Part 1 Accounting 5

COMPANY FINANCIAL STATEMENTS 6

MEASUREMENT PRINCIPLES 11

Adriana ofletea

MANAGERIAL ACCOUNTING 21
OTHER PURPOSES OF ACCOUNTING SYSTEMS 37

Part 2 Banks and Banking 39

The development of banking systems 41
The business of banking 45

English Course For Finance

FUNCTIONS OF COMMERCIAL BANKS 45

INDUSTRIAL FINANCE 52

The principles of central banking 56

RESPONSIBILITIES OF CENTRAL BANKS 57
TECHNIQUES OF CREDIT CONTROL 67

The structure of modern banking systems 83

UNIT BANKING THE UNITED STATES 84
BRANCH BANKING: THE UNITED KINGDOM 88
HYBRID SYSTEMS 89

Part 1
Accounting

Part 3 Insurance 97
Kinds of insurance 99

The purpose of accounting is to provide information

about the economic affairs of an organization. This
information may be used in a number of ways: by the
organization's managers to help them plan and control the
organization's operations; by owners and legislative or
regulatory bodies to help them appraise the organization's
performance and make decisions as to its future; by
owners, lenders, suppliers, employees, and others to help
them decide how much time or money to devote to the
organization; by governmental bodies to determine how
much tax the organization must pay; and occasionally by
customers to determine the price to be paid when
contracts call for cost-based payments.
Accounting provides information for all these
purposes through the maintenance of files of data,
analysis and interpretation of these data, and the
preparation of various kinds of reports. Most accounting
information is historical--that is, the accountant observes
the things that the organization does, records their effects,
and prepares reports summarizing what has been
recorded; the rest consists of forecasts and plans for
current and future periods.
Accounting information can be developed for any kind
of organization, not just for privately owned, profitseeking businesses. One branch of accounting deals with
the economic operations of entire nations.

PROPERTY INSURANCE 99
MARINE INSURANCE 106
LIABILITY INSURANCE 113
SURETYSHIP 128
LIFE AND HEALTH INSURANCE 132

Insurance practice 148

UNDERWRITING AND RATE MAKING 148
LEGAL ASPECTS OF INSURANCE 154
Historical development of insurance 165
Bibliography 171

COMPANY FINANCIAL STATEMENTS

Among the most common accounting reports are those
sent to investors and others outside the management
group. The reports most likely to go to investors are
called financial statements, and their preparation is the
province of the branch of accounting known as financial
accounting. Three financial statements will be discussed:
the balance sheet, the income statement, and the
statement of cash flows.
The balance sheet.
A balance sheet describes the resources that are under
a company's control on a specified date and indicates
where these resources have come from. It consists of
three major sections: (1) the assets: valuable rights
owned by the company; (2) the liabilities: the funds that
have been provided by outside lenders and other creditors
in exchange for the company's promise to make payments
or to provide services in the future; and (3) the owners'
equity: the funds that have been provided by the
company's owners or on their behalf.
The list of assets shows the forms in which the
company's resources are lodged; the lists of liabilities and
the owners' equity indicate where these same resources
have come from. The balance sheet, in other words,
shows the company's resources from two points of view,
and the following relationship must always exist: total
assets equals total liabilities plus total owners' equity.
This same identity is also expressed in another way:
total assets minus total liabilities equals total owners'

equity. In this form, the equation emphasizes that the

owners' equity in the company is always equal to the net
assets (assets minus liabilities). Any increase in one will
inevitably be accompanied by an increase in the other,
and the only way to increase the owners' equity is to
increase the net assets.
Assets are ordinarily subdivided into current assets
and noncurrent assets. The former include cash, amounts
receivable from customers, inventories, and other assets
that are expected to be consumed or can be readily
converted into cash during the next operating cycle
(production, sale, and collection). Noncurrent assets may
include noncurrent receivables, fixed assets (such as land
and buildings), and long-term investments.
The liabilities are similarly divided into current
liabilities and noncurrent liabilities. Most amounts
payable to the company's suppliers (accounts payable), to
employees (wages payable), or to governments (taxes
payable) are included among the current liabilities.
Noncurrent liabilities consist mainly of amounts payable
to holders of the company's long-term bonds and such
items as obligations to employees under company
pension plans. The difference between total current assets
and total current liabilities is known as net current assets,
or working capital.
The owners' equity of an American company is
divided between paid-in capital and retained earnings.
Paid-in capital represents the amounts paid to the
corporation in exchange for shares of the company's
preferred and common stock. The major part of this, the
capital paid in by the common shareholders, is usually
divided into two parts, one representing the par value, or

stated value, of the shares, the other representing the

excess over this amount. The amount of retained earnings
is the difference between the amounts earned by the
company in the past and the dividends that have been
distributed to the owners.
A slightly different breakdown of the owners' equity is
used in most of continental Europe and in other parts of
the world. The classification distinguishes between those
amounts that cannot be distributed except as part of a
formal liquidation of all or part of the company (capital
and legal reserves) and those amounts that are not
restricted in this way (free reserves and undistributed
profits).
The income statement is usually accompanied by a
statement that shows how the company's retained
earnings has changed during the year. Net income
increases retained earnings; net operating loss or the
distribution of cash dividends reduces it.

subtracted from current revenues because it would be

used for many years, not just this one.
Cash from operations is not the same as net income
(revenues minus expenses). For one thing, not all
revenues are collected in cash. Revenue is usually
recorded when a customer receives merchandise and
either pays for it or promises to pay the company in the
future (in which case the revenue is recorded in accounts
receivable). Cash from operating activities, on the other
hand, reflects the actual cash collected, not the inflow of
accounts receivable. Similarly, an expense may be
recorded without an actual cash payment.
The purpose of the statement of cash flows is to throw
light on management's use of the financial resources
available to it and to help the users of the statements to
evaluate the company's liquidity, its ability to pay its bills
when they come due.
Consolidated statements.

The statement of cash flows.

Companies also prepare a third financial statement,
the statement of cash flows. Cash flows result from three
major groups of activities: (1) operating activities, (2)
investing activities, and (3) financing activities.
The income statement differs from the cash flow
statement in other ways, too. Cash was received from the
issuance of bonds and was paid to shareowners as
dividends; neither of those figured in the income
statement. Cash was also paid to purchase equipment;
this added to the plant and equipment asset but was not

Most large corporations in the United States and

other industrialized countries own other corporations.
Their primary financial statements are consolidated
statements, reflecting the total assets, liabilities, owners'
equity, net income, and cash flows of all the corporations
in the group. Thus, for example, the consolidated balance
sheet of the parent corporation (the corporation that owns
the others) does not list its investments in its subsidiaries
(the companies it owns) as assets; instead, it includes
their assets and liabilities with its own.

10

Some subsidiary corporations are not wholly owned

by the parent; that is, some shares of their common stock
are owned by others. The equity of these minority
shareholders in the subsidiary companies is shown
separately on the balance sheet. For example, if Any
Company, Inc., had minority shareholders in one or more
subsidiaries, the owners' equity section of its Dec. 31, 19-, balance sheet might appear as follows:

The consolidated income statement also must show the

minority owners' equity in the earnings of a subsidiary as
a deduction in the determination of net income. For
example:

Commission (SEC). The SEC has a good deal of

authority to prescribe the content and structure of the
financial statements that are submitted to it. Similar
authority is vested in provincial regulatory bodies and the
stock exchanges in Canada; disclosure in the United
Kingdom is governed by the provisions of the Companies
Act.
A company's financial statements are ordinarily
prepared initially by its own accountants. Outsiders
review, or audit, the statements and the systems the
company used to accumulate the data from which the
statements were prepared. In most countries, including
the United States, these outside auditors are selected by
the company's shareholders. The audit of a company's
statements is ordinarily performed by professionally
qualified, independent accountants who bear the title of
certified public accountant (CPA) in the United States
and chartered accountant (CA) in the United Kingdom
and many other countries with British-based accounting
traditions. Their primary task is to investigate the
company's accounting data and methods carefully enough
to permit them to give their opinion that the financial
statements present fairly the company's position, results,
and cash flows.

Disclosure and auditing requirements.

MEASUREMENT PRINCIPLES

A corporation's obligations to issue financial

statements are prescribed in the company's own statutes
or bylaws and in public laws and regulations. The
financial statements of most large and medium-size
companies in the United States fall primarily within the
jurisdiction of the federal Securities and Exchange
11

In preparing financial statements, the accountant has

several measurement systems to choose from. Assets, for
example, may be measured at what they cost in the past
or what they could be sold for now, to mention only two
possibilities. To enable users to interpret statements with

12

confidence, companies in similar industries should use

the same measurement concepts or principles.
In some countries these concepts or principles are
prescribed by government bodies; in the United States
they are embodied in "generally accepted accounting
principles" (GAAP), which represent partly the
consensus of experts and partly the work of the Financial
Accounting Standards Board (FASB), a private body.
The principles or standards issued by the FASB can be
overridden by the SEC. In practice, however, the SEC
generally requires corporations within its jurisdiction to
conform to the standards of the FASB.
Asset value.
One principle that accountants may adopt is to
measure assets at their value to their owners. The
economic value of an asset is the maximum amount that
the company would be willing to pay for it. This amount
depends on what the company expects to be able to do
with the asset. For business assets, these expectations are
usually expressed in terms of forecasts of the inflows of
cash the company will receive in the future. If, for
example, the company believes that by spending $1 on
advertising and other forms of sales promotion it can sell
a certain product for $5, then this product is worth $4 to
the company.
When cash inflows are expected to be delayed, value
is less than the anticipated cash flow. For example, if the
company has to pay interest at the rate of 10 percent a
year, an investment of $100 in a one-year asset today will
not be worthwhile unless it will return at least $110 a

13

year from now ($100 plus 10 percent interest for one

year). In this example, $100 is the present value of the
right to receive $110 one year later. Present value is the
maximum amount the company would be willing to pay
for a future inflow of cash after deducting interest on the
investment at a specified rate for the time the company
has to wait before it receives its cash.
Value, in other words, depends on three factors:
(1) the amount of the anticipated future cash flows,
(2) their timing, and (3) the interest rate. The lower the
expectation, the more distant the timing, or the higher the
interest rate, the less valuable the asset will be.
Value may also be represented by the amount the
company could obtain by selling its assets. This sale price
is seldom a good measure of the assets' value to the
company, however, because few companies are likely to
keep many assets that are worth no more to the company
than their market value. Continued ownership of an asset
implies that its present value to the owner exceeds its
market value, which is its apparent value to outsiders.
Asset cost.
Accountants are traditionally reluctant to accept value
as the basis of asset measurement in the going concern.
Although monetary assets such as cash or accounts
receivable are usually measured by their value, most
other assets are measured at cost. The reason is that the
accountant finds it difficult to verify the forecasts upon
which a generalized value measurement system would
have to be based. As a result, the balance sheet does not
pretend to show how much the company's assets are

14

worth; it shows how much the company has invested in

them.
The historical cost of an asset is the sum of all the
expenditures the company made to acquire it. This
amount is not always easily measurable. If, for example,
a company has built a special-purpose machine in one of
its own factories for use in manufacturing other products,
and the project required logistical support from all parts
of the factory organization, from purchasing to quality
control, then a good deal of judgment must be reflected
in any estimate of how much of the costs of these
logistical activities should be "capitalized" (i.e., placed
on the balance sheet) as part of the cost of the machine.
Net income.
From an economic point of view, income is defined as
the change in the company's wealth during a period of
time, from all sources other than the injection or
withdrawal of investment funds. Income is the amount
the company could consume during the period and still
have as much real wealth at the end of the period as it
had at the beginning. For example, if the value of the net
assets (assets minus liabilities) has gone from $1,000 to
$1,200 during a period and dividends of $100 have been
distributed, income measured on a value basis would be
$300 ($1,200 minus $1,000, plus $100).
Accountants generally have rejected this approach for
the same reason that they have found value an
unacceptable basis for asset measurement: Such a
measure would rely too much on estimates of what will
happen in the future, estimates that would not be readily

15

susceptible to independent verification. Instead,

accountants have adopted what might be called a
transactions approach to income measurement. They
recognize as income only those increases in wealth that
can be substantiated from data pertaining to actual
transactions that have taken place with persons outside
the company. In such systems, income is measured when
work is performed for an outside customer, when goods
are delivered, or when the customer is billed.
Recognition of income at this time requires two sets of
estimates: (1) revenue estimates, representing the value
of the cash that the company expects to receive from the
customer; and (2) expense estimates, representing the
resources that have been consumed in the creation of the
revenues. Revenue estimation is the easier of the two, but
it still requires judgment. The main problem is to
estimate the percentage of gross sales for which payment
will never be received, either because some customers
will not pay their bills ("bad debts") or because they will
demand and receive credit for returned merchandise or
defective work.
Expense estimates are generally based on the
historical cost of the resources consumed. Net income, in
other words, is the difference between the value received
from the use of resources and the cost of the resources
that were consumed in the process. As with asset
measurement, the main problem is to estimate what
portion of the cost of an asset has been consumed during
the period in question.
Some assets give up their services gradually rather
than all at once. The cost of the portion of these assets the
company uses to produce revenues in any period is that

16

period's depreciation expense, and the amount shown for

these assets on the balance sheet is their historical cost
less an allowance for depreciation, representing the cost
of the portion of the asset's anticipated lifetime services
that has already been used. To estimate depreciation, the
accountant must predict both how long the asset will
continue to provide useful services and how much of its
potential to provide these services will be used up in each
period.
Depreciation is usually computed by some simple
formula. The two most popular formulas in the United
States are straight-line depreciation, in which the same
amount of depreciation is recognized each year, and
declining-charge depreciation, in which more
depreciation is recognized during the early years of life
than during the later years, on the assumption that the
value of the asset's service declines as it gets older.
The role of the independent accountant (the auditor) is
to see whether the company's estimates are based on
formulas that seem reasonable in the light of whatever
evidence is available and whether these formulas are
applied consistently from year to year. Again, what is
"reasonable" is clearly a matter of judgment.
Depreciation is not the only expense for which more
than one measurement principle is available. Another is
the cost of goods sold. The cost of goods available for
sale in any period is the sum of the cost of the beginning
inventory and the cost of goods purchased in that period.
This sum then must be divided between the cost of goods
sold and the cost of the ending inventory:

17

Accountants can make this division by any of three

main inventory costing methods: (1) first in, first out
(FIFO), (2) last in, first out (LIFO), or (3) average cost.
The LIFO method is widely used in the United States,
where it is also an acceptable costing method for income
tax purposes; companies in most other countries measure
inventory cost and the cost of goods sold by some variant
of the FIFO or average cost methods. Average cost is
very similar in its results to FIFO, so only FIFO and
LIFO need be described.
Each purchase of goods constitutes a single batch,
acquired at a specific price. Under FIFO, the cost of
goods sold is determined by adding the costs of various
batches of the goods available, starting with the oldest
batch in the beginning inventory, continuing with the
next oldest batch, and so on until the total number of
units equals the number of units sold. The ending
inventory, therefore, is assigned the costs of the most
recently acquired batches. For example, suppose the
beginning inventory and purchases were as follows:

18

The company sold 1,900 units during the year and had
1,100 units remaining in inventory at the end of the year.
The FIFO cost of goods sold is:

The ending inventory consists of 1,100 units at a FIFO

cost of $5.50 each (the price of the last 1,100 units
purchased), or $6,050.
Under LIFO, the cost of goods sold is the sum of the
most recent purchase, the next most recent, and so on,
until the total number of units equals the number sold
during the period. In the example, the LIFO cost of goods
sold is:

The LIFO cost of the ending inventory is the cost of

the oldest units in the cost of goods available. In this
simple example, assuming the company adopted LIFO at
the beginning of the year, the ending inventory cost is the
1,000 units in the beginning inventory at $5 each
($5,000), plus 100 units from the first purchase during
the year at $5.25 each ($525), a total of $5,525.

19

Problems of measurement.
Accounting income does not include all of the
company's holding gains or losses (increases or decreases
in the market values of its assets). For example,
construction of a superhighway may increase the value of
a company's land, but neither the income statement nor
the balance sheet will report this holding gain. Similarly,
introduction of a successful new product increases the
company's anticipated future cash flows, and this increase
makes the company more valuable. Those additional
future sales show up neither in the conventional income
statement nor in the balance sheet.
Accounting reports have also been criticized on the
grounds that they confuse monetary measures with the
underlying realities when the prices of many goods and
services have been changing rapidly. For example, if the
wholesale price of an item has risen from $100 to $150
between the time the company bought it and the time it is
sold, many accountants claim that $150 is the better
measure of the amount of resources consumed by the
sale. They also contend that the $50 increase in the item's
wholesale value before it is sold is a special kind of
holding gain that should not be classified as ordinary
income.
When inventory purchase prices are rising, LIFO
inventory costing keeps many gains from the holding of
inventories out of net income. If purchases equal the
quantity sold, the entire cost of goods sold will be
measured at the higher current prices; the ending
inventory will be measured at the lower prices shown for
the beginning-of-year inventory. The difference between

20

the LIFO inventory cost and the replacement cost at the

end of the year is an unrealized (and unreported) holding
gain.
In the inventory example cited earlier, the LIFO cost
of goods sold ($10,275) exceeded the FIFO cost of goods
sold ($9,750) by $525. In other words, LIFO kept $525
more of the inventory holding gain out of the income
statement than FIFO did. Furthermore, the replacement
cost of the inventory at the end of the year was $6,050
(1,100 $5.50), which was just equal to the inventory's
FIFO cost; under LIFO, in contrast, there was an
unrealized holding gain of $525 ($6,050 minus the
$5,525 LIFO inventory cost).
The amount of inventory holding gain that is included
in net income is usually called the "inventory profit." The
implication is that this is a component of net income that
is less "real" than other components because it results
from the holding of inventories rather than from trading
with customers.
When most of the changes in the prices of the
company's resources are in the same direction, the
purchasing power of money is said to change.
Conventional accounting statements are stated in nominal
currency units (dollars, francs, lire, etc.), not in units of
constant purchasing power. Changes in purchasing
power--that is, changes in the average level of prices of
goods and services--have two effects. First, net monetary
assets (essentially cash and receivables minus liabilities
calling for fixed monetary payments) lose purchasing
power as the general price level rises. These losses do not
appear in conventional accounting statements. Second,
holding gains measured in nominal currency units may

21

merely result from changes in the general price level. If

so, they represent no increase in the company's
purchasing power.
In some countries that have experienced severe and
prolonged inflation, companies have been allowed or
even required to restate their assets to reflect the more
recent and higher levels of purchase prices. The
increment in the asset balances in such cases has not been
reported as income, but depreciation thereafter has been
based on these higher amounts. Companies in the United
States are not allowed to make these adjustments in their
primary financial statements.
MANAGERIAL ACCOUNTING
Although published financial statements are the most
widely visible products of business accounting systems
and the ones with which the public is most concerned,
they are only the tip of the iceberg. Most accounting data
and most accounting reports are generated solely or
mainly for the company's managers. Reports to
management may be either summaries of past events,
forecasts of the future, or a combination of the two.
Preparation of these data and reports is the focus of
managerial accounting, which consists mainly of four
broad functions: (1) budgetary planning, (2) cost
finding, (3) cost and profit analysis, and (4)
performance reporting.

22

Budgetary planning.
The first major component of internal accounting
systems for management's use is the company's system
for establishing budgetary plans and setting performance
standards. The setting of performance standards requires
also a system for measuring actual results and reporting
differences between actual performance and the plans.

Although plans can be either broad, strategic outlines

of the company's future or schedules of the inputs and
outputs associated with specific independent programs,
most business plans are periodic plans--that is, they refer
to company operations for a specified period of time.
These periodic plans are summarized in a series of
projected financial statements, or budgets.
The two principal budget statements are the profit plan
and the cash forecast. The profit plan is an estimated
income statement for the budget period. It summarizes
the planned level of selling effort, shown as selling
expense, and the results of that effort, shown as sales
revenue and the accompanying cost of goods sold.
Separate profit plans are ordinarily prepared for each
major segment of the company's operations.

Figure 1: Budget planning and performance reporting.

The simplified diagram in Figure 1 illustrates the
interrelationships between these elements. The planning
process leads to the establishment of explicit plans,
which then are translated into action. The results of these
actions are compared with the plans and reported in
comparative form. Management can then respond to
substantial deviations from plan, either by taking
corrective action or, if outside conditions differ from
those predicted or assumed in the plans, by preparing
revised plans.

23

Figure 2: Relationship of company profit plan to responsibility

structure.

The details underlying the profit plan are contained in

departmental sales and cost budgets, each part identified
with the executive or group responsible for carrying out

24

that part. Figure 2 shows the essence of this relationship:

the company's profit plan is really the integrated product
of the plans of its two major product divisions. The
arrows connecting the two divisional plans represent the
coordinative communications that tie them together on
matters of mutual concern.
The exhibit also goes one level farther down, showing
that division B's profit plan is really a coordinated
synthesis of the plans of the division's marketing
department and manufacturing department. Arrows again
emphasize the necessary coordination between the two.
Each of these departmental plans, in turn, is a summary
of the plans of the major offices, plants, or other units
within the division. A complete representation of the
company's profit plan would require an extension of the
diagram through several layers to encompass every single
responsibility centre in the entire company.
Many companies also prepare alternative budgets for
operating volumes other than the volume anticipated for
the period. A set of such alternative budgets is known as
the flexible budget. The practice of flexible budgeting
has been adopted widely by factory management to
facilitate evaluation of cost performance at different
volume levels and has also been extended to other
elements of the profit plan.
The second major component of the annual budgetary
plan, the cash forecast or cash budget, summarizes the
anticipated effects on cash of all the company's activities.
It lists the anticipated cash payments, cash receipts, and
amount of cash on hand, month by month throughout the
year. In most companies, responsibility for cash
management rests mainly in the head office rather than at

25

the divisional level. For this reason, divisional cash

forecasts tend to be less important than divisional profit
plans.
Company-wide cash forecasts, on the other hand, are
just as important as company profit plans. Preliminary
cash forecasts are used in deciding how much money will
be made available for the payment of dividends, for the
purchase or construction of buildings and equipment, and
for other programs that do not pay for themselves
immediately. The amount of short-term borrowing or
short-term investment of temporarily idle funds is then
generally geared to the requirements summarized in the
final, adjusted forecast.
Other elements of the budgetary plan, in addition to
the profit plan and the cash forecast, include capital
expenditure budgets, personnel budgets, production
budgets, and budgeted balance sheets. They all serve the
same purpose: to help management decide upon a course
of action and to serve as a point of reference against
which to measure subsequent performance.
Planning is a management responsibility, not an
accounting function. To plan is to decide, and only the
manager has the authority to choose the direction the
company is to take. Accounting personnel are
nevertheless deeply involved in the planning process.
First, they administer the budgetary planning system,
establishing deadlines for the completion of each part of
the process and seeing that these deadlines are met.
Second, they analyze data and help management at
various levels compare the estimated effects of different
courses of action. Third, they are responsible for collating
the tentative plans and proposals coming from the

26

individual departments and divisions and then reviewing

them for consistency and feasibility and sometimes for
desirability as well. Finally, they must assemble the final
plans management has chosen and see that these plans
are understood by the operating executives.
Cost finding.
A major factor in business planning is the cost of
producing the company's products. Cost finding is the
process by which the company obtains estimates of the
costs of producing a product, providing a service,
performing a function, or operating a department. Some
of these estimates are historical--how much did it cost?-while others are predictive--what will it cost?
The basic principle in cost finding is that the cost
assigned to any object--an activity or a product--should
represent the amount of cost that object causes. The most
fully developed methods of cost finding are used to
estimate the costs that have been incurred in a factory to
manufacture specific products. The simplest of these
methods is known as process costing. In this method, the
accountant first accumulates the costs of each separate
production operation or process for a specified period of
time. The total of these costs is then restated as an
average by dividing it by the total output of the process
during the same period.
Process costing can be used whenever the output of
individual processes is reasonably uniform or
homogeneous, as in cement manufacturing, flour milling,
and other relatively continuous production processes.

