

Mr Müller has private health insurance. His children are included in the tariff andtherefore insured with him, but they are not contractual partners.


In non-life insurance the insured person is the one whose risk is covered by theinsurance policy.


Insured person

Obligation to pay the premium

Policyholder Insurance policy Insurer

risk cover

This has to be distinguished, however, from a number of persons on the side of thepolicyholder. It is naturally also possible for several persons to be contractual part-ners.

Example:

The married couple Huber takes out a household insurance policy for their jointdwelling. Both sign the insurance policy and are joint debtors for the premium.

The insured person is not liable for the payment of the premium if he is not identicalwith the policyholder, but he acquires the rights under the insurance contract. How-ever, the insured person cannot demand the insurance policy from the insurer butonly from the policyholder (§ 44 VVG). He needs it, on the other hand, if he wants toexercise his rights arising from the insurance policy or assert them juridically.

The insurer, on the other hand, is only obliged to provide the benefit to the policy-holder if the insured person has agreed.

Special case: Life Insurance

In life insurance, too, the policyholder takes out a policy in principle in his ownname. If the policy is on the life of another, the latter is called the insured person.

In this case, however, insofar as the sum insured exceeds the burial costs, the writ-ten approval of the insured person is absolutely necessary, see §150 Para. 2 VVG.For children there are further special regulations. The reason for this is obvious: theinsured person should be protected from the possibility that his or her death beco-mes financially interesting for another person. Therefore in §162 VVG there is a spe-cial regulation for the situation that the policyholder deliberately causes the death ofthe insured person.

3.4.2 Beneficiary

The beneficiary is the person to whom the policyholder has given the right to re-quest the payment of the sum insured when there is a claim. The law of life insur-ance, disability income benefit and accident insurance recognizes authorizations ofclaim payment.

The policyholder can confer the right to the insurance benefits, without the agree-ment of the insurer in the case of doubt. If the insurer, therefore, only wants to per-mit a particular right of benefit (e.g. to the heirs), it must stipulate this explicitly, andat the same time stipulate that this right may only be changed with its approval.

Furthermore regarding the right to insurance benefits, a distinction is made bet-ween revocable and irrevocable rights. The difference is the point of time when theright to benefit is acquired against the insurer.


Acquisition of the right to benefit

Revocable right to the Irrevocable right to theinsurance benefits insurance benefits

� �At the time On conferringof the claim the right to benefit

The revocable right to benefit is the rule. The beneficiary only acquires the right tothe insurance benefit at the time of the claim. Up to this time the policyholder canrevoke or change the right to the insurance benefits at any time. The policyholderkeeps all the rights and duties arising from the contract and can thus, despite grant-ing the right to the benefits, mortgage the claims under the insurance or assign therights from the contract.

In the case of an irrevocable right to the benefits the right to the insurance benefit isacquired immediately. As soon as the relevant declaration has been made to the in-surer, the right to claim the insurance benefits can only be annulled with the agree-ment of the beneficiary. The policyholder remains, however, also in the event of anirrevocable right of benefit the contractual partner of the insurer and must fulfil allthe duties arising from the insurance contract.

3.4.3 Premium payer / Contribution payer

The policyholder is the contractual partner of the insurer and is the premium debtor.If a third person takes the place of the policyholder in paying the premium, he is thepremium payer. He does not become the premium debtor by doing this, however.

The insurer need only accept the premium from another person than the policyhol-der if it was agreed between the insurer and the policyholder or it is a legally sanc-tioned special case.

In accordance with § 34 Insurance Contract Act (VVG) the insurer must accept pay-ment of premium

� from the insured person in case of insurance on account of a third party,

� from the beneficiary, insofar as he has already gained a right of benefit as well as

� from a bailee.

This regulation applies irrespective of whether the policyholder has a right undercivil law against the premium payer that the latter should pay the premium. The rea-son for this regulation is that the third party beneficiary has an interest in the insur-ance cover and should not bear the consequences of the late premium payment.

3.4.4 Representatives of the contractual partners

Insurance contracts like all other contracts can be concluded without action anddeclarations of intent by the parties if one or both parties is represented by a proxy.

As a matter of principle the insurer as well as the policyholder can confer power ofrepresentation to any person they like.

Example:

Mr Scholz instructs his brother to take out a liability policy for him and gives him theproxy needed for him to do this.

In this case the rights and duties as well as the imputation of knowledge ensuesolely from §§164 ff Code of Civil Law (BGB).

However, if one of the parties lets himself be represented by someone who acts asan intermediary or takes out insurance contracts commercially, this is the insurancebroker for the policyholder, and for the insurance company it is the tied or multipleagent.


insurance intermediary

(§ 59 VVG)

insurance broker

tied agent

(represents only theone insurer)

multiple agent

(representsseveral insurers)

insurance agent

For all these intermediaries there are special regulations; namely those that estab-lish, on the one hand, a certain degree of qualification and financial liability (imple-mented by the integration of the intermediary guidelines into various German lawsin 2007) and, on the other, other regulation govern that the relationship between thecontractual partners and the intermediary. These regulations, which are found in§§ 59 ff Insurance Contract Act (VVG), are described in more detail in what follows.

3.4.4.1 Insurance brokers

The insurance broker is obliged to base his advice to the policyholder on “an ade-quate number of insurance contracts that are on offer in the market” (compare § 60Para. 1 VVG).

This means that he first has to ask the policyholder about his wishes and needs andthen advise him about the best product on the basis of a comprehensive marketoverview. It is not sufficient simply to offer a relevant insurance product. A differentsituation arises only if the broker informs the policyholder of the restricted choice.

The insurance broker can either (only) be asked for advice by the policyholder or beauthorized to conclude a contract. In the latter case, he is authorized to effect theoptimal insurance cover for the policyholder.

3.4.4.2 Insurance agents

The insurance agent is appointed commercially by one or more insurers to arrangeinsurance contracts.

The insurance agent is the “eyes and ears” of the insurer. His knowledge is thusimputed to the insurer. The insurer is responsible for incorrect information of theagent, unless the insurance agent and policyholder have colluded to damage theinsurer.

3.4.4.3 The insurance intermediary’s duty to advise

The insurance broker as well as the insurance agent have a duty towards the policy-holder to inquire and advise. If this duty is violated, the customer can enforce da-mages against the agent himself. With regard to the information, the duty to ques-tion and advise is the same as the insurer’s, which is why you are referred to section3.5.3. The insurance agent’s duty to advise ends with the conclusion of the insur-ance contract, whereas the insurer’s and the insurance broker’s continues for theduration of the policy.

3.5 Conclusion of the insurance contract

3.5.1 Proposal and acceptance

The insurance contract comes into force, like every other contract, in accordancewith the regulations of the Code of Civil Law by two corresponding declarations ofintent (§§145 ff BGB). They are called proposal and acceptance.


The proposal for taking out an insurance policy must be so specific that the othercontractual partner can accept the proposal with a simple “yes”. That is, the exacttariff with the sum insured and the premium must be already known.

In the insurance industry the proposal is usually made by the customer. The initia-tive is taken by an insurance intermediary, however, who advises about the need forand the extent of the insurance cover. In the case of so-called direct marketing, theapplicant contacts the insurance company directly due to brochures or newspaperadvertisements: for example, by a hotline or over the internet.


proposalpolicyholder insurer

acceptance

insurance policy

In principle insurance contracts do not need a set form and can, therefore, be takenout in the form of a text: for example, by e-mail. In such cases the insurer places aform, in paper or electronically, at the policyholder’s disposal.

As well as the actual contractual declaration the insurer will include in this formother important matters that are relevant for its assessment or processing.

Information about the risk

For its risk assessment the insurer can ask questions that relate to the nature of therisk. Other than in the Insurance Contract Law before the reform of 1. 1. 2008, theinsurer cannot ask questions across the board about circumstances that could in-crease the risk, because as a rule the policyholder cannot assess whether somethingis actually relevant for the insurer. The insurer must, therefore, consider very care-fully in advance which facts are important for him (e.g. age, previous medical condi-tions, previous losses, etc.). The policyholder is obliged to answer these questionscompletely and truthfully. If he does not do this, the insurer can in accordance with§§19 ff Insurance Contract Act (VVG) modify, cancel or withdraw from the policy.

Contractual period of commitment

As a rule the future policyholder is bound to his proposal for a defined period.Within this period of time the insurer has to undertake the risk assessment andunder certain circumstances accept the proposal. If the insurer accepts the policybelatedly, this amounts legally to a new proposal, which must again be accepted bythe policyholder in order that an effective contract is concluded.

Miscellaneous explanations

Furthermore, the future policyholder will have to make further declarations, depend-ing on the class of business, such as a declaration of release from professional dis-cretion or a declaration acknowledging awareness of the General Insurance Condi-tions (AVB) and all additional information in accordance with § 7 VVG.

Acceptance

The acceptance can be effected by means of a specific declaration or be implied. Thelatter means that from the behaviour of the contractual parties the will to concludethe contract is recognizable. An implied acceptance of the proposal by the insurercan be the dispatch of the insurance policy or a premium note without comment.The implicit acceptance by the policyholder can be the payment of the premium. Incontrast, it is definitely not sufficient simply not to respond.

Handing over the insurance policy is not necessary to make the insurance contracteffective. In line with § 3 VVG it serves only as evidence that the insurance contracthas been concluded and has purely declaratory effect.

3.5.2 Divergent insurance policy

If the insurance policy differs from the proposal, because, for example, the insurer’srisk assessment had shown that there was a higher risk, thus warranting an exclu-sion or a higher premium, the implicit declaration of acceptance would not corre-spond to the policyholder’s proposal. In accordance with the regulations of the Codeof Civil Law (BGB) this case would constitute a new proposal for a (changed) con-tract, which further would in turn have to be accepted by the policyholder. In thiscase, however, the Insurance Contract Law (VVG) has set up a special regulation in§ 5. According to this the “divergency is approved” if the policyholder does not dis-sent to the change within one month after receipt of the insurance policy with thechanged contents. In this case a lack of response is recognized as a notional declar-ation of intent, in contradiction to the usual regulations. A precondition for this is,however, that the insurer should specifically draw the policyholder’s attention to thediverging conditions and the legal consequences of not responding.



divergent insurance policy+ advice

disagreement

�no insurance contract

Variation 1

3.5.3 Insurer’s duty to give advice prior to contract

§ 6 of the Insurance Contract Law (VVG) imposes on the insurer the duty (newlyintroduced into the VVG) to give advice prior to contract. The insurer is obliged toask the policyholder about his wishes and needs and to advise him accordingly, andto justify the advice finally given. Questioning, advising and justifying must be do-cumented.

The content and extent of this counselling duty is governed by the specifications ofthe Directive on Insurance Intermediaries (Directive 2002/92/EG), which imposes thecorresponding duties on the insurance intermediary. The German legislator wantedto extend these duties to the insurer as well as the insurance intermediary. However,in practice the insurer will generally have to use the insurance intermediary in orderto fulfil these duties, since the insurer itself often does not have any contact withcustomers. The action of the insurance agent, which according to § 278 Code ofCivil Law (BGB) acts as a vicarious agent of the insurer, is imputed to the insurer, incontrast to the insurance broker’s action.



divergent insurance policy+ advice

no response

�changed insurance contract


divergent insurance policy+ no advice

no response

�insurance contract comes into force as originally proposed

Variation 2

Variation 3

The advantage of imposing the above mentioned duties on the insurer as well as theinsurance agent is that in the event of a violation the policyholder can assert a claimfor damages against both of them.

The duties of questioning and advising do not apply if the policyholder is repre-sented by a broker. In this case, based on the broker’s appointment agreement, theduty to make inquiries and advise is already fulfilled by the broker which representsthe interests of the policyholder. Furthermore, large risks as defined in Art. 10 of theIntroductory Law to the Insurance Contract Act (EGVVG) are exempted from theduty to advise, since such policyholders usually possess sufficient expertise. Themost important exception to the duty to advise is distant selling business, since inthis case making inquiries and counselling is either impossible or very difficult. (Seein this connection Wandt, Handbook of the specialist lawyer – insurance law, Luch-terhand, 3rd edition 2008, 1st chapter, marginal 270).

The insurer does not have a general duty to question and counsel, but only one thatarises from a specific situation. This means that from the particular situation inwhich the insurer and policyholder find themselves, there must be indications fromwhich the insurer can draw further conclusions.

Example:

The policyholder tells the sales person of insurance company X that his son has justleft home. The policyholder has taken out a household policy with X. In this case thesales person should point out that the household policy does not cover the son’snew flat and that he should ask whether cover is needed for this.

As well as the situation which must offer a reason for counselling, according to § 6of the VVG the intensity of the counselling depends on the premium payable for theinsurance cover. This rule should protect the insurer from making an unreasonablylarge investment in a counselling session, which is likely to earn him very little pre-mium.

For the sake of proof, questioning and counselling must be documented.

In accordance with § 6 III VVG the policyholder can forego counselling as well as do-cumentation. In order not to undermine the counselling and documentation obliga-tion, the effectiveness of this waiver is bound to particular preconditions. The wai-ver declaration must be in writing on a separate document, and the policyholdermust be explicitly informed that waiving could be disadvantageous if he wants tosue the insurer later.

Similar obligations with regard to questioning, counselling and documentationapply also to the insurance intermediary (§§ 59 ff VVG). The insurer’s as well as theinsurance broker’s duty to counsel goes even farther, however, insofar as they canbe obliged to ask follow-up questions and give advice throughout the duration ofthe contract, if required.


3.5.4 Insurer’s duty to give information prior to contract

The pre-contractual duty to give information is regulated in § 7 Insurance ContractAct (VVG). One of the innovations of the VVG reform is that a distinction is no longermade between consumers and other policyholders: the information is to be givenfor all insurance policies and all policyholders.

Consumer in the meaning of §13 Code of Civil Law (BGB) are all natural persons,who have made a legal transaction for their own private purpose, not for their com-mercial or freelance activity.

An exception to this principle is made only for insurance contracts for large risks, forwhich under the terms of § 7 VVG there is a restricted duty to give information,insofar as the policyholder is a natural person. This information is to be provided intext form. It is thus also sufficient if it is transmitted by e-mail or fax.

The insurer’s duty to give information prior to contract applies only to the insureritself, but not to the insurance intermediary as well. If the insurer uses an insuranceintermediary, it has to make sure that the intermediary contract stipulates that theintermediary has to comply with these duties in its place. If a broker is involvedwhen the contract is concluded, the insurer has to fulfil its duty to provide informa-tion to the broker.

The insurer must convey the following to the policy holder in good time before hesubmits his declaration of intent in order to conclude the contract

� his policy conditions including the AVB and

� the important information in accordance with § 7 VVG in connection with §1 VV-InfoV and

� insofar as the policyholder is a consumer (here the VVG-InfoV makes an excep-tion from the newly introduced principle described above) a product informationsheet as well as

� the statement on the right of revocation in accordance with § 8 VVG and

� insofar as it is a life insurance policy, a disability income benefit, an accidentinsurance of the life insurance kind or a health insurance policy, further particularinformation in accordance with §§ 2 and 3 VVG-InfoV

The background to this instruction is that before concluding the contract the policy-holder must be able to inform himself comprehensively and in good time about itscontents.

3.5.4.1 Contractual requirements including the General Insurance Conditions

(AVB)

The contractual requirements dealt with in the AVB have already been described inSection 3.3.


3.5.4.2 Important information in compliance with § 7 VVG in conjunction

with §1 Insurance Contract Act (VVG-InfoV))

The VVG-InfoV stipulates in detail the content and extent of the “important informa-tion” that has to be provided. This information includes in particular importantinformation about the insurer, its payment commitments (premium and additionalcosts), duration and termination of the contract. The important information doesnot, however, include specific details of the insurance cover.

3.5.4.3 Product information sheet

Since the reform of the Insurance Contract Act (VVG), the insurer has to provide thepolicyholder with a product information sheet, insofar as he is a consumer.

The product information sheet is the first information the policyholder has to re-ceive. The legislators’ intention is that the policyholder should receive a file whichputs together all the important information for him in a logical order. The productinformation sheet, that must be named as such, provides an overview of the mostimportant insurance details. In this connection, the insurer must point out that theinformation is not complete. Assuming the policyholder will often not read the Ge-neral Insurance Conditions, the legislator wants to ensure that that he still receives agood overview of the contents. In addition, the product information sheet must bewritten in a simple and easily comprehensible way.

The product information sheet contains information about the insurance contract,such as the description of the insured risk and the benefit and risk exclusions thatare important in practice, as well as the particularly relevant obligations.

3.5.4.4 Statement on the right of revocation

Under the new regulation of § 8 Insurance Contract Act (VVG) all insurance contractscan in principle be revoked, irrespective of which distribution channel was used toacquire them. In this way the numerous regulations of the old VVG have been sub-stituted by the right of revocation that used only to apply to contracts acquired bydistant selling being extended to all insurance contracts.

The revocation period is 14 days, for life insurance policies 30 days, and beginswhen the policyholder has received all the above mentioned information. Only pol-icies acquired by distance selling, which in compliance with §§ 8 Para. 4 InsuranceContract Act (VVG) in conjunction with 312e Code of Civil Law (BGB) have anotherbeginning to the revocation period, are regulated differently. In these cases therevocation period only begins if furthermore the special obligations arising from§ 312e BGB have been met.

In some explicitly defined cases there is no right of revocation. This is the case forinsurance contracts

� with a duration of less than one month

� with provisional cover (Caution: the right of revocation nevertheless exists in thiscase if the policy was acquired by distance selling)


� for a pension scheme based on a regulation from an employment contract (Cau-tion: the right of cancellation nevertheless exists in this case if the policy wasacquired by distance selling)

� for large risks.

The insurer is obliged to inform the policyholder of the existence or non existence ofits right of revocation, and if it exists, the legal consequences of exercising it.

§ 9 VVG stipulates the legal consequences of a revocation in accordance with § 8VVG. The insurer must return that part of the premium which had been paid for theperiod after the declaration of revocation reached it. Furthermore, a precondition isthat the insurer had informed the policyholder in due form of the revocation and itslegal consequences and that the policyholder had given his consent that the insur-ance cover should already commence before the expiry of the revocation period.

For life insurance the special regulation of §152 VVG applies.

3.5.4.5 Information in accordance with §§ 2 and 3 VVG-InfoV

For life insurance, disability income benefit, accident insurance with return of pre-mium and health insurance the insurer has to give additional information, such asthe distribution of expenses and the paid up values. The background to this is thatthe above types of insurance are particularly difficult for the policyholder to under-stand and that they are long-term contracts.

3.5.4.6 Timely supply of information

The information indicated above must be made available to the policyholder ingood time before he concludes his policy declaration. This formulation is derivedfrom the condition for distant selling contracts in accordance with § 312c Code of Ci-vil Law (BGB), since the legislator wants to make sure, regardless of the sales chan-nel (distant or personal), that the policyholder already has the information when hemakes his policy declaration.

It is unclear what “timely” before the submission of the policy declaration means.The term is not defined in the law and a minimum period of time is not given. Thechoice of words makes it clear, however, that it is certainly not sufficient to give thepolicyholder the information practically at the same time as he submits his policydeclaration. He must have the chance to take note of this. This has implications forthe various ways in which an insurance contract can be concluded.

Policy model

Consequently, the so-called policy model has been dropped, according to whichuntil the VVG reform the insurer could send the information after the contract hadbeen concluded with the dispatch of the insurance policy.

Proposal model

In future the insurer will be restricted to the so-called proposal model, according towhich the policyholder, as described above, must have received the complete infor-mation before the submission of the proposal declaration.


Invitation model

Furthermore, the invitation model is in discussion. It is assumed that the policyhol-der’s “proposal” is not yet a binding declaration of intent pursuant to §145 BGB, butonly a request to the insurer to make an offer. He does that by sending the policy do-cumentation to the policyholder. The policyholder’s acceptance of the contractualoffer is made either explicitly or implicitly by the payment of the premium. Whetherand to what extent the policyholder’s policy declaration can be understood as asimple request to submit an offer depends on each individual case.

Concluding the contract by telephone

If the insurance contract is concluded by telephone at the request of the policyhol-der or by the use of another means of communication which does not permit thetransfer of information in text form, the transfer of the information can exceptionallybe made immediately after the conclusion of the contract.

