The Contract and the Operational Practice of Conventional Insurance

The Contract of Conventional Insurance

As stated above that the purpose of all insurances is to seek protection against all kinds of risk to which man is exposed. The purpose of insured is to prepare himself against probable hazard and loss in his life and trade. He tries to shift the burden of the probable loss on to shoulders of others, who are prepared to take the risk for some financial gains to themselves.

All insurance contracts are based on the law of large numbers[1] and the mathematics of probability. In a large homogeneous population it is possible to estimate the normal frequency of common events, such as deaths and accidents. Losses can be predicted with reasonable accuracy, and this accuracy increases as the size of group expands[2].

All insurance contracts are made on the principle of uncertainty, uncertain events, which involve speculation as well as risk[3]. Both the insurer and the insured enter into contract of mutual risk, the former risking a loss and the latter risking his premiums.

The agreements between the insurer and the insured in insurance contract are embodied in a formal document, called a policy which, afterwards, the insurer is legally bound issue to the insured on the receipt of premium and the insured is legally obligated to pay the premium monthly or annually appropriate with previous agreement between the parties.

The insurance contract is not like the contract of other service companies. It has characteristics as below:

a.       Future contract, because the benefits of this contract just appear when the loss is paid in next day,

b.      Contingent contract, because the loss happens uncertainly and it undertakes based on probable perils,

c.       Service contract, because the insurance provides the services, benefit understanding and suggestions.

d.      Risk contract, the base of insurance contract is the uncertainty with the probable loss of perils. The insurance shifts the risks of this loss on to company’s shoulder as the professional risk bearer[4].

a.      Policy[5]

Policy is a formal document contains the agreements between the insurer and the insured in insurance contract[6]. The policy can be the small sheet of paper contains the concise and simple agreement, or be the long and hard document. All of both documents state dues and obligations of both parties.

The policy plays an important part in the insurance contract, whether in the beginning step, during the contract or in the covering of insurance. For the insured, the policy is the basis evidence to propose the indemnity demand when the insured hazard causes the loss. And for the insurer, the policy is the basis to know the insured’s responsibility toward the hazard[7].

Except life insurance policy, every policies must contains of eight main points, they are:

1.      The day of the insurance covering

2.      The name of the insured who agrees the insurance covering

3.      The clear explanation about the assured goods

4.      The amount of money for how many times the insurance is held

5.      The assured perils and hazards

6.      The beginning time and the end of the insurance

7.      The amount of premium

8.      The matters that normally must be well known by insurer, and the certain promises and clauses between the insured and the insurer[8].

Globally, the eight main points above are divided into four parts, they are[9]:

1.      Declaration.

The declaration is a statement made by insurance applicant, who basically furnishes all such information and documentary evidences about his identity, the value of the goods, and everything related to the covering of insurance contract as the insurer may requires. This information must be appropriated with the utmost good faith principle. The insurance applicant gives this information by filling up the application form or questionnaire, and then he signs it up.  

2.      Insurance clause.

The insurance clause is the main part of the policy. It contains of the provision of whatsoever risks determined in the policy, the requested requirements and the column for the insurer’s liabilities.

3.      Exclusions.

In the sections of the exclusions, the policy determines whatever the excluded matters, whether disasters or hazards, subjects or losses. Hence, the insured must know and understand precisely whatever excluded in the recovering of the purposed policy.

4.      Conditions.

In this part of the policy, be explained all about dues and duties of the parties, whether insurer or insured. These conditions normally contains of premium payment, risks alteration, insured’s duties toward the incidents, report of losses, indemnity, etc.

Thus, except the application form, the insurer is who makes the standardization policy. Then this policy offered to the insured in order to examine the requirements and clauses carefully. If the insured agrees all terms, the policy will be finished and signed up, and after 24 hours it will be returned back to the insured.