27

A second method, job order costing, is used when

individual production centres or departments work on a
variety of products rather than just one during a typical
time period. Two categories of factory cost are
recognized under this method: prime costs and factory
overhead costs. Prime costs are those that can be traced
directly to a specific batch, or job lot, of products. These
are the direct labour and direct materials costs of
production. Overhead costs, on the other hand, are those
that can be traced only to departmental operations or to
the factory as a whole and not to individual job orders.
The salary of a departmental supervisor is an example of
an overhead cost.
Direct materials and direct labour costs are recorded
directly on the job order cost sheets, one for each job.
Although not traceable to individual jobs, overhead costs
are generally assigned to them by means of overhead
rates--i.e., the ratio of total overhead cost to total
production volume for a given time period. A separate
overhead rate is usually calculated for each production
department, and, if the operations of a department are
varied, it is often subdivided into a set of more
homogeneous cost centres, each with its own overhead
rate. Separate overhead rates are sometimes used even for
individual processing machines within a department if
the machines differ widely in such factors as power
consumption, maintenance cost, and depreciation.
Because output within a cost centre is not
homogeneous, production volume must be measured by
something other than the number of units of product,
such as the number of machine hours or direct labour
hours. Once the overhead rate has been determined, a

28

provision for overhead cost can be entered on each job

order cost sheet on the basis of the number of direct
labour hours or machine hours used on that job. For
example, if the overhead rate is $3 a machine hour and
Job No. 7128 used 600 machine hours, then $1,800
would be shown as the overhead cost of this job.
Many production costs are incurred in departments
that don't actually produce goods or provide salable
services. Instead, they provide services or support to the
departments that do produce products. Examples include
maintenance departments, quality control departments,
and internal power plants. Estimates of these costs are
included in the estimated overhead costs of the
production departments by a process known as
allocation--that is, estimated service department costs are
allocated among the production departments in
proportion to the amount of service or support each
receives. The departmental overhead rates then include
provisions for these allocated costs.
A third method of cost finding, activity-based costing,
is based on the fact that many costs are driven by factors
other than product volume. The first task is to identify the
activities that drive costs. The next step is to estimate the
costs that are driven by each activity and state them as
averages per unit of activity. Management can use these
averages to guide its efforts to reduce costs. In addition,
if management wants an estimate of the cost of a specific
product, the accountant can estimate how many of the
activity units are associated with that product and
multiply those numbers by the average costs per activity
unit.

29

For example, suppose that costs driven by the number

of machine hours average $12 per machine hour, costs
driven by the number of production batches average $100
a batch, and the costs of keeping a product in the line
average $100 a year for each kind of material or
component part used. Keeping in the line a product that is
assembled from six component parts thus incurs costs of
6 $100 = $600 a year, irrespective of volume and even if
the product is not made at all during the period. If annual
production amounts to 10,000 units, the unit cost of
product maintenance is $600/10,000 = $.06 a unit. If this
product is manufactured in batches of 1,000 units, then
batch-driven costs average $100/1,000 = $.10 a unit.
And, if a batch requires 15 machine hours, hour-driven
costs average 15 $12/1,000 = $.18 a unit. At the 10,000unit volume, then, the cost of this product is $.06 + $.10
+ $.18 = $.34 a unit plus the cost of materials.
Product cost finding under activity-based costing is
almost always a process of estimating costs before
production takes place. The method of process costing
and job order costing can be used either in preparing
estimates before the fact or in assigning costs to products
as production proceeds. Even when job order costing is
used to tally the costs actually incurred on individual
jobs, the overhead rates are usually predetermined--that
is, they represent the average planned overhead cost at
some production volume. The main reason for this is that
actual overhead cost averages depend on the total volume
and efficiency of operations and not on any one job
alone. The relevance of job order cost information will be
impaired if these external fluctuations are allowed to
change the amount of overhead cost assigned to a

30

particular job.
Many systems go even farther than this. Estimates of
the average costs of each type of material, each
operation, and each product are prepared routinely and
identified as standard costs. These are then readily
available whenever estimates are needed and can also
serve as an important element in the company's
performance reporting system, as described below.
Similar methods of cost finding can be used to
determine or estimate the cost of providing services
rather than physical goods. Most advertising agencies and
consulting firms, for example, maintain some form of job
cost records, either as a basis for billing their clients or as
a means of estimating the profitability of individual jobs
or accounts.
The methods of cost finding described in the
preceding paragraphs are known as full, or absorption,
costing methods, in that the overhead rates are intended
to include provisions for all manufacturing costs. Both
process and job order costing methods can also be
adapted to variable costing in which only variable
manufacturing costs are included in product cost.
Variable costs are those that will be greater in total in the
upper portions of the company's normal range of volumes
than in the lower portion. Total fixed costs, in contrast,
are the same at all volume levels within the normal range.
Unit cost under variable costing represents the average
variable cost of making the product. The main argument
for the variable costing approach is that average variable
cost is more relevant to short-horizon managerial
decisions than average full cost. In deciding whether to
manufacture goods in large lots, for example,

31

management needs to estimate the cost of carrying larger

amounts of finished goods in inventory. More variable
costs will have to be incurred to build the inventory to a
higher level; fixed manufacturing costs presumably will
be unaffected.
Furthermore, when a management decision changes
the company's fixed costs, the change is unlikely to be
proportional to the change in volume; therefore, average
fixed cost is seldom a valid basis for estimating the cost
effects of such decisions. Variable costing eliminates the
temptation to assume without question that average fixed
cost can be used to estimate changes in total fixed cost.
When variable costing is used, supplemental rates for
fixed overhead production costs must be provided to
measure the costs to be assigned to end-of-year
inventories because generally accepted accounting
principles in the United States and in most other
countries require that inventories be measured at full
product cost for external financial reporting.
Cost and profit analysis.
Accountants share with many other people the task of
analyzing cost and profit data in order to provide
guidance in managerial decision making. Even if the
analytical work is done largely by others, they have an
interest in analytical methods because the systems they
design must collect data in forms suitable for analysis.
Managerial decisions are based on comparisons of the
estimated future results of the alternative courses of
action that the decision maker is choosing among.

32

Recorded historical accounting data, in contrast, reflect

conditions and experience of the past. Furthermore, they
are absolute, not comparative, in that they show the
effects of one course of action but not whether these were
better or worse than those that would have resulted from
some other course.
For decision making, therefore, historical accounting
data must be examined, modified, and placed on a
comparative basis. Even estimated data, such as budgets
and standard costs, must be examined to see whether the
estimates are still valid and relevant to managerial
comparisons. To a large extent, this job of review and
restatement is an accounting responsibility. Accordingly,
a major part of the accountant's preparation for the
profession is devoted to the study of methods and
principles of analysis for managerial decision making.
Performance reporting.
Once the budgetary plan has been adopted,
accounting's next task is to prepare information on the
results of company activities and make it available to
management. The manager's main interest in this
information centres on three questions: Have his or her
own actions had the results expected, and, if not, why
not? How successful have subordinates been in managing
the activities entrusted to them? What problems and
opportunities seem to have arisen since the budgetary
plan was prepared? For these purposes, the information
must be comparative, relating actual results to the level of
results that management regards as satisfactory. In each
case, the standard for comparison is provided by the

33

budgetary plan.
Much of this information is contained in periodic
financial reports. At the top management and divisional
levels, the most important of these is the comparative
income statement. This shows the profit that was planned
for this period, the actual results received for this period,
and the differences, or variances, between the two. It also
gives an explanation of some of the reasons for the
difference between a planned and an actual income.
The report in this exhibit employs the widely used
profit contribution format, in which divisional results
reflect sales and expenses traceable to the individual
divisions, with no deduction for head office expenses.
Company net income is then obtained by deducting head
office expenses as a lump sum from the total of the
divisional profit contributions. A similar format can be
used within the division, reporting the profit contribution
of each of the division's product lines, with divisional
headquarters expenses deducted at the bottom.
By far the greatest number of reports, however, are
cost or sales reports, mostly on a departmental basis.
Departmental sales reports usually compare actual sales
with the volumes planned for the period. Departmental
cost performance reports, in contrast, typically compare
actual costs incurred with standards or budgets that have
been adjusted to correspond to the actual volume of work
done during the period. This practice reflects a
recognition that volume fluctuations generally originate
outside the department and that the department head's
responsibility is ordinarily limited to minimizing cost
while meeting the delivery schedules imposed by higher
management.

34

For example, a factory department's output consists

entirely of a single product, with a standard materials cost
of $3 a unit and standard labour cost of $16. Materials
cost represents three pounds of raw materials at $1 a
pound; standard labour cost is two hours of labour at $8
an hour. Overhead costs in the department are budgeted
at $10,000 a month plus $2 a unit. Under normal
conditions, volume is 7,000 units a month, but during
October only 6,000 units were produced. The cost
standards
for
the
month
would
be
as
follows:

The actual cost this month was $17,850 for materials

(17,000 pounds at $1.05), $101,250 for labour (12,500
hours at $8.10 an hour), and $23,000 for overhead. A
summary
report
would
show
the
following:

These variances may be analyzed even further in order to

identify the underlying causes. The labour variance, for
example, can be seen to be the result of both high wage
rates ($8.10 instead of $8.00) and high labour usage
(12,500 hours instead of 12,000). The factory accountant
ordinarily would measure the effect of the rate change in

35

the
way:

following

In most cases, the labour rate variance would not be

reported to the department head, because it is not subject
to his or her control.
Standard costing systems no longer have the central
importance they commanded in many industries up to the
1970s. One reason is that significant changes in
management technology have shifted the focus of cost
control from the individual production department to
larger, more interdependent groups. Just-in-time
production systems require changes in factory layouts to
reduce the time it takes to move work from one station to
the next. They also reduce the number of partly processed
units at each work station, thereby requiring greater
station-to-station coordination.
At the same time, management's emphasis has shifted
from cost control to cost reduction, quality enhancement,
and closer coordination of production and customer
deliveries. Most large manufacturing companies and

36

many service companies have launched programs of total

quality control and continuous improvement, and many
have replaced standard costs with a more flexible
approach using prior period results as current
performance standards. Management is also likely to
focus on the amount of system waste by identifying and
minimizing activities that contribute nothing to the value
that customers place on the product.
Reducing set-up time, inspection time, and time spent
moving work from place to place while maintaining or
improving quality are some of the results of these
programs. Advances in computer-based models have
enabled companies to tie production schedules more
closely to customer delivery schedules while increasing
the rate of plant utilization. Some of these changes
actually increase variances from standard costs in some
departments but are undertaken because they benefit the
company as a whole.
The overall result is that control systems are likely to
focus in the first instance on operational controls (realtime signals to operating personnel that some immediate
remedial action is required), with after-the-fact analysis
of results focusing on aggregate comparisons with past
performance and the planned results of current
improvement programs.

37

OTHER PURPOSES OF ACCOUNTING

SYSTEMS
Accounting systems are designed mainly to provide
information that managers and outsiders can use in
decision making. They also serve other purposes: to
produce operating documents, to protect the company's
assets, to provide data for company tax returns, and, in
some cases, to provide the basis for reimbursement of
costs by clients or customers.
The accounting organization is responsible for
preparing documents that contain instructions for a
variety of tasks, such as payment of customer bills or
preparing employee payrolls. It also must prepare
documents that serve what might be called private
information purposes, such as the employees' own
records of their salaries and wages. Many of these
documents also serve other accounting purposes, but they
would have to be prepared even if no information reports
were necessary. Measured by the number of people
involved and the amount of time required, document
preparation is one of accounting's biggest jobs.
Accounting systems must provide means of reducing
the chance of losses of assets due to carelessness or
dishonesty on the part of employees, suppliers, and
customers. Asset protection devices are often very
simple; for example, many restaurants use numbered
meal checks so that waiters will not be able to submit one
check to the customer and another, with a lower total, to
the cashier. Other devices entail a partial duplication of
effort or a division of tasks between two individuals to
reduce the opportunity for unobserved thefts.

38

These are all part of the company's system of internal

controls. Another important element in the internal
control system is internal auditing. The task of internal
auditors is to see whether prescribed data handling and
asset protection procedures are being followed. To
accomplish this, they usually observe some of the work
as it is being performed and examine a sample of past
transactions for accuracy and fidelity to the system. They
may insert a set of fictitious data into the system to see
whether the resulting output meets a predetermined
standard. This technique is particularly useful in testing
the validity of the programs that are used to process data
through electronic computers.
The accounting system must also provide data for use
in the completion of the company's tax returns. This
function is the concern of tax accounting. In some
countries financial accounting must obey rules laid down
for tax accounting by national tax laws and regulations,
but no such requirement is imposed in the United States,
and tabulations prepared for tax purposes often diverge
from those submitted to shareholders and others.
"Taxable income" is a legal concept rather than an
accounting concept. Tax laws include incentives to
encourage companies to do certain things and discourage
them from doing others. Accordingly, what is "income"
or "capital" to a tax agency may be far different from the
accountant's measures of these same concepts.
Finally, accounting systems in some companies must
provide cost data in the forms required for submission to
customers who have agreed to reimburse the companies
for the costs they have incurred on the customers' behalf.

39

Part 2
Banks and Banking
The principal types of banking in the modern
industrial world are commercial banking and central
banking. A commercial banker is a dealer in money and
in substitutes for money, such as checks or bills of
exchange. The banker also provides a variety of financial
services. The basis of the banking business is borrowing
from individuals, firms, and occasionally governments-i.e., receiving "deposits" from them. With these resources
and also with the bank's own capital, the banker makes
loans or extends credit and also invests in securities. The
banker makes profit by borrowing at one rate of interest
and lending at a higher rate and by charging commissions
for services rendered.
A bank must always have cash balances on hand in
order to pay its depositors upon demand or when the
amounts credited to them become due. It must also keep
a proportion of its assets in forms that can readily be
converted into cash. Only in this way can confidence in
the banking system be maintained. Provided it honours
its promises (e.g., to provide cash in exchange for deposit
balances), a bank can create credit for use by its
customers by issuing additional notes or by making new
loans, which in their turn become new deposits. The
amount of credit it extends may considerably exceed the
sums available to it in cash. But a bank is able to do this
only as long as the public believes the bank can and will
honour its obligations, which are then accepted at face

40

value and circulate as money. So long as they remain

outstanding, these promises or obligations constitute
claims against that bank and can be transferred by means
of checks or other negotiable instruments from one party
to another. These are the essentials of deposit banking as
practiced throughout the world today, with the partial
exception of socialist-type institutions.
Another type of banking is carried on by central
banks, bankers to governments and "lenders of last
resort" to commercial banks and other financial
institutions. They are often responsible for formulating
and implementing monetary and credit policies, usually
in cooperation with the government. In some cases--e.g.,
the U.S. Federal Reserve System--they have been
established specifically to lead or regulate the banking
system; in other cases--e.g., the Bank of England--they
have come to perform these functions through a process
of evolution.
Some institutions often called banks, such as finance
companies, savings banks, investment banks, trust
companies, and home-loan banks, do not perform the
banking functions described above and are best classified
as financial intermediaries. Their economic function is
that of channelling savings from private individuals into
the hands of those who will use them, in the form of
loans for building purposes or for the purchase of capital
assets. These financial intermediaries cannot, however,
create money (i.e., credit) as the commercial banks do;
they can lend no more than savers place with them.

41

The development of banking systems

Banking is of ancient origin, though little is known
about it prior to the 13th century. Many of the early
"banks" dealt primarily in coin and bullion, much of their
business being money changing and the supplying of
foreign and domestic coin of the correct weight and
fineness. Another important early group of banking
institutions was the merchant bankers, who dealt both in
goods and in bills of exchange, providing for the
remittance of money and payment of accounts at a
distance but without shipping actual coin. Their business
arose from the fact that many of these merchants traded
internationally and held assets at different points along
trade routes. For a certain consideration, a merchant
stood prepared to accept instructions to pay money to a
named party through one of his agents elsewhere; the
amount of the bill of exchange would be debited by his
agent to the account of the merchant banker, who would
also hope to make an additional profit from exchanging
one currency against another. Because there was a
possibility of loss, any profit or gain was not subject to
the medieval ban on usury. There were, moreover,
techniques for concealing a loan by making foreign
exchange available at a distance but deferring payment
for it so that the interest charge could be camouflaged as
a fluctuation in the exchange rate.
Another form of early banking activity was the
acceptance of deposits. These might derive from the
deposit of money or valuables for safekeeping or for
purposes of transfer to another party; or, more
straightforwardly, they might represent the deposit of

42

money in a current account. A balance in a current

account could also represent the proceeds of a loan that
had been granted by the banker, perhaps based on an oral
agreement between the parties (recorded in the banker's
journal) whereby the customer would be allowed to
overdraw his account.
English bankers in particular had by the 17th century
begun to develop a deposit banking business, and the
techniques they evolved were to prove influential
elsewhere. The London goldsmiths kept money and
valuables in safe custody for their customers. In addition,
they dealt in bullion and foreign exchange, acquiring and
sorting coin for profit. As a means of attracting coin for
sorting, they were prepared to pay a rate of interest, and it
was largely in this way that they began to supplant as
deposit bankers their great rivals, the "money scriveners."
The latter were notaries who had come to specialize in
bringing together borrowers and lenders; they also
accepted deposits.
It was found that when money was deposited by a
number of people with a goldsmith or a scrivener a fund
of deposits came to be maintained at a fairly steady level;
over a period of time, deposits and withdrawals tended to
balance. In any event, customers preferred to leave their
surplus money with the goldsmith, keeping only enough
for their everyday needs. The result was a fund of idle
cash that could be lent out at interest to other parties.
About the same time, a practice grew up whereby a
customer could arrange for the transfer of part of his
credit balance to another party by addressing an order to
the banker. This was the origin of the modern check. It
was only a short step from making a loan in specie or

43

coin to allowing customers to borrow by check: the

amount borrowed would be debited to a loan account and
credited to a current account against which checks could
be drawn; or the customer would be allowed to overdraw
his account up to a specified limit. In the first case,
interest was charged on the full amount of the debit, and
in the second the customer paid interest only on the
amount actually borrowed. A check was a claim against
the bank, which had a corresponding claim against its
customer.
Another way in which a bank could create claims
against itself was by issuing bank notes. The amount
actually issued depended on the banker's judgment of the
possible demand for specie, and this depended in large
part on public confidence in the bank itself. In London,
goldsmith bankers were probably developing the use of
the bank note about the same time as that of the check.
(The first bank notes issued in Europe were by the Bank
of Stockholm in 1661.) Some commercial banks are still
permitted to issue their own notes, but in most countries
this has become a prerogative of the central bank.
In Britain the check soon proved to be such a
convenient means of payment that the public began to
use checks for the larger part of their monetary
transactions, reserving coin (and, later, notes) for small
payments. As a result, banks began to grant their
borrowers the right to draw checks much in excess of the
amounts of cash actually held, in this way "creating
money"--i.e., claims that were generally accepted as
means of payment. Such money came to be known as
"bank money" or "credit." Excluding bank notes, this
money consisted of no more than figures in bank ledgers;

44

it was acceptable because of the public's confidence in

the ability of the bank to honour its liabilities when called
upon to do so.
When a check is drawn and passes into the hands of
another party in payment for goods or services, it is
usually paid into another bank account. Assuming that
the overdraft technique is employed, if the check has
been drawn by a borrower, the mere act of drawing and
passing the check will create a loan as soon as the check
is paid by the borrower's banker. Since every loan so
made tends to return to the banking system as a deposit,
deposits will tend to increase for the system as a whole to
about the same extent as loans. On the other hand, if the
money lent has been debited to a loan account and the
amount of the loan has been credited to the customer's
current account, a deposit will have been created
immediately.
One of the most important factors in the development
of banking in England was the early legal recognition of
the negotiability of credit instruments or bills of
exchange. The check was expressly defined as a bill of
exchange. In continental Europe, on the other hand,
limitations on the negotiability of an order of payment
prevented the extension of deposit banking based on the
check. Continental countries developed their own system,
known as giro payments, whereby transfers were effected
on the basis of written instructions to debit the account of
the payer and to credit that of the payee.

45

The business of banking

The business of banking consists of borrowing and
lending. As in other businesses, operations must be based
on capital, but banks employ comparatively little of their
own capital in relation to the total volume of their
transactions. The purpose of capital and reserve accounts
is primarily to provide an ultimate cover against losses on
loans and investments. In the United States capital
accounts also have a legal significance, since the laws
limit the proportion of its capital a bank may lend to a
single borrower. Similar arrangements exist elsewhere.
FUNCTIONS OF COMMERCIAL BANKS
The essential characteristics of the banking business
may be described within the framework of a simplified
balance sheet. A bank's main liabilities are its capital
(including reserves and, often, subordinated debt) and
deposits. The latter may be from domestic or foreign
sources (corporations and firms, private individuals, other
banks, and even governments). They may be repayable
on demand (sight deposits or current accounts) or
repayable only after the lapse of a period of time (time,
term, or fixed deposits and, occasionally, savings
deposits). A bank's assets include cash (which may be
held in the form of credit balances with other banks,
usually with a central bank but also, in varying degrees,
with correspondent banks); liquid assets (money at call
and short notice, day-to-day money, short-term
government paper such as treasury bills and notes, and
commercial bills of exchange, all of which can be

46

converted readily into cash without risk of substantial

loss); investments or securities (substantially mediumterm and longer term government securities--sometimes
including those of local authorities such as states,
provinces, or municipalities--and, in certain countries,
participations and shares in industrial concerns); loans
and advances made to customers of all kinds, though
primarily to trade and industry (in an increasing number
of countries, these include term loans and also mortgage
loans); and, finally, the bank's premises, furniture, and
fittings (written down, as a rule, to quite nominal
figures).
All bank balance sheets must include an item that
relates to contingent liabilities (e.g., bills of exchange
"accepted" or endorsed by the bank), exactly balanced by
an item on the other side of the balance sheet
representing the customer's obligation to indemnify the
bank (which may also be supported by a form of security
taken by the bank over its customer's assets). Most banks
of any size stand prepared to provide acceptance credits
(also called bankers' acceptances); when a bank accepts a
bill, it lends its name and reputation to the transaction in
question and, in this way, ensures that the paper will be
more readily discounted.
Deposits.
The bulk of the resources employed by a modern bank
consists of borrowed money (that is, deposits), which is
lent out as profitably as is consistent with safety. Insofar
as an increase in deposits provides a bank with additional
cash (which is an asset), the increase in cash supplements
its loanable resources and permits a more than

47

proportionate increase in its loans.

An increase in deposits may arise in two ways. (1)
When a bank makes a loan, it may transfer the sum to a
current account, thus directly creating a new deposit; or it
may arrange a line of credit for the borrower upon which
he will be permitted to draw checks, which, when
deposited by third parties, likewise create new deposits.
(2) An enlargement of government expenditure financed
by the central bank may occasion a growth in deposits,
since claims on the government that are equivalent to
cash will be paid into the commercial banks as deposits.
In the first instance, with the increase in bank deposits
goes a related increase in the potential liability to pay out
cash; in the second case, the increase in deposits with the
commercial banks is accompanied by a corresponding
increase in commercial bank holdings of money claims
that are equivalent to cash.
Taking one bank in isolation, an increase in its loans
may result in a direct increase in deposits. This may
occur either as a result of a transfer to a current account
(as above) or a transfer to another customer of the same
bank. Once again, there is an increase in the potential
liability to pay out cash. On the other hand, if there has
been an increase in loans by another bank (including an
increase in central bank loans to the government), this
may give rise to increased deposits with the first bank,
matched by a corresponding claim to cash (or its
equivalent). For these reasons a bank can generally
expect that, if there is an increase in deposits, there will
also be some net acquisition of cash or of claims for
receipt of cash. It is in this way that an increase in
deposits usually provides the basis for further bank

48

lending.
Except in countries where banks are small and
insecure, banks as a whole can usually depend on their
current account debits being largely offset by credits to
current accounts, though from time to time an individual
bank may experience marked fluctuations in its deposit
totals, and all banks in a country may be subject to
seasonal variations. Even when deposits are repayable on
demand, there is usually a degree of inertia in the deposit
structure that prevents sharp fluctuations; if money is
accepted contractually for a fixed term or if notice must
be given before its repayment, this inertia will be greater.
On the other hand, if a significant proportion of total
deposits derives from foreign sources, there is likely to be
an element of volatility arising from international
conditions.
In banking, confidence on the part of the depositors is
the true basis of stability. Confidence is steadier if there
exists a central bank to act as a "lender of last resort."
Another means of maintaining confidence employed in
some countries is deposit insurance, which protects the
small depositor against loss in the event of a bank failure.
Such protection was the declared purpose of the
"nationalization" of bank deposits in Argentina between
1946 and 1957; banks receiving deposits acted merely as
agents of the government-owned and governmentcontrolled central bank, all deposits being guaranteed by
the state.
Reserves.
Since the banker undertakes to provide depositors with
cash on demand or upon prior notice, it is necessary to

49

hold a cash reserve and to maintain a "safe" ratio of cash

to deposits. The safe ratio is determined largely through
experience. It may be established by convention (as it
was for many years in England) or by statute (as in the
United States and elsewhere). If a minimum cash ratio is
required by law, a portion of a bank's assets is in effect
frozen and not available to meet sudden demands for
cash from the bank's customers. In order to provide more
flexibility, required ratios are frequently based on the
average of cash holdings over a specified period, such as
a week or a month. In addition to holding part of the
bank's assets in cash, a banker will hold a proportion of
the remainder in assets that can quickly be converted into
cash without significant loss. No banker can safely ignore
the necessity of maintaining adequate reserves of liquid
assets; some prefer to limit the sum of loans and
investments to a certain percentage of deposits, not
allowing their loan-deposit ratio to run for any length of
time at too high a level.
Unless a bank held cash covering 100 percent of its
demand deposits, it could not meet the claims of
depositors if they were all to exercise in full and at the
same time their rights to demand cash. If that were a
common phenomenon, deposit banking could not long
survive. For the most part, the public is prepared to leave
its surplus funds on deposit with the banks, confident that
they will be repaid if needed. But there may be times
when unexpected demands for cash exceed what might
reasonably have been anticipated; therefore, a bank must
not only hold part of its assets in cash but also must keep
a proportion of the remainder in assets that can be
quickly converted into cash without significant loss.