Waiver of duty to provide information

In accordance with § 7 Para. 1 S. 3 VVG the policyholder can forego the right to re-ceive information. Since this possibility would practically undermine the new con-sumer protection as a basic principle of the VVG, exactly how such a waiver declar-ation could be made is very controversial. It is clear, however, that an insurer maynot systematically persuade all its customers to this renouncement in order to avoidthe duty to provide information. In such a case the Federal Financial SupervisoryAuthority (BaFin) could intervene.

Breach of the duty to provide information

The duty to provide information is breached if the information, contents and phras-ing clearly required in law are not complied with or used. This does not apply if theinformation is provided inaccurately.

Breach of the obligation to supply information can have various consequences:

� The revocation period pursuant to § 8 VVG does not commence, the policyholdercan thus revoke the insurance contract for an indefinite period of time and de-mand a return of premium. For the insurance company this is a matter of greateconomic uncertainty.

� If the insurer does not fulfil its obligations to supply information systematically,the Federal Financial Supervisory Authority (BaFin) can in accordance with § 81Para. 2 Insurance Supervisory Act (VAG) insist on the fulfilment of the duties.

� Competitors or consumer associations can take action against the company inaccordance with the regulations of the Unfair Competition Act (UWG).


Example 1:

Insurer X on principle does not hand out product information sheets to its custo-mers. In this way it is in breach of duty to provide information and is exposed to theaforesaid consequences.

Example 2:

Insurer X does hand out a product information sheet to its customers, but it does notmention the most important exclusion. There is no breach of duty to provide infor-mation that could lead to the legal consequences intended in the case of failure toprovide information. This dispute can only lead to liability to pay damages for a fail-ure to comply with pre-contractual obligations.

3.6 Commencement, duration and termination

of the insurance contract

3.6.1 Commencement of the insurance contract

There are three types of insurance commencement: the formal, the material and thetechnical insurance commencement.

3.6.2 Formal insurance commencement (Conclusion of the contract)

The formal insurance commencement is the time at which the contract is concluded:that is, the signing of the agreement in the legal sense.

3.6.2.1 Material insurance commencement (Beginning of the insurance cover)

The material insurance commencement is the contractually agreed time from whichthe insurance cover is in force: that is, when the insurer’s liability (assumption ofrisk) begins. This point of time does not necessarily need to coincide with the formalcommencement of the insurance.

The material insurance commencement is regulated in §10 Insurance Contract Act(VVG), which states that an insurance contract whose duration is determined indays, weeks or months begins at the beginning of the day on which the contract wasconcluded.

Example:

Mr Müller takes out a household insurance policy with X-Insurance on 10. 3. 2009 at11:00 a.m. There is no special agreement as to the commencement of the insurance.The contract is signed with the above date. The material insurance cover beginsaccording to §10 VVG already on 10. 3. 2009 at 0:00 a.m.


Because of §10 VVG the so-called “midday rule” was abandoned, according towhich the insurance commencement was in principle fixed at 12 noon. Since evenduring the period when the midday rule was in force many classes of insurancechose to make the cover begin at 0 hours in order that there was no time gap in thecover, the new general stipulation was made to fit in with these special regulations.

It is possible to diverge from §10 VVG, since it is only a rule of interpretation: indivi-dual agreements regarding the start of the insurance cover are possible.

Payment clause

In addition, until the VVG reform the so-called payment clause applied. A precon-dition for the commencement of the insurance cover was as a matter of principle thepayment of the first premium by the policyholder. After the VVG reform the pay-ment clause in this form is no longer permitted, because since 1.1. 2008 already withthe late payment of the first premium fault has to be considered. A payment clausethat complies with the new law should thus include the default element, and couldread as follows:

“The insurance cover begins at the earliest with the payment of the first premium,unless the policyholder is not responsible for its not being paid.”

If the policyholder is responsible for the non-payment of the first premium, the in-surer is by law already free from its duty to pay insofar as it has drawn the policy-holder’s attention to this effect in a specific message in text form or by means of anoticeable warning in the policy document.

The policyholder is often granted insurance cover before the payment of the firstpremium and thus has immediate cover. In this case the (legally standard) paymentclause is contractually waived. It is then substituted by the so-called “extended pay-ment clause”, according to which the policyholder has insurance protection if thepremium is paid within an agreed period of time or immediately on receipt of theinvoice.

Waiting period

Furthermore, particularly in private health insurance waiting periods can be agreed.In this case the insurance cover begins after they have finished.

There is a difference between a general waiting period and special waiting periodsfor certain illnesses and benefits. The extent to which such waiting periods can beagreed is regulated in §197 VVG. According to this the general waiting period mustlast for a maximum of 3 months, special waiting periods especially for giving birth,psychotherapy, dental treatment, dental prostheses and orthodontics maximally8 months.

3.6.2.2 Technical Insurance commencement

The technical commencement of the insurance cover is the beginning of the periodfor which a premium is required: that is, the period of time for which a premium iscalculated. The technical commencement of the insurance cover coincides regularlywith the material insurance commencement.


The period for which a premium is required is broken down into insurance periods.Each insurance period lasts one year insofar as the premium is not based on shorterperiods of time (§12 Insurance Contract Act (VVG)).

Backdating

There is backdating if the technical but not also the material insurance commence-ment is set before the start of the formal insurance commencement. The period forwhich a premium is due begins before the legal contractual conclusion, but theinsurance cover only begins with the start of the material insurance.

Backdating plays a role in life insurance if the proposer chooses a younger age ofentry in order get a lower premium rate or enjoy tax advantages for a previousperiod of time, or in motor liability insurance in order to achieve a better grading inthe claims-free classes in the future.


technical insurance conclusion of the insurance andcommencement material insurance commencement

January 1st February 1st March 1st

Forward insurance and retroactive insurance

“Forward insurance” is the norm and means that the material insurance commen-cement coincides with the formal insurance commencement or occurs later: that is,in the future.

Example 1:

Ms Meier leaves her parents’ home on 1. 2. 2009 for her own flat. She wants to takeout a household policy and have insurance cover as soon as possible. She meetsher insurance intermediary on the same day, therefore, and takes out the appro-priate policy in which the insurance commencement is also dated 1. 2. 2009.

Example 2:

Family Gruber books a holiday trip to Mallorca which will take place in October. Thefamily takes out baggage insurance for the journey. The material insurance com-mencement is at the same time as the start of the journey.

There is “retroactive insurance” when the technical as well as the material com-mencement of the insurance is set before the formal insurance commencement.The insurance cover should thus already begin before the conclusion of the con-tract.

According to § 2 II VVG the insurer only has a right to the premium payment if it didnot know that the occurrence of the insured loss was excluded before it made thecontractual declaration. Vice versa, the insurer is released from its liability to make

Example:

payment if the policyholder already knows that a claim had occurred when he sub-mits the contractual declaration. If one of the two eventualities is the case, retro-active insurance is excluded.

3.6.2.3 Provisional cover

A contract for provisional cover is concluded if the policyholder needs insurance co-ver immediately, but the insurer would actually still need time to assess the policy-holder’s risk thoroughly and determine the exact policy conditions.

Example:

Ms Schmidt buys a secondhand car and in order to obtain registration she needsproof of compulsory liability insurance. Because she wants to obtain the licence onthe very day of the purchase she applies for provisional cover at Insurer X, since thelatter cannot make a final offer at such short notice.

The contract of provisional cover is an independent insurance policy for which theregulations of the Insurance Contract Act (VVG) apply. Since this contract is usuallymade under great time pressure, §§ 49 to 52 VVG stipulate some exceptions whichfacilitate its conclusion.

Consequently, in accordance with § 49 I VVG it can be specially agreed that theinformation from the insurer stipulated in § 7 VVG need only be given if the policy-holder requires it, at the latest with handover of the policy document. Because of thestrict requirements of the distance selling directive, this concession does not applyto distance selling policies. Furthermore, the policyholder does not have a right ofrevocation as defined in § 8 VVG (which he has in the case of a distance sellingpolicy).

As a matter of principle, the material insurance cover of contracts with provisionalcover begins with the formal conclusion of the contract or the stipulated commen-cement. In contrast to the main policy, the payment clause must be explicitly agreedin accordance with § 51 VVG.

Depending on the wishes of the parties provisional cover should apply only to thepoint of time at which the insurer has finished its risk assessment. There is no dutyto take out the main contract, compare § 50 VVG. Thus in this case it is not a so-cal-led preliminary agreement. The contract for provisional coverage thus terminates atthe latest when the main contract or a further contract for provisional cover wasconcluded: namely, irrespective of which insurer (§ 52 VVG).


technical and material conclusion of the insuranceinsurance commencement policy

January 1st February 1st March 1st

Example:

Example:

On 1. 2. 2009 Ms Schulz takes out a policy for provisional compulsory liability coverwith X-Insurance for her car. On 1. 3. 2009 she takes out the main compulsory liabi-lity policy with Y-Insurance. The policy for provisional cover with X-Insurance endsautomatically on 28. 2. 2009 at 24:00 hours.

Furthermore, the provisional cover ends – provided there are instructions to thiseffect – if the policyholder fails to pay the initial premium.

3.6.3 Duration of the insurance policy

The duration of the insurance contract depends in the first instance on the agree-ment of the contractual partners. The insurance contract can be concluded for adefined period or it can end automatically upon occurrence of a particular event.

Example 1:

A motor insurance policy is taken out for a year. Commencement of the insurance:1. 1. 2009, 0:00 hours, Termination of the insurance: 31. 12. 2009, 24:00 hours. In thiscase the policyholder must take action in order to take out a new insurance policy orin order to renew the existing policy.

Example 2:

Mr Kunze has bought a piece of land and while his house is being built he needs aprincipal’s liability insurance. This ends automatically on completion of the building.

An insurance policy can, furthermore, be taken out for an indefinite period. Thereare two ways of doing this in practice: either the termination of the insurance policyis deliberately not stated and defined as open, or the agreement states that theinsurance duration is one year and is renewed automatically unless one of the par-ties to the policy has cancelled it. In both cases one of the parties to the contractmust take action in order to terminate the policy.

In accordance with §11 I VVG each renewal of the policy must be for maximally oneyear.

3.6.4 Termination of the insurance contract

Insurance policies can be terminated in different ways or they can end automa-tically. The most important are duration, occurrence of a particular event, mutuallyagreed nullification, withdrawal or cancellation.

3.6.4.1 Expiry

An insurance contract can be taken out for a certain period and end automatically atthe date stipulated. To avoid undermining the policyholder’s right of revocation,which could be the case if contracts with extremely long durations were taken out,the legislator in §11 Para. 4 Insurance Contract Law (VVG) has laid down that forcontracts that last for longer than 3 years the policyholder should have a right ofrevocation from the end of the third year. It should be noted that only the policyhol-der has this right of revocation, not the insurer.


Example:

Mr Huber takes out a personal liability policy. In order to get particularly good con-ditions, he takes out the contract for five years.

Version a:

The contract ends automatically without the parties needing to take action after theagreed 5 years.

Version b:

Mr Huber wants to change the insurer after 4 years and gives notice of cancellationas of the end of the 4th insurance year, because he has a special cancellation privi-lege in accordance with §11 Para. 4 VVG.

Also in the case of a temporary contract there can be ways of cancelling it during theagreed duration. But a precondition in this case are special events that would justifyan extraordinary cancellation. Cancellation by agreement with the contractual part-ner is also always possible.

3.6.4.2 Occurrence of particular events

If it is agreed that the contract should be terminated on the occurrence of a particu-lar event, the insurance contract ends when this event occurs without the parties tothe contract needing to take further action. This is always appropriate if the occur-rence of the event cannot (yet) be fixed for a particular date. Examples of suchevents are transports or exhibitions.

As with an insurance contract for a limited period of time, the contract can only becancelled during its defined duration for special reasons or by mutual consent.

3.6.4.3 Withdrawal of the contract

The cases in which one of the contractual partners can give notice of withdrawal areregulated in the Insurance Contract Act (VVG).

Notice of withdrawal is a unilateral declaration of intent which requires acknowled-gement of receipt in the sense of §§116 ff Code of Civil Law (BGB). In contrast to thegeneral law of obligations, withdrawal from an insurance contract does not lead tothe contract being rescinded, because as a continuing obligation it was alreadypartly fulfilled (usually by the insurer carrying the risk for a particular period oftime). Thus the consequences of the withdrawal are regulated in the VVG in eachcase, where the basic principle for the right of withdrawal is also found.

Withdrawal because of breach of the duty of disclosure prior to contract,

§§19 ff VVG

In accordance with §19 VVG the insurer can question the policyholder about the pre-sent risk features before the contract is concluded. This serves the purpose ofgiving the insurer the chance to make a proper calculation and to consider whetheror not it wants to insure a particular risk.


Other than before the reform of the VVG the policyholder needs only disclose signi-ficant risk elements

� which the insurer has inquired about in written form and

� which exist before he submits his contractual declaration

The insurer must consider carefully which circumstances are important for him andwhich questions he would like to ask. Furthermore, he can only ask questions whichare of significance for his risk assessment and not further questions which wouldenable him to offer other insurance policies, for example.

Example 1:

Mr Müller wants to take out private health insurance and submits a proposal to X-In-surance. Following this he receives a questionnaire in which he is asked specificallyabout previous diseases, operations and dental treatment. The insurer needs thisinformation in order to calculate a premium.

Example 2:

Ms Meier wants to take out household insurance. The insurer asks Ms Meier abouther income, because at the same time he sees a chance of offering her an annuity.

This new regulation has the advantage for the policyholder that as long as he ans-wers all the insurer’s questions truthfully he no longer bears the risk of jeopardizingthe insurance cover. If the insurer does not ask a question whose answer is relevantfor the risk assessment, this is to the disadvantage of the insurer. In contrast beforethe VVG reform, the policyholder had to decide which facts were relevant for the riskassessment.

Furthermore, the policyholder need only point out circumstances which he is awareof until he submits his policy declaration. As a rule this is the proposal for taking outthe policy. If the insurer now needs more time for its risk assessment, and shouldadditional dangerous circumstances be known to the policyholder between his po-licy declaration and the acceptance of the insurer, he is only obliged to report theseif the insurer explicitly asks him after his policy declaration. Before the VVG reformthe policyholder was obliged to report any circumstances that could negativelyinfluence the risk that occurred after the contract declaration, without the insurerneeding to inquire specifically.

If the policyholder breaches his duty of disclosure, §19 ll VVG gives the insurer theright to withdraw from the insurance contract, unless the breach was due to simplenegligence. In this case the insurer only has the right of cancellation, compare §19 lllVVG.

Insofar as the right to withdraw exists because of a grossly negligent or intentionalviolation of the duty to disclose, it is nevertheless excluded if the insurer would haveconcluded the contract to other conditions.


Example:

Ms Gruber wants to take out private health insurance, but forgets to declare a chro-nically asthmatic condition, although the insurer had asked about such conditions.Although Ms Gruber has not complied with her duty to disclose, the insurer is notpermitted to withdraw from the contract, because it usually insures asthma suffe-rers – with an extra premium of 5 %, however. Ms Gruber thus has insurance cover,but she must pay the higher premium (with retrospective effect). If Ms Gruber hadnot declared the disease deliberately, the insurer would not be obliged to make thecontractual adjustment, 19 IV VVG.

If because of this the premium is raised by more than 10 percent or if the insurer ex-cludes the risk that was not reported, the policyholder can withdraw from the insur-ance contract by cancelling it, compare §19 Para. VI VVG.

Furthermore, the insurer can only exercise its right to withdrawal if it has informedthe policyholder accordingly by means of a separate note in written form and if ithad no knowledge that the information was incorrect. The insurer should, therefore,enclose a further sheet with the proposal form, in which the consequences of sup-plying false information are spelt out.

If the insurer announces the withdrawal, in accordance with § 39 Para. 1 Sentence 2VVG it can demand the pro rata premium which it is entitled to until the withdrawalannouncement is effective. Until the reform of the VVG the principle of the indivisi-bility of the premium prevailed. The insurer was entitled to the entire premium dueuntil the expiry of the insurance period. This principle of the indivisibility of the pre-mium was suspended, however, in the new VVG, so that pro rata premium pay-ments are possible.

This is nevertheless fair, because the insurer is liable to pay for a claim before thesubmission of the withdrawal announcement if neither the occurrence nor theextent of the insurance claim is due to the breach of the duty of disclosure.

Withdrawal due to non payment of the first or single premium

In the event of late or non payment of the first or single premium, the law also givesthe insurer the right to withdraw from the contract. The preconditions for this will bedealt with in the next chapter, “Premium payment duty”.

The consequence of a withdrawal in accordance with § 37 VVG is that benefitsalready received (e.g. premium or an insurance benefit because of a claim) must bereturned. This is a result of the general withdrawal regulations of the Code of CivilLaw (BGB). However, in § 39 Para.1 Sentence 3 VVG there is a special regulation thatthe insurer can demand a reasonable expense charge.

3.6.4.4 Cancellation of the insurance contract

The cancellation – as also the notice of cancellation – is a unilateral declaration ofintent which requires acknowledgement of receipt. Other than the withdrawal,which is aimed at ending a contract retroactively, the purpose of cancellation is toend the insurance contract for the future.


Whether the cancellation needs a particular form can either be established in law orin the insurer’s General Insurance Conditions (AVB).

It is important to distinguish between contractual notice of termination and extra-ordinary notice of cancellation.

Contractual notice of termination

Contractual notice of termination can be given with effect from a specific time ofcancellation, but in doing so the period of notice must be observed. It is not neces-sary to state the reason for cancellation.

The contractual notice of termination is mainly regulated in §11 Insurance ContractLaw (VVG). As already described above, the following can be given contractualnotice of cancellation:

� Insurance contracts with a renewal clause

� Insurance contracts with a duration of more than three years, at the earliest to theend of the third year

� Open-ended insurance contracts

In the case of the last named, the right of cancellation can be waived for a maximumof two years.

The period of notice must be from one to three months and be the same for bothparties to the contract. In this respect §11 may not be varied to the disadvantage ofthe policyholder.

The legislator has standardized exceptions to these regulations for different types ofinsurance, insofar as particular interests require this.

The insurer cannot give contractual notice of cancellation, for example, for sicknessbenefit, daily benefit or long-term care insurance that replace the statutory benefits.The background to this ruling is the need to protect the policyholder, who becauseof medical underwriting is put into a certain tariff and after falling sick would onlyobtain insurance cover again to considerably worse conditions. The intention ofsubstitutional health insurance is, namely, to provide lifelong insurance cover that isable to replace statutory schemes. The policyholder, on the other hand, is grantedthe right to give contractual notice of cancellation.

There are further exceptions in life and disability income benefit insurance. In motorthird party liability contractual notice of cancellation is also stipulated explicitly.

Extraordinary notice of cancellation

Extraordinary notice of cancellation is possible for temporary as well as for open-ended insurance contracts and can be effected during the year. There must alwaysbe a reason for this (cause of notice of cancellation).

The principles on which an extraordinary notice of cancellation may be issued infavour of the policyholder and / or the insurers can be found in various places of theVVG.


Important examples of this are:

� The insurer’s right of cancellation because of a simple negligent breach of the pre-contractual duty of disclosure

� The insurer’s right of cancellation because of an increase in the risk while thepolicy is in force

� The insurer’s right of cancellation because of a breach of obligation before a lossoccurs

� The insurer’s right of cancellation because of persistent failure of the policyholderto pay the renewal premium

� The policyholder’s right of cancellation because of an increase in the premium

� The right of cancellation of both parties because of a claim in non-life insurance

Extraordinary notice of cancellation does not necessarily mean cancellation withimmediate effect. Rather, the law often fixes periods within which and at whichpoint of time extraordinary notice of cancellation may be given. This serves to pro-tect the policyholder, who should have time to look for new insurance cover.

The law provides for cancellation with immediate effect only in a very few cases, if aparticularly serious breach by one party justifies this.

As well as the usual reasons for an extraordinary notice of cancellation as regulatedin the VVG, there are two other justifications for an extraordinary notice of cancella-tion.

This is, on the one hand, possible with a contractual agreement, especially in theGeneral Insurance Conditions (AVB). However, the AVB often simply repeat therights which are already available by law. If an insurer tries to justify extraordinarynotice of cancellation in its AVB on grounds that the law is not familiar with, it will benecessary to check very carefully whether this is consistent with the relevant basicprinciples of the VVG.