But, practically this short time hardly can be fulfilled, because the insurer must complete the mails and process the received data. So, before the policy can be returned to the insured, temporarily the insured will receive the “cover note” or “bider”, it is a temporary contract of insurance recovering before the policy can be returned[10].

b.      Premium

The premium is the price at which the insurer is prepared to take risks and bear the burden of the probable loss involved in the contract of insurance. The premium is the obligation of the insured against the services of the insurer in an agreed period of time[11].

On the basis of law of averages, the insurer finds through experience an amount of premium with calculating the details as below:

1.      The reasonable amount sufficient to cover the risks,

2.      Other charges, including policy and administration expenses, 

3.      The tip for agents, if the insurance held through the agency,

4.      The profits from the investment of accumulated funds[12].

The contract of insurance becomes effective only when the premium is paid by the insured and received by the insurer. If it is not so, the insurance is unavailable[13]. Thus, the premium must be paid completely during the contract. At the sort-range insurance such as travel insurance, the premium is paid on the beginning of contract. But, at the long-range insurance, the premium can be paid monthly on the previous agreed date, started on the first month periodically. The amount of premium and its payment date are clearly embodied in the policy.

Once the premium is paid by the insured and risk assumed by the insurer, there shall be no apportionment or return of premium afterwards, even though the subject-matter of the risk may vanish before the period of cover has elapsed.

The Operational Practice of Conventional Insurance.

Normally, the insurance company is operated as well as other companies. However, because the transaction of insurance needs special functions in its operational practice, so in this field there are some functions specified for the insurance company only.

Although there are some different functions between life insurance and lost insurance, but the main operational practice of all kinds of insurance company is divided as below[14]:

a.       Underwriting

Underwriting is classifying the risks that will be assured. It is the essential element in the operational practice of insurance company, because the underwriting can maximize the profits through risks distribution.    

The main duty of the underwriter in the risks classification is to ensure no risks can cause great difficulties for the company in next days. For this reason the underwriter must develop sharp consideration through understanding the hazards.

To execute the underwriting process effectively, the underwriter must collect the information as much as possible about the insurance subjects and the cost to get additional data. The underwriter may approve new costumer as long as he complies all underwriting requirements determined by the company. But if he does not so and the hazard risks are too big, the underwriter may reject him.

There are five essential information resources related to the risks, they are:

1)      New costumer’s statement embodied in the questionnaire,

2)      Information from the insurance broker,

3)      Direct investigations toward new costumer’s personality related to the moral hazards such as financial status, occupation, characteristics, etc.

4)      Information from the service bureau concerning to the objects or goods. For instance, health information bureau which stores the files of costumer’s physical checking up for life insurance.

5)      Direct Inspection toward object’s physical condition.

b.      Rating / Pricing

Rate is the price of each protection or exposure units. The rate is different from the premium; the premium is determined by multiplying the rate with the total of bought protection units.

To calculate an equitable rate of premium for an individual risk, the underwriter has recourse either to the pooled record of risks of the same class in his own portfolio, or in the wider record of a group of insurers. Having found the norm of the class concerned, he can adjust the rate upwards or downwards for favourable or unfavourable features in the individual risk to arrive at what he considers a fair rate[15].

By this rate, the income of insurance company from the premium must suffice all losses' covering and operational expenses. To get the income from this premium, insurance company must foretell the claim and distribute the anticipated expenses to every policyholder classes.

c.       Investment

It is the liability of financial staff of company to invest the accumulated amount of money as the accumulated premiums paid by insured. The addition of investment interest purchasing is important variable in determining the rate of premium.

Principally, life insurance is long-range investment. Hence, Life Insurance Company entrusts its funds especially in the long-range investment amounted to 2/3 of asset total invested in the company stocks and the obligation letters, the common stocks amounted to less than 10% and the government’s stocks amounted to 5%.