50

Indeed, in theory, even its less liquid assets should be

self-liquidating within a reasonable time.
A bank may mobilize its assets in several ways. It may
demand repayment of loans, immediately or at short
notice; it may sell securities; or it may borrow from the
central bank, using paper representing investments or
loans as security. Banks do not precipitately call in loans
or sell marketable assets, because this would disrupt the
delicate debtor-creditor relationships and increase any
loss of confidence, probably resulting in a run on the
banks. Ready cash may be obtainable in this way only at
a very high price. Banks must either maintain their cash
reserves and other liquid assets at a high level or have
access to a "lender of last resort," such as a central bank,
able and willing to provide cash against the security of
eligible assets. In a number of countries, the commercial
banks have at times been required to maintain a
minimum liquid assets ratio. But central banks impose
such requirements less as a means of maintaining
appropriate levels of commercial bank liquidity than as a
technique for influencing directly the lending potential of
the banks.
Among the assets of commercial banks, investments
are less liquid than money-market assets such as call
money and treasury bills. By maintaining an appropriate
spread of maturities, however, it is possible to ensure that
a proportion of a bank's investments is regularly
approaching redemption, thereby producing a steady flow
of liquidity and in that way constituting a secondary
liquid assets reserve. Some banks, particularly in the
United States and Canada, have at times favoured the
"dumbbell" distribution of maturities, a significant

51

proportion of the total portfolio being held in long-dated

maturities with a high yield, a small proportion in the
middle ranges, and another significant proportion in
short-dated maturities. Following redemption, the banks
usually reinvest all or most of the proceeds in longerterm maturities that in due course become increasingly
short-term. Interest-rate expectations frequently modify
the shape of a maturity distribution, and, in times of great
uncertainty with regard to interest rates, banks will tend
to hold the bulk of their securities at short term, and
something like a T-distribution may then be preferred
(mainly shorts, supported by small amounts of medium to
longer dated paper). Investments and money-market
assets merge into each other. The dividing line is
arbitrary, but there is an essential difference: the liquidity
of investments depends primarily on marketability
(though sometimes it also depends on the readiness of the
government or its agent to exchange its own securities for
cash); the liquidity of money-market assets, on the other
hand, depends partly on marketability but mainly on the
willingness of the central bank to purchase them or
accept them as collateral for a loan. This is why moneymarket assets are more liquid than investments.

52

INDUSTRIAL FINANCE
Long-term and medium-term lending.
Banks that do a great deal of long-term lending to
industry must ensure their liquidity by maintaining
relatively large capital funds and a relatively high
proportion of long-term borrowings (e.g., time deposits,
or issues of bonds or debentures), as well as valuing their
investments very conservatively. Such banks, notably the
French banques d'affaires and the German commercial
banks, have developed special means of reducing their
degree of risk. Every investment is preceded by a
thorough technical and financial investigation. The initial
advance may be an interim credit, later converted into a
participation. Only when market conditions are
favourable is the original investment converted into
marketable securities, and an issue of shares to the public
is arranged. One function of these banks is to nurse an
investment along until the venture is well established.
Even assuming its ultimate success, a bank may be
obliged to hold such shares for long periods before being
able to liquidate them. In addition, they often retain an
interest in a firm as an ordinary investment as well as to
ensure a degree of continuing control over it.
The long-term provision of industrial finance in
Britain and the Commonwealth countries is usually
handled by specialist institutions, with the commercial
banks providing only part of the necessary capital. In
Japan the long-term financial needs of industry are met
partly by special industrial banks (which also issue
debentures as well as accepting deposits) and partly by

53

the ordinary commercial banks. In Germany the

commercial banks customarily handle long-term finance.
Since World War II the commercial banks in the
United States have developed the so-called term loan,
especially for financing industrial capital requirements.
The attempt to popularize the term loan began in the
economic depression of the 1930s, when the banks tried
to expand their business by offering finance for a period
of years. Most term loans have an effective maturity of
little more than five years, though some run for 10 years
or more. They are usually arranged between the customer
and a group of lending banks, sometimes in cooperation
with other institutions such as insurance companies, and
are normally subject to a formal term loan agreement.
Banks in Britain, western Europe, the Commonwealth,
and Japan began during the 1960s to give term loans both
to industry and to agriculture.
Short-term lending.
Short-term loans are the core of the banking business
even in countries where commercial banks make longterm loans to industry. Much short-term lending consists
in the provision of working capital, but the banks also
provide temporary finance for fixed capital development,
aiding a customer until long-term finance can be found
elsewhere.
Much of this short-term lending is done by overdraft,
particularly in the United Kingdom and a number of the
Commonwealth countries, or by way of "current account
lending" in many western European countries. The
overdraft permits a depositor to overdraw an account up
to an agreed limit. In theory, overdrafts are repayable on

54

demand or after reasonable notice has been given, but

often they are allowed to run on indefinitely, subject to a
periodic review. An advance is reduced or repaid
whenever the account is credited with deposits and
recreated when new checks are drawn upon it, interest
being paid only on the amount outstanding.
An alternative method of short-term lending is to debit
a loan account with the amount borrowed, crediting the
proceeds to a current account; interest is usually payable
on the whole amount of the loan, which normally is for a
fixed period of time. (In Britain arrangements are
sometimes more flexible, and the term of the loan may be
set by oral agreement.)
In a number of countries, including the United States,
the United Kingdom, France, Germany, and Japan, shortterm finance is often made available on the basis of
discountable paper--commercial bills or promissory
notes. Some of this paper is usually rediscountable at the
central bank, thus becoming virtually a liquid asset,
unlike a bank advance or loan.
Credit may be offered with or without formal security,
depending on the reputation and financial strength of the
borrower. In many countries, a customer may use a
number of banks, and these institutions usually freely
exchange information about joint credit risks. In Britain
and The Netherlands, however, most concerns tend to
use a single banking institution for most of their needs.
Traditionally bankers took the view that the liabilities
of a bank (in particular, its deposits) were more or less
stable and concerned themselves primarily with the
investment of these funds. Since the late 1950s and '60s,
especially in North America and latterly in the United

55

Kingdom, there has been a change in emphasis. Banks

began to find it more difficult to obtain deposits. Interest
rates rose to high levels, and banks were obliged to
compete with each other and with other institutions for
funds. At the same time, there was little point in paying a
high rate of interest for money unless it could be
employed profitably. Bankers began to relate the cost of
borrowed money directly to the return on loans and
investments. Previously the main limitation on a bank's
expansion had been its ability to find profitable new
business, but now the determining factor became the
availability of funds to lend out. The essence of assets
and liabilities management, as it came to be called, was
deciding what kinds of new money to buy and what to
pay for it. In the United States the liabilities side of bank
balance sheets now included, inter alia, in much larger
proportion than during the 1960s, repurchase agreements
(under which securities are sold subject to an agreement
to repurchase at a stated date), federal funds purchases
(on the assets side, federal funds sales), excess balances
of commercial banks and other depository institutions
(regularly traded throughout the United States),
negotiable certificates of deposit (which can be traded on
a secondary market), and, for the larger banks,
Eurocurrency borrowings, mostly Eurodollars (dollar
balances held abroad). In the United Kingdom, "bought"
money consisted of wholesale (i.e., large) deposits (on
which money market rates were paid), negotiable
certificates of deposit, interbank borrowings, and
Eurocurrency purchases. This bought money could then
be used to finance the loan demand, including term loans,
long favoured in the United States but a more recent

56

innovation in the United Kingdom and elsewhere, where

they were developed considerably in the 1970s. Although
much of the lending financed by bought money was by
way of term loans, these could be "rolled over," with an
interest rate adjustment, every three or six months, and
there could therefore be a measure of interest-rate
matching and also sometimes a matching of maturities. In
less sophisticated environments than North America and
the United Kingdom, there was again an increasing
emphasis on bought money to meet any expansion in
loan demands (much of which was now term lending),
with an adjustment at the margin when more funds were
needed--e.g., wholesale deposits, certificates of deposit,
interbank borrowings, and purchases of Eurocurrencies.

The principles of central banking

The principles of central banking grew up in response
to the recurrent British financial crises of the 19th
century and were later adopted in other countries.
Modern market economies are subject to frequent
fluctuations in output and employment. Although the
causes of these fluctuations are various, there is general
agreement that the ability of banks to create new money
may exacerbate them. Although an individual bank may
be cautious enough in maintaining its own liquidity
position, the expansion or contraction of the money
supply to which it contributes may be excessive. This
raises the need for a disinterested outside authority able
to view economic and financial developments objectively
and to exert some measure of control over the activities
of the banks. A central bank should also be capable of

57

acting to offset forces originating outside the economy,

although this is much more difficult.
RESPONSIBILITIES OF CENTRAL BANKS
The first concern of a central bank is the maintenance
of a soundly based commercial banking structure. While
this concern has grown to comprehend the operations of
all financial institutions, including the several groups of
nonbank financial intermediaries, the commercial banks
remain the core of the banking system. A central bank
must also cooperate closely with the national
government. Indeed, most governments and central banks
have become intimately associated in the formulation of
policy.
Relationships with commercial banks.

One source of economic instability is the supply of

money. Even in relatively well-controlled banking
systems, banks have sometimes expanded credit to such
an extent that inflationary pressures developed. Such an
overexpansion in bank lending would be followed almost
inevitably by a period of undue caution in the making of
loans. Frequently the turning point was associated with a
financial crisis, and bank failures were not uncommon.
Even today, failures occur from time to time. Such crises
in the past often threatened the existence of financial
institutions that were essentially sound, and the
authorities sometimes intervened to prevent complete

58

collapse.
The willingness of a central bank to offer support to
the commercial banks and other financial institutions in
time of crisis was greatly encouraged by the gradual
disappearance of weaker institutions and a general
improvement in bank management. The dangers of
excessive lending came to be more fully appreciated, and
the banks also became more experienced in the
evaluation of risks. In some cases, the central bank itself
has gone out of its way to educate commercial banks in
the canons of sound finance. In the United States the
Federal Reserve System examines the books of the
commercial banks and carries on a range of frankly
educational activities. In other countries, such as India
and Pakistan, central banks have also set up departments
to maintain a regular scrutiny of commercial bank
operations.
The most obvious danger to the banks is a sudden and
overwhelming run on their cash resources in consequence
of their liability to depositors to pay on demand. In the
ordinary course of business, the demand for cash is fairly
constant or subject to seasonal fluctuations that can be
foreseen. It has become the responsibility of the central
bank to protect banks that have been honestly and
competently managed from the consequences of a sudden
and unexpected demand for cash. In other words, the
central bank came to act as the "lender of last resort." To
do this effectively, it was necessary that the central bank
be permitted either to buy the assets of commercial banks
or to make advances against them. It was also necessary
that the central bank have the power to issue money
acceptable to bank depositors. But if a central bank was

59

to play this role with respect to commercial banks, it was

only reasonable that it or some related authority be
allowed to exercise a degree of control over the way in
which the banks conducted their business.
Most central banks now take a continuing day-to-day
part in the operations of the banking system. The Bank
of England, for example, has been increasingly in the
market to ensure that the banks have a steady supply of
cash, even during periods of credit restriction. It also
lends regularly to the discount houses, supplementing
their resources whenever the commercial banks feel the
need to call back money they have on loan to them. In the
United States the Federal Reserve System has operated in
a similar way by buying and selling securities on the
open market and by lending to dealers in government
securities on the basis of repurchase agreements. The
Federal Reserve may also discount paper submitted by
the commercial banks through the Federal Reserve banks.
The various techniques of credit control in use are
discussed in greater detail below.
The evolution of those working relations among banks
implies a community of outlook that in some countries is
relatively recent. The whole concept of a central bank as
responsible for the stability of the banking system
presupposes mutual confidence and cooperation. For this
reason, contact between the central bank and the
commercial banks must be close and continuous. The
latter must be encouraged to feel that the central bank
will give careful consideration to their views on matters
of common concern. Once the central bank has
formulated its policy after a full consideration of the facts
and of the views expressed, however, the commercial

60

banks must be prepared to accept its leadership.

Otherwise, the whole basis of central banking would be
undermined.
The central bank and the national economy.

Relationships with other countries.

Since no modern economy is self-contained, central
banks must give considerable attention to trading and
financial relationships with other countries. If goods are
bought abroad, there is a demand for foreign currency to
pay for them. Alternatively, if goods are sold abroad,
foreign currency is acquired that the seller ordinarily
wishes to convert into the home currency. These two sets
of transactions usually pass through the banking system,
but there is no necessary reason why, over the short
period, they should balance. Sometimes there is a surplus
of purchases and sometimes a surplus of sales. Shortperiod disequilibrium is not likely to matter very much,
but it is rather important that there be a tendency to
balance over a longer period, since it is difficult for a
country to continue indefinitely as a permanent borrower
or to continue building up a command over goods and
services that it does not exercise.
Short-period disequilibrium can be met very simply by
diminishing or building up balances of foreign exchange.
If a country has no balances to diminish, it may borrow,
but normally it at least carries working balances. If the
commercial banks find it unprofitable to hold such

61

balances, the central bank is available to carry them;

indeed, it may insist on concentrating the bulk of the
country's foreign-exchange resources in its hands or in
those of an associated agency.
Long-period equilibrium is more difficult to achieve.
It may be approached in three different ways: price
movements, exchange revaluation (appreciation or
depreciation of the currency), or exchange controls.
Price levels may be influenced by expansion or
contraction in the supply of bank credit. If the monetary
authorities wish to stimulate imports, for example, they
can induce a relative rise in home prices by encouraging
an expansion of credit. If additional exports are necessary
in order to achieve a more balanced position, the
authorities can attempt to force down costs at home by
operating to restrict credit.
The objective may be achieved more directly by
revaluing a country's exchange rate. Depending on the
circumstances, the rate may be appreciated or
depreciated, or it may be allowed to "float." Appreciation
means that the home currency becomes more valuable in
terms of the currencies of other countries and that exports
consequently become more expensive for foreigners to
buy. Depreciation involves a cheapening of the home
currency, thus lowering the prices of export goods in the
world's markets. In both cases, however, the effects are
likely to be only temporary, and for this reason the
authorities often prefer relative stability in exchange rates
even at the cost of some fluctuation in internal prices.
Quite often governments have resorted to exchange
controls (sometimes combined with import licensing) to
allocate foreign exchange more or less directly in

62

payment for specific imports. At times, a considerable

apparatus has been assembled for this purpose, and,
despite "leakages" of various kinds, the system has
proved reasonably efficient in achieving balance on
external payments account. Its chief disadvantage is that
it interferes with normal market processes, thereby
encouraging rigidities in the economy, reinforcing vested
interests, and restricting the growth of world trade.
Whatever method is chosen, the process of adjustment
is generally supervised by some central authority--the
central bank or some institution closely associated with
it--that can assemble the information necessary to ensure
that the proper responses are made to changing
conditions.
Economic fluctuations.
As noted above, monetary influences may be an
important contributory factor in economic fluctuations.
An expansion in bank credit makes possible, if it does not
cause, the relative overexpansion of investment activity
characteristic of a boom. Insofar as monetary policy can
assist in mitigating the worst excesses of the boom, it is
the responsibility of the central bank to regulate the
amount of lending by banks and perhaps by other
financial institutions as well. The central bank may even
wish to influence in some degree the direction of lending
as well as the amount.
An even greater responsibility of the central bank is
that of taking measures to prevent or overcome a slump.
Recessions, when they occur, are often in the nature of
adjustments to eliminate the effects of previous

63

overexpansion. Such adjustments are necessary to restore

economic health, but at times they have tended to go too
far; depressive factors have been reinforced by a general
lack of confidence, and, once this has happened, it has
proved extremely difficult to stimulate recovery. In these
circumstances, prevention is likely to be far easier than
cure. It has therefore become a recognized function of the
central bank to take steps to preclude, if possible, any
such general deterioration in economic activity.
For the central bank to be effective in regulating the
volume and distribution of credit so that economic
fluctuations may be damped, if not eliminated, it must at
least be able to regulate commercial bank liquidity (the
supply of cash and "near cash"), because this is the basis
of bank lending. Monetary authorities in a number of
countries have begun to resort increasingly to the
management of monetary aggregates as a basic policy.
This does not mean an uncritical acceptance of
monetarist philosophy but rather what the U.S. economist
and banker Paul A. Volcker has called "practical
monetarism." In addition to the Federal Reserve in the
United States, a growing number of western European
countries have adopted the practice of setting growth
targets for the money supply and sometimes other
monetary targets as well (like domestic credit expansion),
usually setting some range of allowable variation. Japan
has had reservations and has preferred to indicate
monetary projections or forecasts, partly because of the
difficulty of changing a set target should it become
necessary. Nor is there any great degree of consensus as
to which target or aggregate to employ. In general terms,
choice of a particular aggregate as a basis for reference

64

would be linked to the theories--more or less explicit--on

which the actions of a particular central bank are based
and also on the state of the country's economy and its
financial environment. Where there are publicly declared
targets, these can have an important effect by the very
fact of being announced.
There is now little dispute about the broad objectives,
though the techniques of control are various and depend
to some extent on environmental factors. It would be
incorrect to suppose, however, that the actions of the
central bank can, unaided, achieve a high degree of
stability. It can by wise guidance contribute to that end,
but monetary action is in no sense a panacea; at all times,
the degree to which it is likely to be effective depends on
the provision of an appropriate fiscal environment
Banking services.
Another responsibility of the central bank is to ensure
that banking services are adequately supplied to all
members of the community that need them. Some areas
of a country may be "under-banked" (e.g., the rural areas
of India and the northern and more remote parts of
Norway), and central banks have attempted, directly or
indirectly, to meet such needs. In France, this need
underlay the early extension of branches of the Bank of
France to the dpartements. In India the authorities
encouraged the opening of "pioneer" branches by the
former Imperial Bank of India and its successor, the State
Bank of India, latterly by all the nationalized banks, and
particularly their extension to rural and semirural areas.
In Pakistan, officials of the State Bank of Pakistan played
an active part in the foundation of the semipublic

65

National Bank of Pakistan with a similar objective in

view.
A different sort of problem arises when the business
methods of existing banks are unsatisfactory. In such
circumstances, a system of bank inspection and audit
organized by the central banking authorities (as in India
and Pakistan) or of bank "examinations" (as in the United
States) may be the appropriate answer. Alternatively, the
supervision of bank operations may be handed over to a
separate authority, such as France's Banking Control
Commission or South Africa's Registrar of Banks.
In developing countries, central banks may encourage
the establishment and growth of specialist institutions
such as savings institutions and agricultural credit or
industrial finance corporations. These serve to improve
the mechanism for tapping existing liquid resources and
to supplement the flow of funds for investment in
specific fields.
Responsibilities to the government.

Central banks have over the years acquired a number

of well-defined responsibilities to their respective
national governments. Some, notably the Bank of
England, developed into central banks after being, in
origin, bankers to the government. More recently it has
become a matter of course for a new central bank to
accept responsibility for the financial affairs of its
government. The reasons are self-evident. Government
transactions have become of increasing importance in

66

influencing the workings of the economy, and the

institution that holds the government's account is in a
strategic position to cushion the commercial banks
against the impact of large movements of cash
originating in this way. As banker to the government,
furthermore, the central bank has an obvious
responsibility to provide routine banking services, such
as arranging loan flotations and supervising their service,
renewal, and redemption. The central bank also usually
issues the currency.
Equally important are its responsibilities as an adviser
on the probable monetary consequences of any proposed
action. In this role the central bank should scrutinize the
government's proposals with a certain amount of
objectivity and state its point of view with vigour. One
may cite a now-famous dictum of Montagu Norman as
governor of the Bank of England:
I think it is of the utmost importance that
the policy of the Bank and the policy of the
Government should at all times be in
harmony--in as complete harmony as
possible. I look upon the Bank as having
the unique right to offer advice and to
press such advice even to the point of
"nagging"; but always of course subject to
the supreme authority of the Government.

public institution whose major function is to serve the

community as a whole, untrammelled by narrow dictates
of profit and loss. Most central banks, nevertheless, make
very handsome profits.
TECHNIQUES OF CREDIT CONTROL
Central banks have developed a variety of techniques
for influencing, regulating, and controlling the activities
of commercial banks. These may be divided into (1) the
so-called classical, or indirect, techniques and (2) various
direct controls. The classical techniques make use of
open-market purchases or sales by the central bank of
certain types of assets that are invariably associated with
fluctuations in interest rates. Direct, or quantitative, credit
controls are employed to influence the cash and liquidity
bases of commercial bank lending by means of freezing
or unfreezing their liquid resources; sometimes ceilings
are imposed on bank loans.
Open-market operations.