A further right to extraordinary notice of cancellation can result from § 314 Code ofCivil Law (BGB) (cancellation of a continuing obligation for an important reason) ifone party “after consideration of the mutual interests cannot be expected to conti-nue the contractual relationship.”

This very broadly expressed right of cancellation can naturally only apply if therewas not already an ultimate rule for each violation in the VVG.

Excursus: Death of the policyholder

The death of the policyholder does not in principle end the insurance relationship,but this is transferred to his heirs, since the insured risk basically remains (Example:motor liability insurance). Extraordinary notice of cancellation is thus not justified. Ifthe risk depends only on the person, however (for example, health or accident insu-rance) there is no longer insurable interest, so that the insurance contract can be ter-minated in accordance with § 80 VVG. For life and accident insurance the death doesnot only mean the cessation of the risk but also the claim event, which triggers theclaim to the insurance benefit.


3.7 Duty to pay the premium

With the insurance contract the policyholder undertakes to pay the premium thathas been agreed.

The premium is the policyholder’s payment for the risk that the insurance carries. Itis, therefore, the price for the insurance cover. The premium is called “contribution”by mutual insurance companies (compare § 24 Insurance Contract Law (VVG)).Nevertheless, the legal regulations, which only refer to the premium, apply also tothe contributions.

The contractual partners are free in principle to agree the premium level. Wherethe insurer has mass business, however, there will naturally be no individual nego-tiations about the premium. Rather, the insurer refers instead to its precalculatedtariff tables, which reflect different risk groups.

Although price control by the supervisory authority was stopped in 1994, for theclasses of insurance of sociopolitical relevance – life insurance, accident insurancewith return of premium and the form of health insurance that replaces statutorycover – there are still standard rules from in the Insurance Supervisory Act (VAG)about the principles of calculation and later premium adjustment.

3.7.1 Types of premium

There are different types of premium


Premium

single premium

initial premium renewal premium

regular premium

A single premium is one which the policyholder has to pay on conclusion of theinsurance contract and then no further premiums are due. Single premiums pay arole especially for policies of shorter duration (e.g. travel cancellation insurance).

For all policies with regular premiums the premium is generally paid per year,unless shorter periods of time were fixed by the insurer (compare §12 InsuranceContract Law (VVG)).

For policies with regular premiums a distinction is made between the first premiumthat has to be paid (first premium) and the other premiums (renewal premiums).This distinction reflects the fact that a policyholder who has not paid the first pre-mium (promptly) must reckon with more serious consequences than a policyholderwho does this in the course of a long contractual relationship.

On the other hand, in law the single premium and the first premium are treatedequally.

It is necessary to distinguish between a shortened insurance duration for which aparticular premium is payable and a longer insurance period with agreed instal-ments. The latter case constitutes only a contractual agreement about payments.The reduction of the insurance duration, however, would affect the right of contrac-tual notice of cancellation

Example 1:

Insurer X writes in its policy conditions:

The insurance policy is taken out for 6 months and is automatically renewable by 6months if one of the contractual partners does not submit notice of cancellation atleast one month before expiration. In this case a duration of only 6 months has beenagreed and for this period a premium has to be paid. If the policy is renewed, thepremium for the next 6 months becomes due. Contractual notice of cancellation canalways be given to the end of the insurance periods.

Example 2:

Insurer Z writes in its policy conditions:

The duration of the contract is one year. The premium is always due quarterly,always at the beginning of the new quarter. In this case the insurance duration isone year. The premium is payable in instalments. Contractual notice of cancellationcan only be submitted to the end of the insurance year.

3.7.2 Premium due dates

The due date is the point of time when the creditor can request the benefit and whenthe debtor must deliver. First premiums, single premiums and renewal premiumshave different due dates.

First and single premium

In accordance with § 33 Para. 1 Insurance Contract Law (VVG) the first and singlepremium are “payable immediately after the expiry of two weeks after receipt of theinsurance policy”. In the old version of the VVG there was not yet this two week shiftof the payment date. With this change the legislator expresses its clear intentionthat payment should only be made when the revocation period has run out and theinsurance policy is in force.

It is, therefore, questionable whether § 33 Para. 1 VVG from which deviations arealso possible to the detriment of the policyholder, can be changed by means of theGeneral Insurance Conditions to such effect that the premium is immediately pay-able on receipt of the insurance policy. Such a clause could be invalid according to§ 307 Code of Civil Law (control of content), because it is not consistent with impor-tant basic principles of the legal regulation, which is being deviated from.

This would be the case if the two week payment period fitted in with the generalprinciples of the new VVG and its basic concepts.


For those insurance contracts for which there is no right of revocation (e.g. policieswith a duration of less than a month), the agreement of the immediate due date ofthe first and single premium is certainly possible, because the principles outlinedabove are not relevant in this case and the policyholder does not have justifiableinterest in making a later payment.

For all other insurance policies both opinions could be pleaded for. Many factorsindicate that the legislator did not want to link the duty to pay the premium to theduration of the right of revocation because otherwise the premium period would befurther extended if the right of revocation began to run belatedly, for example, be-cause of inadequate information.

Renewal premium

The due date of the renewal premium depends on the period insured, since the pre-mium is calculated according to the duration of the insurance period. With the be-ginning of the new insurance periods the renewal premium is due. Special paymentmodalities can naturally be agreed with the policyholder (e.g. payment within 4weeks of the commencement of the new insurance period or only after the receipt ofan invoice, etc.).

3.7.3 Debtor of the insurance premium

The only main duty of the policyholder is to pay the premium. Also for a contract forthe account of a third party or if another person pays the premium, the policyholderalone remains the one who owes the premium.

3.7.4 Late premium payment

As already mentioned, the first premium and renewal premium are due at differenttimes. The legal implications if the duty to pay the premium is not met are also dif-ferent.

3.7.4.1 Non payment / Late premium payment

§ 37 Insurance Contract Act (VVG) regulates the consequences of a late payment ofthe first or single premium.

Right of withdrawal

If the policyholder does not pay the first or the single premium although it is due,the insurer is justified in withdrawing from the contract as long as the payment hasnot been made. In other words an existing right of withdrawal expires at the latestwith the payment of the first premium.

The fiction of the law before the VVG reform of 1.1. 2008, according to which it coun-ted as withdrawal if the premium could not be legally ascertained within 3 months,no longer applies. Today the insurer must take action in order to withdraw from acontract in force.


A precondition for the right to withdraw continues to be that the policyholder has totake responsibility for the non payment, that is, he is culpable for not paying the pre-mium.

Example:

Ms Müller has taken out an insurance policy and the premium is due on 1. 6. 2008. Inthe week before Ms Müller has appendicitis and must go immediately to hospitalfrom which she is only released on 3. 6. 2009. On 4. 6. 2009 Ms Müller transfers themoney. In this case there would be no fault, and the insurer would not be justified inwithdrawing from the contract.

If the insurer declares withdrawal justifiably, the parties must return their benefitsinsofar as they have received any. A claim for premium payment – also pro rata – nolonger exists. The insurer can only demand a reasonable administration fee, since ithad administration costs due to the issue of the policy and the policyholder did notbehave fairly.

The insurer naturally has the right to hold on to the policy in force and sue for thepayment of the premium.

Release from obligation to perform

If the policyholder does not pay the first or single premium because of his own fault,the insurer is released from its obligation to pay quite apart from a declaration ofwithdrawal if a claim occurs before the premium has been paid.

Beside the precondition of fault, to invoke release of liability the insurer is obligedto make the policyholder aware of the legal consequences by means of a specificmessage in text form or a noticeable indication in the policy document.

Example:

On 1. 4. 2009 Mr Huber takes out a baggage insurance policy. Failing an agreementto the contrary he must pay the single premium only two weeks after receipt of theinsurance policy. It is agreed, however, that the insurance should be immediately inforce if he pays the premium punctually at the end of these two weeks. There is nofurther information about this matter.

On 2. 4. 2009 Mr Huber has a baggage loss and reports this to his insurance com-pany, which on 6. 4. 2009 already deals with the claim amounting to € 500,–. Mr Hu-ber forgets to pay the premium.

The insurer cannot claim release from the obligation to perform, because it did notissue the noticeable information that was needed.

3.7.4.2 Non payment / Payment default with the renewal premium

§ 38 Insurance Contract Act (VVG) regulates the results of a payment default of therenewal premium.

In the case of non payment of the renewal premium the policyholder had alreadypaid the first premium and so obtained insurance cover. He obviously owes the


insurer the renewal premium, but he should not easily lose the insurance protec-tion. For this reason the insurer must request the policyholder to pay the premium(qualified reminder in accordance with § 38 Para. 1 VVG) with two weeks’ noticebefore there can be legal consequences. In this payment demand the insurer has tostate the consequences of non payment.

Only if the policyholder is still in default with the renewal premium after this periodof notice is over,

� is the insurer released from the duty to pay if the insured loss event occurs afterexpiry of the notice period but before the premium has been paid.

� can the insurer cancel the policy without observing a period of notice. The can-cellation becomes ineffective, however, if the renewal premium is neverthelesspaid within a month of the receipt of notice of cancellation. According to the newVVG it does not matter in this connection as to whether an insured loss hasoccurred in the meanwhile. For the insured loss that occurred between the end ofthe notice and the payment there is in any case no insurance cover.

Example:

Ms Huber has comprehensive insurance for her car. She does not pay the renewalpremium, which is due on 1. 1. 2009. Thereupon her insurer Z sends her a reminderon 5. 2. 2009, in which it states that she must pay the premium by 24. 2. 2009. The re-minder states that after the expiry of the term the contract is deemed to be cancelledwith immediate effect. Z points out to Ms Huber in due form what the legal conse-quences will be. On 28. 2. 2009 Ms Huber makes a claim and pays the premium on3. 3. 2009.

The notice of cancellation was effective in law and can, as in the example, be con-nected with the qualified reminder. Although with the payment of the premiumwithin the month the effects of the cancellation cease to apply, there is no insurancecover for the insured loss between the end of the period of notice and the paymentof the premium. Since Ms Huber is still in default with the renewal premium afterthe period of notice has run out, Z is released from its liability to pay.

3.8 Obligations

As well as the payment of the premium the insurer is naturally interested in ways inwhich the policyholder behaves, in order in the first place to be able to assess its riskand during the policy that the risk does not become greater and in the event of a lossso that the claim is as small as possible. To this end the insurer has the instrumentof warranties at hand.

An obligation is not a statutory duty, however, because the insurer cannot bring anaction for it or claim damages (compare Wandt, l.c., marginal 522, 532). Compliancewith the rules of behaviour is only in the interests of the policyholder in order tomaintain his right to cover.


3.8.1 Legal and contractual obligations

The legislator distinguishes between legal obligations, which are already compul-sory in law for the policyholder, and contractual obligations, which the insurer ge-nerally makes an element of the insurance policy by means of the General InsuranceConditions (AVB).

The legal obligations are found in the Insurance Contract Act (VVG) irrespective ofwhen they should be observed or whether they apply to the insurance of indemnityor the insurance for a specified amount.

There are legal obligations before the contract is concluded (duty of disclosure inaccordance with §§19 ff VVG), during the term of the contract (avoidance and dis-closure of an increase in risk, §§ 23 ff VVG) and after the occurrence of a loss (duty tonotify and give information, §§ 30, 31 VVG). In indemnity insurance the obligation toreduce the claim in accordance with § 82 VVG is certainly one of the most import-ant legal duties.

Legal obligations often have additional regulations which describe the legal conse-quences of breaching them. If an insurer incorporates a legal obligation unchangedinto its AVB, the obligation remains, nevertheless, a legal one. If the insurer, how-ever, modifies the facts of the case or the legal consequence, the legal obligation be-comes a contractual one. The same applies for legal obligations for which the legis-lator has not stipulated any legal consequences if they are breached. If the insurerincorporates such an obligation into its AVB, and couples its breach with legalconsequences, the obligation becomes a contractual one.

Since there are special requirements for contractual obligations, it is important thatobligations should be recognizable as such. It may be problematical to distinguishthem from exclusions. Since whereas compliance with an obligation can be influen-ced by the policyholder so that it is the insurer’s concern to encourage the policy-holder to behave in a desired way, in the case of a risk exclusion the insurer wants toremove part of the cover irrespective of whether or not the policyholder can influ-ence it.

In this respect according to the consistent judgments of the Federal Court of Justice(BGH) it does not depend on the phrasing of the clause or its status in the AVB, butonly on the material content (compare Wandt, l.c., marginal number 539).

Example:

Ms Müller has insured her expensive mountain bike. In the Exclusions/Limitationsthere are the following clauses:1. There is insurance cover only between 6:00 and 22:00 hours. Between 22:00 and

6:00 hours there is insurance cover if the bicycle is secured with a lock.2. There is no insurance cover as long as the bicycle is being used for the purpose

for which it was intended.

The first clause is a so-called implicit obligation, because the insurer wants toencourage the policyholder to secure it with a lock. The second is a real exclusion,because the insurer definitely does not want to assume risks when the bicycle isbeing used, although Ms Müller could naturally also not use the bicycle.


As the example has already shown, the distinction can be very difficult in the parti-cular case.

In laws which apply to compulsory forms of insurance, there are often further requi-rements for obligations in order to maintain a minimal standard of insurance coverfor the protected third party.

3.8.2 Breach of obligations

The legal consequences of breaching a legal obligation are regulated (variably) bythe particular stipulation in the law.

The legal consequences of breaching a contractual obligation are, on the contrary,fixed in § 28 Insurance Contract Act (VVG). A distinction is made between contrac-tual obligations after taking out the insurance policy but before the occurrence of aloss and obligations after the loss occurrence. The regulation is half mandatory, sothat it may not be modified to the detriment of the policyholder.


obligations

legal

before the occurrenceof the insured loss

after the occurrenceof the insured loss

contractual

Legal consequences for breach of obligation before the occurrence of the

insured loss

If the policyholder breaches an obligation before the occurrence of an insured loss,the insurer can cancel the insurance contract without observing a period of notice.This severe legal consequence shall only apply, however, if the breach is intentionalor at least grossly negligent. There is no right of withdrawal, however, and it alsocannot be contractually agreed.

Note: the insurer only has the right to cancel if the policyholder has breached anobligation before the loss occurrence. If the breach of obligation occurs after theoccurrence of the insured loss, this possibility does not exist.

After the occurrence of the insured loss, however, the insurer as well as the policy-holder have the right of cancellation, §§ 92, 111 VVG.

Legal consequences for breach of obligation before or after the occurrence of the

insured loss

If the policyholder breaches a contractual obligation, the insurer can be releasedwholly or partly from the liability to make payment. In this case the legislator no lon-ger makes a distinction between the times of the violation (before or after the occur-rence of the insured event).

Before the reform of the VVG of 1. 1. 2008 the so-called “all or nothing” principleapplied. According to this the insurer was either completely liable (the policyholderthen received everything) or completely free of liability (the policyholder receivednothing) if an obligation had been breached.

Since the border between negligence and gross negligence is blurred, but theconsequences are very different, the legislator has abandoned this principle andreplaced it by the “more or less” principle.

In accordance with § 28 VVG the insurer is thus only released from liability if thepolicyholder acted intentionally. If the policyholder acted with gross negligence, theinsurer only has the right to reduce its benefit in accordance with the degree ofresponsibility. In the case of simple negligence the insurer is completely liable.


breach of a

contractual obligation

simply negligent grossly negligent intentional

full benefit partial benefit no benefit

A further precondition for a reduction or rejection of the duty to provide indemnifi-cation is that the breach of obligation was the cause of the loss occurrence or theloss manifestation. This only does not apply if the policyholder has acted fraudu-lently.

Furthermore, the insurer can only claim (partial) release from the obligation to per-form if it has previously pointed out to the policyholder the consequences of abreach of obligation. This applies only to informational and explanatory obligationsafter the occurrence of an insured loss, however, because the policyholder hasalready fulfilled or breached its obligations when the insurer learns of the insuredloss and cannot thus inform the policyholder of the effects of a breach in good time.

Example:

Mr Müller has taken out baggage insurance. His case is stolen from his hotel room.It states in the insurance conditions that in the case of theft the policyholder has toreport the loss at the next police station immediately. Mr Müller does not want tospoil his holiday and reports the loss 10 days later when he returns home. Since MrMüller is in deliberate breach of obligation, the insurer is released of any liability.The breach also affects the possibility of establishing whether the loss occurred andif it did, its extent, because the local police only have a good chance of catching thethief and finding the booty immediately after the theft. The insurer could not informthe policyholder of the effects of the breach of duty because duty of disclosureoccurred “immediately” and the insurer only learnt later of the loss.

3.9 The insurer’s duties

The insurer’s main contractual duty is to carry the risk on behalf of the policyholderand to provide the agreed benefit if the risk should occur.

As a rule, the insurer will have to provide a financial benefit in the event of an in-sured loss, although other benefits can also be agreed, such as in liability insurancethe rejection of unjustified claims, or certain assistance services such as the organi-zation of patient transport in the case of travel health insurance.

Just what benefits are to be provided depends in the first instance on the contrac-tual agreement.

3.9.1 Insurance for a specified amount

With insurance for a specified amount the agreed sum (the sum insured) must bepaid if the insured loss occurs, quite independently of what damage the insured lossactually caused. Thus the insurance for a specific amount has no insurable value. Itis fixed by the policyholder according to the principle of the abstract need for cover.The payment of the sum insured can take the form of a lump sum payment or anannuity.

3.9.2 Indemnity insurance

With indemnity insurance, on the other hand, the specific loss that the policyholderhas suffered must be replaced. The insurer’s liability is limited to the level of the lossthat actually occurred.

Insured value

Because the possible loss level is directly connected to the value of the insurableinterest (insurance value as in the legal definition of § 74 Insurance Contract Act(VVG)), finding what it is is relevant for the risk assessment. Already at the proposalstage the insurer will inquire about the value of the insurable interest, in order to cal-culate its risk on the basis of this figure. The higher the insurance value, the highercan be the obligation to pay in the event of a claim.

In indemnity insurance the figure counts as the insurance value that the policyhol-der has to pay at the time of the insured loss for the replacement of the object asnew after subtraction of the difference between old and new. The regulation of § 88VVG is flexible, however, and the parties to the contract can agree other arrange-ments, which makes particularly good sense if the insurance value cannot be estab-lished without a great deal of effort. For example, the reinstatement value of anobject can also be insured.

Sum insured

In indemnity insurance the sum insured is the limit of the replacement benefit. Theinsurer never has to provide more than the amount of the actual loss, however, evenif the sum insured is higher.


Insurance at full value

There is full cover insurance if the agreed sum insured is the same as the insurancevalue. Only in this case is there sufficient insurance cover.

Over-insurance

There is over-insurance according to § 74 VVG if the sum insured is significantlyhigher than the insurable value. Each contractual partner can request that the over-insurance should be corrected with immediate effect by lowering the sum insuredand the premium respectively so that there is full cover insurance.

If the policyholder has stated a sum insured that is too high in order to enrich him-self fraudulently, the insurance contract is nullified. In this case the insurer candemand the premium up to the time when it learnt of the nullification.

Underinsurance

There is underinsurance if the sum insured is significantly lower than the insurablevalue at the time when the insured loss occurs, compare § 75 VVG.

In this case the insurer only needs to provide its benefit in the relation of the suminsured to the insurable value.

sum insured x losscompensation =

insurable value

Example:

Mr Braun has taken out a household contents insurance policy and he stated thatthe insurable value is € 50,000. The value of the household contents is actually€ 100,000, however. There is now an insured loss of € 25,000.

The insurer need pay only € 12,500 in this case.

First loss insurance

There is first loss insurance if the insurer, other than in § 75 VVG, pays the claim upto the level of the sum insured, although the insurable value is higher than the suminsured and ignores underinsurance.

Example:

Ms Koch has taken out a household contents insurance policy and the insurablevalue is stated as being € 50,000. The actual value is € 100,000, however. In herinsurance conditions the following is stated: The insurer will not subtract anyamount for underinsurance. There is now an insured loss of € 25,000. The insurermust pay the full claim of € 25,000.


Partial insurance

There is partial insurance if not the whole insurable value but only a fraction of it,that is a certain part of it is insured on a value basis. Partial insurance makes senseif it is very unlikely that the occurrence of the insured event could affect all theinsured objects.

Example 1:

Company X has a furniture store. The complete value is € 1,000,000. Since X wantsto save premium and it is unlikely that all the furniture could be stolen at once,it takes out partial insurance against burglary. A 10 % share is insured – that is,€ 100,000.