And loss insurance, normally, is short-range investment. Hence, Loss Insurance Company invests half of its assets total in the government and private company’s stocks. The investment percentage composition of life insurance and loss insurance can be seen in the table below[16]:

Investment Capital	Life Insurance (%)	Loss Insurance (%)
Stock	9,7	32,4
Obligation	36,6	28,8
Government's Obligation	5,2	28,9
Mortgage	30,8	0,2
Real Estate	3,3	1,6
Policy Loan	8,5	-
Premium Balance	-	7,2
Other Investments	5,9	7,3

d.      Loss Adjustment

Before the insurance company covers the losses, it must finish the process of loss adjustment. Loss adjustment is most difficult step for insurance company; therefore it needs a good adjuster in claim section.

It is important for insurance company to pay for the claim properly, speedy and satisfactory, because it is the effective promotion device. And it is important also for insurance company to refuse the unevaluated claim, and to prevent the payment more than full indemnity.

There are two basic actions for insurance company toward a claim, those are payment and rejection. There are two matters provided the basis for insurance company to refuse the claim:

1)      No losses happen,

2)      The involved policy does not cover the loss, because it's out of the insurance contract, whether the contract becomes invalid or the insured violates the clauses of the legal policy. 

In determining which whether the insurance company must pay or refuse the claim, the adjuster must attend settlement procedures with four main steps as below[17]:

1)      Loss information, the insured informs the insurance company that the loss was happening.

2)      Loss investigation, the insurer ensures the loss fact by direct investigation which whether that loss assured by policy or not. Then the amount of losses will be countable.

3)      Loss evidence, made by the insured after informing the loss.

Payment or rejection. If all steps run as well as the clauses of policy, the insurance company will draw the draft to indemnify the insured. But if they do not so, the insurance company will refuse that claim.

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[1]The law of a mathematical concept states that the ability to predict losses improves with larger groups. Using calculations based on statistics and actuaries to accurately predict the losses of a large population, even without knowing when or how any one individual will experience loss. (See in Microsoft Encarta Encyclopedia 2004, loc. cit)

                [2]Afzalur Rahman, op.Cit, p. 74.

[3]Ibid, p. 89.

[4]Drs. Herman Darmawi, op. cit, p. 71.

[5]See the example of insurance policy at Appendix I.

[6]Supardjono, op. cit, p. 20. 

[7]Ibid, p. 21.

[8]KUHD, section 256, quoted by Dr. Sri Rejeki Hartono, S.H., op. cit, p. 125

[9] Please see in Dr. Sri Rejeki Hartono, S.H., ibid, p. 129 – 131.

[10]Dr. Sri Rejeki Hartono, S.H., op. cit, p. 130. 

[11]Afzalur Rahman, op. cit, p. 89

[12]Supardjono, op. cit, p. 40.

[13]Drs. Thomas Suyatno, MM. Et. All, Kelembagaan Perbankan, (Jakarta: PT. Gramedia Pustaka Umum, 1999), third edition, p. 92.

[14]See Drs. Herman Darmawi, op. cit, p. 31 - 52.

[15]Afzalur Rahman, op. cit, p. 150.

[16]Drs. Herman Darmawi, Op. cit, p. 50

[17]Ibid, p. 47

Conventional Insurance

The Definition of Conventional Insurance

Terminologically, insurance is contract made by a company or society, or by a state, to provide a guarantee of compensation for loss, damage, sickness, death, etc in return for regular payment[1].  

According to Fuad Mohd Fachruddin the commercial insurance is a contract between two parties, insured and insurer, with the policy, the insurer receives the premium; it’s one of the regular sum of paid, in cash or credit, from the insured and the insurer promises to indemnify all of losses may be suffered him[2].

Afzalur Rahman provided the similar definition with Fuad Mohd Fakhruddin;he defined the insurance as a contract whereby one person, called the insurer, undertakes, in return for agreed consideration, called the premium to pay to another person, called the insured, a sum of money, or its equivalent, on the happening of a specified event[3]. The specified event must have some element of uncertainty about it; the uncertainty may be either as the case of life insurance, in the fact that, although the event is bound to happen in the ordinary course of nature, the time of its happening is uncertain, or in the fact that the happening of the event depends upon accidental causes, and the event, therefore, may never happen at all. 