Many central banks are now nationalized, reflecting

the increasingly general recognition of the significance of
the central bank's role as a servant, if not a creature, of
the government. This development is also, in a way, a
final recognition of the central bank as a responsible

67

The way in which open-market operations influence

the cash reserves and, through them, the general liquidity
of the commercial banks is essentially simple. If the
central bank buys securities in the open market, the cash
it offers in exchange adds to the reserves of the banks; if
the central bank sells securities in the open market, the
cash necessary to pay for them is either withdrawn from
the banks' reserves or obtained by diminishing holdings

68

of other assets (with the possibility of capital losses in

consequence of these sales). It does not matter whether
this buying and selling takes place between the central
bank and the commercial banks directly or between the
central bank and other financial sectors, including the
public at large, since these are the customers of the
commercial banks.
Open-market operations are invariably associated with
related changes in one or more "strategic" rates of
interest, the most influential of these rates being the
minimum rate at which the central bank does business
(the bank rate, or the discount rate), since other rates
tend to move in sympathy with it. The central bank seeks
to achieve an appropriate and consistent structure of
interest rates. If a particular rate structure is desired (e.g.,
prior to a new issue of government securities or in order
to change the emphasis of institutional investment
between, say, long-term and short-term securities), it may
be necessary to precondition the market by means of
open-market operations. To achieve its purposes the
central bank must possess (if it is selling) or be willing to
absorb (if it is buying) the appropriate types of securities.
In London the specialist banks known as discount
houses effectively put to work the revolving fund of cash
that circulates through the British banking system. If
temporarily there is an inadequate supply of cash, the
Bank of England either lends on a short-term basis or
buys some of the assets held by the discount market.
(From 1980 there was a shift in emphasis from lending to
open-market operations, especially by dealing in bankers'
acceptances.) Alternatively, the Bank of England may
buy assets from the clearing banks (the large joint-stock

69

banks), which then make the relevant moneys available

to the market. On the other hand, if the discount market is
oversupplied with funds, the Bank of England sells
treasury bills, in this way mopping up the excess of cash.
These transactions are known as smoothing-out
operations. In addition, the Bank of England is also
responsible for managing the national debt, and, whether
the object is to influence the flows of money or not, such
transactions in fact have monetary effects.
In the United States the Federal Reserve System
regulates the money supply. Within the Federal Reserve
System, the Federal Open Market Committee is the
most important single policy-making body. It is presided
over by the chairman of the Board of Governors, with the
president of the Federal Reserve Bank of New York as its
permanent vice chairman. The main responsibility of the
Open Market Committee is to decide upon the timing and
amount of open-market purchases or sales of government
securities. Since open-market operations must obviously
be consistent with other aspects of monetary and credit
policy, it is in the committee that broad agreement is
reached on matters such as changes in discount rates or
reserve requirements.
One of the big differences between London and New
York is that the central banking authorities in New York
maintain direct relationships more or less continuously
with the nonbank government securities dealers as well
as with the commercial banks. The Federal Reserve Bank
of New York may make temporary accommodation
available to some 35 primary dealers (including certain
banks) under a repurchase agreement, whereby securities
are sold to the bank under an agreement that they be

70

repurchased after a stipulated time. These agreements are

made only for the purpose of supplying reserves to the
banking system, but from the dealer's standpoint they are
helpful in financing portfolios. Such repos, as they are
called, may also be done with foreign official accounts.
Since early 1966 the bank has also been prepared to mop
up money by undertaking reverse repurchase agreements,
in which the dealers act as intermediaries for large
commercial banks with temporarily surplus money that
they are prepared to place against bills, subject to the
bank's repurchasing them a few days later; the
commercial bank concerned lends the dealer the money
to finance the holding of the bill. Similar arrangements
are also made by the Federal Reserve directly with bank
dealers.
All member banks of the Federal Reserve System, and
now also other depository institutions, have direct access
to the discount service of their Federal Reserve Bank, of
which there is one in each of 12 districts. This is a
privilege, however, and not a right. In the early years of
the system, the banks would sell discountable paper to
the Federal Reserve, but now they usually borrow against
a pledge of government securities held in safe custody
with the Federal Reserve Bank in question. The Federal
Reserve lends for a number of purposes but always at a
time of general stress. It is assumed that, as the pressure
abates, borrowing banks will repay their indebtedness as
quickly as possible. Under ordinary conditions, the
continuous use of Federal Reserve credit by a member
bank over a considerable period is not regarded as
appropriate.

71

Direct control of assets.

The so-called classical techniques of credit control-open-market operations and discount policy--can be
employed only where there is a sufficiently developed
complex of markets in which to buy and sell assets of the
type that commercial banks ordinarily hold. Direct credit
controls have a wider range of application. They may be
used either as a substitute for the classical techniques or
as a supplement to them. Direct controls are more likely
to be resorted to when the money market is
undeveloped, because then a central bank can only
impose its authority by means of direct action. This is
often the situation facing a newly established central
bank. Rather than wait for the slow evolution of a money
market, the authorities may provide the central bank from
the start (as in Pakistan, the Philippines, Sri Lanka, and
Malaysia) with very full powers to control the banking
system.
The aim in imposing a direct, quantitative regulation
of credit is to curb inflationary pressures that may result
from an expansion of commercial bank lending. This can
be done in four main ways: (1) the commercial banks
may be required to maintain stated minimum reserve
ratios of cash to deposits, a stated liquid assets ratio, or
some combination of both; (2) part of the cash resources
of the commercial banks may be immobilized at the
discretion of the central bank; (3) ceilings may be
imposed on the amount of accommodation to be made
available to the commercial banks at the central bank
(sometimes referred to as "discount quotas"); and (4) a

72

ceiling may be prescribed for commercial bank lending

itself.
Minimum reserve requirements.
The variation of minimum cash reserve requirements
as a direct means of quantitative credit control has
become increasingly general in recent years. The practice
has largely derived from experience in the United States.
In its origin the U.S. insistence on stated minimum
reserve requirements for commercial banks was simply a
means of prescribing minimum standards of sound
behaviour. Only later did such ratios come to be seen as a
useful supplementary quantitative credit control.
The power granted by the Banking Act of 1935 to the
Federal Reserve System to determine the cash reserves of
the commercial banks in the United States was employed
for the first time during the boom of 1936-37, and
periodic variation of minimum reserve requirements
subsequently came to be recognized as an appropriate
technique for controlling the money supply. The Federal
Reserve Board's decisions were sometimes subject to
considerable criticism, but, as it became more
experienced in the use of this technique, variation in
reserve requirements combined with other measures
came to be regarded as a useful means of cushioning the
economy against a recession. The variation of reserve
requirements did not prove as effective in preventing
inflation, largely because of the government's insistence
that the Federal Reserve simultaneously support the
prices of government bonds through open-market
operations. This insistence was abandoned by the

73

Treasury in March 1951. Since then, much greater

emphasis has been placed on the use of open-market
operations, which had become more effective, and the
importance of varying minimum reserve requirements as
a means of controlling the credit base has diminished in
the United States. The technique is still widely used,
however, in many countries.
In some countries, the authorities require the
maintenance of minimum liquid assets ratios. This is
often combined with minimum requirements for cash
reserves, as in India, Pakistan, and Germany, though not
always (in France, for example, until 1967 there were no
minimum cash reserve requirements). Where prescribed
minima relate to liquid assets and not to cash as such,
reserves are held in the form of earning assets--an
important distinction from the point of view of the
commercial banks.
An important step toward a uniform and explicit
minimum liquidity ratio for the London clearing banks
was taken in 1951, when the governor of the Bank of
England indicated to the banks that a liquidity ratio of
from 32 to 28 percent would be regarded as normal and
that it would be undesirable for the ratio to be allowed to
fall below 25 percent. By 1957 a fairly rigid 30-percent
minimum was in place (it was reduced to 28 percent in
1963). After 1946 the London clearing banks (but not the
Scottish banks) also observed a more or less fixed cash
ratio of 8 percent. A new element was introduced in
1960, when the Bank of England launched its system of
"special deposits" as a means of reinforcing other
methods of credit control. Calls were made from time to
time on the London clearing banks to deposit with the

74

Bank of England by a specified date some specified

percentage of their gross deposits; similar arrangements
applied to the Scottish banks, but the calls were smaller.
This system lasted until 1971, when a new 12.5-percent
minimum reserve ratio (excluding till cash) was
introduced. This ratio related to "eligible liabilities"
(primarily sterling deposits of up to two years maturity,
including sterling certificates of deposit). The banks
could also be required to place special deposits with the
Bank of England. These arrangements were replaced in
August 1981 by a voluntary holding of operational funds
with the Bank of England by the London clearing banks
("for clearing purposes") and a uniform requirement of
0.5 percent of an institution's eligible liabilities that
would be applied to all banks and licensed deposit-takers
with eligible liabilities averaging more than 10,000,000.
All banks that were eligible acceptors were also normally
required to hold an average equivalent to 6 percent of
their eligible liabilities either as secured money with
discount houses or as secured call money with money
brokers and gilt-edged jobbers, but the amount held in the
form of secured money with a discount house was not
normally to fall below 4 percent of eligible liabilities.
This money became known as "club money."
The use of variable minimum reserve requirements as
a means of credit control can, if carried far enough,
produce results, especially when the requirements include
the holding of cash balances. It is more useful as an antiinflationary weapon than as a means of countering
recession, since it cannot overcome a possible
unwillingness of the banks to lend or of their customers
to borrow. It is a somewhat clumsy technique, however,

75

and cannot make adequate allowance for the special

needs of different institutions.
Immobilization of cash resources
A second group of direct quantitative credit controls
involves keeping a portion of the cash resources of
commercial banks immobilized at the discretion of the
central bank. Two leading examples of this technique
were the use of the Treasury Deposit Receipt (TDR) in
the United Kingdom during and after World War II and
the "special account procedure" adopted in Australia in
1941. Both were means of immobilizing the increased
liquidity deriving from wartime government expenditure.
The direct issue of Treasury Deposit Receipts at a
nominal rate of interest to banks in the United Kingdom
began in July 1940. They were not negotiable in the
market or transferrable between banks, but they could be
tendered in payment for government bonds (and tax
certificates); hence, during the war years they had a
limited degree of liquidity. The Bank of England
communicated to the banks collectively the amount of the
weekly call, which was divided among them in
proportion to their deposits. After the war, TDR's were
replaced by treasury bills; in order to reduce the
consequent high liquidity of the banks, there was a
"forced funding" of 1,000,000,000 of treasury bills in
November 1951, which were required to be invested in
Serial Funding Stocks.
The special account procedure introduced in
Australia in 1941 had a similar objective. The surplus
investable funds of the Australian trading banks, defined

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as the amount by which each bank's total assets in

Australia at any time exceeded the average of its total
assets in Australia in August 1939, were required to be
placed in special deposit accounts with the
Commonwealth Bank (then the central bank) at a
nominal rate of interest. A bank was not to withdraw any
sum from its special account except with the consent of
the Commonwealth Bank; during the war years, the bank
generally directed the trading banks to lodge in their
special accounts each month an amount equal to the
increase in their total assets in Australia during the
preceding month, although as a rule a lodgment was not
required if it was known that a rise in assets would be
followed by an early fall. Legislation in 1945 adopted the
special account procedures as a means of general credit
control (e.g., to curb inflation), but the provisions were
made more flexible. In 1953 a more complicated formula
was introduced, and in 1960 the system was abandoned
in favour of minimum reserve ratios.
Direct control of loans.
Accommodation ceilings.
Some countries have tried limiting the amount of
accommodation that the central bank may make available
to the commercial banks. The difficulty in this type of
quantitative credit control is to make it effective while
also allowing for changes in the economy; its most
obvious use is as a means of checking inflation, but, if
the upward pressures on prices are strong, there is a
temptation to increase the ceilings so that the restraint

77

then becomes little more than a temporary check.

Usually, it is only when a control begins to be felt and
to affect bank profits that the banks become really
sensitive to changes in credit policy and the
implementation of the control becomes truly effective.
The postwar experience of France is a case in point.
Plafonds, or "ceilings," were first introduced in France in
1948. Rediscount ceilings (or discount quotas) were fixed
for each bank, though some categories of paper were
excluded. Ceilings could be increased or (after 1957)
reduced.
From the authorities' point of view, the chief difficulty
in operating this control was the persistent building up of
pressure against the ceilings. This was met partly by
upward revisions in the ceilings themselves and partly by
instituting a number of safety valves. The degree of
elasticity required constituted the chief weakness of the
ceiling technique. The central bank was constantly under
pressure to adjust the ceilings upward. Some upward
revisions were unavoidable, but the problem was to
decide which claims were legitimate and which not.
Much bilateral bargaining took place between the Bank
of France and individual commercial banks, but the
banks continued to complain that the strictness of the
control was excessive and that the technique was lacking
in flexibility.
The inadequacies of the plafonds technique in its
original form became apparent when prices began to rise
rapidly during the Korean War boom, and even the builtin safety valves failed fully to accommodate the pressures
on bank liquidity. The need to strengthen the mechanism
was obvious, and this was attempted in 1951. Previously,

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rediscounts had frequently exceeded the ceilings during

the month and were only brought within the plafonds by
special action (e.g., through open-market purchases). The
situation was brought under control by introducing a
secondary ceiling to which a penalty rate of interest was
applied. This was extended in 1958 to permit rediscounts
even beyond the secondary ceiling, provided a further
penalty was paid; each application, however, was
scrutinized by the Bank of France. The system lasted
until about the spring of 1964, though it did not finally
disappear until 1968, when it was largely replaced by
Bank of France operations in the open market. After early
1967, banks also were subject to minimum reserve
requirements.
Plafonds, or discount quotas, also are employed in
Germany. They were introduced in West Germany in
1952 and strengthened in 1955. Quotas may be reduced
periodically (after 1964 they were also used to discourage
institutions from borrowing abroad). Again there were
safety valves (although less generous than in France) and
the possibility of extra accommodation (Lombard credits)
at a higher rate. In some circumstances, supplementary
quotas might be approved for up to six months. A bank
might also raise funds through the money market, though
likely at higher cost. Discount quotas are still an
important tool of credit control in Germany.
Other countries have employed this technique,
including Sweden, where for a time the central bank
imposed formal or informal ceilings on banks and
sometimes on finance companies. If the banks failed to
observe the ceiling, a penalty was applied based on the
amount of the excess borrowing and its duration. In

79

Finland, commercial banks have at times been able to

borrow limited amounts from the Bank of Finland by
way of traditional credit quotas. Beyond these quotas,
funds could formerly be obtained as supra-quota credit at
a higher rate, but banks now are forced into the official
call-money market. Denmark, too, has permitted
borrowing from the central bank in tranches, with higher
(penalty) rates applying after the first tranche of the loan
quota has been resorted to, a practice that can be
expensive.
General ceilings on credit.
Attempts have been made to prescribe a general
ceiling within which the quantity of commercial bank
lending must be held. This is even more difficult to
achieve. One example of such an attempt was the
adoption of a "rising ceiling" by Chile in 1953. All banks
were required not to expand the volume of their loans to
businesses and individuals by more than 1.5 per-cent a
month, using as their basis the average of a bank's
advances on selected dates in 1953. Certain types of
loans were forbidden, and bank resources were to be
directed to productive and distributive activities that
really contributed to the expansion of the national
economy. Banks were also required to provide
information on the destination of their loans. In
succeeding years, adjustments were made on several
occasions in the maximum permitted credit increase,
expressed either as a percentage of advances or
sometimes as a total for the banking system as a whole.
In 1959 all quantitative credit restrictions were removed,

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and banks were permitted to advance funds up to their

financial capacity, provided that they operated within the
general banking law. There was no evidence the controls
had been effective, but the major problem in Chile was
budgetary rather than monetary. A temporary ceiling on
loans was imposed by agreement in Canada (in 1951-52),
The Netherlands (1957-58), and France (1958-59).
The United Kingdom had considerable experience
with this type of ceiling, introducing it as a temporary
measure in 1955, when the banks were asked to bring
their advances down by an average of 10 percent. Later
an attempt was made to impose a true ceiling, requiring
that bank advances not exceed the average of the period
October 1956 to September 1957. This was continued
until July 1958. Again, in 1961, the authorities indicated
the banks must aim at checking the rate of rise in bank
advances; this came to be interpreted as a request that the
level of advances at the end of 1961 be no higher than in
the previous June. The banks also were not to encourage
an increase in the volume of commercial bills. The
request was modified in May 1962 and largely withdrawn
in October; but it was made again in May 1965, when the
clearing banks were requested not to increase their
advances to the private sector, at an annual rate of more
than about 5 percent, in the 12 months to mid-March
1966 (likewise with commercial bills). Other financial
institutions were requested to observe a comparable
degree of restraint. For 12 months after March 1966,
advances and discounts, allowing for seasonal factors,
were not permitted to rise above levels set for March
1966. This represented an intensification of the credit
squeeze because prices were rising. The credit restriction

81

led to a falling off in business confidence, and,

consequently, toward the end of 1966, bank lending was
well below the official ceiling. In April 1967, authorities
announced a change in techniques, with an emphasis on
making calls to special deposits, but the ceilings returned
again in November 1967. There was to be no increase in
bank advances to the private sector (excluding exports
and shipbuilding) except for seasonal reasons. In May
1968 a new ceiling was instituted for all such lending
(including that for exports and shipbuilding); the clearing
banks were asked to restrict the total of this lending, after
seasonal adjustment, to 104 percent of the November
1967 figure, with priority to be given to finance for
exports and for activities directly related to improving the
balance of payments. The restrictions also extended to
other types of credit. Credit became even tighter (in
March 1969) when the ceiling was reduced to 98 percent
of the November 1967 level. The banks had considerable
difficulty in meeting this requirement and agreed merely
to "do their best." Advances increased above the ceiling,
and, as a penalty, the interest paid by the Bank of
England on special deposits was halved. Not until late
1969 did it become clear that the authorities were
prepared to abandon their long campaign to get bank
loans down to the target figure. The ceiling was
subsequently replaced by minimum reserve requirements.
The system of quantitative credit control requires, for its
successful implementation, the full cooperation of the
banking community. In the United Kingdom, where
banks base much of their lending on the overdraft
technique, the system was very unpopular.

82

In France, however, the encadrement du crdit, as it is

called, temporarily imposed in 1958-59, was revived
during the first half of 1973. Subject to certain exclusions
(e.g., certain investment credits, agricultural credits,
export credits, the financing of energy savings and
innovation, leasing transactions, and special mediumterm construction loans), the mechanism chosen was to
permit a certain percentage rate of growth in bank credits
in relation to a particular month in the previous year,
these limits being fixed quarterly and subject to variation
from time to time. Subsequently, in early 1975, reference
was made to a fixed base defined as equal to an index of
100, in relation to which the index might be increased (or
decreased) and credit expanded (or contracted). The
system was further refined to vary the rate of change of
credits within different financial sectors, and it has been
subject in the interests of flexibility to many amendments
over the years. In effect, there has been a combination of
quantitative and qualitative credit controls.
In addition to regulating the quantity of credit, central
banks have sometimes attempted to influence the
directions in which the commercial banks lend. A loose
system of control prevailed in the United Kingdom
during World War II and afterward, based initially on
directives from the Capital Issues Committee and later on
requests from the Bank of England. A highly formalized
technique was employed in Australia during the war and
earlier postwar years; detailed and specific instructions
were given to the trading banks, marginal cases being
referred to the central bank. The system of Voluntary
Credit Restraint in the United States in 1951 was similar.
The more formal controls seemed to be no more effective

83

than the looser system employed in the United Kingdom.

Selective controls have been imposed on consumer
installment finance in the United States and elsewhere
(e.g., by stipulating the percentage of deposit that is
required and the length of the term over which
repayments may be made). Even when these are not
varied in order to serve as a control over credit, there is a
case for insisting on such requirements for prudential
reasons. In the United States, under the Securities
Exchange Act of 1934, the Federal Reserve can vary the
margins that purchasers of securities must pay in cash,
thereby limiting the credit available for this purpose.
The structure of modern banking systems
The banking systems of the world have many
similarities, but they also differ, sometimes in quite
material respects. The principal differences are in the
details of organization and technique. The differences are
gradually becoming less pronounced because of the
growing efficiency of international communication and
the tendency in each country to emulate practices that
have been successful elsewhere.
Banking systems may be classified in terms of their
structure as unit banking, branch banking, or hybrids of
the two. For example, unit banking prevails in large areas
of the United States. In other countries it is more usual to
find a small number of large commercial banks, each
operating a highly developed network of branches. This
is the system used in England and Wales, among others.
Examples of hybrid systems include those of France,

84

Germany, and India, where banks that are national in

scope are supplemented by regional or local banks. Some
of these hybrid systems are slowly changing their
character, the banks becoming fewer in number and
individually larger, with a larger number of branches.
UNIT BANKING: THE UNITED STATES
Bank organization in the United States during the
years after World War II was still passing through a
phase of structural development that many other
countries had completed some decades earlier.
Development in the United States has been subject to
constraints not found elsewhere. The federal Constitution
permits both the national and state governments to
regulate banking. Some states prohibit branch banking,
largely because of the political influence of small local
bankers, thus encouraging the establishment and
retention of a large number of unit banks.
Even in its early years, the United States had an
unusually large number of banks. As the frontiers of
settlement were pushed rapidly westward, banks sprang
up across the country. One reason for this was the
demand for capital in the expanding frontier economy.
There was also an obvious need for a large number of
banks to serve the diverse and rapidly expanding
demands of a growing and constantly migrating
population. It must be remembered, too, that at this time
communications between the frontiers of settlement and
the established centres of commerce and finance were
still inadequately developed.

85

As long as communications remained imperfect, the

existence of large numbers of competing institutions is
not difficult to explain. The subsequent failure of bank
mergers or amalgamations to produce a concentration of
financial resources in the hands of large banking units
can be attributed in part to the character of the federal
Constitution as noted above. Among the people,
moreover, there was a widespread distrust of monopoly
and a deep-rooted fear that a "money trust" might
develop. This went hand in hand with a political
philosophy that emphasized the virtues of individualism
and free competition; restrictions on branching, merging,
and on the formation of holding companies were a
feature of both the state and the federal banking laws.
Where permitted, however, bank branches are numerous
in the United States (especially in California and in New
York); in states in which branching is prohibited, one
often finds local bank monopolies in small towns.
Interstate banking is prohibited by federal law, but large
banking organizations have provided financial services
(e.g., through loan offices and offices of nonbank
subsidiaries) for many years across state lines. A number
of states have passed limited interstate or reciprocal
banking laws, so that banks in other states with similar
laws can acquire or merge with local banks. The banking
system of the United States would not work without a
network of correspondent bank relationships, which are
more highly developed there than in any other country.
From the 1970s there was an acceleration in the
evolution of U.S. banking patterns. Unregulated financial
institutions (and some nonfinancial institutions) moved
into traditional banking activities; at the same time,

86

depository institutions began offering a fuller range of

financial services. Money-market mutual funds, for
example, secured access to open-market interest rates for
investors with relatively small amounts of money.
Securities firms and insurance companies moved
aggressively into providing a range of liquid financial
instruments. Likewise, large manufacturing and retail
firms moved into the commercial and retail lending
businesses--e.g., by acquiring a savings and loan
association, a securities brokerage house, an industrial
loan company, a consumer banking business, or even a
commercial bank. Meanwhile, depository institutions
developed a number of new services, most notably the
Negotiable Order of Withdrawal (NOW) account, an
interest-bearing savings account with a near substitute for
checks. These appeared first in 1972 in New England and
after 1980 spread to the whole nation; they were offered
both by commercial banks and by thrift institutions.
Share drafts at credit unions also became a means of
payment, and after 1978 the automatic transfer services
of commercial banks permitted savings account funds to
be transferred automatically to cover overdrafts in
checking accounts. So-called Super-NOW accounts (with
no interest rate ceilings and unlimited checking facilities
with a minimum balance) were subsequently introduced,
along with money-market deposit accounts, free of
interest rate restrictions but with limited checking.
Rapid changes in financial structure and the supply of
financial services posed a host of questions for
regulators, and, after much discussion, the Depository
Institutions Deregulation and Monetary Control Act was
passed in 1980. The object was to change some of the

87

rules--many of them obsolete--under which U.S. financial

institutions had operated for nearly half a century. The
principal objectives were to improve monetary control
and equalize more nearly its cost among depository
institutions; to remove impediments to competition for
funds by depository institutions, while allowing the small
saver a market rate of return; and to expand the
availability of financial services to the public and reduce
competitive inequalities among financial institutions
offering them. The major changes were: (1) Uniform
Federal Reserve requirements were phased in on
transaction accounts (demand deposits, NOW accounts,
telephone transfers, automatic transfers, and share drafts)
at all depository institutions--commercial banks (whether
Federal Reserve members or not), savings and loan
associations, mutual savings banks, and credit unions. (2)
The Federal Reserve Board was authorized to collect all
data necessary for the monitoring and control of money
and credit aggregates. (3) Access to the discount window
at Federal Reserve banks was widened to include any
depository institution issuing transaction accounts or
nonpersonal time deposits. (4) The Federal Reserve was
to price its services, to which all depository institutions
would now have access. (5) Regulation Q, which had
long set interest-rate ceilings on deposits, was to be
phased out over a six-year period. (6) An attempt was
made to grasp the nettle of the state usury laws. (7) NOW
accounts were authorized on a nationwide basis and
could be offered by all depository institutions. Other
services were extended. (8) The permissible activities of
thrift institutions were broadened considerably. (9)
Deposit insurance at commercial banks, savings banks,

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savings and loan associations, and credit unions was

raised from $40,000 to $100,000. (10) The "truth in
lending" disclosure and financial regulations were
simplified to make it easier for creditors to comply.
BRANCH BANKING: THE UNITED
KINGDOM
If the United States banks can be taken as
representative of a unit banking system, the British
system is the prototype of branch banking. Its
development was linked to the growth of transportation
and communications, for otherwise banks cannot clear
checks drawn on other banks and effect remittances
speedily and efficiently. The Scots favoured branch
banking from the very beginning (the Bank of Scotland
was founded in 1695), but at first they were not very
successful--largely because of poor communications and
the difficulty of supplying branches with adequate
amounts of coin. Not until after the Napoleonic Wars,
when the road system of Scotland had been greatly
improved, did branch banking begin to develop
vigorously there. As the Industrial Revolution progressed
and as the size of businesses increased, the structure of
English banking underwent a corresponding change.
Greater resources were required for lending, and banks
also needed more extensive interconnections in order to
provide an increasing range of services. Where banks
remained small, they were frequently unable to take the
strain of the larger demand; they tended to become
overextended and often failed.