Example 2:

Company A has a furniture store. The complete value is € 2,000,000. However, A re-ports the total value as being € 1,000,000, because he estimates this as being muchlower and then takes out partial insurance with a share of 10%. Furniture worth€ 80,000 is lost in a burglary. In this case the insurance company need pay only€ 40,000, because there was underinsurance.

Multiple insurance

One and the same risk may be insured against the same peril by several insurersand the total of the sums insured may be greater than the insurable value. In accor-dance with § 78 VVG the insurers are liable as joint debtors for the contractual agree-ment, at the most, however, for the amount of the claim. Internally, the insurers’payments are apportioned according to the indemnification which each insurerwould have had to pay according to its policy.

Example:

Ms Schneider is covered for health insurance abroad by her private health insurer X.X pays 80 % of the costs of treatment according to the General Insurance Conditions(AVB). There is also foreign travel health insurance of the insurer Y in her credit cardwith which she paid for the journey. The share of the costs in this case is 100 %. Inthe USA Ms Schneider has an accident and must be treated in hospital. The costs oftreatment amount to € 100,000. Ms Schneider reports the damage to Y, which mustalso pay the claim in full. By way of recourse it can claim € 40,000 from X, however.

Retentions

The insurer’s liability can, furthermore, be limited by retentions. There are variousforms of retention. They can be agreed as fixed amounts, which have to be paidfor each claim (e.g. a retention in comprehensive motor insurance of € 300 eachinsured loss), as a percentage (e.g. 80 % of the cancellation costs in travel cancella-tion insurance will be paid for) or as a franchise, whereby the claim up to certainamount is not paid for at all, but claims that exceed this amount are paid for com-pletely (compare Wandt, l.c., marginal 743).


3.9.3 Performance

The insurer’s benefit is provided after the insured loss has been reported, informa-tion has been supplied on request and documents have been provided.

Due date

The insurer’s payment is due on the conclusion of the investigation needed to estab-lish the insured loss and the amount to be paid by the insurer, see §124 InsuranceContract Act (VVG). This legal regulation is not mandatory. For this reason manyinsurers have a clause stipulating that there must be indemnification within twoweeks after admission of the insurer’s liability and agreement as to the amount.

If investigations have not been completed by the end of the month after the report-ing of the claim, the policyholder can request a part payment as high as the mini-mum amount that the insurer probably has to pay as things stand. This regulationmust be to the advantage of the policyholder. The deadline is, however, suspendedif it is the policyholder’s fault that the conclusion of the investigation is hindered,such as when the policyholder fails to bring documents requested by the insurer.

Limitation of actions

Other as before the reform of the VVG claims from insurance policies are no longersubject to a special limitation of actions. The general statutes of limitations applyin accordance with §§194 ff Code of Civil Law (BGB). This means that also theseclaims are usually limited to three years, whereby the limitation of actions beginswith the end of the year in which the policyholder knew of the claim against theinsurer or must have known it.

There is still a special regulation for insurance policies in §15 VVG, however, accord-ing to which the limitation of action is suspended during the period between thereporting of the claim to the insurer and the receipt of the insurer’s decision by thepolicyholder.

A further deadline up to which the legal action must be taken is no longer providedfor in the reformed VVG, since this leads to a de facto reduction of the period of thelimitation.

3.10 Possibilities for the policyholder’s complaints

and asserting his will

3.10.1 Complaints to BaFin

If customers are dissatisfied with the proposal procedure, actions during the policyduration or the claims handling, they complain to, for example, the Management orthe Supervisory Board of the insurer.

Furthermore, customers of insurance companies can complain to BaFin about insur-ance companies on the basis of Art. 17. Basic Constitutional Law (GG) in connectionwith § 81 Insurance Supervisory Act (VAG). Legally this complaint is classified as a


petition, since the verdict of the supervisory authority does not have any effect incivil law. It cannot help the complainant to achieve an enforceable claim. As a rule,however, an insurance company will follow the view of BaFin.

The basis of BaFin’s authority for claims stems from § 81 VAG. According to this it isthe task of the supervisory authority to see that the interests of the insured are ade-quately safeguarded (compare Kollhosser in Prölss’ Insurance Supervisory Law,C. H. Beck, 12th edition 2005, § 81 marginal 57).

3.10.2 Insurance ombudsman procedure

The insurance industry has created the so-called insurance ombudsman as a neutralmediation body. This procedure is based on the regulations of the code of pro-cedure of the insurance ombudsman. The customers of an insurance company canonly make a complaint to the insurance ombudsman if the insurance company hasjoined the Association of Insurance Ombudsman e.V.

The insurance ombudsman is allowed to decide about disputes up to € 5,000. Thisdecision is binding for the insurance company, but not for the complainant. Forhigher dispute values the ombudsman can only make a non-binding recommenda-tion.

Private health insurers do not take part in the insurance ombudsman procedure, be-cause they have appointed their own private health insurance (PKV) ombudsman.

3.10.3 Dispute procedure

As for all civil claims the policyholder can bring an action against an insurer in acivil court and win a writ of execution. As long as a claim is being examined by theombudsman procedure, limitation of action is suspended.


4Insurance practiceand statistics

byDr.Georg Erdmann

4.1 Insurance risk

Insurance business is based on the idea that in accordance with the principle ofequivalence an insurance company receives premiums, on the one hand, and paysinsurance benefits and expenses, on the other, thus making a spread of risks poss-ible. Although the premium computation (premium calculation) is based on statisti-cal documentation, an exact calculation of the risk premium is a priori not possible.The actual development of claims and expenses can deviate quite considerablyfrom the results as calculated.

The basic problem in offering insurance protection is thus that a premium is requi-red and calculated before the insurer knows whether or when it must pay and howhigh the benefit will be. The insurer promises to pay a benefit, and this is a futureand compensatory benefit that depends on chance. It requires an adequate pre-mium for this, but can only estimate how high this should be. This estimate is basedon data from the past. The insurance risk arises from this situation.

The insurance risk is the danger that in a given period the total losses of the insuredportfolio will exceed the sum of the share of the total premium available to cover therisk as well as the available capital. This risk is a specifically insurance risk, becauseit depends on the kind of business conducted (acceptance of risks in return for a pre-mium). The insurance risk has various origins/components.

Origins/components of the insurance risk:

4.1.1. Risk of random loss

Variations in expected claims are called the risk of random loss. These occur as aresult of the random development of the number and size of the incurred losses,e.g.:– Accumulation risk: an event causes a great number of losses at the same time– Risk of infection: an event causes a succession of many insurance losses or claims

by the first risk “infecting” further risks.– Catastrophe risk or risk of a major loss

The expected loss is thus subject to random fluctuations. It is uncertain as to the le-vel and number of claims. Using historical data it is possible to calculate stochasticregularities which indicate the losses the insurer can expect. Fortuity itself cannot becalculated, since these values are subject to random fluctuation.

Measures to counteract the risk of random loss are, for example:– Safety loadings– Fluctuation reserves– Increasing the portfolio size– Risk reduction (objectively/spacially)– Reinsurance and coinsurance– Balance over time (long-term contracts)– Sufficient owners’ equity– Claims statistics for many years

Insurance practice and statistics 95

4.1.2 Risk of error

= Error in the stochastic regularities. This error results in erroneous calculations ofthe expected loss and consequently leads to wrong premium requirements. Anerror can occur if a mistake is made in analyzing historical data, as a result of whicherroneous assumptions are made. The risk of error is thus a result of the analysisand projection risk, whereby the analysis risk aggregates the available statisticaldata incorrectly and the projection risk interprets the statistical aggregation incor-rectly.

Measures to counteract the risk of error are, for example:

– Loss statistics that are interpretable (Consideration of the law of large numbers;statistics over a long period of time)

– Appropriate risk features

– Adjustment of the risk features to changed circumstances

– Suitable statistical estimate procedures

4.1.3 Risk of change

The risk of change is, in contrast to the risk of random loss, impossible or very diffi-cult to calculate. The divergence of the actual from the expected loss experience isin this case not the result of random fluctuations against the background of a con-stant risk environment, but the result of a change in the risk situation itself. Thechanges can scarcely be quantified in advance, because many factors can exert aninfluence over time, the development of which is unforeseeable. Unforeseeablechanges occur in the insurer’s environment, which mean that the forecasts of ex-pected claims are no longer true. The insurance risk is not only dependent on ran-dom events, but also on changes in the insured risks themselves and on the basicconditions. Such areas of change occur in the basic conditions of

– the economy (fluctuations and changes in economic activity)

– society (shifts in values)

– the state (changes of law)

– ecological environment (climatic changes)

– technical environment.

Measures against the risk of change are, for example:

– Safety loadings

– Fluctuation reserves

– Restriction to short-term benefit promises (short-term contracts)

– Adjustment clauses (premium and benefit)

– Reinsurance and coinsurance

– Mix of risks (objectively/geographically)

– Sufficient owners’ capital


4.2 Basic principles of the premium calculation

4.2.1 Purposes and Targets

The purpose of the premium calculation is to fix a price that matches the risk. Thepremium must conform to the principle of equivalence. A distinction is made bet-ween the individual and the collective principle of equivalence:

– Individual principle of equivalence: for each individual insured risk the policyhol-der’s premium and the benefits of the insurance company should match.

– Collective principle of equivalence: even if the whole population is observed, pre-miums and benefits should match.

4.2.2 Risk factors and premium differentiation

A distinction is made between objective and subjective risk features.

– Objective risk factors: These risk/influencing factors do not depend on the behav-iour of the policyholder and can be determined beforehand.

– Subjective risk factors: These risk/influencing factors are person related and thepolicyholder can influence them. They cannot be determined beforehand.

– Moral risk (moral hazard): By this is meant the psychological phenomenon thatsome policyholders change their behaviour after taking out an insurance policy.

Differentiating premiums

– Primary premium differentiation: the premium for the insurance protection isfixed in advance: that is, on taking out the policy. However, in reality only theobjective features are known at the outset. That is, before the insurance policy istaken out and before knowing the policyholder’s risk behaviour, it is only possibleto classify a risk as belonging to a particular premium class if features are used ascriteria that are already known in advance from the objective population data.

– Subjective features can only be brought into the process of differentiating premi-ums if the individual claims experience of a risk is known at the end of the period.The differentiation of premiums on the basis of subjective features is calledsecondary premium differentiation or experience rating, since it is based on ex-perience with the individual loss experience/behaviour of the policyholder. Thesubjective features are thereby gradually brought into the rating later.


Basic formula of the premium calculation

Net risk premium+ Safety loading= Risk premium (Net premium, gross risk premium)+ Extra for operating expenses[– Cash flow underwriting (Profits taken out of the investments are factored into

the premium in order to lower it for competitive reasons)]+ Profit extra–/+ Discounts/Extras+ Extra for premium payment more frequent than annually= Gross premium+ Insurance tax= Total premium

Structure of the premium rate in insurance companies

The insurance premium or the insurance contribution is the policyholder’s financialcontribution to the insurance company for carrying the risk or for providing indem-nification.

The policyholder’s premium must not only cover the operating expenses or the ad-ministration costs (e.g. salaries, commissions, rents, depreciations) and the profit,but also the risk and claims expenses of the insurance company.

The following overview shows the components of the gross or premium rate ofhousehold insurance.


Basis of calculation Structure Use

Claims statistics

Book-keepingCost accounting

Net risk premium

– safety loading

= Risk premium(Net premium)

+ Loading for operatingexpenses

+ Loading for profit

= Gross or premium rate

Risk contribution ca. 58 %Operating expenses ca. 36 – 40 %Profit ca. 2 – 6 %

Insurance benefit

Balance of theinsurance risk

Acquisitionand administrationexpenses

The above percentages for the operating expenses only serve as an example. Theydepend on the expenses of the individual insurance companies – especially on thesales system (direct selling or sales by agents) and from the class of insurance sold(risk premium). The operating expenses and under certain circumstances the profitare usually added as a percentage extra onto the risk premium.

For each risk group the claims frequency (claims probability) and the average claimis calculated:

Number of claimsClaims frequency =

Number of risks (policies)

Sum of claimsAverage claim =

Number of claims

The risk premium is a product of:

Risk premium = Loss frequency * average size of claim

Example:

The claims experience for a household insurance in Tariff Zone III is such thatfor every 100,000 contracts there are 8,000 claims. The total sum of claims is€ 10,400,000, the average sum insured is € 70,000

What is the risk premium rate?

Solution:

Risk premium = Loss frequency * average size of claim

8,000 10,400,000Risk premium = ________ * __________ = € 104

100,000 8,000

A risk premium of € 104 per policy is needed.

4.3 Emergence and distribution of surpluses

4.3.1 Reasons for the emergence of surpluses

4.3.1.1 Emergence of surpluses in all classes of insurance

Cost overrun

Due to rationalization measures and economical administration the actual acquisi-tion and administration expenses can be less than the calculated costs.

Example life insurance:

The acquisition and administration expenses calculated into the premium– actual acquisition and administration expenses

= profit on expenses


The profit on expenses is expressed as a percentage of the premium or as a permille rate of the sum insured.

Example:

With premium income of € 66,443,750 the actual expenses for acquisition and ad-ministration were € 12,436,900 whereas € 13,500,000 had been calculated.

How high was the profit on expenses expressed as a percentage?

Solution:

Calculated share of expenses: € 13,500,000– Actual expenses: € 12,436,900

= Profit on expenses: € 1,063,100

Profit on expenses as a percentage of the premium: € 66,443,750 = 100 %€ 1,063,100 = x %

x = 1,063,100 x 100

x = 1,066,443,750

x = 1.6 %

Surplus by the release of hidden reserves

These result, for example, from the sale of buildings that have been written off orfrom the sale of bonds that have been valued according to the strict principle of thelower of cost or market value. The selling price is then higher than the book value.

Technical surplus

The actual claims payments are less than the calculated ones.

Surplus from reinsurance business

A surplus exists if the reinsurance commission for the direct insurer is greater thanits proportional share of the administration expenses

4.3.1.2 Emergence of surplus in life insurance

Risk surplus (mortality profit)

The actual mortality is more favourable than had been calculated, because of posi-tive selection and outdated mortality tables, for example.

Evaluating the mortality profit

All risk premiums (premiums for pure term insurance and the share of risk pre-miums from policies with a savings component) accumulate during the business


year. From these the death benefits are paid for term insurance policies and the sumat risk for the death benefit of policies with a savings component (sum insuredminus mathematical reserve).

The annual surplus is the mortality profit.

Calculated risk premiums– Death benefits of the term insurance– (Death benefits – mathematical reserve) in life policies with a savings component

= Mortality profit

Mortality profit is expressed as a percentage of the premium or as a per mille rate ofthe sum insured.

Example:

An insurer has paid out € 529,890,000 in claims for policies with a savingscomponent. This amount contains savings components amounting to a total of€ 212,760,000. For the corresponding insurance policies the life insurer has receivedrisk premiums of € 384,600,000.

Calculate the mortality profit in €.

Solution:

Calculated risk premiums: € 384,600,700– (actual benefits – mathematical reserve paid out)= € 529,890,000 – € 212,760,000 = € 317,130,000

= Mortality profit: € 67,470,700

Interest surplus (extra interest)

The profit from investments is higher than the technical interest rate calculated intothe premium. The technical interest rate is, for example, 2.5 %, but the insurer earnsan average rate of interest of 4.5 % on the investments.

Calculation of the interest profit

If due to a wise investment strategy a life insurance company makes profits frominvestments which are higher than the calculated technical interest rate of 2.5 % p.a.,the yield which exceeds the technical rate of interest is available to it as interestprofit for the profit participation.

Yield from investments– Technical interest rate (e.g. 2.5 %)– Expenses for asset management

= Interest profit


The interest profit is achieved by the investment of the mathematical reserve. Forthis reason it is expressed as a percentage of the mathematical reserve.

Example:

A life insurance company achieves a total interest yield of € 2,525,893 from amathematical reserve of € 56,897,000. The technical interest rate is 2.5 %, the cost ofthe asset management € 284,485.

a) How high is the interest profit in €?b) How high is the interest profit as a percentage of the mathematical reserve?

Solution a):

Interest total: € 2,525,893– Technical interest rate = 2.5 % of 56,897,000: € 1,422,425– Cost of the asset management: € 284,485

= Interest profit: € 818,983

Solution b)

Profit on expenses as a percentage of the premium: € 56,897,000 = 100 %€ 818,983 = x %

x = 818,983 x 100

x = 56,897,000

x = 1.4 %

Surrender surplus

If the policyholder cancels the life insurance policy before maturity, the insurer cancharge a cancellation fee if this had been agreed with the policyholder and theamount of the reduction is reasonable. The cancellation fee is calculated as a per-centage of the capital at risk. The percentage depends on the age of entry and theduration of the policy. If the cancellation fee is higher than the actual expenses, thenthe insurer earns a surplus.

The surrender value corresponds to the current value reduced by the cancellationfee. The cancellation fee is, however, only permissible if it was agreed in the condi-tions.

The surrender value of a life insurance policy is basically calculated as follows:

Savings components with compound interest– unamortized acquisition costs

= zillmerized mathematical reserve– credited and earned surpluses

= current value, however, at least the current value for theguaranteed insurance benefit with waiver of premium

– surrender fee (insofar as agreed)

= surrender value


Example:

For an endowment policy of € 30,000 a mathematical reserve of € 2,040 was accu-mulated over a period of 27 months.

According to the insurer’s documentation 90 % of the acquisition costs (40 %o of thesum insured) are not amortized. Surpluses (credited and earned) of €120 have to betaken into account.

Calculate the surrender value of this policy if a cancellation fee amounting to 1% ofthe sum at risk had been agreed.

Solution:

Savings components: € 2,040

Unamortized acquisition costs40%o of € 30,000 = € 1,200, of which 90%: – € 1,080

Surpluses (credited and earned) + € 120

Cancellation fee1% of € 30,000 - € 2,040 = 1% of 27,960: – € 279.60

= calculated surrender value: € 800.40

4.3.2 Distribution of surpluses

4.3.2.1 Distribution of surpluses in non-life insurance

Premium refund (depending on success)

If there is a surplus in the class of business (e.g. household insurance), part of it isreturned to the policyholder.

4.3.2.2 Distribution of surpluses in life insurance

For the shares of surplus that are allocated to the individual insurance policy thereare the following distribution possibilities:

Cash payment

A cash payment of the surpluses to the policyholder is seldom used for tax reasons.

Premium offset

Especially in the case of term insurance policies the surplus is set off against the pre-miums. In this way the policyholder has to pay a lower premium for an unchangedsum insured. This procedure is tax neutral.

Accumulation of interest

The surplus shares accumulate for the policyholder and are invested with interest.On the due date the sum thus saved is paid out with the sum insured. Due to com-pound interest the interest on the amount saved grows slowly at first, but towards


the end of the contract duration strongly, so that the system of profit distribution isparticularly favourable for those customers who continue their contract to maturityand want the highest possible maturity benefit.

Reversionary bonus system (bonus system)

The annual share of the surplus is regarded as a single premium payment and isused for the calculation of an additional sum insured. By means of the annuallyincreasing sum insured the risk protection provided by the policy is considerablyimproved. This form of surplus sharing leads to a higher benefit in the event of earlydeath than with the accumulation of interest, since the single premium payment re-sults in a higher sum insured than the sum of the share of the surplus plus interest.

Example of a surplus statement for a life insurance policy. (Other bases of assess-ment could also be agreed, and the rates are only examples. They differ frominsurer to insurer and also from year to year.):

– 1.5 % of the mathematical reserve, and it is contractually agreed how this mathe-matical reserve is to be determined at the policy anniversary before the distribu-tion: for example, in accordance with the actuarial basis of the premium calcula-tion on renewal:

– 20 % of the risk premium

– 2 % of the premium

– 0.1% of the sum insured

Relative importance of the types of profit distribution for the market

All the types of profit distribution shown are offered in the market. A number of lifeinsurance companies do not let their policyholders choose between different typesof profit distribution and it is agreed – especially in the case of life insurance policieswith a savings component – that the bonus system should be the basic form of pro-fit distribution.

Should insurance companies plan to offer different types of profit distribution, anumber of life insurance companies often combine some of them. It can thus beagreed that part of the surplus be used for an increase in the sum insured and thatthe rest should be invested at a rate of interest. If there is an additional benefit to themain cover, the profit share from the additional benefit is often used to lower thepremium (immediate offset), whilst the surplus from the main policy is used for theaccumulation of interest or to increase the sum insured.