Willet, Kulp, Riegel, Miller and Peffer, all provide similar definition that insurance is the concept of risk pooling-of group sharing of losses. That is, persons exposed to loss from a particular source combine their risk and agree to share losses on some equitable basis[4].

Thus, in very simple word, a contract of insurance is a contract between two parties, the insurer and the insured, the former promises to compensate the latter on the happening of a definite event in return for his contribution.

Based on some ideas of economic experts toward the definition of insurance above, it can be concluded that an insurance agreement involves five essential conditions:

a.       There must be a contract of insurance between the parties,

b.      The event should involve some amount of uncertainty,

c.       There must be contract for the payment of some amount of money, or some benefit which becomes payable to the insured person on the happening of an event,

d.      Compensation is promised by the insurer in return for the payment of contributions of premiums by the insured,

e.       The event must be against the interest of the insured.

The History of Conventional Insurance Development

The concept of insurance is closely related to group life. It originated from the human need to find safeguards against the problem risks to himself and his property, but when, how and by what people it was started is shrouded in mystery and obscurity.  

All historians agreed that the concept of insurance didn’t appear in primitive era yet. With assumption, in primitive society, people lived together in families or tribe in which their needs fully met and protected through cooperation and mutual. They, therefore, did not feel the need for insurance because they were fully protected against all sorts of risks by community.    

The appearance of insurance is closely related to human civilization. The historians have marked Egypt and Mesopotamia as the oldest centers of civilization[5], with its fertile valleys of Nile, the Euphrates and the Tigris, where men would cease to wander and settle down almost unawares, forgetting all about their nomadic group life[6]. Traders in that territory used the basic of insurance concept since around 4.000 years B.C. They implemented this concept because they felt uncertain accidents would against their security and safety in trading, cause of nature or non-nature factors[7].     

Yet, however the written insurance concept regulation just comes to be known at era of Hammurabi, the fourth king of Babylon[8] (1782-1682 B.C), with archaeological discoveries which shown a law book[9] contained 300 sections. One of these sections contained one of insurance principles; it was “One for all”[10]. The contract found in this book, was the embryo of a concept later to be known the whole world over as the contract of Bottomry or Respondentia. Bottomry is, or rather was, a commercial contract whereby money (or goods) was advanced for trade purposes either as:

a.       True loans at a certain fixed rate of interest, under which the lender had no right to any share in the proceeding of the trading venture,

b.      Mixed loans and partnerships which, in addition to the payment of a fixed rate of interest to the lender irrespective of the result of the trading, entitled him to receive a share of the profits, if such profits exceeded a certain sum[11].     

The next stage in the evolution of Bottomry was its development by the Greeks during the ninth and tenth centuries B.C., it was not merely adopted, it was also adapted and perfected. Romans, whose adopted business concepts from Babylon, Phoenicia[12] and Greek, developed these concepts to be insurance form.  

But the economists are sharply divided on the concept of bottomry; did it can be called as insurance concept. Anyhow, the though kernel of Bottomry was the beginning of modern insurance development.

Any early signs of modern insurance in scientific form and on premium basis seemed to appear in the European countries in the middle of the thirteenth century[13]. This insurance was known as marine insurance. This form was undoubtedly associated with the merchants of the cities of Lombardy and notably Florence in Italy, 1250. Dinsadle said that in the Middle Ages, trade was mainly centered in the Mediterranean, with well-known trade routes to the East; Constantinople and India, and to the North; Florence, Genoa, Palermo and Venice which became the centers for banking, commerce and insurance at that time[14].

From Italy, then marine insurance spread to Spain, France, England and other countries of Europe. The intensive trading by Barcelona since the end of fourteenth century caused marine insurance to flourish early in Spain. The earliest agreement known bears the date of the April 12^th 1428. On November 21^st 1435, by the insurance Ordinance of the Magistrates of Barcelona, Marine Insurance was for the first time, regulated by legal confirmation of existing practice[15]. Marine insurance was practiced in London, England and Le Rochele and Merseilles, France on the beginning of fifteenth century. They practiced the same style with the insurance in Italy.