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The growth in size of banks was also greatly

encouraged by legislation that encouraged joint-stock
ownership, beginning in 1826. Joint-stock ownership,
which reduced the risk to any individual, must be
distinguished from limited liability, which did not
become widely accepted until the failure of the City of
Glasgow Bank in 1878 demonstrated the need for a legal
device to protect the stockholder. The early joint-stock
banks tended to remain localized in their business
interests; it was only gradually (with the spread of limited
liability and disclosure of accounts) that amalgamations
began to convert the banking system in England and
Wales into its highly concentrated modern form. The
main movement was completed before World War I,
though there was to be a further degree of concentration
in the years after World War II. By these means, British
banks were able to attract deposits from all parts of the
country and to spread the banking risk over a wide range
of industries and areas.
HYBRID SYSTEMS
A third group of banking systems differs from the unit
banking system of the United States and also from the
branch banking systems of countries that have followed
the British model (such as Australia, Canada, New
Zealand, and South Africa). This group is characterized
by the existence of a small number of banks with
branches throughout the country, holding a significant
part of total deposits, along with a relatively large
number of smaller banks that are regional or local in

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emphasis. Such systems exist in France, Germany, and

India. Japan has a small number of large city banks with
branch networks but a larger number of local banks.
France.
Banking institutions in France were classified after
World War II into three main groups: deposit banks,
banques d'affaires (or investment banks), and institutions
that were either specialized or operated mainly outside
France. New banking legislation in 1966 greatly reduced
the importance of the distinction between deposit banks
and banques d'affaires. There was also (1) a further
concentration of banking resources, as a result of several
large mergers and also of greater financial integration
through share-exchange agreements and interlocking
directorates, and (2) the conversion of a number of
banques d'affaires into deposit banks, which hived off
their investment interests into separate investment or
holding companies.
Further legislation in 1982 nationalized the remaining
large and medium-sized banks (36 in all, plus two
financial holding companies--those of Indosuez and
Paribas); the largest deposit banks had already been
nationalized after World War II. Another new law in
1984 abolished the old divisions between the several
categories of banks, which were now defined simply as
tablissements de crdit, able to receive deposits from the
public, undertake credit operations (including loans), and
provide means of payment. The intention was to move
cautiously toward a system of "universal banking." The
new law was extended to cover the Caisse Nationale de
Crdit Agricole, the banques populaires, the crdit

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mutuel, the central organizations of the cooperatives and

the savings banks (and thereby institutions affiliated with
them), and semipublic institutions like the Crdit Foncier
and the Crdit National, but not the Caisse des Dpts et
Consignations nor the central banking institutions.
All the regional banks and some local banks have
branches. The balanced character of the regional
economies often provides these banks with a good
portfolio of risks; they serve not only a prosperous
agriculture but also a number of local industries. Some of
the local banks are also very sound institutions, despite
their small size.
The survival of a hybrid system in France, despite the
long-run trend toward centralization, reflects certain
characteristics of French society. These included, until
recently, a strong emphasis on small business, together
with a preference for individual and personal service.
Particularism in some parts of France manifests itself in
support for local institutions, and the local banker also
often has the advantage of special knowledge of local
industries and people, which makes possible the
acceptance of risks that the big banks decline.
Germany.
An even more direct conflict between the forces
favouring concentration and those working against it may
be seen in Germany, where banking grew in the latter
part of the 19th century along with industry. The banks
were inclined to rely mainly on their own capital
resources and did not at first try to attract deposits from
the public. Not until 1874 did the Deutsche Bank A.G.
begin to seek deposits through offices specially opened

92

for the purpose. This was done to provide cheap finance

for traders, the deposits being invested in mercantile bills
that were regarded as both safe and liquid. In pursuit of
deposits, the banks built up a widespread network of
branch offices, which were also used to establish and
maintain industrial contacts throughout the country. The
unification of Germany in 1871 removed the political
obstacles to a more integrated banking system, and the
selection of Berlin as the capital made that city the
country's financial centre. Four of the largest banks were
already established there; the new Reichsbank was set up
in 1876. In addition, the larger and more enterprising of
the provincial banks were attracted to the capital. The
Berlin stock exchange rapidly displaced that of Frankfurt
am Main as the country's leading securities market.
The Berlin banks extended their influence by
developing correspondent relationships and subsequently
by acquiring a financial interest in the provincial banks
and being represented on their boards. Each of the big
Berlin banks came to be associated with a group of
provincial banks more or less under its control. At the
same time, all of the banks, Berlin and provincial alike,
expanded their business by opening branches.
During World War I the degree of centralization
increased; by 1918 the big Berlin banks held more than
65 percent of total deposits. In the early 1920s there were
amalgamations, and branch systems became much larger.
Bank failures and the financial crisis of 1931 resulted in
further consolidation until the German banking system
was dominated by three giants. But there were
countervailing forces. Probably the most important of
these was the establishment of publicly owned banking

93

institutions, such as the communal savings banks and

their central institutions, the Girozentralen, which
became of increasing importance after World War II.
German savings banks, which were permitted to have
checks drawn on them from 1909 and which had giro
clearing from the 1920s, now offer a wide range of
services, especially to lower income groups and smaller
businesses. The large commercial banks have concerned
themselves more with big business and with wealthy
individuals. The savings banks now compete in
wholesale banking as well. A number of them, together
with their Girozentralen, are to all intents and purposes
"universal banks," like the Big Three and the larger
regional banks. The Big Three (the Deutsche Bank, the
Dresdner Bank, and the Commerzbank) remain
unchallenged only in stock exchange and foreign banking
business.
Of the private bankers, only about a half-dozen are of
any size. The bigger private banks are important in the
fields of investment and wholesale banking, while the
smaller ones flourish in the leading stock-exchange cities,
such as Dsseldorf and Frankfurt am Main. Many of
these private bankers, however, are not bankers in the
true sense; they subsist mainly on stock-exchange
transactions, investment services, portfolio management,
and insurance and mortgage brokerage. There are also
consumer finance institutions, mortgage and other
specialist banks, and a large number of cooperatives.
Regional and private banks are often within the sphere
of influence of the Big Three. In some cases the latter
have a financial interest in these banks, and in some cases
they own them. The Big Three also have shares in certain

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of the private mortgage banks. There are also

"cooperation agreements," and a number of mergers have
taken place. In these several ways, much more integration
exists than appears on the surface. While banking in
Germany remains a hybrid system, a trend toward
greater concentration is evident.
India.
Until the 1950s, banking in India was carried on by a
large number of banks, many of them quite small. India is
still primarily an agricultural country, with an economic
and social structure based largely on the village. The
integration of banking has been impeded by poor
communications, by illiteracy, and by the barriers of
language and caste. Banking and credit have remained
largely in the hands of the so-called indigenous banker
and the village moneylender. Although their influence
has been greatly reduced in recent years, they still remain
important in many an up-country area. The indigenous
banker, who is also a merchant, offers genuine banking
services: accepting deposits and remitting funds; making
loans quickly and with a minimum of formality; and, by
means of the hundi (a credit instrument in the form of a
bill of exchange), financing a still significant, if
declining, portion of India's internal trade and commerce.
Efforts were made to eliminate the moneylender by
developing a network of rural credit cooperatives. When
progress proved to be slow, a more successful alternative
was found in requiring banks to open "pioneer" branches
in rural areas. The first branches were those of the
semipublic Imperial Bank of India and its nationalized
successor, the State Bank of India (and its subsidiaries).

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Many smaller banks began to disappear, sometimes by

merger and sometimes as a result of failure. Between
1952 and 1967 the number of "reporting" banks fell from
517 to 90. Nationalized banks, including the State Bank
of India and its seven subsidiaries, the 14 large
commercial banks taken over in 1969, and the six
additional banks nationalized in 1980, accounted for
more than 90 percent of aggregate deposits in
commercial banks. Banking services are also provided by
chit funds, which accept and pay interest on monthly
deposits against which it is possible to draw only by way
of loan, and by Nidhis, mutual loan societies that have
developed into semibanking institutions but deal only
with their member shareholders.
The main path of banking development in India is the
expansion of bank branches into the under-banked areas.
The authorities have sought to expand the number of
branches but to avoid their concentration in the larger
towns and cities and, in particular, to provide the rural
areas with adequate facilities. The ultimate objective is to
encourage the mobilization of deposits on a massive scale
throughout the country, a formidable challenge in a
country of 575,000 villages, and a stepping up of lending
to weak sectors of the economy.
Japan.
Banking business in Japan is largely concentrated in
the hands of the big banks (some of which are
specialized), though a number of small banks still
survive. The principal classes of banks are city banks and
regional banks, but it should be noted that the distinction
has no legal basis, though they are separately supervised.

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Both belong to the Federation of Bankers' Associations

of Japan. The city banks service mainly manufacturing
industry and commerce, particularly the big firms, while
the regional banks are based on a prefecture, though
some extend their operations into neighbouring
prefectures, collecting deposits and lending to local
businesses and smaller firms. The regional banks have
city bank correspondents, not only to hold surplus
balances but also for assistance in investing their funds,
especially in the call-money market. In addition, a city
bank may introduce certain of its large customers to a
regional bank (e.g., a big company having a local
factory). City correspondents in Japan do not, however,
provide the wide range of ancillary services common in
the United States.
Since World War II there has been much stability in
Japanese banking, but the city banks have suffered a
relative decline in the importance of their business in
competition with other institutions, especially the
agricultural cooperatives, which attract the larger part of
the Treasury's payments owing to government purchases
of the rice crop. There has also been a relative increase in
the importance of the life insurance companies and the
trust funds, which have attracted sizable funds from the
general public.

Part 3
Insurance
Insurance is a method of coping with risk. Its
primary function is to substitute certainty for uncertainty
as regards the economic cost of loss-producing events.
Insurance may be defined more formally as a system
under which the insurer, for a consideration usually
agreed upon in advance, promises to reimburse the
insured or to render services to the insured in the event
that certain accidental occurrences result in losses during
a given period.
Insurance relies heavily on the "law of large
numbers." In large homogeneous populations 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 the group expands. From a
theoretical standpoint, it is possible to eliminate all pure
risk if an infinitely large group is selected.
From the standpoint of the insurer, an insurable risk
must meet the following requirements:
1. The objects to be insured must be numerous enough
and homogeneous enough to allow a reasonably close
calculation of the probable frequency and severity of
losses.
2. The insured objects must not be subject to
simultaneous destruction. For example, if all the
buildings insured by one insurer are in an area subject to

97

98

flood, and a flood occurs, the loss to the insurance

underwriter may be catastrophic.
3. The possible loss must be accidental in nature, and
beyond the control of the insured. If the insured could
cause the loss, the element of randomness and
predictability would be destroyed.
4. There must be some way to determine whether a loss
has occurred and how great that loss is. This is why
insurance contracts specify very definitely what events
must take place, what constitutes loss, and how it is to be
measured.
From the viewpoint of the insured person, an insurable
risk is one for which the probability of loss is not so high
as to require excessive premiums. What is "excessive"
depends on individual circumstances, including the
insured's attitude toward risk. At the same time, the
potential loss must be severe enough to cause financial
hardship if it is not insured against. Insurable risks
include losses to property resulting from fire, explosion,
windstorm, etc.; losses of life or health; and the legal
liability arising out of use of automobiles, occupancy of
buildings, employment, or manufacture. Uninsurable
risks include losses resulting from price changes and
competitive conditions in the market. Political risks such
as war or currency debasement are usually not insurable
by private parties but may be insurable by governmental
institutions. Very often contracts can be drawn in such a
way that an "uninsurable risk" can be turned into an
"insurable" one through restrictions on losses,
redefinitions of perils, or other methods.

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Part 3
Insurance
Insurance is a method of coping with risk. Its
primary function is to substitute certainty for uncertainty
as regards the economic cost of loss-producing events.
Insurance may be defined more formally as a system
under which the insurer, for a consideration usually
agreed upon in advance, promises to reimburse the
insured or to render services to the insured in the event
that certain accidental occurrences result in losses during
a given period.
Insurance relies heavily on the "law of large
numbers." In large homogeneous populations 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 the group expands. From a
theoretical standpoint, it is possible to eliminate all pure
risk if an infinitely large group is selected.
From the standpoint of the insurer, an insurable risk
must meet the following requirements:
1. The objects to be insured must be numerous enough
and homogeneous enough to allow a reasonably close
calculation of the probable frequency and severity of
losses.
2. The insured objects must not be subject to
simultaneous destruction. For example, if all the
buildings insured by one insurer are in an area subject to

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Kinds of insurance

flood, and a flood occurs, the loss to the insurance

underwriter may be catastrophic.
3. The possible loss must be accidental in nature, and
beyond the control of the insured. If the insured could
cause the loss, the element of randomness and
predictability would be destroyed.
4. There must be some way to determine whether a loss
has occurred and how great that loss is. This is why
insurance contracts specify very definitely what events
must take place, what constitutes loss, and how it is to be
measured.
From the viewpoint of the insured person, an insurable
risk is one for which the probability of loss is not so high
as to require excessive premiums. What is "excessive"
depends on individual circumstances, including the
insured's attitude toward risk. At the same time, the
potential loss must be severe enough to cause financial
hardship if it is not insured against. Insurable risks
include losses to property resulting from fire, explosion,
windstorm, etc.; losses of life or health; and the legal
liability arising out of use of automobiles, occupancy of
buildings, employment, or manufacture. Uninsurable
risks include losses resulting from price changes and
competitive conditions in the market. Political risks such
as war or currency debasement are usually not insurable
by private parties but may be insurable by governmental
institutions. Very often contracts can be drawn in such a
way that an "uninsurable risk" can be turned into an
"insurable" one through restrictions on losses,
redefinitions of perils, or other methods.

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PROPERTY INSURANCE
Two main types of contracts--homeowner's and
commercial--have been developed to insure against loss
from accidental destruction of property. These contracts
(or forms) typically are divided into three or four parts:
insuring agreements, identification of covered property,
conditions and stipulations, and exclusions.
Homeowner's insurance.
Homeowner's insurance covers individual, or
nonbusiness, property. Introduced in 1958, it gradually
replaced the older method of insuring individual property
under the "standard fire policy."
Perils insured.
In homeowner's policies, of which there are several
types, coverage can be "all risk" or "named peril." Allrisk policies offer insurance on any peril except those
later excluded in the policy. The advantage of these
contracts is that if property is destroyed by a peril not
specifically excluded the insurance is good. In namedperil policies, no coverage is provided unless the
property is damaged by a peril specifically listed in the
contract.
In addition to protection against the loss from
destruction of an owner's property by perils such as fire,
lightning, theft, explosion, and windstorm, homeowner's
policies typically insure against other types of risks faced

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by a homeowner such as legal liability to others for

injuries, medical payments to others, and additional
expenses incurred when the insured owner is required to
vacate the premises after an insured peril occurs. Thus
the homeowner's policy is multi-peril in nature, covering
a wide variety of risks formerly written under separate
contracts.
Property covered.
Homeowner's forms are written to cover damage to or
loss of not only an owner's dwelling but also structures
(such as garages and fences), trees and shrubs, personal
property (excluding certain listed items), property away
from the premises (such as boats), money and securities
(subject to dollar limits), and losses due to forgery. They
also cover removal of debris following a loss,
expenditures to protect property from further loss, and
loss of property removed from the premises for safety
once an insured peril has occurred.
Limitations on amount recoverable.
Recovery under homeowner's forms is limited to loss
due directly to the occurrence of an insured peril. Losses
caused by some intervening source not insured by the
policy are not covered. For example, if a flood or a
landslide, which usually are excluded perils, severely
damages a house that subsequently is destroyed by fire,
the homeowner's recovery from the fire is limited to the
value of the house already damaged by the flood or
landslide.

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Recovery under homeowner's forms may be on the

basis of either full replacement cost or actual cash value
(ACV). Under the former, the owner suffers no reduction
in loss recovery due to depreciation of the property from
its original value. This basis applies if the owner took out
coverage that is at least equal to a named percentage--for
example, 80 percent--of the replacement value of the
property.
If the insurance amount is less than 80 percent, a
coinsurance clause is triggered, the operation of which
reduces the recovery amount to the value of the loss
times the ratio of the amount of insurance actually carried
to the amount equal to 80 percent of the value of the
property. However, the reduced recovery will not be less
than the "actual cash value" of the property, defined as
the full replacement cost minus an allowance for
depreciation, up to the amount of the policy. For
example, assume that a property is valued at $100,000
new, has depreciated 20 percent in value, insurance of
$60,000 is taken, and a $10,000 loss occurs. The actual
cash value of the loss is $8,000 ($10,000 minus 20
percent depreciation). The operation of the coinsurance
clause would limit recovery to 6/8 of the loss, or $7,500.
However, since the actual cash value of the loss is
$8,000, this is the amount of the recovery.
Recovery under homeowner's forms is also limited if
more than one policy applies to the loss. For example, if
two policies with equal limits are taken out, each
contributes one-half of any insured loss. Loss payments
also are limited to the amount of an insured person's
insurable interest. Thus, if a homeowner has only a onehalf interest in a building, the recovery is limited to one-

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Conditions.

half of the insured loss. The co-owners would need to

have arranged insurance for their interest.

Excluded perils.
Among the excluded perils (or exclusions) of
homeowner's policies are the following: loss due to
freezing when the dwelling is vacant or unoccupied,
unless stated precautions are taken; loss from weight of
ice or snow to property such as fences, swimming pools,
docks, or retaining walls; theft loss when the building is
under construction; vandalism loss when the dwelling is
vacant beyond 30 days; damage from gradual water
leakage; termite damage; loss from rust, mold, dry rot,
contamination, smog, and settling and cracking; loss
from animals or insects; loss from earth movement,
flood, war, or spoilage (e.g., chemical deterioration); loss
from neglect of the insured to protect the property
following a loss; and losses arising out of business
pursuits. Special forms for business risks are available.
Under named-peril forms, only losses from the perils
named in the policy are covered. The named perils are
sometimes defined narrowly; for example, theft claims
are not paid if the property is merely lost and theft cannot
be established.
Earthquake and flood loss, while excluded from the
basic homeowner's forms, may usually be covered by
endorsement.

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Homeowner's policies may include the following

conditions: (1) Owners are required to give immediate
written notice of loss to the insurer or the insurer's agent.
(2) The insured must provide proof of the amount of loss.
This suggests that owners should keep accurate records
of the items in a building and of their original cost. (3)
The insured must cooperate with the insurer in settling a
loss. (4) The insured must pay the premium in advance.
(5) The insurer has a right of subrogation (i.e., of
pursuing liable third parties for any loss). This prevents
an owner from collecting twice, once from the insurer
and once from a liable third party. (6) A mortgagee's
interest in a property can be protected. (7) The policy
may be canceled by the insurer upon due notice, usually
10 days. If the insurer cancels, a pro rata refund of
premium must be returned to the insured; if the insured
cancels, a less-than-proportionate return of a premium
may be recovered from the insurer. (8) Fraud by the
insured, including misrepresentation or concealment of
material facts concerning the risk, is ground for denial of
benefits by the insurer.
Also available is a form called renter's insurance,
which provides personal property insurance for tenants.
Business property insurance.
Insurance for business property follows a pattern that
is similar in many ways to the one for individual
property. A commonly used form is the "building and
personal property coverage form" (BPP). This form

106

permits a business owner to cover in one policy the

buildings, fixtures, machinery and equipment, and
personal property used in business and the personal
property of others for which the business owner is
responsible. Coverage also can be extended to insure
newly acquired property, property on newly acquired
premises, valuable papers and records, property
temporarily off the business premises, and outdoor
property such as fences, signs, and antennas.
Direct losses.
Coverage on the BPP form can be written on a
scheduled basis, whereby specific items of property are
listed and insured, or on a blanket basis, whereby
property at several locations can be insured for a single
sum.
Perils insured under the BPP are listed in the policy.
All-risk coverage is also written, subject to specified
exclusions.
Losses may be settled on a replacement-cost coverage
on the BPP by endorsement. Otherwise recovery is on an
actual cash value basis that makes an adjustment for
depreciation.
Coverage for business personal property with
constantly changing values is available on a reporting
form. The business owner reports values monthly to the
insurer and pays premiums based on the values reported.
In this way, only the insurance actually needed is
purchased.

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Indirect losses.
An entirely different branch of the insurance business
has been developed to insure losses that are indirectly the
result of one of the specified perils. A prominent example
of this type of insurance is business income insurance.
The insurer undertakes to reimburse the insured for lost
profits or for fixed charges incurred as a result of direct
damage. For example, a retail store might have a fire and
be completely shut down for one month and partially shut
down for another month. If the fire had not occurred,
sales would have been much higher, and therefore
substantial revenues have been lost. In addition, fixed
costs such as salaries, taxes, and maintenance must
continue to be paid. A business income policy would
respond to these losses.
Forms of indirect insurance include the following: (1)
contingent business income insurance, designed to cover
the consequential losses if the plant of a supplier or a
major customer is destroyed, resulting in either reduced
orders or reduced deliveries that force a shutdown of the
insured firm, (2) extra expense insurance, which pays the
additional cost occasioned by having extra expenses to
pay, such as rent on substitute facilities after a disaster,
and (3) rent and rental value insurance, covering losses in
rents that the owner of an apartment house may incur if
the building is destroyed. Rental income insurance pays
for rent lost when a peril destroys an owner's property
that has been rented to others.

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MARINE INSURANCE
Marine insurance is actually transportation
insurance. After insurance coverage on ocean voyages
had been developed, it was a natural step to offer
insurance on inland trips. This branch of insurance
became known as inland marine. In many policy forms,
the distinction between inland and ocean marine has
disappeared; it is common to cover goods from the time
they leave the warehouse of the shipper, even if this
warehouse is situated at a substantial distance from the
nearest seaport, until they reach the warehouse of the
buyer, which likewise may be located far inland.
Ocean marine insurance.
Ocean marine contracts are written to cover four major
types of property interest: (1) the vessel or hull, (2) the
cargo, (3) the freight revenue to be received by the ship
owner, and (4) legal liability for negligence of the shipper
or the carrier. Hull insurance covers losses to the vessel
itself from specified perils. Usually there is a provision
that the marine hull should be covered only within
specified geographic limits. Cargo insurance is usually
written on an open contract basis under which shipments,
both incoming and outgoing, are automatically covered
for the interests of the shipper, who reports periodically
the values exposed and pays a premium based upon these
values. By means of a negotiable open cargo certificate,
which is attached to the bill of lading, insurance coverage
is automatically transferred to whoever has legal title to
the goods in the course of their movement from seller to

109

buyer.
Freight revenue may be insured in several different
ways. If there is an obligation by the shipper to pay the
carrier's freight bill regardless of whether the goods are
delivered, the value of the freight is declared a part of the
value of the cargo and is insured as part of this value. If
the freight revenue is contingent upon safe delivery of the
goods, the carrier insures the freight as a part of the
regular hull coverage.
Major clauses or provisions that are fairly
standardized are (1) the perils clause, (2) the "running
down" clause, or RDC, (3) the "free of particular
average," or FPA, clause, (4) the general average clause,
(5) the sue and labour clause, (6) the abandonment
clause, (7) coinsurance, and (8) express and implied
warranties. Each of these will be discussed in turn.
Perils clause.
Until 1978 the main insuring clause of modern ocean
marine policies was preserved almost unchanged from
the original 1779 Lloyd's of London form. The clause is
as follows:
Touching the adventures and perils which
we the assurers are contented to bear and
do take upon us in this voyage: they are of
the seas, men-of-war, fire, enemies,
pirates, rovers, thieves, jettisons, letters of
mart and countermart, surprisals, takings
at sea, arrests, restraints, and detainments
of all kings, princes, and people, of what
nation, condition, or quality soever,

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(Collision loss to the vessel itself is part of the hull

coverage.) The RDC clause covers negligence of the
carrier or shipper that results in damage to the property of
others. A companion clause, the protection and indemnity
clause (P and I), covers the carrier or shipper for
negligence that causes bodily injury to others.

barratry of the master and mariners, and

of all other perils, losses, and misfortunes,
that have or shall come to the hurt,
detriment, or damage of the said goods
and merchandises, and ship, etc., or any
part thereof.
Although the clause reads as if it were an all-risk
agreement, courts have interpreted it to cover only the
perils mentioned. Essentially, the clause insures the
voyage from perils "of" the sea. Perils on the sea, such as
fire, are not covered unless specifically mentioned.
Furthermore, although the perils clause indicates
coverage from "enemies, pirates, rovers, thieves," the
policy does not cover losses from war. (War risk
insurance is offered in some nations through
governmental agencies.)
In 1978, at the request of the UN Conference on Trade
and Development, the 1779 language was modernized
and a revised insuring clause was proposed. The new
form restricts coverage on losses from poor packing,
places the burden of proof of seaworthiness on the
shipper rather than on the carrier, and excludes losses
resulting from insolvency of the common carrier, with
the burden of proof placed on the shipper that the carrier
is financially sound. The revised form has not been
adopted by all insurers.
RDC clause.
The RDC, or "running down" clause, provides
coverage for legal liability of either the shipper or the
common carrier for claims arising out of collisions.