4.4 Insurance accounting

Purposes of the annual financial statement

– The first duty is to provide information about the company or, with the assistanceof the accounting department, to report about the deployment of the availableresources


– The second duty is the distribution of income or the measure of assets

– The third function is that of protection. Company stakeholders (staff, creditors,suppliers, customers) should be protected, but also the company itself by meansof the enforcement of self information.

Receivers of financial accounting

– Employees and salaried insurance agents

– Supervisory authority

– Owners

– Investors

– Interested public

– Associations and unions

– State

– BAV

– Customers and policyholders

– Potential staff

– Injured third parties

– Direct and reinsurance companies

Sections of the annual financial statement

– Balance sheet § 246 l HGB

– Profit and loss account § 246 l HGB

– Schedule § 264 I HGB

– Management report § 264 I HGB

– Cashflow statement § 297 I 2 HGB

– Segment report § 297 I 2 HGB

Description of the balance sheet of an insurance company

Insurance companies have to prepare the balance sheet – in contradiction to § 266HGB – in accordance with a form (§ 2 RechVersV). The organization in accordancewith § 266 HGB thus does not apply to insurance companies. The differences areparticularly clear on the assets side of the balance sheet: § 266 HGB subdivides theasset side into fixed and liquid assets. This arrangement mainly depends on thedegree of liquidity of the assets. Such a distinction is not possible in an insurancebalance sheet.

Reasons for the deviation from the commercial balance sheet

The following reasons can be given for the deviation of an insurance balance sheetfrom a “normal” commercial balance sheet:

– The intangible nature of the insurance product means that there are no identifica-tion problems for products and also no evaluation process.


– The time relationship of the insurance policies causes delineation problems for aone period overview such as that given in the balance sheet. This is clear, forexample, with the mathematical reserve or the fluctuation reserve, which containlong-term assumptions.

– The random nature of insurance business leads to an extension of the principlesof creditor protection to the policyholders. This is particularly obvious in the dutyto set up further insurance specific reserves. In so doing due to its legal nature(uncertainty as to existence, point of time and the amount of the obligation) areserve can adequately replicate the features of the insurance product that alsohas an uncertain duty to pay with regard to existence and amount.

The general evaluation rules of §§ 252 to 256 HGB apply to the drawing up of theinsurance company’s balance sheet. They are complemented by the regulations forlarge limited liability companies in §§ 273 to 283 HGV as well as the specificallyinsurance regulations of §§ 341 ff. HGB, which the insurance company has to apply.Furthermore, the insurers must continue to observe the complementary regulationsof RechVersV.

Asset side of an insurance company’s balance sheet

A. Outstanding assets of the share capital

B. Intangible assets

C. Investments

I. Land, land rights and buildings

II. Investments in affiliated companies and holdings1. Shares in affiliated companies2. Lending to affiliated companies3. Holdings4. Lending to companies with which there is a holding relationship

III. Miscellaneous investments1. Shares, investment shares, and other fixed interest bonds2. Coupon bonds and other fixed interest bonds3. Mortgages, land charges and rent charges4. Miscellaneous lending5. Outstanding credit contributions with credit institutions6. Other investments

IV. Deposit receivables from reinsured business

D. Investments for the account of and risk of holders of life insurance policies(§14 RechVersV)

In unit-linked life insurance the insurance company does not carry the invest-ment risk, but the policyholder, since he determines the kind of investment. Inthis case the information about amount of capital invested for the unit-linked lifeinsurance is in terms of the current value.


E. Requirements

I. Requirements arising from the insurance business with1. policyholders2. insurance intermediaries3. members and carriers

II. Accounting requirements arising from reinsurance business

III. Miscellaneous requirements

F. Miscellaneous assets

I. Tangible assets

II. Cash with banks, cheques and cash in hand

III. Treasury stock

IV. Other assets

G. Accrued and deferred items

H. Deficit not covered by owners‘ equity

J. Settlement amount

Liabilities side of an insurance company’s balance sheet

A. Owners’ equity

I. Share capital or similar items

II. Additional paid-in capital

III. Profit reserves

IV. Balance sheet profit

B. Participation rights capital

C. Subordinated liability

D. Extraordinary items with reserve funds (§ 273 S.1 i.V. m. § 247 III S.1 HGB)

E. Provisions for own account

In accordance with § 341e I HGB reserves must be set up in excess of what isallowed by § 249 HGB, in order to guarantee permanently the commitmentsfrom the insurance policies (especially the insurance industry’s principle of pru-dence). Because of the temporal difference between the premium payment andthe uncertain claims payment they serve the purpose of allocating the profitsand expenditure to the year in which the premiums had been earned and inwhich the claims had occurred.

For a life insurance company they amount to ca. 90 %, in the case of a property /accident insurer ca. 60 %, of the total assets on the balance sheet, i.e. they are onthe liabilities side the largest and most important item.


I. Unearned premium reserves (§ 341e II No. 1)They must be set up “for the part of the premiums, which represents theprofit over a certain time after the balance sheet date.” Unearned premiumreserves actually constitute a passive accrued and deferred item. They con-stitute the part of the booked gross premiums which are to be accounted tothe following year as profit for a time after the balance sheet date.

II. Mathematical reserve (§ 341f HGB)The mathematical reserve in life insurance business constitutes about 80 %of the total assets on the balance sheet. It serves the purpose of coveringthe liabilities as they occur from the life insurance business and from thebusiness that is conducted like life insurance.Why does the insurer have commitments towards the policyholder forwhich it has to set up a mathematical reserve?1. The risk component of the premium is constant over the whole dur-

ation. It follows from this that in the first policy years the risk premiumis too high and in the last years it is too low. Consequently, in the firstyears provision (as a sort of reserve) is set up, which in the last years isreleased, so that the risk premium is correctly apportioned.

2. The insurer receives a savings component from the policyholder, whichhas to be paid back with interest. Here, too, the insurer is liable to thepolicyholder, with the result that provision must be made, since thelevel and timing of the repayment is uncertain.

According to § 25 I S.2 RechVersV the insurance company can choose totake account of one off acquisition costs in the mathematical reserve (Zill-merung). Already in the first business year the insurer is allowed to chargethe policyholder for the paid acquisition costs. If the acquisition costs arehigher than the first year premium, there is a negative balance for the liabil-ity of the insurer towards the policyholder: that is, the policyholder wouldactually be liable to the insurance company.The mathematical reserve is called an ageing reserve in health insurance.

III. Provision for outstanding claims (§ 341b HGB)This reserve is generally referred to as a loss reserve. It contains especially– Reserve for the indemnification of claims that have occurred and are

known to the insurer but which have not yet been regulated.– Late loss reserve for claims that have occurred but which the insurer

does not yet know about. The technical term for this is also IBNR claims(incurred but not reported).

IV. Reserve for premium refunds dependent on success or not dependent onsuccess (§ 341e II No. 2 HGB)

V. Equalization reserve and similar reserves (§ 341h HGB)– It has an equalization function: that is, it serves the purpose of smooth-

ing out fluctuations in the annual claims expenditure that the insurancecompany has to carry itself.

– Related to this is the security function as a measure against fluctuationsin particular classes of insurance. In this way there is a safeguardagainst future major losses.


How does the equalization reserve fulfil its security and smothing function?

1. Case: Low claims year: that is, fewer claims than average. In this casethe equalization reserve is increased. That is, there is an allocation, bywhich the expenditure increases and less profit is declared.

2. Case: High claims year: that is, more claims than average. In this casethe equalization reserve is released affecting net income, by which theloss is reduced.

By allocation or release the claims expenditure is smoothed out over theyears. At the same time, the equalization reserve that has already accumu-lated serves as a safety cushion.

VI. Miscellaneous technical insurance reserves

In this mixed item five single technical insurance reserves are summarized,of which only the 1st and 2nd have special importance:

1. Reserve for anticipated lapses

2. Reserve for threatened losses out of the insurance business (§ 341e IINo. 3 HGB, vgl. also § 249 I 1 HGB)

For a better understanding: a delineation from other technical insurancereserves:

– Unearned premium reserves are collected premiums which do not con-tribute to the profit of the business year, whereas the reserve for contin-gent losses results from the mismatch of benefit and consideration.

– In the case of the loss reserve the focus is on claims that have alreadyoccurred or have been caused, whilst with the reserve for contingentlosses future claims that occur after the cut-off date are taken intoaccount.

– The equalization reserve smooths out fluctuations in claims expenditurewhich is under control, whereas in the case of the reserve for contingentlosses a loss is seriously suspected: that is, the premiums are actuallyinsufficient.

F. Technical reserves in life insurance, insofar as the investment risk is carried bythe policyholders (§ 32 RechVersV).

Technical reserves must be set up for commitments from life insurance policieswhose value or profit is determined by the investments for which the policyhol-der carries the risk or by which the benefit is index linked.

G. Other reserves

H. Deposits received from reinsured insurance business

I. Other liabilities

I. Other liabilities from insurance policies underwritten by the company itself

1. Policyholders

2. Insurance intermediates

3. Affiliated companies and pension fund carriers


II. Accounting liabilities from reinsurance business

III. Bonds

IV. Liabilities towards credit institutions

K. Passive accruals and deferrals

L. Settlement amount

Construction of the Profit and Loss Account

The Profit and Loss Account is divided into an insurance related and a non insurancerelated account. It is constructed as follows:

Insurance related business (including or excluding investment profitability)

+/– Change of the fluctuation reserve (not for life insurers)= Real technical insurance result+/– Insurance related business (excluding or including investment profitability)= Result of the normal business activity+/– Extraordinary profit/loss+/– Tax+/– Transfer of losses/Transfer of profits= Surplus for the year/Deficit for the year

Insurance profits and expenditure according to Form 2

1. Earned premiumsWritten premiums– Reinsurance premiums paid+/– Change in the gross premium transfer+/– Change in the share of the reinsurance in the gross premium transfer= Earned premiums for own account

2. Technical interest earnings

3. Miscellaneous technical insurance profit

4. Expenditure for claimsa) Claims settlementsb) Change of the reserve for claims not yet settled

5. Change of the other technical insurance net reservesa) Net mathematical reserveb) Miscellaneous technical insurance net reserves

6. Expenditure for premium refunds that depend and do not depend on profit-ability

7. Expenditure for the insurance business1. Claims regulation: internal and external, direct and indirect claims handling

expenditure2. Acquisition of insurance policies: commission, brokerage, expenditure for

issuing policies3. Administration of insurance policies: premium collection, claims prevention

and containment


8. Miscellaneous technical insurance expenditure

9. Change in the equalization reserve

10. Underwriting result

Non insurance related profits and expenditure

1. Investment yieldThese are only for property and accident insurers and reinsurers in the noninsurance related account. For life insurers they are a part of the insurancerelated account.a) Profits from holdingsb) Yields from other investmentsc) Profits from appreciationsd) Profits from the outflow of investmentse) Profits from profit pools and transfer of profits contractsf) Profits from the release of extraordinary items with reserve funds

2. Expenditure on investmentsa) Expenditure for the administration of investmentsb) Depreciation of investmentsc) Losses from the outflow of investmentsd) Expenses from transfer of lossese) Adjustments in the extraordinary items with reserve funds

3. Technical interest yield

4. Miscellaneous profits

5. Miscellaneous expenditure

6. Result of the normal business activity

7. Extraordinary profits

8. Extraordinary expenditure

9. Tax from income and profit

10. Miscellaneous taxes

11. Profits from transfer of losses

12. Transferred profits

13. Surplus for the year/Deficit for the year

The following offset generally follows, which is decided by the management andprovides room for manoeuvre:

Surplus for the year/Deficit for the year+/– Profit/Loss carried forward from the previous year+ Withdrawal from retained earnings/additional paid in capital+ Withdrawal from the participation rights capital– Adjustment in the retained earnings/additional paid in capital– Replenishment of the participation rights capital

= Balance sheet profit / loss


Functions of the Schedule

1. Release function: the schedule releases the balance sheet and the profit and lossaccount from too much information.

2. Explanation function: the methods of drawing up a balance sheet and evaluationmust be supplied.

3. Supplementary function: there is additional information in the schedule, which isnot given in the balance sheet and the profit and loss account.

4. Correction function: if because of special circumstances the balance sheet andthe profit and loss account do not succeed in communicating a picture of theassets, finances and the profits of the company that reflects the reality, it isnecessary to provide additional information in the schedule. (§ 264ii S. 2 HGB).

5. In the schedule of insurance companies the current values of investments mustbe given (§§ 54–56 RechVersV). Since 1997 all investments except land must bevalued according to current value. Since 1999 this also applies to land.

Functions and content of the management report

The management report also has “only” one information function. In detail, thefollowing should be shown:

1. Course of business until the balance sheet date (historical view)

2. Company situation (cut off day view)

3. Extraordinary events between the end of the business year and preparation of thebalance sheet (View of the period of time of the most recent past)

4. Future development of company

5. Risk report

4.5 Insurance mathematics and actuarial science

Insurance mathematics is a part of mathematics. It is chiefly concerned with mathe-matical modelling and also with the statistical estimates of insured risks (especiallypersonal injury or property damage), the calculation of the price needed for takingover such risks (premium calculation), the calculation of insurance reserves or thenecessary equity capital resources, controlling including the reporting system, riskmanagement and asset liability management. Insurance mathematics belongs toapplied mathematics and is an important field of application for the theory of prob-abilities and statistics. To show the financial risks which are also in insurance con-tracts, methods of financial mathematics are also used. These can be subdivided asfollows:

� Life insurance mathematics

� Health insurance mathematics

� Pension insurance mathematics

� Non-life insurance mathematics


Because of the comprehensive application of insurance mathematics to all types ofrisk, financial mathematics can also be understood as a special case of insurancemathematics that focusses on financial risks.

Statistics

Tasks, working steps and statistical procedures

– In order to be able to calculate premiums that fairly reflect risk and to regulate atany time all claims that have to be indemnified, insurance companies need in mo-tor third party liability, for example, information about claims frequency and theaverage level of losses of the various types of car.

– In order to keep market share, insurance companies need among other thingsinformation about the demand for products of households and companies, pre-mium developments in the individual classes of insurance, the disposable incomeof the various groups of households and the price inflation rate for a wide varietyof goods and services.

– For adequate personnel planning insurance companies need, for example, infor-mation about the average age and gross income of staff, broken down amongother things into internal and external activities, gender, possible fields of em-ployment internally and staff qualifications.

Statistics includes the methods and procedures with which information about ob-servable mass phenomena can be captured, prepared and analyzed

The aim of the statistics is in the first instance to describe the current situation inorder serve as a basis for the explanation of causal relationships and to assist indecision making.


Course of statistical examinations

1 2 3

Questions are Data captureformulated to fit Decisions on thethe particular Data preparation basis of thepurpose data analysis

Data analysis

� �A precondition for the use of statistical procedures is that the events and the cir-cumstances to be examined should be described exactly and be quantifiable. Statis-tics is not concerned with the individual case but always with a plurality of similarsingle phenomena.

By the term statistics is understood the method by which events and circumstancesare examined as well as the tables and figures by which the events of an examin-ation are presented clearly.

In descriptive statistics the data needed are collected by a full inventory count: thatis, by capturing all cases. In inferential or inductive statistics on the basis of a ran-dom sample, that should be as representative as possible, the recurring features ofa population are established.


Example: Population statistics

Descriptive Inductive

Size of the survey Census = the data of Micro-census = the datathe whole population of ca.1 % of the populationliving in a certain area living in a certainare captured area are captured

Statistics as a Preparation of the data Preparation of the dataprocedure from all households from the random

sample and extrapolationof the data for allhouseholds

Statistics as a result Tables and graphs to describe the structureof the population of the German Federal Republic

The occupational description of an expert in insurance mathematics is insurancemathematician. They can also be called actuaries, especially if they have extensiveknowledge of insurance that is beyond pure insurance mathematics.

The aim of actuarial activity is to estimate and evaluate risks such as insurance risks,investment risks and liquidity risks. Expressed broadly, an actuary is concerned witheconomic processes in which mathematical or statistical methods are used.

Actuaries work particularly in insurance companies, but also in public authorities,consulting companies, surveyors or trustees. The department where they work iscalled an actuarial department.

In German speaking countries there is no single job description of an actuary or trai-ning requirements. The professional name is also not protected. In other countriessome occupational activities can only be carried out by actuaries with a specialtraining. In other countries the membership of a professional organization is alsorequired.

For certain insurers because of legal requirements the Appointed Actuary is a re-quired person, who has special legal duties in securing the financial integrity of theinsurer and protecting the interests of the policyholders. This person must have theprofessional qualification of actuary and thus be a specialized and experiencedinsurance mathematician.

In Germany the Insurance Supervisory Law (VAG) requires insurances of the personas well as non-life and accident insurers which have mathematical reserves derivingfrom liability and accident insurance to employ an appointed actuary. He has the

duties of guaranteeing the correct calculation of the mathematical reserve and thecalculation of adequate insurance premiums. Moreover, in life insurance he makesproposals to the board of management regarding the distribution of the policy-holders’ surplus.

The institution of the appointed actuary is enshrined in the Insurance SupervisoryLaw (VAG, §11a). The following insurers must employ an appointed actuary:

– Life insurers (including pension schemes and burial funds)

– Accident insurers that offer accident insurance with return of premium

– Non-life / Accident insurers with annuity benefits from accident and liability insur-ances.

– Health insurers which provide comprehensive tariffs that replace statutory healthinsurance

The appointed actuary must be reliable and have adequate knowledge of insurancemathematics and business experience. The appointed actuary is appointed or dis-missed by the supervisory board, and if there is none, by “a suitably high authority”and must be nominated by the supervisory authority. The supervisory authority candemand that another appointed actuary be employed.

Tasks of the actuary

The appointed actuary has to guarantee that in the calculation of the premiums andthe mathematical reserves the relevant legal regulations have been kept. This doesnot apply to burial funds and pension schemes, for which a statement according to§156a Abs. 3 Satz 5 VAG was not issued (“regulated pension schemes”), since inthese cases the calculation is done according to the approved business plan.

He has to examine the insurance company’s financial situation, whether the liabil-ities for the insurance policies can be fulfilled on a sustainable basis, and whetheradequate equity capital is available at the level of the solvency margin.

He has to confirm that the mathematical reserve in the balance sheet has been setup in accordance with the relevant legal regulations (insurance mathematical confir-mation). (Exception: smaller associations in accordance with § 53 VAG). For burialfunds and regulated pension schemes confirmation is required that the mathema-tical reserve is in line with the business plan.

The appointed actuary has to explain in a report to the board of management(“Actuarial Report”) what the approach and assumptions are that underlie this con-firmation. This does not apply to health insurers and regulated pension schemesand burial funds. In these companies the appointed actuary cannot “freely” deter-mine the basis of calculation. In health insurance the fundamentals of the calcula-tion of the mathematical reserve is based on legal regulations. The calculation ofregulated pension schemes and burial funds is fixed by the business plan.

Should the appointed actuary find that he is unable to confirm, or only in a qualifiedform, he has in this case to inform the board of management and under certain cir-cumstances also the supervisory authority. This also applies to circumstances whichcould prejudice or endanger the development or the portfolio of the company.


The appointed actuary has to suggest a reasonable distribution of surplus to theboard of management for the policies that are entitled to a distribution of surplus.This does not apply to health insurance.

In the case of larger insurance companies the appointed actuary is generally eithera member of the board of management or the head of the insurance mathematicaldepartment (actuarial department).

Small insurers, e.g. many company pension schemes, do not have their own actu-arial department. In this situation as a rule the consultant that works for the insurerprovides the appointed actuary.

4.6 Fundamentals of claims handling

The expression “claims management” refers to the organized control of claims byinsurance companies. Two meanings have to be distinguished:

– Claims management as a company controlling task; in insurance companies thisterm is popular as a name for the organizational unit (department, team), whichestablishes the work processes of the claims department.

– Claims handling in the individual case. By claims handling the insurance industryunderstands all activities in connection with the handling and settlement of claims(claims regulation). Claims management belongs to the business benefit pro-cesses and is an important part of the insurance production. It includes all busi-ness processes from the entry of the claim over each stage of the handling to thesettlement or replacement.