At the sixteenth century, marine insurance contract grew up steadier than before. At that time, the insurance contract has used the printed policies[16]. Those policies were still written in Italian language, cause of Italian traders' domination. In this century, the practice of marine insurance resembled the practice of modern insurance that applied nowadays. Beside policies, they also used the insurance covering system which done collectively. And this collective covering system dominated entire practices of sea transportation insurance during ten years, up to the beginning of nineteenth century.

Specifically, the insurance companies appeared since eighteenth century. And on nineteenth century they developed rapidly in Europe, for instance in France with “Compagnie d’Assurances Generales” on 1753, and in England with “The Sun Fire” on 1710. Meanwhile in USA, were established “Mutual Relief Association” on 1752 and “Insurance Corporation” on 1772 as the first insurance company in Philadelphia[17].

The insurance arrived in Indonesia far before independent day, brought by Dutch who more than 350 years colonized this country. With proof, on 1845 was established a life insurance “N.V. Levens Verzekering Maatschappy van de Nederlande van” and fire insurance “Bataviasche See”[18]. But, formally, the insurance and its institution be included in agenda of Indonesia law on 1848, herewith the legalization of Dutch Trading Laws in Indonesia.

Furthermore, in the second decade of the beginning of twentieth century, were established many indigene insurance companies, one of the oldest was “Onderlinge Levernverzekering Maatschappy Bumi Putra” established on February 2^nd 1912 in Magelang, Central Java. Four years later, the group of Chinese ethnic in Semarang established also a loss insurance company, named by “NV. Indische Llyod, Algemene Verzekering Maatschappy”[19].

After the independent day on 1945, up toward 1950, the political situation in Indonesia did not give opportunity for insurance to develop. On 1950, Indonesian Government Banking established the insurance company, named by “Maskapai Asuransi Indonesia”, and on the years later came afterward many insurance companies in Indonesia[20]. Up to now, on 2003, hundred insurance companies were established in Indonesia, for only life insurance companies found more that 53 companies. One of them was PT. Asuransi Takaful Keluarga, the only one of life insurance company based on Islamic law[21].

The Principles of Conventional Insurance

As the other many profit oriented businesses, insurance has principles, they are:

a.       Principle of Indemnity[22]

Except life and personal accident insurance, every contract of insurance is normally a contract of indemnity because it insures compensation for loss to the insured. The insurance company agrees to recover this loss as the change of the receipt premium. The purpose of this agreement is to shift the burden of the probable risk from the insured on to the shoulders of insurance company[23].

The maximum limit of the insurer obligation is to take the insured on to his economic position as well as before the loss happening[24]. According to this principle, the insured is indemnified according to the limit of his loss and no more. He cannot receive any sum of money from insurer more than the value of his loss under any circumstances. In this matter, the insured is not allowed to make a profit.

b.      Principle of insurable interest

The insured must has an insurable interest; where a man is so circumstanced with respect to matter exposed to certain risks or damages, or to have a moral certainly of advantage or benefit, but for those risks or dangers, he may be said to be interested in the safety of the thing. To be interested in the preservation of a thing, is to be so circumstanced with respect to it as to have benefit from its existence, prejudice from its destruction[25]. 

In his book, T.J. Dorhout Mess explained that the definition of interest is a pure economic factor, so it is absolutely difficult to give its law limitation[26]. A man can has the insurable interest because of value decreasing of own subjective due. A burning house, for instance. This burning cause the house’s owner loses the interest that he has before the happening. Also, the man may have the interest because of his missing hope to gain something. Based on some cases above, it can be concluded that the definition of insurable interest, normally, is the risk.