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FPA clause.
The FPA, or "free of particular average," clause
excludes from coverage partial losses to the cargo or to
the hull except those resulting from stranding, sinking,
burning, or collision. Under its provisions, losses below a
given percentage of value, say 10 percent, are excluded.
In this way the insurer does not pay for relatively small
losses to cargo. The percentage deductible varies
according to the type of cargo and its susceptibility to
loss.
General average clause.
The general average clause in ocean marine insurance
obligates the insurers of various interests to share the cost
of losses incurred voluntarily to save the voyage from
complete destruction. Such sacrifices must be made
voluntarily, must be necessary, and must be successful.
For example, if a shipper's cargo is voluntarily jettisoned
in a storm in order to save the vessel from total loss, the
general average clause requires the insurers of the hull
and of all other cargo interests to make a contribution to
the loss of the shipper whose goods were sacrificed.
Other types of losses may also be covered. It has been

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held, for example, that losses suffered from efforts to put

out a fire on shipboard, which result in damage to
specific goods, can be included in a general average
claim. Similarly, losses from salvage efforts to free a
stranded vessel may qualify under a general average
claim to which all interests must contribute.
Sue and labour clause.
The sue and labour clause requires the ship owner to
make every attempt to reduce or save the exposed
interests from loss. Under the terms of the clause, the
insurer pays for any necessary costs incurred in carrying
out the requirements of the sue and labour clause. Thus,
if a ship is stranded, under the sue and labour clause the
hull owner would be required to hire salvors to attempt to
save the ship. Such expenses are paid even if the salvage
attempts fail.
Abandonment clause.
If salvaging or rehabilitating a ship or cargo following
a marine loss costs more than the goods are worth, the
loss is said to be constructively total. Under such
conditions, the ocean marine policy permits the insured
to abandon the damaged ship or cargo to the insurer and
make a claim for the entire value. In this case, the salvage
belongs to the insurer, who may dispose of it in any way.
Abandonment is not permitted in other forms of property
insurance.

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Coinsurance.
Although there is no coinsurance clause as such in the
ocean marine policy, losses are settled as though a 100
percent coinsurance clause existed. Thus, if an insured
takes out coverage equal to 50 percent of the true
replacement cost of the goods, only 50 percent of any
partial loss may be recovered.
Warranties.
In the field of ocean marine insurance there are two
general types of warranties that must be considered:
express and implied. Express warranties are promises
written into the contract. There are also three implied
warranties, which do not appear in written form but bind
the parties nevertheless.
Examples of expressed warranties are the FC&S
warranty and the strike, riot, and civil commotion
warranty. The FC&S, or "free of capture and seizure,"
warranty excludes war as a cause of loss. The strike,
riot, and civil commotion warranty states that the insurer
will pay no losses resulting from strikes, walkouts, riots,
or other labour disturbances. The three implied
warranties relate to the following conditions:
seaworthiness, deviation, and legality. Under the first, the
shipper and the common carrier warrant that the ship will
be seaworthy when it leaves port, in the sense that the
hull will be sound, the captain and crew will be qualified,

114

and supplies and other necessary equipment for the

voyage will be on hand. Any losses stemming from lack
of seaworthiness will be excluded from coverage. Under
the deviation warranty, the ship may not deviate from its
intended course except to save lives. Clauses may be
attached to the ocean marine policy to eliminate the
implied warranties of seaworthiness or deviation. The
implied warranty of legality, however, may not be
waived. Under this warranty, if the voyage itself is illegal
under the laws of the country under whose flag the ship
sails, the insurance is void.
Inland marine insurance.

Although there are no standard forms in inland marine

insurance, most contracts follow a typical pattern. They
are usually written on a named-peril basis covering such
perils of transportation as collision, derailment, rising
water, tornado, fire, lightning, and windstorm. The
policies generally exclude losses resulting from pilferage,
strike, riot, civil commotion, war, delay of shipments,
loss of markets, illegal trade, or leakage and breakage.
The scope of inland marine is greatly extended by
means of "floater" policies. These are used to insure
certain types of movable property whether or not the
property is actually in transit. Business floater policies
are purchased by jewelers, launderers, dry cleaners,
tailors, upholsterers, and other persons who hold the
property of others while performing services. Personal
property floaters are used to cover, on a comprehensive

115

basis, any item of personal property owned by a private

individual. They may also cover the property of visitors,
or the property of servants while on the premises of the
insured. They exclude certain types of property for which
other contracts have been designed, such as automobiles,
aircraft, motorcycles, animals, or business and
professional equipment.
LIABILITY INSURANCE
Liability insurance arises mainly from the operation
of the law of negligence. Individuals who, in the eyes of
the law, fail to act reasonably or to exercise due care may
find themselves subject to large liability claims. Court
judgments have been issued for sums so large as to
require a lifetime to pay.
There are at least four major types of liability
insurance contracts: (1) liability arising out of the use of
automobiles, (2) liability arising out of the conduct of a
business, (3) liability arising from professional
negligence (applicable to doctors, lawyers, etc.), and (4)
personal liability, including the liability of a private
individual operating a home, carrying on sporting
activities, and so on.
Practically all liability contracts falling in these four
categories have some common elements. One is the
insuring clause, in which the insurer agrees to pay on
behalf of the insured all sums that the insured shall
become legally obligated to pay as damages because of
bodily injury, sickness or disease, wrongful death, or
injury to another person's property. The liability policy
covers only claims that an insured becomes legally

116

obligated to pay; voluntary payments are not covered. It

is often necessary to resort to legal or court action to
determine the amount of these damages, although in a
vast majority of cases the damages are settled out of court
by negotiation between the parties.
All liability insurance contracts contain clauses that
obligate the insurer to conduct a court defense and to pay
any settlement, including premiums on bonds, interest on
judgments pending appeal, medical and surgical expenses
that are necessary at the time of the accident, and other
costs. Liability insurance has sometimes been termed
defense insurance because of this provision. The insurer
agrees to defend a suit even though it is false or
fraudulent, so long as it is a suit stemming from a peril
insured against. The insured is required to cooperate with
the insurer in all court actions by appearing in court, if
necessary, to give testimony.
Limits of liability.
Practically all liability insurance policies contain
limitations on the maximum amount of a judgment
payable under the contract. Further, the cost of defense,
supplementary payments, and punitive damages may or
may not be paid in addition to the judgment limits.
Separate limits often apply to claims for property damage
and bodily injury. An annual aggregate limit may also be
purchased, which puts a maximum on the amount an
insurer must pay in any one policy period.
Limits may apply on a per-occurrence or a claimsmade basis. In the former, which gives the most
comprehensive coverage, the policy in force in year one
covers a negligent act that took place in year one, no
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matter when a claim is made. If the policy is made on a

claims-made basis, the insurance in force when a claim is
presented pays the loss. Under this policy, a claim can be
made for losses that occur during the policy period but
have their origins in events preceding its starting date; the
period of time before this date for which claims can be
made is, however, restricted. For an additional premium
the discovery period can be extended beyond the end of
the policy period. The claims-made basis for liability
insurance is considered much more restrictive than a peroccurrence policy.
Liability insurance contracts have in common the fact
that the definition of "the insured" is broad. An
automobile liability policy, for example, includes not
only the owner but anyone else operating the car with
permission. In business liability insurance, all partners,
officers, directors, or proprietors are covered by the
policy regardless of their direct responsibility for any act
of negligence. Other parties may be included for an extra
premium.
Another element common to all liability insurance
policies is certain exclusions. Policies covering business
activities almost invariably exclude liability arising out of
the personal activities of the insured. Each kind of
liability contract tends to exclude the liability for which
another contract has been devised: a personal liability
coverage in the homeowner's contract, for example,
excludes automobile liability because a special contract
has been created for this particular type of liability.
Another common element in liability policies is
subrogation: the insurer retains the right to bring an

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action against a liable third party for any loss this third
party has caused.
Business liability insurance.
Business liability contracts commonly written include
the following: liability of a building owner, landlord, or
tenant; liability of an employer for acts of negligence
involving employees; liability of contractors or
manufacturers; liability to members of the public
resulting from faulty products or services; liability as a
result of contractual agreements under which liability of
others is assumed; and comprehensive liability. The latter
contract is designed to be broad enough to encompass
almost any type of business liability, including
automobiles. There has been increasing use of coverage
for liability stemming from defective products, because
some
court
judgments
have
awarded
huge
compensations.
Business liability contracts may be written to cover
loss even if the act that produced the claim was not
accidental. The only requirement is that the result of the
act be accidental or unintended. Thus if a contractor is
making an excavation that produces large amounts of
dust and this dust causes loss to neighbouring property,
the contractor's liability policy would respond to claims
for loss, even though the act that produced the dust was a
deliberate act.
Professional liability insurance.
Known as malpractice, or errors-and-omissions,
insurance, professional liability contracts are
distinguished from general business liability policies
because of the specialized nature of the liability.
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Professional persons requiring liability contracts include

physicians and surgeons, lawyers, accountants,
engineers, and insurance agents. Important differences
between professional and other liability contracts are the
following:
1. No distinction is made between bodily injury or
property damage liability, and there is no limit on the
number of claims per accident but rather a limit of
liability per claim. This recognizes the fact that one
negligent act on the part of a professional person may
involve more than one party, each of whom could bring a
legal action against the professional person. Thus a
doctor might administer the wrong medicine to a number
of patients, each of whom could bring a legal action.
2. Claims against a professional person may have an
adverse effect upon his or her reputation. The policy
therefore permits the insured to carry any action to court,
since an out-of-court settlement might conceivably imply
guilt in the eyes of the professional's public or clientele.
3. In professional liability insurance there is an exclusion
for any agreement guaranteeing the result of any
treatment. Suits stemming from clients' dissatisfaction
with the service performed are thus not covered.
Personal liability insurance.
The most common form of personal liability insurance
is issued as part of the homeowner's liability insurance
policy. It is an all-risk agreement and contains relatively
few exclusions. The policy covers any act of negligence
of the insured or residents of the home that results in

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legal liability. It may also include medical payments

insurance covering accidental injury to guests and other
nonresidents without regard to the question of
negligence.
Automobile insurance.

Nearly half of all property-liability insurance written

in the United States is in the area of automobile
insurance. Set up as a comprehensive contract in most
parts of the world, automobile insurance covers liability,
collision loss of the vehicle, all other types of loss (called
comprehensive loss), and medical expenses incurred by
the driver, passengers, and other persons. Coverage
usually applies to anyone driving the car with permission
of the owner. Thus, drivers are insured whether driving
their own or someone else's car.
Automobile liability coverage is mandated by law in
many countries up to specified monetary limits. The
policy states what happens if the driver is covered by
other automobile policies that may cover the loss. It also
covers the liability of persons, such as parents, who have
legal responsibility for actions of the driver. Coverage
includes legal defense costs, usually in addition to the
policy liability limits. Many policies exclude coverage
for the time the automobile is driven in a foreign country.
Theft insurance.
Theft generally covers all acts of stealing. There are
three major types of insurance contracts for burglary,
robbery, and other theft. Burglary is defined to mean the
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unlawful taking of property within premises that have

been closed and in which there are visible marks
evidencing forcible entry. Such narrow definition is
necessary to restrict burglary coverage to a particular
class of criminal act. Robbery is defined as that type of
unlawful taking of property in which another person is
threatened by either force or violence. In the robbery
peril, therefore, the element of personal contact is
necessary.
Perhaps the most common of all burglary coverages is
on safes. Often the loss in the form of damage to the safe
itself from the use of explosives and other devices is as
great as the loss of the money, jewelry, or securities it
contains. Accordingly, the policy covers both types of
claims. Another common burglary policy applies to
mercantile open stock. In this type of policy, there is
usually a limit applicable on any article of jewelry or any
article contained in a showcase where susceptibility to
loss is high. In order to prevent underinsurance, the
mercantile open stock policy is usually written with a
coinsurance requirement or with some minimum amount
of coverage.
Another common theft policy for business firms is a
comprehensive crime contract covering employee
dishonesty as well as losses on money and securities both
inside and outside the premises, loss from counterfeit
money or money orders, and loss from forgery. This
policy is designed to cover in one package most of the
crime perils to which an average business is subject.
A broad form of crime protection for individuals is
offered both as a separate contract and as part of a

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"homeowner's policy." It covers all losses of personal

property from theft and mysterious disappearance.
Aviation insurance.
Aviation insurance normally covers physical damage
to the aircraft and legal liability arising out of its
ownership and operation. Specific policies are also
available to cover the legal liability of airport owners
arising out of the operation of hangars or from the sale of
various aviation products. These latter policies are similar
to other types of liability contracts.
Perhaps the major underwriting problem is the
"catastrophic" exposure to loss. The largest passenger
aircraft may incur losses of $300,000,000 or more,
counting both liability and physical damage exposures.
The number of aircraft of any particular type is not large
enough for the accurate prediction of losses, and each
type of aircraft has its special characteristics and
equipment. Thus a great deal of independent individual
underwriting is necessary. Rate making is complex and
specialized. It is further complicated by rapid
technological change and by the constant appearance of
new hazards.
Policies are written to cover liability of the owner or
operator for bodily injury to passengers or to persons
other than passengers and for property damage. Medical
costs, including loss of income, are usually paid to
passengers suffering permanent total disability without
the requirement of proving negligence. This type of
coverage has been called admitted liability insurance.

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Workers' compensation insurance.

Workers' compensation insurance, sometimes called

industrial injury insurance, compensates workers for
losses suffered as a result of work-related injuries.
Payments are made regardless of negligence. The
schedule of benefits making up the compensation is
determined by statute.
The scope of employment injury laws, originally
limited to persons in forms of employment recognized as
hazardous, has, as the result of associating the right to
compensation with the existence of a contract of service,
been gradually extended to clerical employment.
Nevertheless, the large exception of agricultural
employees continues in some Third World countries,
Canada, much of the United States, and the countries of
eastern Europe. Other classes of exception are employees
in very small undertakings and domestic servants. The
exclusion of employees with middle-class salaries
persists in parts of the former British Empire. In a few
countries, working employers are permitted to insure
themselves as well as their employees.
The notion of employment injury was at first confined
to injuries of accidental origin, but during the 20th
century it was extended to include occupational diseases
in increasing number. To entitle the worker to benefit, the
accident must occur during employment, and many laws
also require the accident to have been caused by the
employment in some way; however, the trend seems to
be toward accepting the former condition as sufficient.
Following the German law of 1925, some 30 countries

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included accidents occurring on the way to and from

work. Injuries due to the employee's willful misconduct
are generally excluded. Occupational diseases are
covered to some extent by virtually all national laws.
Classes of benefits.
Four classes of benefits are provided by compulsory
insurance, and, except for certain diseases, a right to them
is acquired without any qualifying period of previous
employment. First is a medical benefit, which includes
all necessary treatment and the supply of artificial limbs.
If its duration is limited, the maximum is likely to be one
year. Second is a temporary incapacity benefit, which
lasts as long as the medical benefit except that a waiting
period of a few days is frequently prescribed. The benefit
varies from country to country, ranging from 50 percent
of the employee's wage to 100 percent; the most common
benefits are 66 2/3 percent and 75 percent. Third is a
permanent incapacity benefit, which, unless the degree is
very small, in which case a lump sum is paid, takes the
form of a pension. If the incapacity is total, the pension
is usually equal to the temporary incapacity benefit. If the
incapacity is partial, the pension is proportionately
smaller. In some 60 countries an additional pension is
granted if the victim needs constant attendance. In cases
of death, the pensions are distributed to the widow (or
invalid widower) and minor children, and, if the
maximum total has not then been attained, other
dependents may receive small pensions. The maximum is
the same as for total incapacity.

125

In a growing number of industrialized countries

(Austria, France, Germany, Ireland, Israel, The
Netherlands, and Switzerland) the fourth type of benefit-systematic arrangements for retraining and rehabilitation
of seriously injured persons--is provided, and employers
may even be required to provide employment to such
persons.

Financing and administering employment

injury insurance.
Almost all systems of employment injury insurance
are financed by employers' contributions exclusively, and
in almost all these systems the contribution is
proportional to the risk represented by the class of
activity in which the employer is engaged. Usually the
insurance institution adapts the contribution to the
accident experience of the undertaking individually or to
any special preventive measures it may have taken. On
the other hand, mainly for simplicity, but partly perhaps
in order to subsidize basic but dangerous industries, a
uniform contribution rate for all classes of activity has
been established in several countries.
Social insurance against employment injury, as against
other risks, is in most countries administered by
institutions under the joint management of employers and
employees and often of government representatives as
well; in eastern Europe, however, the administration is
entrusted to trade unions. Disputes are settled by arbitral
organs without resort to the courts.

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In the United States an employer may comply with the

provisions of most workers' compensation laws in three
ways: by purchasing a private workers' compensation and
employer liability policy from a commercial insurer, by
purchasing coverage through a state fund set up for this
purpose, or by setting aside reserves sufficient to cover
the risks involved. Most workers' compensation benefits
are financed by the first two methods.
State laws in the United States are not uniform with
respect to the amount of the monetary compensation or
length of time for which income payments are made. For
example, only about half the states give lifetime income
benefits for occupational injuries. In others there is a
statutory limitation of between 400 and 500 weeks of
payments. Again, most states provide liquidating
damages for an injury that is permanent but does not
totally incapacitate the worker, such as the loss of an arm
or leg. The size of these liquidating damages varies
greatly. Most state laws also provide complete medical
benefits, including rehabilitation expenses, and survivors'
benefits in the event of the worker's death.
Costs.
Following the publication in the early 1970s of about
40 studies revealing inadequacies in workers'
compensation in the United States, most states passed
laws increasing the number of workers covered, raising
weekly benefits to equal or exceed 66 2/3 percent of the
average weekly wage, and making other improvements.
Compensable claims now include those involving back
pain, stress, and heart conditions traceable to
employment conditions. Many claims also involve court

127

litigation, which greatly magnifies settlement costs. For

employers, these and other factors have increased the
average cost of benefits from less than 1 percent of wages
before 1960 to 2.3 percent in 1992.
Credit insurance.
The use of credit in modern societies is so various and
widespread that many types of insurance have grown up
to cover some of the risks involved. Examples of these
risks are the risk of bad debts from insolvency, death, and
disability; the risk of loss of savings from bank failure;
the risk attaching to home-loan debts when installments
are not paid for various reasons, resulting in foreclosure
with subsequent loss to the creditor; and the risk of loss
from export credit because of war, currency restrictions,
cancellation of import licenses, or other political causes.
Merchandise credit insurance.
Credit insurance for domestic buyers and sellers is
available in the United States, Canada, Mexico, and most
European countries. It is sold only to manufacturers,
wholesalers, and certain service agencies, not to retailers.
The insurance is designed to enable the seller to recover a
certain percentage of losses from insolvency of the
debtor, but the contracts list a number of conditions under
which the creditor may initiate a claim regardless of the
question of insolvency. The policy is designed primarily
to meet the needs of those sellers whose business is
concentrated on a few buyers, insolvency of any one of
which would seriously jeopardize the financial stability
of the seller.
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because of defective title or from costs incurred to cure

defects of the title.

Export credit insurance.

A special form of credit insurance is available to
exporters against losses from both commercial and
political risks. In the United States, for example, export
credit insurance is written through a consortium of
insurance companies organized by the Foreign Credit
Insurance Association (FCIA). The Export-Import
Bank of the United States assumes the ultimate liability
for loss, while the FCIA serves as the underwriting
agency. Coverage is usually limited to 90 or 95 percent
of the account. Prior approval from the FCIA is usually
required before export credit insurance is granted. In
some cases, the exporter is required to purchase coverage
on all credit sales in a given country as a device to reduce
adverse selection.
Export credit insurance is used more widely in some
countries than in others. In the United Kingdom
approximately one-quarter of all export sales are covered,
compared with about 6 percent in the United States.
Export sales are not eligible for insurance if they are
made for cash or financed directly or indirectly through
government-guaranteed loans.
Title insurance.
Title insurance is a contract guaranteeing the
purchaser of real estate against loss from undiscovered
defects in the title to property that has been purchased.
Such loss may stem from unmarketability of the property

129

The need for title insurance arises from the fact that real
estate transactions are complex and technical. Any legal
error, no matter how detailed or minute, may cause a
defect in the title that impairs its marketability. Examples
of such defects are forgeries, invalid or undiscovered
wills, defective probate proceedings, or transfers of
property by persons lacking full legal capacity to
contract.
Miscellaneous insurance.
Special casualty forms are issued to cover the hazards
of sudden explosions from equipment such as steam
boilers, compressors, electric motors, flywheels, air
tanks, furnaces, and engines. Boiler and machinery
insurance has several distinctive features. A substantial
portion of the premium collected is used for inspection
services rather than loss protection. Second, the boiler
policy provides that its coverage will be in excess of any
other applicable insurance. In this sense, it may be looked
upon as an "umbrella policy" to fill in gaps in the
insured's program. Third, the policy lists the specific
losses that will be paid, such as the loss of the boiler or
machinery itself due to accident, expediting expenses,
property damage liability, bodily injury liability, defense
settlement and supplementary payments, business
interruption, outage (interruption of service), power
interruption, consequential loss due to spoilage of goods,
and furnace explosion. The policy will satisfy each of
these claims in the order in which they appear, up to the
limit of the coverage.
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The extensive use of plate glass in modern

architecture has produced a special comprehensive
insurance that covers not only plate glass but glass signs,
motion-picture screens, halftone screens and lenses, glass
bricks, glass doors, and so forth. It may be written to
cover loss from any source except fire or nuclear
radiation.
Increasing international business activity has caused
greater use of policies generally termed difference-inconditions insurance (DIC). The DIC policy insures
property and liability losses not covered by basic
insurance contracts. It can be written to insure almost any
peril, including earthquake and flood, subject to
deductibles and stated exclusions. It is often written on an
all-risk basis. An international business firm may use the
DIC to secure uniform coverage for all countries in
which it operates and to obtain higher policy limits than
those available from domestic insurers in the various
foreign countries.
SURETYSHIP
Surety contracts are designed to protect businesses
against the possible dishonesty of their employees. Surety
and fidelity bonds fill the gap left by theft insurance,
which always excludes losses from persons in a position
of trust. A bond involves three contracting parties instead
of two. The three parties are the principal, who is the
person bonded; the obligee, the person who is protected;
and the surety, the person or corporation agreeing to
reimburse the obligee for any losses stemming from
failures or dishonesty of the principal. The bond covers

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events within the control of the person bonded, whereas

insurance in the strict sense covers loss from random
events generally outside the direct control of the insured.
In bonding, the surety always has the right to try to
collect its losses from the person bonded, whereas in
insurance the insurer may not attempt to recover losses
from the insured. Of course, under property and liability
policies the insurer may attempt to recover from liable
third parties under the right of subrogation, but
subrogation rights are often not possible to enforce in
practice. Bonds are not usually cancelable by the insurer,
whereas most insurance contracts, except life, are
cancelable by the insurer upon due notice.
Fidelity bonds are written to cover the obligee, usually
an employer, against loss from dishonest acts of
employees; surety bonds cover not only dishonesty but
also incapacity to perform the work agreed upon. Surety
bonds are normally written on principals who are acting
in an independent or semi-independent capacity, such as
building contractors or public officials, whereas fidelity
bonds are written on employees acting under the
guidance and supervision of their employer. Finally,
surety bonds are often issued with the requirement of
collateral, whereas fidelity bonds are not. The surety
bond is an instrument through which the superior credit
of the surety is substituted for the uncertain credit of the
principal; hence, if the surety is asked to bond a principal
of somewhat doubtful credit, the requirement of cash
collateral is frequently imposed.