Process of claims management

1. Recording the claim

– Exclusion of double records

– Acceptance of the claim notification

– Opening a claim file

– Checking of the insurance cover

2. Dealing with the claim

– Obtaining statements from the policyholder, the injured third party, witnesses,etc.

– Under certain circumstances obtaining reports from experts, doctors, etc.

– Checking for fraud

– Appraisal of the claim by a clerk

3. Claims regulation/Settlement

– Information of the policyholder about the result of the appraisal

– Instruction to pay or replace

– Recourse


5Coinsuranceand reinsurance

byDr.Gerhard Mayr

5.1 Functions

To minimize risks direct insurers and reinsurers work together. Already in the fieldof direct insurance a fragmentation of risks takes place in such a way that several in-surance companies participate in a large risk, for example in the fire insurance of anindustrial company. This procedure is called coinsurance.

Reinsurance, on the other hand, is an insurance product for insurance companies.That is, in this case an insurance company insures itself with another insurancecompany. This can be a specialized “professional” reinsurance company as well asanother direct insurance company.

5.2 Coinsurance

Coinsurance is the agreed participation of several insurers on a risk in such a waythat each takes over a pro rata share of the sum insured or a certain amount. Thereare as many contracts as there are insurers. In the insurance policy the individualcompanies are listed by name with their shares. One insurance contract is thus con-cluded between the policyholder and each coinsurer for the respective share that iscovered: that is, as far as the policyholder is concerned, each insurance company isregarded as a direct insurer. In the case of a claim the individual coinsurers are liableto the extent of their share of the total sum insured.

Example:

A manufacturing company is insured with a sum insured of € 100 MM. Using co-insurance five direct insurers take on the risk in such a way that one company parti-cipates with 40 %, two companies with each 20 % and two companies each of whichhave 10 %.

To facilitate the settlement of claims the leading company, usually that insurer withthe largest share, conducts the negotiations in the name of the other participatingdirect insurers. A so-called leader’s clause is agreed, according to which the leadinginsurance company in the relationship with the policyholder is authorized to submitand receive notifications and declarations of intent. For its efforts the leading insurergenerally receives a lead office commission or an overrider.

The leadership clause or the trial conduct clause authorizes the leading insurer byname to regulate contractual matters, to receive premiums, regulate claims andunder certain circumstances also to settle legal disputes with the policyholder onbehalf of the other coinsurers.

The lead office commission generally amounts to between 1 and 3 % of the othercoinsurers’ premium share.

The participation of the coinsurers on a risk is laid down in a schedule of distribu-tion.

118 Dr. Gerhard Mayr

Example:

The following direct insurers participate pro rata on an industry fire insurance con-tract with a sum insured of € 16,500,000 at a rate of 1.4 ‰: A – 15 %, B – 25 %, C (leadoffice) – 30 %, D – 10 %, E – 20 %.

a) Set up a schedule of distribution. Work out the individual coinsurers’ shares ofthe total sum insured and the premium (with and without insurance tax – notio-nal tax rate 10 %).

b) The lead office C receives a lead office commission of 2 % of the premium sharesof the other coinsurers (without insurance tax). How much commission do theindividual coinsurers have to pay the lead office?

Solution of a):

The pro rata shares of the sums insured and the premium should be calculated fromthe total sum insured and the total premium respectively, using the given percen-tage rates for the shares of the individual coinsurers.

Distribution plan

Coinsurer’s Sum Premium without Insurance Premium incl.share insured insurance tax tax insurance tax

A 15 % 2,475,000 3,465 346.50 3,811.50B 25 % 4,125,000 5,775 577.50 6,352.50C 30 % 4,950,000 6,930 693.00 7,623.50D 10 % 1,650,000 2,310 231.00 2,541.00E 20 % 3,300,000 4,620 462.00 5,082.00100 % 16,500,000 23,100 2,310.00 25,410.00

(All figures in €. A fictive insurance tax of 10 % was assumed)

Solution of b):

The lead office C receives as leader:

… from insurer Premium share Share of thewithout insurance tax lead office commission

A 2 % of € 3,465 € 69.30B 2 % of € 5,775 € 115.50D 2 % of € 2,310 € 46.20E 2 % of € 4,620 € 92.40

Total lead office commission for Insurer C € 323.40

Coinsurance and reinsurance 119

5.3 Reinsurance

5.3.1 Overview

Reinsurance is a unique security measure between insurance companies. Insurancebusiness is based on the idea that in accordance with the principle of equivalencepremium income, on the one hand, and insurance benefits and expenses, on theother, correspond so that a spread of risks is possible. Although the calculation isbased on statistical information, a correct evaluation of the risk premium is notpossible. The actual loss experience can depart considerably from the results as cal-culated. This possibility is called the underwriting risk. There are several reasonsfor it.


Underwriting risk

Phenomena

Risk of

random loss

Risk of change Accumulation or

catastrophe risk

Risk of error

The actual lossexperience differsrandomly fromthe anticipatedtrend. Moreover,unwanted fluctu-ations can occurbecause of theinsurance of highrisks.

For many risks thedirect insurer hasno or insufficientinformation onwhich to base acalculation. Thisinadequate basisof calculationmakes it difficult toforesee structuralchanges in the riskprofile.

A loss accumula-tion (e. g. aircraftcrashes, naturaldisasters)endanger theportfolio balance.

The premiumcalculation orthe rating of therisks is basedon erroneouscalculations orestimates.

The purpose of reinsurance to reduce this insurance risk for the direct insurer. In thisway reinsurers contribute to the greater stability and security of the insurance busi-ness, since they spread the risk to several insurance companies. Consequently, thisenables a direct insurer to take over the cover for larger risks, too (industrial insur-ance or liability insurance for whole concerns). The direct insurer keeps only somuch of the risk it has taken over for its own account as it can in accordance withinsurance principles without putting its own portfolio at risk. Reinsurance is thusone of the most important ways of release for the direct insurer.

The risk transfer takes place by concluding a reinsurance treaty. Its partners areknown as direct insurer (cedant) and reinsurer. The acceptance of risks is known asactive reinsurance or indirect business or business taken in reinsurance. In contrast,the outward transfer of risks is known as passive reinsurance.

The original insurance relationship between the policyholder and the direct insureris not affected by the reinsurance treaty: that is, the direct insurer alone remainsresponsible to the policyholder for payments against the insurance policy. In thisway reinsurance differs fundamentally from coinsurance. (There the policyholderhas a direct claim against each of the coinsurers).

Insurance companies which only carry out reinsurance business are known as pro-fessional reinsurers. Direct insurers can also act as reinsurers in the market, how-ever. In contrast to direct insurance there are no regionally limited reinsurance mar-kets, because the supply and demand for reinsurance protection are traditionallyinternationally oriented and thus cross the borders of individual countries.

Reinsurance protection is required by both direct and reinsurance companies. Al-most all direct insurers have to transfer part of their risks by means of reinsurance,but also reinsurers cover risks by means of further reinsurance (so-called retroces-sion) with other direct insurers or reinsurers. In this way, a large number of insur-ance companies participate in the risks. At the same time this fact explains the inter-national nature of reinsurance, which serves the purpose of spreading riskworldwide (geographical diversification).


Important basic reinsurance terms

Tranche

Surplus

Capacity

Limit

Line

Deductible

Quota share

Cedant

Cession

Transferee

= Extent of liability of a reinsurance treaty= Part of the sum insured that exceeds the retention= Retention + surplus= Extent of the reinsurer’s liability= Retention in the case of a surplus treaty= Share of the claim carried by the cedant= Pro rata relationship= Direct insurer= Share of risk transferred from the direct insurer= Reinsurer

5.3.2 Reinsurance forms

The various reinsurance forms are distinguished by the type of contract.

Facultative reinsurance relates to large single risks. The direct insurer that wants totake on this kind of risk or that has already taken it on, offers the reinsurer a share ofit. The offer includes details of the policyholder, the type and size of the risk, theinsurance period, the premium as well as the retention of the direct insurer. Theterm “facultative” means that the reinsurer is free to accept or reject the offer. Thusfacultative reinsurance involves case by case risk acceptance by the reinsurer, alsofrequently after other possibilities of gaining cover have been exhausted.

Obligatory reinsurance constitutes the greatest volume of reinsurance business. Itresults in a stronger and longer term commitment between the contractual partners.In the case of obligatory reinsurance the insurance cover relates to the insuranceportfolio as described in the treaty. The direct insurer is obliged to transfer certainrisks to the reinsurer. In the same way the reinsurer promises to take over theserisks. Obligatory reinsurance mandatorily guarantees the direct insurer reinsuranceprotection from the point of time that the insurance policy is concluded with thepolicyholder.

5.3.3 Types of reinsurance

5.3.3.1 Overview

The types of reinsurance have developed out of the direct insurer’s purpose intaking reinsurance. It can happen that the direct insurer wants to avoid significantvariations in claims experience and so gives up high sums to make the portfoliomore well balanced. But it is also conceivable that the direct insurer only wants totransfer the claims burden to the reinsurer after a certain level.


Reinsurance can be taken

on the basis on the basisof the sum insured of the claims

Reinsurance based on the sum insured(proportional reinsurance)

The direct insurer invites the reinsurerto participate in a certain proportionof the reinsured portfolio:i. e. premium, liability and claims aresplit proportionately between directinsurer and reinsurer.

Claims based reinsurance(non-proportional reinsurance)

The reinsurance benefit is definedby the level of the claim only.The reinsurer’s liability beginswhen the direct insurer’s deductibleis exceeded. The reinsurance premiumis negotiable.

5.3.3.2 Proportional reinsurance (Reinsurance based on the sum insured)

With proportional reinsurance the reinsurer’s participation is based on the suminsured, by the transfer of a quota share and/or the peaks of certain risks. This iscalled reinsurance based on the sum insured or proportional reinsurance, becausethe sum insured, premiums and claims are shared pro rata by direct insurer andreinsurer.

In the case of a quota share treaty the reinsurer participates with an agreed con-stant percentage (quota share) of all the risks ceded to the treaty for its duration.This quota share (e.g. 10 or 25 %) determines the distribution of the premiums andthe claims.

The purpose of a quota share reinsurance treaty is to reduce the fluctuations of thecedant’s small and medium sized claims, and thus to reduce the size of an insuranceloss. The reinsurer participates with the same share on all risks in the insuranceportfolio.

With surplus reinsurance the reinsurer participates only on those risks whose sumsinsured exceed a certain amount. The insurer decides on the highest amount that itis prepared to accept as the retention.

This retention is called a line. Its level is fixed by the individual companies in linetables. It depends on the capacity of the insurance company, the degree of danger ofthe individual risk and the particular class of insurance.

That part of the sum insured that exceeds the retention and is ceded as reinsuranceis called the surplus. The reinsurer’s obligation to accept is usually limited in that ittakes over a certain number of lines (e.g. 10 lines). It follows from this that the directinsurer can give ten times the amount it keeps for its own account to the reinsurer.

Surplus reinsurance serves the purpose of improving the balance of the insuranceportfolio if there is great variation in sums insured (e.g. in industrial fire insurance).

Example quota share treaty:

A liability insurer has a quota share treaty with a reinsurer: quota share 30 %, Limit€ 2 m: i.e. the reinsurer accepts the quota share of maximally € 2 m, even if theactual sum insured of the policy concerned is higher. The direct insurer can coverthis amount facultatively (= from case to case) with a further reinsurance.

Work out the reinsurer’s share of the premium and claim for the following treaties ofthe direct insurer:

Sum insured Premium Claim

A) € 600,000 € 390 € 84,000B) € 1,200,000 € 810 € 360,000C) € 2,500,000 € 1,240 € 1,600,000

Solution:

Share of premium

a) 30 % of € 390 � € 117.00b) 30 % of € 810 � € 243.00c) Reinsurer takes over up to a limit of € 2 m

30 % of 4/5 of the premium (= € 992) � € 297.60

€ 657.60

Share of claims

a) 30 % of € 84,000 � € 25,200b) 30 % of € 360,000 � € 108,000c) 30 % of 4/5 of the claim (= € 1,280,000) � € 384,000

€ 517,200


Example surplus treaty:

For a household insurer there is a surplus treaty with a retention of € 100,000(= 1 line). The reinsurer takes over € 500,000 (= 5 lines). In the direct insurer’s port-folio there are i.a. the following insurance policies:

Sum insured Premium Claims

a) € 600,000 € 1,440 € 18,900b) € 250,000 € 700 € 7,200c) € 85,000 € 204 € 56,300d) € 750,000 € 1,875 € 24,000

Work out for each policy the reinsurer’s share of the premium, liability and claims.

Solution:

There is a corresponding reinsurance quota share to work out for each single policy

Policy a):

Proportionality

Retention € 100,000 � 1Surplus € 500,000 � 5

� Distribution of premium, liability and claims between direct insurer and reinsurerin proportion 1:5:

Proportionality Premium Liability Claims

Direct insurer 1 € 240 € 100,000 € 3,150Reinsurer 5 € 1,200 € 500,000 € 15,750

€ 1,440 € 600,000 € 18,900


Policy b):

Proportionality

Retention € 100,000 � 2Surplus € 150,000 � 3



Direct insurer 1 € 280 € 100,000 € 2,880Reinsurer 5 € 420 € 150,000 € 4,320

€ 700 € 250,000 € 7,200

Policy c):

Retention € 100.000Surplus € 100.000 (no surplus, since sum insured < € 100,000)

� Direct insurer carries premium, liability and claims alone

Policy d):

Proportionality

Retention + € 100,000 1+ € 150,000 (the amount by which the treaty capacity is exceeded)

Surplus + € 500,000 2



Direct insurer 1 € 625 € 250,000 € 8,000Reinsurer 2 € 1,250 € 500,000 €16,000

€ 1,875 € 750,000 € 24,000


Example Quota share + surplus treaty (mixed form)

A direct insurer agrees in a quota share treaty a reinsurance share of 25 %, a reten-tion from the quota share of € 80,000 (= 1 line) and as surplus 3 lines.

Work out the reinsurer’s share of the premium and claims for an insurance policy of€ 240,000.


Solution:

Since the quota share surplus treaty is a combination of a quota share and surplusreinsurance treaty, the calculation of the share of the premium and claims for theinsurance policy must be done in 2 steps:

Share of the Share of theDirect insurer Reinsurer

1st step

(Quota share reinsurance treaty):Splitting up of the sum insured of € 240,000pro rata for direct insurer and reinsurer:

Sum insured € 240,000

(Direct insurer quota share: 75 % of € 240,000 (Reinsurer’s(EV-Quote: = €180,000 quota share 25 %)

of € 240,000= € 60,000

2nd step

(Surplus reinsurance treaty)Division of the direct insurer’s quota shareinto the agreed retention and surplus

(Retention)€ 80,000 (Surplus)

Sum: € 100,000

€ 80,000 € 160,000

Proportionality� Direct insurer’s share: € 80,000 1/3� Reinsurer’s share: € 160,000 2/3

� For an insurance policy of € 240,000 the reinsurer receives 2/3 of the premiumand pays 2/3 of the claims.

5.3.3.3 Non-proportional reinsurance (Reinsurance based on claims)

In non-proportional reinsurance the reinsurer’s liability is determined exclusively bythe amount of the claim. There is thus no proportional distribution of the individualrisk and the premium required for that. Rather, a separately calculated premium isagreed for the non-proportional cover.

In the case of excess of loss reinsurance the reinsurer pays that part of a claim thatexceeds a contractually fixed amount. This amount that the direct insurer carries forits own account is called the deductible or priority. The reinsurance cover beginsfrom this deductible. The reinsurer is liable only if the deductible is exceeded.Claims below this limit must be borne by the direct insurer alone: the reinsurer doesnot participate in them.

The purpose of excess of loss reinsurance is thus to protect the direct insurer fromlarge claims. The degree to which the reinsurer participates in a particular claimdepends, therefore, on its size and is not already fixed as soon as the reinsurancetreaty has been agreed, as is the case with surplus reinsurance.

In the case of stop loss reinsurance the reinsurer does not cover the amount of aparticular single loss which exceeds the direct insurer’s deductible but all the claimsthat exceed the direct insurer’s contractually agreed retention ratio. Consequently,the reinsurer is liable only when the claims expenditure of the direct insurer exceedsa certain loss ratio. A highest loss ratio is always fixed for the liability of the reinsurer.

This form of reinsurance is called stop loss, because it limits a direct insurer’s totalclaims expenditure for the business year. It is especially important for classes ofinsurance that are subject to annually fluctuating claims expenditure, such as hailand storm insurance.

The premium for excess of loss reinsurance is generally fixed as a percentage of theannual premium, which the direct insurer earns from the reinsured portfolio.

Example risk excess of loss:

For a risk excess of loss the following conditions apply:Direct insurer’s deductible € 5 MM; Reinsurer A takes over Layer 1 from the deduct-ibe up to a limit of € 15 m, Reinsurers B and C take over the Layer 2 from € 15 m upto a limit of € 35 m with the same shares.

Work out each reinsurer’s share of the following claims:a) € 4 m, b) € 13 m, c) € 27 m

Solution:

Claims a) b) c)

Claim amount € 4,000,000 € 13,000,000 € 27,000,000– Direct insurer’s deductible € 4,000,000 € 5,000,000 € 5,000,000

(Max € 5 m per claim)= Subtotal – € 8,000,000 € 22,000,000– Liability of Reinsurer A – € 8,000,000 € 10,000,000

(Max € 10 m per claim)= Liability of Reins. B & C (each 50 %) – – € 12,000,000

(Total max. of € 20 m per claim)


Example stop loss:

A hail insurer has agreed a stop loss with the following conditions:

Retention 75 % of the annual premium for the portfolio;

Stop loss maximally 50 % of the annual premium income following the retention.

As agreed, at the end of the year the direct office reports to its reinsurer that theannual premium amounted to € 89,500,000.

The year’s expenditure for claims:a) € 78,670,800b) € 103,290,000c) € 124,358,000

What is the reinsurer’s contribution to the year’s claims expenditure in the cases ofa), b) or c)?

Solution a):

Claims expenditure for the year € 78,670,800– Retention (75 % of € 89,500,000) € 67,125,000

= Stop loss € 11,545,800

The reinsurer pays € 11,545,800 of the claims expenditure for the year

Solution b):

Claims expenditure for the year € 103,290,000 – Retention (75 % of € 89,500,000 €) € 67,125,000

= Stop loss € 36,165,000

The reinsurer pays € 36,165,000 of the claims expenditure for the year.

Solution c):

Claims expenditure for the year € 124,358,000– Retention (75 % of € 89,500,000) € 67,125,000

= € 57.233.000– Stop loss

max. 50 % of € 89,500,000 € 44,750,000

= Share, which the direct insurer has to carry itself in addition € 12,483,000

The reinsurer carries the maximum possible share of the stop loss payment of€ 44,750,000.

(The direct insurer in addition to its retention of € 67,125,000 pays € 12,483,000)


5.3.4 Other ways of atomizing risk

5.3.4.1 Insurance pools

An insurance pool is a joint venture for the atomization of risk in which several in-surance companies (direct insurers and reinsurers) join together in order to carryrisks collectively. The pool members undertake to bring all risks into the pool thatmeet certain criteria, in order to participate in all the business of the pool for theirpreviously agreed shares. Each member participates in the risks covered by the poolonly to the extent that its share has been previously laid down in the agreement.Each pool member takes on this share not only of risks which it has underwritten,but also of risks that have been brought into the pool by other pool members. Eithera corporate pool member or a pool administrator has the responsibility for man-aging a pool. Expenses are divided among the members.

Pool agreements serve above all the purpose of atomizing and collectively bearingrisks that are new, especially dangerous or unbalanced. Thus a financially strongrisk bearing community is created with large underwriting capacity.

In Germany the following insurance pools exist at present:

The German Atomic Insurance Pool (Atompool)

Provides liability and property cover against perils connected with the erection andrunning of nuclear reactors and similar plants.

Pharma Reinsurance Pool (Pharmapool)

For the business of liability insurance of pharmaceutical companies in accordancewith the German Pharmaceuticals Act.

Until the end of 2003 there was in addition the German Aircraft Pool (for aviationinsurance).

5.3.4.2 Financial Reinsurance

Starting in the USA forms of reinsurance were developed that focus on annualfinancial statements, supervisory regulations, fiscal and financial targets. In thiscase the transfer of insurable risk is not in the forefront. Because the driving forcebehind it is financial and economic success, this form of reinsurance is called finan-cial reinsurance.