The principle of insurable interest is important for policyholder because it can decide whether the insured is able to propose the claim. Therefore, the insured must know exactly the sources of insurable interest, whether it has the quality of article or the quality of due. 

c.       Utmost Good Faith Principle

The insured is required to state all facts accurately and in good faith. He must not make any misrepresentation with regard any facts. Any facts known to him must be disclosed, and he cannot escape the consequences of not revealing them by saying that he did not know. Failure to do so will render the contract voidable[27]. And finally, the insured cannot claim the insurer to fulfill the contract, and to compensate the loss, because the happening risk is different with the assured risk in the previous agreement.

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[1]AS. Hornby, loc. cit.

[2]Fuad  Mohd Fachruddin, loc.Cit.

[3]Afzalur Rahman, op.Cit, p. 18.

[4]Ibid. 

[5]Morris, Civilization: An Historical Review of its Elements, Vol. I, p. 21, quoted by Dr. Mohammad Muslehuddin, MA, P.Hd., Insurance and Islamic Law, (Lahore: Islamic Publications Limited, 1978), Second Edition, p. 9.

[6]Wells, The Outline of History, p. 160-161, quoted by Dr. Mohammad Muslehuddin, MA, P.Hd, Ibid, p. 10.

[7]Dr. Sri Rejeki Hartono, S.H., Hukum Asuransi dan Perusahaan Asuransi, (Jakarta: Sinar Grafika, 2001), fourth edition, p. 32.

[8]Babylonia (Babylonian Bābili,”gate of God”; Old Persian Babirush), ancient country of Mesopotamia, known originally as Sumer and later as Sumer and Akkad, lying between the Tigris and Euphrates rivers, south of modern Baghdād, Iraq. (See in Microsoft Encarta Encyclopedia 2004 © 1993-2003 Microsoft Corporation. All rights reserved).

[9]This law book known as Code of Hammurabi, it is collection of the laws and edicts of the Babylonian king Hammurabi, and the earliest legal code known in its entirety. (See in Microsoft Encarta Encyclopedia 2004, ibid). 

[10]Drs. Supardjono, Peransuransian di Indonesia, (Jakarta: Departemen Pendidikan dan Kebudayaan, 1999), first edition, p. 1. 

[11]Afzalur Rahman, op. cit, p. 20.

[12]Phoenicia is ancient designation of a narrow strip of territory on the eastern coast of the Mediterranean Sea, now largely in modern Lebanon. (See in Microsoft Encarta Encyclopedia 2004, loc. cit.).

[13]Afzalur Rahman, op. cit, p. 25.

[14]Dinsdale, W.A., Elements of Insurance, London, 1965, p. 17, quoted by Afzalur Rahman, ibid.

[15]Afzalur Rahman, Ibid, p. 26.

[16]Dr. Sri Rejeki Hartono, S.H., op. cit, p. 37. 

[17]Ibid, p. 39.

[18]Drs. Supardjono, op. cit, p. 4.

[19]Dr. Sri Rejeki Hartono, S.H., op. cit, p. 52.

[20]Ibid.

[21]Ir. Agus Haryadi, Prospek Bisnis: Asuransi Syariah Takaful, www.tazkia.com, Tuesday, April 24^th 2001.

[22]Indemnity, in law, is an undertaking to compensate another for damage, loss, trouble, or expenses, or the money paid by way of such compensation. (See A.S. Hornby, op. cit, p. 633 and see also Microsoft Encarta Encyclopedia 2004, loc. cit)

[23]Supardjono, op. cit, p. 9.

[24] KUHD (Kitab Undang-Undang Hukum Dagang) section 253 verse: 1, see in Dr. Sri Rejeki Hartono, S.H., op. cit, p. 99.  Dinsdale, W.A., Principles and Practices of Accident Insurance (London: 1969), p. 46, quoted by Afzalur Rahman, op. cit, p. 91.

[25]Afzalur Rahman, op. cit, p. 82

[26]Dr. Sri Rejeki Hartono, S.H., op. cit, p.13  who excerpted the same matter from T.J. Dorbout Mees,  Schadeverzekeringsrecht, p. 108

[27]KUHD, section: 1338, verse: 3 and section: 251, quoted by Supardjono, op. cit, p. 13.