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Major types of fidelity bonds.

Major types of surety bonds.

Fidelity bonds differ according to whether specific

persons are named as principals or whether all employees
or persons are covered as a group. The latter are most
frequently used by employers with a large number of
employees, because they offer automatic coverage on
given classes of workers, including new employees, and
greater ease of administration, including simpler claims
procedures. Fidelity bonds are usually written on a
continuous basis--that is, they are effective until canceled
and have no expiration date. The penalty of the bond (the
maximum amount payable for any one loss) is unchanged
from year to year and is not cumulative. The bonds
specify a discovery period (usually two years) limiting
the time for discovering losses after a bond is
discontinued. When a new bond is put into effect, it can
be written to cover losses that have occurred but are
undiscovered before the effective issue date of the bond.
A salvage clause also is included, stating the way in
which any salvage recovered by the surety from the
principal is to be divided between the surety and the
obligee. This clause is significant, because the obligee
may have losses in excess of the penalty of the bond.
Some salvage clauses require that any salvage be paid to
the obligee up to the full amount of all losses, and others
provide that any salvage be divided between the surety
and the obligee on a pro rata basis, in the proportion that
each party has suffered loss.

133

There are various classes of surety bonds. Contract

construction bonds are written to guarantee the
performance of contractors on building projects. Bonds
are particularly important in this field because of the
general practice of awarding commercial building
contracts to the lowest bidder, who may promise more
than can actually be performed. The surety who is
experienced in this field is in a position to make sounder
judgment about the liability of the various bidders than
anyone else and backs up its judgment with a financial
guarantee.
Court bonds include several different types of surety
bonds. Fiduciary bonds are required for court-appointed
officials entrusted with managing the property of others;
executors of estates and receivers in bankruptcy are
frequently required to post fiduciary bonds.
Other types of surety bonds include official bonds, lost
instrument bonds, and license and permit bonds. Public
official bonds guarantee that public officials will
faithfully and honestly discharge their obligations to the
state or to other public agencies. Lost instrument bonds
guarantee that if a lost stock certificate, money order,
warehouse receipt, or other financial instrument falls into
unauthorized hands and causes a loss to the issuer of a
substitute instrument, this loss will be reimbursed.
License and permit bonds are issued on persons such as
owners of small businesses to guarantee reimbursement
for violations of the licenses or permits under which they
operate.

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LIFE AND HEALTH INSURANCE

Life insurance.
Life insurance may be defined as a plan under which
large groups of individuals can equalize the burden of
loss from death by distributing funds to the beneficiaries
of those who die. From the individual standpoint life
insurance is a means by which an estate may be created
immediately for one's heirs and dependents. It has
achieved its greatest acceptance in Canada, the United
States, Belgium, South Korea, Australia, Ireland, New
Zealand, The Netherlands, and Japan, countries in which
the face value of life insurance policies in force generally
exceeds the national income.
In the United States in 1990 nearly $9.4 trillion of life
insurance was in force. The assets of the more than 2,200
U.S. life insurance companies totaled nearly $1.4 trillion,
making life insurance one of the largest savings
institutions in the United States. Much the same is true of
other wealthy countries, in which life insurance has
become a major channel of saving and investment, with
important consequences for the national economy.
Life insurance is relatively little used in poor
countries, although its acceptance has been increasing.
Types of contracts.
The major types of life insurance contracts are term,
whole life, and universal life, but innumerable
combinations of these basic types are sold. Term
insurance contracts, issued for specified periods of
years, are the simplest. Protection under these contracts
expires at the end of the stated period, with no cash value
135

remaining. Whole life contracts, on the other hand, run

for the whole of the insured's life and gradually
accumulate a cash value. The cash value, which is less
than the face value of the policy, is paid to the
policyholder when the contract matures or is surrendered.
Universal life contracts, a relatively new form of
coverage introduced in the United States in 1979, have
become a major class of life insurance. They allow the
owner to decide the timing and size of the premium and
amount of death benefits of the policy. In this contract,
the insurer makes a charge each month for general
expenses and mortality costs and credits the amount of
interest earned to the policyholder. There are two general
types of universal life contracts, type A and type B. In
type-A policies the death benefit is a set amount, while in
type-B policies the death benefit is a set amount plus
whatever cash value has been built up in the policy.
Life insurance may also be classified, according to
type of customer, as ordinary, group, industrial, and
credit. The ordinary insurance market includes customers
of whole life, term, and universal life contracts and is
made up primarily of individual purchasers of annualpremium insurance. The group insurance market consists
mainly of employers who arrange group contracts to
cover their employees. The industrial insurance market
consists of individual contracts sold in small amounts
with premiums collected weekly or monthly at the
policyholder's home. Credit life insurance is sold to
individuals, usually as part of an installment purchase
contract; under these contracts, if the insured dies before
the installment payments are completed, the seller is
protected for the balance of the unpaid debt.

136

Insurance may be issued with a premium that remains

the same throughout the premium-paying period, or it
may be issued with a premium that increases periodically
according to the age of the insured. Practically all
ordinary life insurance policies are issued on a levelpremium basis, which makes it necessary to charge more
than the true cost of the insurance in the earlier years of
the contract in order to make up for much higher costs in
the later years; the so-called overcharges in the earlier
years are not really overcharges but are a necessary part
of the total insurance plan, reflecting the fact that
mortality rates increase with age. The insured is not
overpaying for protection, because of the claim on the
cash values that accumulate in the early years; the
policyholder may borrow on this value or may recapture
it completely by lapsing the policy. The insured does not,
however, have a claim on all the earnings that accrue to
the insurance company from investing the funds of its
policyholders.
By combining term and whole life insurance, an
insurer can provide many different kinds of policies. Two
examples of such "package" contracts are the family
income policy and the mortgage protection policy. In
each of these, a base policy, usually whole life insurance,
is combined with term insurance calculated so that the
amount of protection declines as the policy runs its
course. In the case of the mortgage protection contract,
for example, the amount of the decreasing term insurance
is designed roughly to approximate the amount of the
mortgage on a property. As the mortgage is paid off, the
amount of insurance declines correspondingly. At the end
of the mortgage period the decreasing term insurance

137

expires, leaving the base policy still in force. Similarly, in

a family income policy, the decreasing term insurance is
arranged to provide a given income to the beneficiary
over a period of years roughly corresponding to the
period during which the children are young and
dependent.
Some whole life policies permit the insured to limit
the period during which premiums are to be paid.
Common examples of these are 20-year life, 30-year life,
and life paid up at age 65. On these contracts, the insured
pays a higher premium to compensate for the limited
premium-paying period. At the end of the stated period,
the policy is said to be "paid up," but it remains effective
until death or surrender.
Term insurance is most appropriate when the need for
protection runs for only a limited period; whole life
insurance is most appropriate when the protection need is
permanent. The universal life plan, which earns interest
at a rate roughly equal to that earned by the insurer
(approximately the rate available in long-term bonds and
mortgages), may be used as a convenient vehicle by
which to save money. The owner can vary the amount of
death protection as the need for it changes in the course
of life. The policy offers flexibility and saves the owner
commission expense by eliminating the need for
dropping one policy and taking out another as protection
requirements change.

138

Settlement options.
The death proceeds or cash values of insurance may
be settled in various ways. The insured may take the cash
value and lapse the policy. A beneficiary may take a
lump sum settlement of the face amount upon the death
of the insured. The beneficiary may, instead, elect to
receive the proceeds over a given number of years or in
some fixed amount, such as $100 a month, for as long as
the proceeds last. The money may be left with the insurer
temporarily to draw interest. Or the proceeds may be
used to purchase a life annuity, which in effect is another
insurance policy guaranteeing regular payments for the
life of the insured.
Other provisions.
Life insurance policies contain various clauses that
protect the rights of beneficiaries and the insured.
Perhaps the best-known is the incontestable clause, which
provides that if a policy has been in force for two years
the insurer may not afterward refuse to pay the proceeds
or cancel the contract for any reason except nonpayment
of premiums. Thus, if the insured made a material
misrepresentation when the policy was originally
obtained, and this misrepresentation is not discovered
until after the contestable period, beneficiaries may still
receive the value of the policy so long as the premiums
139

are maintained. Another protective clause is the suicide

clause, which states that after a given period, usually two
years, the insurer may not deny liability for subsequent
suicide of the insured. If suicide occurs within the period,
the insurer tenders to the beneficiary only the premiums
that have been paid. If the age of the insured was
misstated when the policy was taken out, the
misstatement-of-age clause provides that the amount
payable is the amount of insurance that would have been
purchased for the premium had the correct age been
stated. Many life insurance policies, known as
participating policies, return dividends to the insured.
The dividends, which may amount to 20 percent of the
premiums, may be accumulated in cash left with the
insurer at interest, used to buy additional life insurance,
used to reduce premium payments, or used to pay up the
contract sooner than would otherwise have been possible.
Special riders.
The insured may, at a nominal charge, attach to the
contract a waiver-of-premium rider under which
premium payments will be waived in the event of total
and permanent disability before the age of 60. Under the
disability income rider, should the insured become totally
and permanently disabled, a monthly income will be
paid. Under the double indemnity rider, if death occurs
through accident, the insurance payable is double the face
amount.
Private health insurance.
In many countries health insurance has become a
governmental institution. In some, doctors and other
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professional staff are employed, directly or indirectly, by

a government agency on a full-time or part-time salaried
basis, and health facilities are owned or operated by the
government. This has been the practice in Australia,
Brazil, Canada, Chile, Greece, Ireland, Mexico, New
Zealand, Sweden, Turkey, and the countries of eastern
Europe. In other countries the government pays for
medical care provided by private physicians; these
countries include Austria, Denmark, The Netherlands,
Norway, and Spain. In some countries private health
insurance programs exist along with, or as part of, the
government program. Various combinations of programs
are possible, and it is difficult to summarize all the
arrangements that actually exist. The United States
provides government-run medical services in veterans'
hospitals and mental hospitals, and it also has a
governmental health insurance program for citizens age
65 and over (Medicare) under the Social Security Act
amendments of 1965, but most health insurance in the
United States still consists of private programs. Much
private health insurance in the United States is operated
on a group basis, generally through groups of employees
whose payments may be subsidized by their employer.
Types of policies.
The major types of health insurance coverage are
hospitalization, surgical, regular medical, major medical,
disability income, dental, and long-term care. Health
insurance contracts are not highly standardized. The
policy provisions discussed below should be considered
as typical, not universal or invariant.

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Hospitalization insurance indemnifies for room and

board in the hospital, laboratory fees, use of special
facilities, nursing care, and certain medicines and
supplies. The contracts contain specific limitations on
coverage, such as a maximum number of days in the
hospital and maximum allowances for room and board.
Surgical expense insurance covers the surgeon's charge
for given operations or medical procedures, usually up to
a maximum for each type of operation. Regular medical
insurance contracts indemnify the insured for expenses
such as physicians' home or office visits, medicines, and
other medical expenses. Major medical contracts are
distinguished from other health insurance policies by
offering coverage without many specific limitations;
usually there is only a maximum per person, a deductible
amount, and a percentage deductible, called coinsurance,
under which the insured usually pays 20 percent of each
medical bill above the deductible amount. Disability
income coverage provides periodic payments when the
insured is unable to work as a result of accident or illness.
There is normally a waiting period before the payments
begin. Definitions of disability vary considerably. A strict
definition of disability requires that one be unable to
perform each and every duty of one's regular occupation
for a given period, say two years, and thereafter be
unable to perform the duties of any occupation for which
one is reasonably fitted by training or experience. More
liberal definitions of disability require only the inability
to perform the duties of one's usual occupation.
Dental insurance, usually sold on a group plan and
sponsored by an employer, covers such dental services as
fillings, crowns, extractions, bridgework, and dentures.

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Most policies contain relatively low annual limits of

coverage, such as $2,500, as well as deductibles and
coinsurance provisions. Some policies limit benefits to a
percentage of the cost of services.
Long-term care insurance (LTC) has been developed
to cover expenses associated with old age, such as care in
nursing homes and home care visits. LTC insurance,
though relatively new, is already attracting strong interest
because of the rapid growth of the elderly population in
the United States. Policies specify a maximum limit per
day plus an overall maximum benefit amount, with the
result that the insurance typically covers the expenses of
a maximum of four or five years in a nursing home. A
common provision is a 20-day waiting period before
benefits begin. Some policies exclude certain conditions
such as Alzheimer's disease and do not cover custodial
care. For an additional premium, some LTC policies offer
an inflation provision, which increases the daily benefit
by some percentage, such as 5 percent a year.
Renewability.
An important condition of health insurance is that of
renewability. Some contracts are cancelable at any time
upon short notice. Others are not cancelable during the
year's term of coverage, but the insurer may refuse to
renew coverage for a subsequent year or may renew only
at higher rates or under restrictive conditions. Thus the
insured may become ill with a chronic disease and
discover that upon renewal the policy excludes all future
coverage for this disease. Only policies that are both

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noncancelable and guaranteed renewable assure

continuous coverage, but these are much more expensive.
Problems.
Private health insurance contracts are in general quite
restricted in coverage, to the point that many consider
them to be inadequate for modern conditions. They also
lend themselves to abuses such as overutilization of
coverage, multiple policies, and insuring for more than
100 percent of the expected loss. Health insurance, by its
very existence, helps to escalate rising medical care
costs; for example, insured medical losses tend to run
higher than noninsured losses because physicians often
charge according to "ability to pay," and insurance
increases this ability. Through insurance it is also easier
to pass on rising hospital costs to the patient. Finally,
since there is a tendency for those most likely to have
losses to take out health insurance, an element of adverse
selection exists. Careful underwriting to screen out those
who are trying to take advantage of the insurance
mechanism to pay for known bills is considered essential,
but this undoubtedly denies coverage to many who need
protection.
Group insurance.
Groups have always been important in the insurance
field, from the burial societies of the Romans and the
insurance funds of the medieval guilds to the fraternal
and religious insurance plans of modern times. In the
20th century private insurance companies have written
increasingly large amounts of group insurance,
particularly in life insurance, health insurance, and
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annuities. In 1990 more than 95 percent of the industrial

labour force in the United States was covered by group
life and health insurance plans established by employers.
Much of the impetus for these employee benefit plans
came from the labour unions, which pressed for such
"fringe benefits" in bargaining with employers.
Group insurance is widely used throughout the world,
both in the form of private plans and as social insurance
plans. Social security plans with group coverage exist in
more than 140 nations. Private group plans are generally
offered wherever private life and health insurance
companies operate. Group life insurance is the most
commonly offered plan; group health plans are
government-operated in many nations. In many countries,
group pension plans are common as a supplement to
social insurance pension schemes.
Group insurance has been especially popular in
Japan, where many employees serve a company for life.
All Japanese life insurance companies offer group life
insurance. Health insurance is provided by the
government. Funded group pensions became popular
after a 1962 tax law made contributions tax-deductible
for Japanese employers. In addition, virtually all
Japanese employers provide lump-sum retirement
allowances to their workers.
Group life insurance.
Under group life insurance an employer signs a
master contract with the insurance company outlining the
provisions of the plan. Each employee receives a
certificate that gives evidence of participation in the plan.

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The amount of insurance depends on the employee's

salary or job classification; usually the employer pays a
portion of the premium and the employee pays the rest,
but sometimes the employer pays the entire cost of the
plan.
A major advantage of group life insurance to an
employee is that usually coverage may be obtained
regardless of health. An employee who leaves the group
may, without a medical examination, convert the group
coverage to an individual policy. The premiums on group
life insurance are considerably less than on comparable
individual policies, mainly because the selling and
administrative costs are minimal.
Group health insurance.
Major types of health insurance written on a group
basis include insurance against the losses occasioned by
hospitalization, surgical expense, and disability.
Hospitalization insurance is designed to cover daily room
and board and other expenses. Surgical expense
insurance usually provides specified allowances for
physicians' charges for various operations. Regular
medical expense coverage is generally aimed at covering
part of the costs of medicines and doctor calls. Major
medical insurance offers the insured a large monetary
coverage, designed to meet catastrophic costs of illness
or accident with few restrictions as to the type of medical
expense for which reimbursement is allowed. The insured
must bear a percentage of any loss, usually 20 percent.
Temporary disability income offers the insured a weekly
indemnity for a period of up to six months if the insured

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is temporarily disabled and unable to work. Long-term

disability extends the income for periods longer than six
months. Accidental death and dismemberment insurance
offers an insured or a beneficiary a lump sum; it is used
widely as a form of travel accident insurance.
Under the typical group health insurance contract, the
insured person enjoys several elements of protection not
obtainable in individual contracts. Cancellation of
coverage is not permitted unless coverage for the entire
group is canceled. The insured enjoys protection against
rate increases unless the rate for all members of the class
is increased. Typically the group protection may be
converted to some kind of individual policy, or the
insured may transfer to another group plan. The insurer
tends to be liberal on claims settlement because the
typical premium under a group plan is large enough for
the insurer to be unwilling to jeopardize the good will of
the clientele through miserly claims treatment.
Most group insurance plans require that certain
conditions be met. Sometimes there must be a minimum
number of persons covered, such as 10 or 25. The group
must also have some reason for existence other than to
obtain insurance. The most usual types of groups are
employees of a common employer, members of a labour
organization, debtors of a common creditor, or members
of a professional or trade association.
Mention must also be made of nonprofit prepayment
plans (e.g., the Blue Cross-Blue Shield plans and health
maintenance organizations [HMOs] in the United
States), which resemble the above plans in most respects
but are not operated by insurance companies. These plans
often indemnify the hospital or the physician, on the basis

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of services performed, rather than the patient. Health

insurance plans may also be established independently by
large employers, labour unions, communities, or
cooperatives. Outside the United States this kind of
health insurance has been taken over by government
programs. In Sweden, before the enactment of the
compulsory insurance program in 1955, 70 percent of the
population was covered by private plans. In Great
Britain, before the National Health Service was instituted
in 1948, about half the population was privately covered.
In The Netherlands about half the population was so
covered before the government program began, and there
were still many private funds run by various groups.
In spite of the success of private group health
insurance in the United States, it is estimated that in 1992
approximately 37 million people were without health
insurance coverage. Many attempts over the years to
establish universal national health insurance in the United
States have failed.
Group annuities.
An annuity in the literal sense is a series of annual
payments. More broadly it may be defined as a series of
equal payments over equal intervals of time. A life
annuity, a subclass of annuities in general, is one in
which the payments are guaranteed for the lifetime of one
or more individuals. A group annuity differs from an
individual annuity in that the annuity payments are based
upon the assumed length of lives of members of a given
group. The size of the payments depends on several
factors: the assumed interest rate, the life expectancy of

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the individual or of the individuals making up the group,

the length of the period during which payments are
guaranteed, the length of time elapsing before the
payments begin, and the number of lives on which the
payments are continued. For example, if payments to an
annuitant aged 65 are to be guaranteed for 20 years, they
will be substantially smaller than if they are guaranteed
only for the remainder of the person's life.
The typical group life annuity is sponsored by an
employer, who may pay all or part of the cost. Under the
usual arrangement, every employee receives each year a
credit with the life insurance company for an annuity
purchased to begin at age 65. The final pension received
is made up of the sum of the individual annuities
purchased throughout the worker's life. As a rule, an
irrevocable claim to these annuity rights is gained only
after the person has worked with the employer for a given
number of years or has reached a given age.
The basic advantage of an annuity is that it provides
an income for life that is larger than the amount that the
holder would receive by putting money out at simple
interest. It is the reverse of life insurance, in that the
insurer pays premiums to the insured; it resembles
insurance in that the payment is based on life expectancy.
The problem of inflation has led to experimentation
with variable annuities in order to protect annuitants
against decreases in purchasing power. The major
distinguishing characteristic of a variable annuity is that
the payments vary according to underlying trends in the
stock market. Funds paid in for the variable annuity are
invested in common stock rather than in bonds,
mortgages, or other fixed-interest investments as is true

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of regular annuities. In simplified terms, if the stock

market rises 10 percent in one year, the annuitant may
expect payments to go up by approximately 10 percent in
the following year. Conversely, if the stock market drops
10 percent, the annuitant will suffer a 10 percent
reduction in income. To the extent that the stock market
reflects changes in the cost of living, the annuitant's
income is automatically adjusted for these changes each
year; and, if the stock market also reflects increases in
productivity in the economy, then the annuitant may
expect to receive a share in such increases in the
productivity as the economy may gain.
Some variable annuity plans are tied directly to a costof-living index. In order to finance the increased benefits,
the employer invests a portion of the funds in equities
such as common stock and real estate. An assumption is
made that there will be a sufficient gain from this source
to enable the employer to pay the increased cost of living,
but the employee is not expected to suffer reductions in
annuity payments.
The problem of adjusting retirement benefits to
changes in the economy has been of concern in many
countries. Some governments have pegged the price of
government bonds to the cost-of-living index. Retired
individuals purchasing government bonds may then
receive automatic increases in interest payments if the
cost of living rises. Their interest will not fall below a
specified amount. Social security legislation in most parts
of the world is geared in various ways to changes in the
cost of living. In some cases benefits are directly tied to a
price index. In other cases the legislature from time to

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time must be asked to make adjustments in social

security benefits.

Insurance practice
UNDERWRITING AND RATE MAKING
The two basic functions in insurance are underwriting
and rating, which are closely related to each other.
Underwriting deals with the selection of risks, and rating
deals with the pricing system applicable to the risks
accepted.
Underwriting principles.
Underwriting has to do with the selection of subjects
for insurance in such a manner that general company
objectives are met. The main objective of underwriting is
to see that the risk accepted by the insurer corresponds to
that assumed in the rating structure. There is often a
tendency toward adverse selection, which the underwriter
must try to prevent. Adverse selection occurs when those
most likely to suffer loss are covered in greater
proportion than others. The insurer must decide upon
certain standards, terms, and conditions for applicants,
project estimated losses and expenses through the
anticipated period of coverage, and calculate reasonably
accurate rates to cover these losses and expenses. Since
many factors affect losses and expenses, the underwriting
task is complex and uncertain. Bad underwriting has
resulted in the failure of many insurers.