These types of reinsurance contract are constructed individually and generally“tailor made”. Investment income is explicitly and as a matter of principle taken intoaccount in the price calculation, and as a rule over the duration of the contract,which is usually long, a balance of interest is found that is unique to each agree-ment. For these contracts to be recognized as reinsurance in accounting, supervis-ory and fiscal law, there must nevertheless be a minimum amount of risk transfer.

A few examples of financial insurance are described below:


Funded cover

The direct insurer sets up an interest bearing fund with the reinsurer, which is usedfor the reinsurance share of future claims. The fund can take on a negative value inthe case of negative experience, so that the direct insurer has liabilities towards thereinsurer.

Treaties that finance acquisition costs (especially in the field of life insurance)

At the beginning a direct insurer can incur heavy expenses in acquiring new busi-ness for an insurance portfolio. By means of treaties that finance acquisition costs atthis stage the reinsurance treaty is constructed in such a way that the direct insurerachieves a payment surplus and profit, which in the ensuing period is then repaidwith interest to the reinsurer.

Spread loss contracts

With spread loss contracts the reinsurer provides up front financing of claims, whichin the ensuing period is amortized by the direct insurer paying regular instalments.

5.3.4.3 Alternative Risk Transfer

Parallel to classical reinsurance and financial reinsurance Alternative Risk Transfer(ART) is considered to be a third type of reinsurance. By ART is understood thefinancing of risks with non-traditional covers of the insurance companies. That is,in this case the insurance cover is created outside the insurance market by capitalmarket investors acting as the insurers’ secondary risk carriers.

In this construction insurance risks are transferred into the capital market with origi-nal (Insurance Linked Bonds) or derivative financial titles (Loss derivates or insur-ance futures contracts). The repayment and/or the payment of interest of the parti-cular financial instrument is made dependent on the development of a special lossportfolio (indemnity trigger) or a parameter that is external to the company (indextrigger). These instruments are employed especially in the coverage of catastropherisks (e.g. CatBonds), since in this way the underwriting capacity of the classicalreinsurance market can be considerably increased.

Sources

Farny, Dieter: Versicherungsbetriebslehre. 4th Edition. Karlsruhe: VVW, 2006

Liebwein, Peter: Klassische und moderne Formen der Rückversicherung.2nd Edition. Karlsruhe: Verlag Versicherungswirtschaft, 2009

Pfeiffer, Christoph: Einführung in die Rückversicherung: Das Standardwerk fürTheorie und Praxis. 5th Edition. Wiesbaden: Gabler, 1999

Rockel, Werner; Helten, Elmar; Loy, Herbert; Ott, Peter; Sauer, Roman:Versicherungsbilanzen: Rechnungslegung nach HGB, US-GAAP und IFRS.2nd Edition. Stuttgart: Schäffer-Poeschel Verlag, 2007


6Cost accountingand results accounts

byDr.Georg Erdmann

6.1 Tasks and terms

Cost accounting is company internal accounting which serves the purpose of cap-turing and allocating periodic loss of value caused by the production of business. Inthis connection only those costs are relevant that are actually directly related tothe company’s business. External and extraordinary elements are not taken intoaccount in cost accounting.

In this way it serves the following purposes:

– Control of the efficiency of the business process and identification of sources ofloss

– Calculation of the risk premium (or fixing of the premium limit)

Cost accounting supplies information

– for deciding on future plans

– for checking decisions

– for reviewing performance

– on the liquidity status of the insurance company (together with the management)

– for carrying out comparative calculations

Thus the information from the cost accounting constitutes an important controllinginstrument for the management.

In the case of results accounting the benefits are captured analogue to the costaccounting and are delineated both temporally and according to type of business.The accounting goal of results accounting is to calculate the benefits produced inan accounting period or the revenues gained in the market, as well as the offsettingof the benefits or revenues by the production of relationships to reference figures.The insurance company’s benefits are economic goods created by the employmentand combination of production factors, irrespective of how they are utilized. Theyhave a quantity component (volume of created benefit) and a price component(valuation of the volume). The following types of benefit and revenues can be dis-tinguished:

– Benefits within the company

– Revenues from sold insurance products

– Revenues not derived from insurance products sold (especially investments)

By setting up the costs and benefits accounting parallel to each other, the businesssuccess (profit) can be quantified by calculating the difference between costs andbenefits, This makes an important contribution to the decision-making process andthe achievement of plans.

The capture and evaluation of the relevant business events is divided into three sub-sections by the cost accounting:


Cost accounting and results accounts 133

In accordance with the criterion “accounting way of the costs” the following costaccounting systems can be differentiated. Irrespective of the type of cost accountingsystem, the accounting way of the costs is broken down into three subsections.

– The cost-type accounting stands at the start of cost accounting and has thefunction of capturing and breaking down all the types of cost that have beenincurred in the course of the particular accounting period. Question: Which costshave been incurred?

– In cost centre accounting the costs are allocated to the business areas (cost units)in which they have been incurred. This distribution is made in the course of thecost accounting and has a dual function: firstly, for cost control and to know whathas influenced the costs it is necessary to know where the costs were incurred,and secondly exact unit product costing is only possible if the costs of those de-partments which deliver these benefits are allocated to the company products.Question: Where have the costs been incurred?

– The purpose of product cost accounting (cost accounting, unit product costing,costing) is to calculate the unit costs of all goods and services created (unit costs).Question: Why have the costs been incurred?

6.1.1 Cost-type accounting

In an insurance company we distinguish between the following costs:

– Personnel costs (salaries, social costs, such as the employer’s contribution tosocial security, company pensions, holiday pay, sickness benefit, Christmas bo-nus, among others). The costs of the sales force (travel expenses, salaries, com-missions) are often broken down into these items.

– Costs for intermediaries (all commissions to self-employed agents and brokersincluding allowances of all kinds)

– Costs of working capital, e.g.– Depreciation and amortization and repair costs– Running costs, e.g. costs of material and electricity– Rents for office space, data processing systems, motor and other working capi-

tal– Miscellaneous operating expenses, such as telephone costs, post, travel expen-

ses, among other things

– Taxes chargeable as expenses, e.g. for motor, fire brigades and value added tax.Claims expenditure for own account (after subtracting the shares of the reinsurer).Under this item payments and the loss reserves for the accounting period arerecorded.

– Reinsurance costs: they arise from the reinsurance premiums paid minus thereinsurance commission and profit shares.

A further important type of expense are imputed costs. These are costs for whichthere has been no expenditure or another level of expenditure. Examples of im-puted costs are imputed depreciation and amortization, imputed interest, imputedrents and imputed risk costs.

– Cost-accounting depreciation and amortization: for depreciation and amortizationcriteria are often relevant that are irrelevant for a calculation of material require-ments and control accounting, such as the principle of balance sheet continuity asalso fiscal criteria. Should a plant have been written off to a reminder value of €1,for example, further book depreciations are not permissible, even if the plant isstill in use. The fact of further use means, however, that past depreciations weretoo high and thus wrongly estimated. This can be corrected within the cost ac-counting, so that plants still in use can be accounted for, even if they have alreadybeen completely written down in the financial accounts department.

– Imputed interest: In the financial accounts department only effectively payableinterest is accounted. Thus interest is set off against borrowed capital only, andinterest on owners’ capital does not apply. In cost accounting, however, imputedinterest on the assets needed for the business and thus also the interest on theowners’ equity is accounted. The owners’ equity admittedly does not produce aneffective interest payment, but due to the investment of the owners’ equity in thebusiness, the possibility of using it for another external capital investment hasbeen denied.

– Imputed rents: If the insurance company pays no rent for the use of its own prem-ises, the cost accounting has to take imputed rents into account. This makes acomparison possible with companies or entities that do not have their own prem-ises available.

– Imputed risk costs: By setting up imputed risks certain loss risks should be cap-tured. In this connection imputed risk costs should be mentioned for which thereis no equivalent in the financial accounts department (risk of loss of an invest-ment) and such by which there is a premium oriented difference (credit risk, guar-antee risk, etc.). Apart from insurance related risks other risks emerge out of theactivity of the insurance business, such as the contractual risk, the investment riskor the portfolio risk.

Within the framework of cost-type accounting the following terms occur:

Fixed costs are independent of the production volume, whereas variable costs aredependent on the level of the output (or the degree of employment). Before a busi-ness can begin production, certain basic preconditions must be fulfilled (purchaseor hire of equipment, setting up of an organization, etc.). Output (production) pre-supposes the creation of operational readiness. The creation of operational readi-ness produces costs, which are called fixed costs. Their level remains the same,whether 50 cars are turned out each day, or 2,000.

Examples:– Rents (Rent must be paid, irrespective of whether all members of staff work or

only half of them)– Personnel costs for employees– Cost of working capital for depreciations and amortizations– Interest for the use of borrowed capital (credit interest)

Variable costs are production related expenses, i.e. variable costs are costs whichincrease with increasing production. They are thus dependent on the use of thecapacity by the production of goods.



They vary with the volume of the output.

Examples:

– Production costs

– Manufacturing costs

– Material costs

– Distribution costs

Direct costs

Direct costs are costs which can be directly allocated to a reference object (costcentre or cost object).

Direct costs are the costs for material, wages, among other things, which aredemonstrably used for a particular object, a single order or a special policy.

Direct costs are usually variable costs, since they are caused by the production, of aproduct, for example. They could be avoided if this product were not manufactured.

Overhead costs

Whereas direct costs can be directly allocated to a particular cost object (proposal,policy), this is not the case with overhead costs. They cannot be allocated to a par-ticular product, since they have been incurred for several products or for all pro-ducts of the cost areas.

6.1.2 Cost centre accounting

In cost centre accounting the individual types of expense are spread over the costcentres in which they were incurred. Such cost centres are part of the business suchas, for example, the purchasing, assembly, administration and distribution func-tions. The purpose of this accounting lies first of all in the cost control and costorganization and it also serves the purpose of determining calculation rates, in orderto allocate overhead costs to the individual products.

Cost centre accounting inquires as to where the costs were incurred. Cost centredirect costs (e.g. staff salaries) can be directly allocated to the cost centres. Over-head costs (e.g. administration expenses, energy expenses and similar expenses)have to be allocated to the individual cost centres using a key.

How cost centres can be set up

a) Departments or organization of the insurance company

Important cost centres are intermediaries, branch offices as well as departmentsof the head office. It is an advantage that the different types of cost are easy tocalculate, being to a large extent direct expenses of the cost centre, as well asbeing easy to control. There are disadvantages in further charging the area coststo the cost object, because the allocation connection is often not clear.

b) Among the business functions are management, procurement, production (busi-ness, claims, reinsurance), sales, administration and financing. This organizationcan be consistent with the structure of the organization if it conforms to businessfunctions. It is an advantage that it easy to allocate the area costs to the cost ob-jects since the allocation principles are easily recognizable. There are disadavan-tages in allocating the types of cost to the cost centres if the structure of theinsurance company does not match the business functions.

c) Areas of responsibility

The allocation is advantageous if the productivity and efficiency are appliedwhen the cost accounting is further developed to a planned cost calculation or ifindividual areas are managed as profit centres (independent profit areas).

Type of cost units

From an allocational point of view a distinction should be made between a prelimi-nary cost centre and a final cost centre. The costs calculated for the preliminary costcentre are not allocated to the cost object, but assigned to the final cost centre,which utilizes the products of the preliminary cost centre.

The preliminary cost centre is thus something in which internal company productsare used, which are used in the accounting period by other areas of the business.Consequently, the terms indirect cost centre and primary cost centre are used. Themost important preliminary cost centres are staff divisions of all kinds, a large partof the administration areas (personnel, property management, internal administra-tion) the temporary posts for special services. In large insurance companies the areatechnical equipment and installation, including IT, is usually treated as a preliminarycost centre.

Cost centres in practice

In practice cost centres are usually set up to reflect the actual structure of the com-pany. This results in the following organization of the cost centre plan for a com-posite insurer or an insurance concern with a standard structure:

Decentralized areas

– Intermediaries, further subdivided into types of intermediary (agents, brokers) oraccording to other aspects

– Own company entities, if necessary subdivided into departments as in the mainbusiness.

– Inspectorate, further subdivided into types of inspectorate (universal or specialinspectorates for intermediary support, acquisition, claims handling, individualclasses of insurance, individual customer groups)

– Claims regulating offices



Centralized areas (Head office)

– Products and staff divisions

– Manufacturing departments (insurance departments)– Business departments for initial processing and renewal processing, further

subdivided into functions, insurance classes, customer groups, regional areas– Claims departments, further subdivided into functions, insurance classes, types

of claim, customer groups, regional areas– Reinsurance departments

– Sales departments, usually includes the department for sales force support

– Administration departments, especially personnel, property management andaccounting (mainly preliminary cost centres)

– Finance department including the investment department

– Internal product departments (preliminary cost centres)– Technical equipment and installation, including IT– Supporting services, e.g. typing pools, registry, fleet, post room, telephone and

facsimile

Allocation of the area costs

The close of the cost centre accounting is the allocation of the area costs to the costobjects. In practice this is the most difficult cost accounting problem, since in thisallocation step keys for the allocation of the costs have to be used to a considerabledegree.

Before the costs of the final cost centre are allocated, the costs of the preliminarycost centre are assigned to the final cost centre. For example, the costs for person-nel and property management and the costs of the technical equipment and instal-lation must be allocated, which generally happens with the help of keys (e.g. thecosts of the personnel department according to numbers, IT costs according to timeshares for the areas responsible for the assignment). The fact that some of the pre-liminary cost centres produce reciprocal products for each other can be approxi-mately allowed for by means of a practical sequence of allocation steps. Those pre-liminary cost centres should be settled first which deliver to many other areas andwhose cost amounts are high.

In allocating the costs of the final cost centres, keys should be used that are custom-ized for each company, provided they are not direct costs of the cost object.

6.1.3 Product cost accounting

The unit costs of the business products are calculated by means of product costaccounting. The allocation of the direct costs to the cost object is direct, the allo-cation of the overhead costs being indirect over the bases of calculation in the costcentre accounting. The unit costs or also the manufacturing costs of a product areneeded in the short-term profit and loss account and as the basis for the companypricing policy.

From the management perspective the aims of product cost accounting are amongother things the

– optimization and control of the profitability of the insurance classes and invest-ments, by the product cost accounting preparing the data for strategic estimatesof the contribution margins

– calculation of the premiums for the insurance classes

– product sales decisions (sell aggressively, brake, stop products)

These goals are achieved within the framework of cost object unit accounting andcost object time accounting. Cost object time accounting is accruals accounting,which broken down into products determines all the products and costs as well asthe business result in the accounting period. Cost object unit accounting is indi-vidual specification oriented accounting. It establishes the manufacturing costs orproduction costs of the business product units (unit costs) and is thus the actual cal-culation.

Types of unit cost

Depending on the utilization of the benefits produced in the insurance company, adistinction is made between preliminary cost objects and final cost objects.

Preliminary cost objects are internal benefits, which are designated for renewed usein the own insurance company and which are thus activated in the internal balancesheet and are written down in line with their expected useful life. This relates in thefirst instance to the conclusion of contracts and the sales force. In particular cases,the costs for a complete rearrangement of the administration, for an own IT pro-gramme and similar investments can also be dealt with in the same way.

Final cost objects are particular products for the business market. They are first of allthe types of insurance protection which are offered by insurance companies or con-cerns, and secondly products of the insurance company that have nothing to dowith protection. Among these are in the first place the capital and rent utilization(investments), which are sold in special markets, as well as further benefits, such asmanagement services in syndicate business, business management assignmentsfor other companies, insurance intermediary services, intermediate businesses ofother kinds and IT services for third parties.

Above all, in the internal account the costs and revenues for byproducts in the formof different services should be ascertained with great care, so that their profitabilityis transparent. In practice, in accounting the non-insurance business is often mixedwith insurance business, because they are to some extent produced by the samefactors of production and in the same cost centres.

Insurance contracts or insured risks as cost objects?

The allocation of the costs to cost objects assumes that between the costs that haveto be allocated and the cost objects there is a one to one allocation relationship. Anexamination of the productivity correlation in the insurance company shows thatthe correlations between elements of the factors of production, on the one hand,and the services that are produced, on the other, are different.



The operating expenses, apart from commissions, are linked with respect to theirorigin to the individual insurance contracts: that is, their level is mainly determinedby the features of the insurance contracts, irrespective of whether in the individualinsurance policies one risk or several risks, large or small risks, are insured. For ex-ample, if there is a causal relationship between collection costs and a household po-licy as a whole, this is independent of whether this includes the fire peril or the fiverisks of the combined household insurance policy. Or: the costs for the preparationof a motor insurance certificate are almost completely independent of whether thepolicy covers only the motor third party liability or the insurance of partial risks. Or:the costs of claims handling in life insurance do not depend on whether a large orsmall sum insured will be paid out. The insurance contract constitutes a joint pro-duction of insurance protection consisting of subsets of different types and size. Thecosts are only calculable for the combined product: not, however, for its parts. It fol-lows that product cost accounting for the capture of the operating expenses has tobe carried out according to the types of insurance contract.

The risk costs, namely claims expenditure, reinsurance expenses and imputed inter-est on the insurance liabilities and security, exhibit on the contrary a causal con-nection to single insured risks: that is, their level is determined by features of theinsured risks without taking into account whether or not they are bundled togetherin few or many insurance contracts. In this way the cost of claims for combinedhousehold insurance policies can be allocated to the individual perils of fire, bur-glary, tap water, storm and vandalism. The reinsurance costs for a motor excess ofloss treaty can be directly allocated, even if these are all bundled in an all risks con-tract. For the calculation of the claims, reinsurance and interest expenses the pro-duct cost accounting must be broken down according to the types of insured risk.

Problems in allocating costs

1. Despite complicated assignment keys a causally justified distribution of overheadcosts is only to some extent possible.

2. With simple assignment keys the allocation is relatively arbitrary (e.g. Depart-ments. The different fluctuation – and consequently more work for the personneldepartment – is not taken into account).

3. Occasionally the costs are allocated according to the principle of financial viabil-ity. This principle contradicts cost allocation based on the principle of causality.(Principle of financial viability = a highly profitable class of insurance is allocatedmore costs – or: Class, for which the “cost matching” premium matches the riskand which is higher than the competition, is “relieved” of costs).

4. The costs incurred must be broken down into non-recurring and recurring costs.The non-recurring costs (e.g. new business commission for life insurance) shouldbe spread over the average policy duration. (The sum of the running costs andthe annual share of the acquisition or non-recurring costs are the relevant operat-ing expenses per year).


Types of cost

unit costs – direct costs unit costs – overhead expenses

immediate cost centre EK cost centre GK

immediate allotted

primary cost centre costs

internal cost allocation(secondary)

primary cost centre costs

calculation rates

unit costs

Diagram of cost accounting in the insurance industry


5. Problems also arise, for example, in connection with the cost allocation for com-bined and packaged policies (allocation of the costs for underwriting: for exam-ple, for a family protection policy).

6. A distinction must continue to be made between fixed and variable costs. Theunderwriting costs of a life insurance policy are broadly similar – irrespective ofwhether a sum insured for € 20,000 or € 80,000 is processed. The commissioncosts, however, depend directly on the sum insured.

7. The identification of operating costs is recorded in numerous items of the profitand loss account, because the expenditure (costs) are captured partly accordingto type and partly according to functions or business areas. (For example, salaryexpenses in expenditure for insurance business, for insurance claims and forinvestments). The total amount cannot be established, because parts of the oper-ating expenses (for example, expenses for claims handling) are included in theitem “claims expenditure”.

8. The net result of the operating expenses after withdrawal of reinsurance com-missions and profit shares can distort the picture.

9. In many insurance companies a fixed extra for operating expenses is added tothe risk costs. This means for low sums insured the operating costs are scarcelycovered, for high sums insured the customer is burdened with operating coststhat are much too high.

Example contents insurance:

Premium rate: 2.0 ‰

1.2 ‰ risk costs = 60 % of the premium

0.8 ‰ operating expenses = 40 % of the premium

2.0 ‰

a) Sum insured € 50,000; Share of the operating costs € 40

b) Sum insured € 200,000; Share of the operating costs € 160

For a sum insured of € 200,000 the policyholder pays a four times higher share ofthe operating costs than for a sum insured of € 50,000, because these costs increaseproportionately with the sum insured. This is justified for new business and renewalcommission, because these expenses increase proportionately to the sum insured.The costs for the underwriting and policy issue processes will, however, hardly befour times those of a policy for € 50,000.

Possible solutions

– Suitable cost discounts are granted; there are no cost extras; instead a minimumamount applies.

– The operating costs are divided into sum insured variable and sum insured fixedcosts. (Commissions – variable costs – fixed costs). For sum insured fixed costs afixed amount (unit cost extra) is allowed for.

Example contents insurance:

Premium rate 1.7 ‰ + € 30 units costs extra

1.2 ‰ risk costs

0.5 ‰ operating costs (variable)

€ 30 operating costs (fixed)

a) Sum insured € 50,000. The customer pays € 25 variable and € 30 fixed operatingcosts – in total € 55

b) Sum insured € 200,000. The customer pays €100 variable and € 30 fixed operat-ing costs – in total € 130

6.2 Contribution margin accounting

Cost accounting procedure

Besides the three areas of cost accounting (cost-type accounting, cost centre ac-counting, product cost accounting) two cost accounting procedures have to bedistinguished, namely: full cost accounting and marginal costing.

Whilst in the case of full cost accounting all costs (direct costs and overhead costs)are spread over the individual cost objects, in the case of marginal costing at firstonly part of the costs – for example, only the direct costs – are allocated to the costobjects. The overhead costs are dealt with at the end in this case.

Full cost accounting thus foresees a complete allocation of all costs onto the costobject. On the one hand, this is also its great advantage, since there cannot be anygaps which can be used to avoid cost controlling by those who do not want to takeresponsibility for costs they have induced. On the other hand, the result is that thedistribution of overheads is only possible by breaking down costs. In doing this theprinciple of cost causality is inevitably violated, which can result in various strains inindividual cost centres. This means that full cost accounting cannot deliver the basisfor business planning.

In marginal costing, as already mentioned, the distribution of particular costs, suchas fixed costs, is waived. In the insurance industry contribution margin accountingis being increasingly employed as results oriented accounting on the basis of mar-ginal costing.

Features of contribution margin accounting

Contribution margin accounting allocates only the direct costs and revenues thatcan be assigned to the cost centres and cost objects. The enterprise reports theoverheads as a whole. In this way a more or less correct allocation of the over-head costs to the cost objects and cost units (= branches and insurance policies) isavoided with the help of keys.

As reference figures (= headers) cost objects (products), cost centres and otheritems can be chosen.



Controlling using contribution margin accounting

– Control of periodical contribution margins for other allocation bases. Using thesame procedure contribution margins can be calculated from insurance businesswith individual company groups, in certain sales areas, with branches and inter-mediaries. To do this, the allocation bases (headers of the contribution marginaccounting) must be suitably changed.

– Control of the periodical contribution margin of customer portfolios or individualinsurance contracts. By using this itemization it is possible to control which con-tribution margins a business connection with a particular customer brings over aperiod of time. The contribution margin for only one accounting period is, how-ever, hardly meaningful).

– Premium decisions: The premium revenues for the individual classes of insurancemust cover at least the calculated direct costs. Furthermore, the contribution mar-gin should also cover part of the overhead costs. In the underwriting policy it mustbe checked on a case by case basis as to whether additional business brings apositive contribution margin. If this were the case, the overall results of the insur-ance company would improve, because an additional contribution margin wouldbe available for the overhead costs. But if the premium for this business is noteven sufficient to cover the direct costs that can be allocated directly, then thisbusiness must be declined.

However, premiums and underwriting decisions must be made only for the indi-vidual case with the assistance of contribution margin accounting. If the insureroriented its complete pricing policy on the contribution margin, the overheadswould probably not be covered in the long-term. A long-term general premiumpolicy is thus only possible with full cost accounting.

– Programme decisions: If capacity is tight – for the sales force or for advertizingmeasures – contribution margin accounting can give good information. The in-surer will then choose the class of insurance for more intensive sales and advertiz-ing measures from which it can expect the higher contribution margin.

Advantages of contribution margin accounting

– A more or less correct allocation of overhead costs to the cost objects and the costcentres is avoided with the help of keys.

– The overheads are mainly fixed costs. If the business is shrinking, in the case offull cost accounting individual contracts have to be declined, because the share offixed costs per cost object (= fixed costs per contract) increases without the pre-mium being able to be increased – or the gross premium would be higher than themarket premium and the business would shrink even more.

Example:

The fixed costs of an insurance company’s motor vehicle liability insurance are€ 200,000.

With 10,000 policies the fixed cost share per policy is € 20. If the number of policiesdecreases to 5,000, for example, the fixed cost share per policy increases to € 40 perpolicy: that is, the insurer would have to raise the premium. Then the number ofunits would presumably further sink.

Summary

Construction of contribution margin accounting (Head office)

Revenues per class of business

– Direct costs per class of business

= Contribution margin per class of business

The overheads are not distributed, but shown together as a block by the insurancecompany.

Total of the contribution margins

– Overhead costs

= Insurer’s profit


Example:

Contribution margin accounting head office (simplified)

Relationrevenues& costs

Indus-trialfire

Agri-culturalfire

Simplebusi-nessfire

Totalfire

Restnon-life

Totalnon-life

Invest-ments

Totalcom-pany

Total

Premiumrevenues

80 26 70 140 316

Invest-mentrevenues

20 20

Totalrevenues

80 26 70 140 20 336

Per-sonnelcosts

4 2 2 1 5 3 5 30 52

Inter-mediarycosts

8 3 7 14 5 37


Business result = 336 – 314 = 22

Relationrevenues& costs

Indus-trialfire

Agri-culturalfire

Simplebusi-nessfire

Totalfire

Restnon-life

Totalnon-life

Invest-ments

Totalcom-pany

Total

Costs ofworkingcapital

2 1 1 2 2 1 1 23 33

Depre-ciation &amor-tizetionof newbusiness

2 3 5 8 18

Claimsexpen-dituref.o.a.

34 10 28 46 118

Reinsur-anceexpenses

20 6 5 25 56

Totalcosts

70 25 48 3 100 4 6 58 314

Explanation

This insurer offers only non-life insurance. The premium revenues (= directly allo-cated revenues) are allocated to the insurance branches. Then the direct costs, forexample, of the clerks of the industrial fire insurer (€ 4,000) are allocated to thisclass. For the fire insurance departmental management there is a total of €1,000, forthe whole of non-life (for example, board of management, non-life) € 3,000 for per-sonnel costs. “Total fire insurance” and “Total non-life” have no revenues, sincethe premiums are allocated to the individual sub-classes of insurance. In the case of“Total fire/non-life” only the costs of the departmental management are shown. Theintermediary expenses (commissions) are also distributed as directly allocateddirect costs to the sub-classes of insurance. € 5,000 (under intermediary costs)could not be directly allocated. They are captured under “insurance company as awhole”. To this, office allowances could be credited to the agents.

Belonging to the operating costs are, for example, depreciations and amortizations,repair costs, material and electricity costs, as well as office rents, IT plant, and so on.Here, too, direct costs (for example, € 2,000 for industrial fire) and overhead costs(for example, € 23,000 under “insurance company as a whole) are differentiated.

Explanation

The direct costs are subtracted from the directly allocated direct revenues of thesub-classes of insurance. The result (= € 73,000) is the contribution margin for thesub-classes of insurance. (Contribution margin = surplus from direct revenues anddirect costs which should cover the overhead costs). If the direct costs of the depart-mental management are subtracted from the contribution margin of sub-classes ofinsurance, the contribution margin of the non-life line of business is obtained, atotal of € 66,000. If the direct revenues (= interest, dividends, etc.) and direct invest-ment costs are taken into account, the contribution margin for the classes of bu-siness is obtained (€ 80,000). This contribution margin has to cover the overheads(€ 58,000). This gives a business result of € 22,000.


Contribution margin flow

Industrialfire

Agri-culturalfire

Simplebusinessfire

Restnon-life

Invest-ments

Individual revenues 80 26 70 140 20

– Direct costs of thesub-classes

– 70 – 25 – 48 – 100

10 1 22 40

73

Contribution marginof the sub-classes

– Direct costs of theinsurance classes

– 3– 4

– Contributionmargin of non-life

66

– Direct costsof capital

– 6

– Contributionmargin of linesof business 80

14

– Total costs ofinsurance co.

– 58

Profit 22

��


Example of premium calculations:

For contents insurance the insurance company has calculated a premium rate witha full cost account of e.g. 2 ‰.

The contribution margin is 1.6 ‰: that is, with 1.6 ‰ the claims and direct operatingexpenses are covered.

If the insurer in particular cases cannot achieve 2.0 ‰, it can go down to 1.6 ‰. Butthese policies then cover only the direct costs – not their share of overhead costs. Ifmany policies between 1,6 ‰ and 2,0 ‰ are accepted, then the contents insurer willprobably make a loss, since this class must also carry its share of the overheadcosts.

Example for controlling customer relationships

For example, the total costs of the customer Schulz have been observed over thelast five years (premiums, commission and claims added together)

Domestic Contents Liability Combined Trader’sbuildings insurance insurance shop combinedinsurance contents policy

insurance

Premiums € 2,500 € 2,000 € 1,800 € 24,800 € 12,000– Commissions – € 450 – € 360 – € 320 – € 2,880 – € 1,440– Claims – € 400 € 0 – € 9,200 – € 4,600 – € 13,000

Contributionmargins € 1,650 € 1,640 – € 7,720 € 16,520 – € 2,840

The total contribution margin is € 9,250, so that the development of costs is posi-tive.

This accounting could be even more finely tuned if further direct costs were broughtinto it. In practice often only the premiums and the claims are accounted for,whereby large claims are capped.

7Controlling

byDr.Georg Erdmann

Controlling 149

7.1 Nature of controlling

The term “controlling” is often translated into German by the word “kontrollieren”(double-check), based on the English word “control”, and this is how the task ofcontrolling is perceived. Controlling, however, does not mean to double-check, butmanage, plan or supervise. Controlling is not geared to the past, as is accountancy,but is future oriented, in order to safeguard the long-term future of the enterprise.

A company management that sets itself objectives needs a system that will enableit to

– receive and evaluate information about the procedures in a company

– plan and manage with this information

– supervise the company processes

– recognize dysfunctions early and react immediately

– learn from experience and incorporate the insights into the new planning and ma-nagement.

Controlling is the totality of tasks which the co-ordination of the company leader-ship has as well as the supplying of the company management with information, inorder that its objectives can be realized.

Controlling supports the board in corporate management, especially in

– planning and co-ordination,

– the analysis of deviations,

– the capture and preparation of information,

– the organization of a comprehensive reporting system

– performance reviewing and reporting.

Sub-areas of controlling

Controlling consists of the four functional sub-areas information, planning, corpor-ate management and control.

1. The information function should capture the communicative and directive con-nections between decision makers, the totality of controlling tasks and the basisof information.

2. The planning function consists of the sub-areas

– Supply of the relevant control instruments

– Strategic definition of aims

– Operative definition of strategies

3. By corporate management is understood the objective orientation of companyactivity. Its main purposes are:

– Supply of controlling instruments

– Provision of information appropriate for the level of the decision-makers

– Co-ordination


4. The efficient employment of the above-mentioned corporate management in-struments presupposes continuous control. The main focus of control is the com-parison of the planned target with the current specifications using a comparisonof the two figures.

Where controlling can be used in an insurance company

– Cost controlling is the planning, corporate management and control of the costsincurred in company business activity that is undertaken to achieve company tar-gets, especially the cost targets set.

– Distribution controlling is the planning, corporate management and control of thesales organizations whose aim is the realization of the sales targets.

– Claims controlling is the planning, corporate management and control of theclaims that occur.

– Process controlling means those steps which are concerned with making com-pany processes as focussed and co-ordinated as possible.

From an organizational point of view controlling is usually institutionalized in insur-ance companies in the form of staff divisions or staff departments, which are underthe immediate direction of the management. Because of its proximity to the direc-tors the function of controlling is expressed as corporate management, as well asbeing important for the whole company.

7.2 Strategic and operative controlling

Depending on the time frame a distinction is made between strategic controlling(time frame long-term, three to five years) and operative controlling (time frameshort-term, one month to two years). In the course of strategic planning the com-pany management establishes the targets it wishes to reach in the longer term. Thisis a rough plan, lasting for a period of at least three years. Operative controlling, onthe other hand, generally covers a business year. The short and long-term goals tobe targeted are established.

The areas of activity of strategic controlling are

– Participation in the capture and further development of the planning and corpor-ate management system

– Service task. By service task is meant the function of controlling to prepare decisi-ons: that is, to filter out the most important data and to prepare accordingly.

– Security and controlling function. By means of constant supervision the companyprocesses and decisions are controlled so that the existence of assets / and thesurvival of the company are assured.

The targets of operative controlling can be, for example:

– Increasing profit

– Decreasing costs

– Understanding the deviations between planned and realized results

Controlling 151

For the targets aimed at plan figures are developed (for example, cost reduction by10 % of premium collection). The plan figures for the near future can also be adap-ted from historical data. Furthermore, controlling accompanies target-focussedbusiness activity and supports it with information and co-ordination.

7.3 Controlling instruments

Important controlling instruments are the following:

– Performance figures systems: performance figures are calculated from the actualfigures and these are evaluated.

– Target/Actual comparison. Plan data (target figures) are compared with the actualearned data and the deviations are examined.

– Budgeting. The planning simulates target values in the form of quantifications (forexample, number of units of new business in a class of insurance) or values (e.g.reduction of claims expenditure in a class of insurance), which are then later com-pared with what has actually been achieved.

– Information and reporting systems. Information about the targeted goals is col-lected, evaluated and presented.

Controlling instruments in insurance companies

A performance figures system in insurance is a systematic collection of businessindicators that is compiled either for the internal business comparison or for thecomparison of entities (= branch performance indicators) or to control the businessresults.

Besides the business performance figures about efficiency to be found in all compa-nies, the performance figures relating to productivity and production are of greatimportance. As indicators of business changes, developments and results they indi-cate to the controller when and to what extent intervention is necessary.

Basically, the whole cost accounting is suitable for cost controlling. Investment indi-cators can also provide capital controlling with information. For the insurance com-pany, distribution and internal business indicators are important. The hit rate is theratio of insurance offers to closed contracts:

Total acquisitions of new business * 100Hit rate new business =

Number of visits

Total acquisitions of business in force * 100Hit rate business in force =

Number of visits

If the insurer combines them, it obtains the total hit rate of its sales staff. The sig-nificance is limited, however, because the rate changes greatly with the (individual)specifications of the target visits.


The cancellation rate is significant for the insurance company. It gives the ratio ofthe withdrawn policies to those taken out in an accounting period and directlyaffects the income of the sales personnel (new business and renewal commission).To prevent sales personnel forcing up their new business commission and bonusesby acquiring hazardous business, insurers grant these only for longer term businessthat is in force. The rate can be calculated by various parameters: for example, unitsor premiums.

Cancellation (unit) * 100Cancellation rate of new business =

New contracts * 100

Cancellation (premium) * 100Cancellation rate of business in force =

Business in force (premium)

The premium growth rate indicates to the insurer how its portfolio is developingfrom the beginning to the end of an accounting period. Using the example of motorinsurance the following values are obtained (slice view):

Development of private motor business

Insuranceclass

Premiumvol. 1.1.Bus. Yr

€

Bus. inforce can-cellationin Bus. Yr.

%

New bus.in Bus.Yr.

€

New bus.cancella-tion inBus. Yr.

%

Premiumvol. 31.12.Bus. Yr.

€

Growthrate in %

Motor-fullRider

1,200,000300,000

2.54.5

90,00024,000

4.02.0

1,256,400310,020

4.73.3

1,500,000 114,000 1,566,420

Furthermore, a short term calculation of the growth rate can give the insuranceagency an ongoing indication of whether the insurance target will be reached or not.The agency owner can then react before the year is over when his financial targetswould be unattainable.

For the area of cost controlling the calculation of the administration cost ratio is im-portant. It shows the relationship of the agency costs to the revenues and finds itslogical conclusion in profit centre considerations, since here the responsibility forexpenses and revenue are transferred to the agency. Only personnel and adminis-tration costs should be regarded as expenses, the revenues corresponding to thatpart of the renewal commission which is earned by customer service. The adminis-tration cost ratio is calculated as follows:

(Expenditure for personnel + generaladministration) * 100

Administration cost ratio =Revenues from customer service

Controlling 153

Example:

From the cost accounting the insurance company has the following data:

Expenditure for administration costs € 37,400Expenditure for energy € 5,000Salaries € 115,000Social expenditure € 32,000Expenditure for rents € 24,000Expenditure for taxes € 14,000

Administration costs € 227,400

Revenues from renewal commissions € 372,250

227,400 * 100Administration cost ratio = = 61.09 %

372,250

So far the loss ratio has been ignored in considering the performance figures. Theloss ratio is calculated as follows:

Total claims of business class in agency’s portfolio * 100Loss ratio =

Premium volume of portfolio

Selected performance figures for sales management (using the example of a branchoffice)

1) Production output1) – Target compared to new business1) – Class comparison new business1) – Contribution margin new business

2) Costs and profits2) – Loss ratio2) – Expense ratio2) – Growth rate gross premium

3) Portfolio3) – Composition of portfolio3) – Average premium per contract3) – Cancellation rate3) – Contribution margin per contract / customer

Balanced scorecard as a controlling instrument

In the past few years the concept of the balanced scorecard, developed by Kaplanand Norton, has gained universal recognition.

The balanced scorecard is an achievement-oriented and strategic managementinstrument that brings together qualitative and quantitative performance figuresfrom the perspectives of finance, customers/market, processes and members of


staff. On the basis of a clear vision strategic targets are abstracted from these per-spectives into a causal relationship with each other, as well as being operationalizedand made quantifiable by performance figures.

Aims of the balanced scorecard

– Conversion of the company strategy into measurable targets.

– High degree of transparency and shared understanding of the strategy (cause andeffect relationships) and of the strategic aims at all levels of the company.

– High degree of acceptance, motivation and identification by the members of staff(promotion of the company culture)

– Communication of achievement-oriented results and value drivers

– Improved customer relations

– Increase in company value

– Effective and efficient cultivation of the market

– Strategic management of investments

By “balanced” is meant the equilibrium between short and long-term targets, mo-netary and non-monetary performance figures as well as between external andinternal criteria. From this a holistic view of the company emerges.

The word “Scorecard” indicates that the company is observed from the point ofview of strategically relevant reports.

The balanced scorecard contains four perspectives for comprehensive corporatemanagement:

1. Financial perspective (Appraisal of the company achievement from the investors’point of view)

2. Customer perspective (Appraisal of the company achievement from the custo-mers’ point of view)

3. Organizational and process perspective (Which processes are important for thecompany and how efficient are they?)

4. Learning and development perspective (How will the company’s long termsuccess be safeguarded? – Personnel, IT, Organization)

Solvency II as a requirement for the controlling in the insurance company

Solvency II is a project of the EU Commission for a fundamental reform of insurancesupervision in Europe, especially of the solvency regulations for the supply of equitycapital for insurance companies. On July 10th 2007 the European Commission sub-mitted a proposal to the European Parliament and Council for a Solvency II frame-work regulation. According to a directive regarding the relevant implementationregulations Solvency II will be implemented at a national level. As with Basel II (sol-vency regulations for the equity capital requirements for banks) there will be a 3 pil-lar concept. In contrast to the banks, however, the focus is not on single risks, butthe concept is holistic with the focus being on total solvency. As well as quantitativeaspects (Is adequate solvency capital always available?), qualitative aspects are alsoconsidered (Does the company have adequate risk management?)

Controlling 155

The 1st pillar deals with the level of the minimum solvency capital, the minimumcapital requirements (MCR minimum capital requirements) and the target solvencycapital that has to be set up, the solvency capital requirement (SCR) in relation to thedeductible equity capital (eligible own funds).

The 2nd pillar applies to the risk management system and above all contains quali-tative requirements, such as the qualification of the board members of insurancecompanies (the so-called “fit and proper” criteria).

The 3rd pillar regulates the reporting duties of the insurance company: the reportingduties to supervisory authorities (supervisory reporting) as well as information thatmust be published (public disclosure). With the reporting duties a close connectionto other legal reporting duties should be attained, especially to other legally requi-red reporting duties, such as that in the field of accounting, especially IFRS (Interna-tional Financial Reporting Standards).

Study Book Insurance I

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Transcript of Study Book Insurance I