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In some types of insurance major underwriting

decisions are made in the field, and in other types they
are made at the home office. In the field of life insurance
the agent's judgment is not accepted as final until the
home-office underwriter can make a decision, for the life
insurance contract is usually noncancelable, once written.
In the field of property and liability insurance, on the
other hand, the contract is cancelable if the home-office
underwriter later finds the risk to be unacceptable. It is
not uncommon for a property and liability insurer to
accept large risks only to cancel them at a later time after
the full facts are analyzed. The insurance underwriter
must tread a thin line between undue strictness and undue
laxity in the acceptance of risk. The underwriter's
position is not unlike that of the credit manager in a
business corporation, in which unreasonably strict credit
standards discourage sales but overly weak credit
standards invite losses.
An important initial task of the underwriter is to try to
prevent adverse selection by analyzing the hazards that
surround the risk. Three basic types of hazards have been
identified as moral, psychological, and physical. A moral
hazard exists when the applicant may either want an
outright loss to occur or may have a tendency to be less
than careful with property. A psychological hazard exists
when an individual unconsciously behaves in such a way
as to engender losses. Physical hazards are conditions
surrounding property or persons that increase the danger
of loss.
An underwriter may suspect the existence of a moral
hazard on applications submitted by persons with known
records of dishonesty or when excessive coverage is

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sought or the replacement value of the property exceeds

its value as a profit-making enterprise. Underwriters are
aware that fire losses are more likely to occur during
business depressions. The underwriter can detect moral
hazard in various ways: An applicant's credit may be
checked; courthouse and police records may reveal a
criminal history or a history of bankruptcy; and other
insurance companies can be queried for information
when it is suspected that an individual is trying to obtain
an excessive amount of coverage or has been turned
down by other insurers.
The psychological type of hazard can take a number of
forms. Some persons are said to be "accident-prone"
because they have far more than their share of accidents,
suggesting that unconsciously they want them. It is well
known that persons applying for annuities tend to have
longer than average lives, and consequently a special
mortality table is used for annuitants. Certain types of
insanity have to be watched for--notably the impulse to
set fires.
Physical hazards include such things as wood-frame
construction in buildings, particularly in areas where such
properties are densely concentrated. Earthquake
insurance rates tend to be high where geologic faults
exist (as in San Francisco, which is built almost directly
over such a fault).
Each kind of insurance has its characteristic hazards.
In fire insurance the physical hazards are analyzed
according to four major factors: type of construction, the
protection rating of the city in which the property is
located, exposure to other structures that may spread a
conflagration, and type of occupancy.

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In underwriting automobile insurance, the

underwriter considers the following factors: the age, sex,
and marital status of the driver and members of the
driver's household; length of driving experience;
occupation; stability of employment and residence;
physical impairments; accident and conviction record;
extent of use of alcohol and drugs; customary use of the
vehicle; age, condition, and maintenance of the vehicle;
and records of insurance cancellation or refusal. In some
cases tests of emotional maturity are administered. Some
underwriters even consider such factors as the school
records of student drivers and whether or not driving
courses have been taken.
The hazards considered in the underwriting of general
liability insurance depend on the type of business and the
record of the person applying for coverage. In the field of
contracting, for example, the underwriter is interested in
the type of equipment owned or rented by the applicant;
the applicant's losses in the past, attitude toward safe
practice, cooperation with building inspectors, and
financial position and credit standing; the stability of
supervisory employees; and the degree to which the
applicant has been a successful contractor in the past.
Rate making.

Closely associated with underwriting is the ratemaking function. If, for example, the underwriter decides
that the most important factor in discriminating between
different risk characteristics is age, the rates will be

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differentiated according to age.

The rate is the price per unit of exposure. In fire
insurance, for example, the rate may be expressed as $1
per $100 of exposed property; if an insured has $1,000 of
exposed property, the premium will thus be $10. The rate
reflects three major elements: the loss cost per unit of
exposure, the administrative expenses, or "loading," and
the profit. In property insurance, approximately one-third
of the premium covers expenses and profit, and twothirds covers the expected cost of loss payments. These
percentages vary somewhat according to the particular
type of insurance.
Rates are calculated in the following way. A policy,
for instance, may be written covering a class of
automobiles with an expected loss frequency of 10
percent and an average collision loss of $400. The
expenses of the insurer are to average 35 percent of the
premium, and there must be a profit of 5 percent. The
pure loss cost per unit is 10 percent of $400, or $40. The
gross premium is calculated by the formula L/[1 - (E +
P)], in which L equals the loss cost per unit, E equals the
expense ratio, and P equals the profit ratio. In this case
the gross premium would be $40/[1 - (.35 + .05)], or
$66.67.
Four basic standards are used in rate making: (1) the
structure of rates should allocate the burden of expenses
and costs in a way that reflects as accurately as possible
the differences in risk--in other words, rates should be
fair; (2) a rate should produce a premium adequate to
meet total losses but should not bring unreasonably large
profits; (3) the rate should be revised often enough to
reflect current costs; and (4) the rate structure should tend

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to encourage loss prevention among those who are

insured.
Some examples will illustrate the nature and
application of the criteria outlined above. In life
insurance, the rate is generally more than adequate to
meet all reasonably anticipated losses and expenses; in
other words, the insured is charged an excessive
premium, part of which is then returned as a dividend
according to actual losses and expenses. The requirement
that the rate reflect fairly the risk involved is much more
difficult to achieve. In workers' compensation insurance,
the rate is expressed as a percentage of the employer's
payroll for each occupational class. This may seem fair
enough, but an employer with relatively high-paid
workers has fewer employees for a given amount of
payroll than one whose workers are paid a lower wage. If
the two employers fall into the same occupational class
and have the same total payroll, they are charged the
same premium even though one may have a larger
number of workers than the other and hence greater
exposure to loss. Fairness may be an elusive goal.
Insurance rates are revised only slowly, and, since
they are based upon past experience, they tend to remain
out of date. In life insurance, for example, the mortality
tables used are changed only every several years, and rate
adjustments are reflected in dividends. In automobile
insurance, rates are revised annually or even more often,
but they still tend to be out of date.
Two basic rate-making systems are in use: the manual,
or class-rating, method and the individual, or meritrating, method. Sometimes a combination of the two
methods is used.

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A manual rate is one that applies uniformly to each

exposure unit falling in some predetermined class or
group, such as people of the same age, workers of one
employer, drivers meeting certain characteristics, or all
residences in a given area. Presumably the members of
each class are so homogeneous as to be indistinguishable
so far as risk characteristics are concerned.
Merit rating is used to give recognition to individual
characteristics. In commercial buildings, for example,
fire insurance rates depend on such individual
characteristics as the type of occupancy, the number and
type of safety features, and the quality of housecleaning.
In an attempt to reflect the true quality of the risk, a
percentage charge or credit may be applied to the base
rate for each of these features. Another example is found
in employer group health insurance plans where the
premium or the rate may be adjusted annually depending
on the loss experience or on the amount of claims service
provided.
In order to obtain broader and statistically sounder
rates, insurers often pool loss and claims experience by
setting up rating bureaus to calculate rates based on
industrywide experience. They may have an agreement
that all member companies must use the rates thus
developed. The rationale for such agreements is that they
help insurers meet the criteria of adequacy and fairness.
Rating bureaus are used extensively in fire, marine,
workers' compensation, automobile, and crime insurance.

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Underwriting cycle.
Profits in property and liability insurance have tended
to rise and fall in fairly regular patterns lasting between
five and seven years from peak to peak; this phenomenon
is termed the underwriting cycle. Stages of the
underwriting cycle may be described as follows: initially,
when profits are relatively high, some insurers, wishing
to expand sales, start to lower prices and become more
lenient in underwriting. This leads to greater
underwriting losses. Rising losses and falling prices
cause profits to suffer. In the second stage of the cycle,
insurers attempt to restore profits by increasing rates and
restricting underwriting, offering coverage only to the
safest risks. These restrictions may be so severe that
insurance in some lines becomes unavailable in the
marketplace. Insurers are able to offset a portion of their
underwriting loses through earnings on investments.
Eventually the increased rates and reduced underwriting
losses restore profits. At this point, the underwriting
cycle repeats itself.
The general effect of the underwriting cycle on the
public is to cause the price of property and liability
insurance to rise and fall fairly regularly and to make it
more difficult to purchase insurance in some years than
in others. The competition among insurers caused by the
underwriting cycle tends to create cost bargains in some
years. This is especially evident when interest rates are
high, because greater underwriting losses will, in part, be
offset by greater investment earnings.

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Reinsurance.
A significant insurance practice is that of reinsurance,
whereby risk may be divided among several insurers,
reducing the exposure to loss faced by each insurer.
Reinsurance is effected through contracts called treaties,
which specify how the premiums and losses will be
shared by participating insurers.
Two main types of treaties exist-- pro rata and excessof-loss treaties. In the former, all premiums and losses
may be divided according to stated percentages. In the
latter, the originating insurer accepts the risk of loss up to
a stated amount, and above this amount the reinsurers
divide any losses. Reinsurance is also frequently arranged
on an individual basis, called facultative reinsurance,
under which an originating insurer contracts with another
insurer to accept part or all of a specific risk.
Reinsurance enlarges the ability of an originating
insurer to accept risk, since unwanted portions of the risk
can be passed on to others. Reinsurance stabilizes insurer
profits, evens out loss ratios, reduces the capital needed
to underwrite business, and offers a way for insurers to
divest themselves of an entire segment of their risk
portfolio.
LEGAL ASPECTS OF INSURANCE
Government regulation.
The insurance business is subject to extensive
government regulation in all countries. In European
countries insurance regulation is a mixture of central and
local controls. In Germany central authority over
insurance regulation is provided by the Federal Insurance
159

Supervisory Authority (BAV), which exercises tight

control of premiums, reserves, and investments of
insurers. The BAV's regulation of life insurance, for
example, allows no more than 20 percent of investments
in equities.
In the United Kingdom, regulation generally allows
the managing agency fairly complete liberty of action and
is concerned only with final business results. In this the
United Kingdom differs from most other European
countries, in which the purpose of insurance supervision
is to regulate more closely the conditions in which
insurers operate.
In the countries of the European Community (EC;
under articles 59-60 of the Treaty of Rome) an attempt is
being made to obtain greater uniformity among national
insurance statutes. This is intended to facilitate the
operations of insurers across national borders. Rate
regulation, however, remains within the jurisdiction of
individual countries.
Although 1992 was established as the goal year for
completing the harmonization process for insurance in
the EC, separate regulation in the various countries
continues. Many legal and regulatory barriers to
expansion of insurance operations in various countries in
the world still exist. Examples include strict licensing
requirements, prohibiting of unadmitted insurance,
mandatory hiring of local nationals, requirements that
insurers make local investments or enter into joint
ventures with local insurers, prohibition of free exchange
of currencies or repatriation of profits, and onerous
taxation.
An important legal force influencing insurance

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regulation in such countries as France, Belgium, Egypt,

Greece, Italy, Lebanon, Spain, Turkey, and the former
French African colonies is the Napoleonic Code. The
influence of the code may be seen, for example, in the
matter of third-party liability, in which the burden of
proof may be upon the defendant rather than upon the
plaintiff.
In some countries not all classes of insurance are
regulated. In The Netherlands only life insurance is
regulated, and in Belgium only life, industrial injury, and
thirdparty motor vehicle liability insurance. In some
countries the scope of supervision may embrace many
aspects of the insurance business, but in the United
Kingdom and The Netherlands only financial matters
are subject to regulation.
In several European countries insurers may not write
both life insurance and general insurance (property and
liability insurance). Minimum capital requirements vary,
depending on the type of business written, usually being
highest for life insurance.
In most European countries policies are submitted to
supervisory authorities for approval or for information. In
some countries standard clauses or forms of contracts
must be used; for instance, in Sweden insurers must use a
standard compulsory motor vehicle third-party liability
policy, and in Switzerland a standard contract for war
risks and life insurance is required.
Insurance is often compulsory. In general, laws
frequently require individuals to carry third-party liability
insurance and industrial injury insurance. Fire insurance
is required on immovable property in Germany. A
number of countries require aviation insurance (for

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accident and sickness) on airline passengers and crews.

Although individuals generally have the freedom to
select whichever insurer they wish, there are restrictions
on buying insurance from foreign insurers. In some
countries buyers must use domestic insurers for
compulsory coverages but are free to take out insurance
from foreign insurers when coverage is not available
from domestic insurers. In other countries certain types
of insurance may not be placed in foreign countries.
About half the countries of the world prohibit
"nonadmitted" insurance, defined as insurance written by
an insurer not authorized to do business in that country.
In the United States most regulation of insurance is in
the hands of the individual states, although the federal
government also has authority over insurers when it is
deemed that state regulation fails to regulate effectively
activities such as unfair trade practices, misleading
advertising, boycotts, and monopolistic practices. States
regulate four main aspects: rate making, minimum
standards for financial solvency, investments, and
marketing practices.
In rate making, three basic requirements must be met:
rates must be adequate to cover expected losses, must not
be excessive, and must not be unfairly discriminatory
among different classes of risk. In meeting minimum
standards of financial solvency, state laws specify
minimum capital requirements, accounting practices,
minimum security deposits with state insurance
commissioners, and procedures for liquidating insolvent
insurers. In investments, states limit the types and quality
of securities in which insurers may invest their assets. In
marketing, states regulate advertising, licensing of

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agents, policy forms and wording, service and process

procedures for handling claim disputes, expense
allowances for acquiring new business, and other agency
and insurer operations, including being admitted to do
business in the state. Many states maintain a special
division to register and handle consumer complaints.
Contract law.
In general, an insurance contract must meet four
conditions in order to be legally valid: it must be for a
legal purpose; the parties must have a legal capacity to
contract; there must be evidence of a meeting of minds
between the insurer and the insured; and there must be a
payment or consideration.
To meet the requirement of legal purpose, the
insurance contract must be supported by an insurable
interest (see further discussion below); it may not be
issued in such a way as to encourage illegal ventures (as
with marine insurance placed on a ship used to carry
contraband).
The requirement of capacity to contract usually means
that the individual obtaining insurance must be of a
minimum age and must be legally competent; the
contract will not hold if the insured is found to be insane
or intoxicated or if the insured is a corporation operating
outside the scope of its authority as defined in its charter,
bylaws, or articles of incorporation.
The requirement of meeting of minds is met when a
valid offer is made by one party and accepted by another.
The offer is generally made on a written application for
insurance. In the field of property and liability insurance,

163

the agent generally has the right to accept the insured's

offer for coverage and bind the contract immediately. In
the field of life insurance, the agent generally does not
have this power, and the contract is not valid until the
home office of the insurer has examined the application
and has returned it to the insured through the agent.
The payment or consideration is generally made up
of two parts--the premiums and the promise to adhere to
all conditions stated in the contract. These may include,
for example, a warranty that the insured will take certain
loss-prevention measures in the care and preservation of
the covered property.
Warranties.
In applying for insurance, the applicant makes certain
representations or warranties. If the applicant makes a
false representation, the insurer has the option of voiding
the contract. Concealment of vital information may be
considered
misrepresentation.
In
general,
the
misrepresentation or concealment must concern a
material fact--defined as a fact that would, if it were
known, cause the insurer to change the terms of the
contract or be unwilling to issue it in the first place. If the
agent of the insurer asks the applicant a question the
answer to which is a matter of opinion and if the answer
turns out to be wrong, the insurer must demonstrate bad
faith or fraudulent intent in order to void the contract. If,
for example, in answer to an agent's question, the
applicant reports no history of serious illness, in the
mistaken belief that a past illness was minor, the court
may find the statement to be an honest opinion and not a
misrepresented fact.
164

A basic principle of property liability insurance

contracts is the principle of subrogation, under which
the insurer may be entitled to recovery from liable third
parties. In fire insurance, for example, if a neighbour
carelessly sets fire to the insured's house and the
insurance company indemnifies the insured for the loss,
the company may then bring a legal action in the name of
the insured to recover the loss from the negligent
neighbour. The principle of subrogation is complemented
by another basic principle of insurance contract law, the
principle of indemnity. Under the principle of indemnity
a person may recover no more than the actual cash loss;
one may not, for example, recover in full from two
separate policies if the total amount exceeds the true
value of the property insured.

may insure the life of her husband, and a father may

insure the life of a minor child, because there is a
sufficient pecuniary relationship between them to
establish an insurable interest.
In life insurance the insurable interest must exist at the
time of the contract. Continued insurable interest,
however, need not be demonstrated. A divorced woman
may continue life insurance on the life of her former
husband and legitimately collect the proceeds upon his
death even though she is no longer his wife.
In the field of property insurance, on the other hand,
the insurable interest must be demonstrated at the time of
the loss. If an individual insures a home but later sells it,
no recovery can be made if the house burns after the sale,
because the insured has suffered no loss at the time of the
fire.

Insurable interest.

Liability law.

Closely associated with the above legal principles is

that of insurable interest. This requires that the insured
be exposed to a personal loss if the peril insured against
should occur. Otherwise it would be possible for a person
to take out a fire insurance policy on the property of
others and collect if the property burned. Any financial
interest in property, or reasonable expectation of having a
financial interest, is sufficient to establish insurable
interest. A secured creditor such as a mortgagee has an
insurable interest in the property on which money has
been lent.
In the field of personal insurance one is held to have
an unlimited interest in one's own life. A corporation may
take life insurance on the life of a key executive. A wife

165

In most countries, an individual may be held legally

liable to another for acts or omissions and be required to
pay damages. Liability insurance may be purchased to
cover these contingencies.
Legal liability exists when an individual commits a
legal injury that wrongly encroaches on another person's
rights. Such injuries include slander, assault, and
negligent acts. A negligent act involves failure to behave
in a manner expected when the results of this failure
cause a financial loss to others. An act may be classed as
negligent even if it is unintentional. Negligence may be
imputed from one person to another. For example, a
master is liable not only for his own acts but also for the
negligent acts of servants or others legally representing

166

him. It is not uncommon for a municipality to require that

businesses using city property assume what would
otherwise have been the city's negligence for the use of
its property. Statutes may impute liability on individuals
when no liability would exist otherwise; thus a parent
may be legally liable for the acts of a minor child who is
driving the family automobile.
In common-law countries such as the United States
and the United Kingdom, three defenses may be used in a
negligence action. These are assumed risk, contributory
negligence, and the fellow servant doctrine. Under the
assumed risk rule, the defendant may argue that the
plaintiff has assumed the risk of loss in entering into a
given venture and understands the risks. Employers
formerly used the assumed risk doctrine in suits by
injured employees, arguing that the employee understood
and assumed the risks of employment in accepting the
job.
The contributory negligence defense is frequently
used to defeat negligence actions. If it can be shown that
one party was partly to blame, then that party may not
collect from any negligence of the other party. Some
courts have applied a substitute doctrine known as
comparative negligence. Under this, each party is held
responsible for a portion of the loss corresponding to the
degree of blame attached to that party; a person who is
judged to be 20 percent to blame for an accident may be
required to pay 20 percent of the injured person's losses.
The fellow servant defense has been used at times by
employers; an employer would argue in some cases that
the injury to an employee was caused not by the
employer's negligence but by the negligence of another

167

employee. However, workers' compensation statutes in

some countries have nullified such common law defenses
in industrial injury cases.
In many countries, the courts have tended to apply
increasingly strict standards in adjudicating negligence.
This has been termed the trend toward strict liability,
under which the plaintiff may recover for almost any
accidental injury, even if it can be shown that the
defendant has used "due care" and thus is not negligent in
the traditional sense. In the United States, manufacturers
of polio vaccine that was found to have caused polio
were required to pay large damage claims although it was
demonstrated that they had taken all normal precautions
and safeguards in the manufacture of the vaccine.
Historical development of insurance
Insurance in some form is as old as historical society.
So-called bottomry contracts were known to merchants
of Babylon as early as 4000-3000 BC. Bottomry was also
practiced by the Hindus in 600 BC and was well
understood in ancient Greece as early as the 4th century
BC. Under a bottomry contract, loans were granted to
merchants with the provision that if the shipment was lost
at sea the loan did not have to be repaid. The interest on
the loan covered the insurance risk. Ancient Roman law
recognized the bottomry contract in which an article of
agreement was drawn up and funds were deposited with a
money changer. Marine insurance became highly
developed in the 15th century.
In Rome there were also burial societies that paid
funeral costs of their members out of monthly dues.

168

The insurance contract also developed early. It was

known in ancient Greece and among other maritime
nations in commercial contact with Greece.
England.
Fire insurance arose much later, obtaining impetus
from the Great Fire of London in 1666. A number of
insurance companies were started in England after 1711,
during the so-called bubble era. Many of them were
fraudulent, get-rich-quick schemes concerned mainly
with selling their securities to the public. Nevertheless,
two important and successful English insurance
companies were formed during this period -- the London
Assurance Corporation and the Royal Exchange
Assurance Corporation. Their operation marked the
beginning of modern property and liability insurance.
No discussion of the early development of insurance
in Europe would be complete without reference to
Lloyd's of London, the international insurance market. It
began in the 17th century as a coffeehouse patronized by
merchants, bankers, and insurance underwriters,
gradually becoming recognized as the most likely place
to find underwriters for marine insurance. Edward Lloyd
supplied his customers with shipping information
gathered from the docks and other sources; this
eventually grew into the publication Lloyd's List, still in
existence. Lloyd's was reorganized in 1769 as a formal
group of underwriters accepting marine risks. (The word
underwriter is said to have derived from the practice of
having each risk taker write his name under the total

169

amount of risk that he was willing to accept at a specified

premium.) With the growth of British sea power, Lloyd's
became the dominant insurer of marine risks, to which
were later added fire and other property risks. Today
Lloyd's is a major reinsurer as well as primary insurer,
but it does not itself transact insurance business; this is
done by the member underwriters, who accept insurance
on their own account and bear the full risk in competition
with each other.
United States.
The first American insurance company was organized
by Benjamin Franklin in 1752 as the Philadelphia
Contributionship. The first life insurance company in the
American colonies was the Presbyterian Ministers' Fund,
organized in 1759. By 1820 there were 17 stock life
insurance companies in the state of New York alone.
Many of the early property insurance companies failed
from speculative investments, poor management, and
inadequate distribution systems. Others failed after the
Great Chicago Fire in 1871 and the San Francisco
earthquake and fire of 1906. There was little effective
regulation, and rate making was difficult in the absence
of cooperative development of sound statistics. Many
problems also beset the life insurance business. In the era
following the U.S. Civil War, bad practices developed:
dividends were declared that had not been earned,
reserves were inadequate, advertising claims were
exaggerated, and office buildings were erected that
sometimes cost more than the total assets of the
companies. Thirty-three life insurance companies failed

170

between 1870 and 1872, and another 48 between 1873

and 1877.
After 1910 life insurance enjoyed a steady growth in
the United States. The annual growth rate of insurance in
force over the period 1910-90 was approximately 8.4
percent--amounting to a 626-fold increase for the 80-year
period. Property-liability insurance had a somewhat
smaller increase. By 1989 some 3,800 property-liability
and 2,270 life insurance companies were in business,
employing nearly two million workers. In 1987 U.S.
insurers wrote about 37 percent of all premiums collected
worldwide.
Japan.
Insurance in Japan is mainly in the hands of private
enterprise, although government insurance agencies write
crop, livestock, forest fire, fishery, export credit, accident
and health, and installment sales credit insurance as well
as social security. Private insurance companies are
regulated under various statutes. Major classes of
property insurance written include automobile and
workers' compensation (which are compulsory), fire, and
marine. Rates are controlled by voluntary rating bureaus
under government supervision, and Japanese law requires
rates to be "reasonable and nondiscriminatory." Policy
forms generally resemble those of Western nations.
Personal insurance lines are also well developed in Japan
and include ordinary life, group life, and group pensions.
Health insurance, however, is incorporated into Japanese
social security.
Japan's rapid industrialization after World War II was

171

accompanied by an impressive growth in the insurance

business. Toward the end of the 20th century, Japan
ranked number one in the world in life insurance in force.
It accounted for about 25 percent of all insurance
premiums collected in the world, ranking second behind
the United States. The number of domestic insurers is
relatively small; foreign insurers operate in Japan but
account for less than 3 percent of total premiums
collected.
Worldwide operations.
Because of the great expansion in world trade and the
extent to which business firms make investments outside
their home countries, the market for insurance on a
worldwide scale has expanded rapidly in the 20th
century. This development has required a worldwide
network of offices to provide brokerage services,
underwriting assistance, claims service, and so forth. The
majority of the world's insurance businesses are
concentrated in Europe and North America. These
companies must service a large part of the insurance
needs of the rest of the world. The legal and regulatory
hurdles that must be overcome in order to do so are
formidable.
In 1990 the 10 leading insurance markets in the world
in terms of the percentage of total premiums collected
were the United States (35.6 percent); Japan (20.5
percent); the United Kingdom (7.5 percent); Germany
(6.8 percent); France (5.5 percent); the Soviet Union (2.6
percent); Canada (2.3 percent); Italy (2.2 percent); South
Korea (2.0 percent); and Oceania (1.8 percent).

172

Major world trends in insurance include a gradual

movement away from nationalism of insurance, the
development of worldwide insurance programs to cover
the operations of multinational corporations, increasing
use of reinsurance, increasing use by corporations of selfinsurance programs administered by wholly owned
insurance subsidiaries (captive companies), and
increasing use of mergers among both insurers and
brokerage firms.

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