CHAPTER 3: INTRODUCTION TO INSURANCE

Content
3.0 Aims and Objectives
3.1 Introduction
3.2 What is Insurance?
3.3 Social and Economic Value of Insurance
3.4 Limitation and Disadvantage/Costs of Insurance
3.4.1 Costs/Disadvantages of Insurance
3.4.2 Limitation of Insurance
3.5 Characteristics of Insurable Risk
3.6 Summary
3.7 Answer to Check Your Progress Exercise

3.0 AIMS AND OBJECTIVES

After reading this unit, students should be able to:

- define the term insurance
- explain social and economic benefits of insurance
- outline the disadvantages/costs, and limitations of insurance
- describe the conditions that distinguish insurable risks from non-insurable risks
- discuss the basic principles that guide operation of insurance.

3.1 INTRODUCTION

Risk is a fact of life. We are confronted with so many risks in our daily life. It is not possible for
individuals to avoid risk totally. It is also difficult to forecast all the risks and calamities that are
going to happen in the future. Many happy families are ruined by unexpected death of a person
on whom the family is dependent. Many persons lost part of their body due to accident, precious
properties at times consumed or lost by the various perils such as fire, flood, burglaries, and
accidents.

These sufferings may be reduced by precautionary measures. For example efficient police
department will reduce the incidence of burglaries, relief department may lessen the sufferings
due to floods, very alert fire brigade can control a fire and reduce loss, efficient medical service
may enhance the average expectations of life. However, these measures cannot eliminate
burglaries, flood, fire or death.

Therefore, the various risks that we face in our day-to-day life cannot be totally avoided. But its
effect can be lessened. However, the ultimate victims of these risks cannot bear these
consequences by themselves. As a result it is a necessity for a device or institution to provide the
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needed help to these unfortunate individuals and organizations. Such a device is known as
Insurance and the institution, which provides such help, is called Insurance Company. In this
section of the material we will discuss this important risk management device-insurance in detail.

3.2 WHAT IS INSURANCE?

Sometimes it is difficult to define certain terms. However, it is possible to describe them. Some
definition, though not comprehensive by themselves may provide reasonably sufficient
explanations about the term insurance. The following are some of the definitions given b y
different scholars.

Insurance may be defined in economic, legal business, social, and mathematical point of view as
follows:

1. In economic sense: insurance is an important tool that provides certainty or predictability

aiming at reducing uncertainty in regard to pure risks. It accomplishes this result by
pooling or sharing of risk.
2. Legal point of view: insurance is a contract by which one party, in consideration of the
price paid to him adequate to the risk, becomes security to the other that he shall not
suffer loss, damage or prejudices by the happening of the perils specified in the policy.

Article 654(1) of the commercial code of Ethiopia states insurance as follows:

"A contract whereby a person called the insurer undertakes against payment of one or
more premiums to pay a person, called the beneficiary, sum of money where a specified
risk materializes".

From this definition we can learn that insurance is contractual agreement between two
parties: the person (Insured) and Insurance companies. When a person buys private
insurance, she/he is entering into a contract with the insurer that entitles the person
(Insured) to certain advantages but also imposes certain responsibilities such as payment
of a premium and satisfying certain conditions specified in the policy.

3. Business Point of views: as a business institution, insurance has been defined as a plan by
which large number of people associate themselves and transfer risks of individuals to the
shoulders of all members of the policy.

4. Social View Point: insurance is defined as a social device for making payment for the
accumulation of fund to meet uncertain losses of capital which is carried out through the
transfer of risk of many individuals to one person or a group of persons. It is advice through
which few unfortunates are paid by many who are member of the policy.

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5. Mathematical viewpoint: insurance is the application of actuarial (Insurance mathematics)
principles. Laws of probability and statistical techniques are used to achieve predictable
results.

Williams and Heins defines defined insurance as "a device by means of which the risks of
two or more persons or firms are combined through actual or promised contributions to a
fund out of which claimants are paid."

Dinsdale and McMurdie also defined insurance as "a device for transfer of risks of individual
entities to an insurer, who agrees, for a consideration (called the premium), to assume to a
specified extent losses suffered by the insured".

From the definitions, it can be learned that:

1) Insurance is a system used to transfer risk of individuals for payment of premium.

The insured considers insurance as a transfer device where as from the point of view of
the insurer (Insurance company), it is regarded as retention and combination device. Of
course, one may ask, "Why the insurer accepts risks that other people try to avoid?"
Insurance companies /Insurers accept the risks of others because, as compared to
individual insureds:

i) They have the knowledge and the skill to apply various risk reduction and risk
control measures;
ii) Combination or pooling of similar risks will enable the insurer to predict the actual
loss experience with a reasonable accuracy.
iii) They have financial capacity to assume/ take risk
iv) They are in a position to enforce certain loss reduction and prevention measures
v) For losses that are beyond their capacity, insurers arrange a reinsurance mechanism.
From this we can say that risk in the business of insurance companies. The insured is
required to pay some amount of money in relation for the transfer of his/her risk to the
insurer. They do this because they want to remain secured financially and/or mentally.
2) It is a scheme that establishes a common fund out of which financial compensation is
made to those who faces accidental losses.
3) It is a pooling of risks of many people who are exposed to the same risk.
4) It is a device used to spread the loss suffered by an individual or firm to the members in
the group.
5) It is a method to provide security to the insured person against the probable loss.
3.3 THE FUNCTIONS OF INSURANCE

The functions of insurance can be studied in two parts: primary and secondary functions.

3.3.1 Primary Functions

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 Insurance executes the following functions primarily.
a. Providing certainty. Insurance provides certainty of payment at the uncertainty of loss. The
uncertainty of loss can be reduced by better planning and administration. Insurance removes
all uncertainties and assurance is given to payment of compensation at the time of loss. The
insurer charges premium for providing the said certainty.

b. Protection. The main function of insurance is to provide protection against the probable
chances of loss. Insurance guarantees the payment of loss and this protects the assured from
sufferings.

c. Risk-sharing. When the risk takes place, all the persons who are exposed to the risk share
the loss.

3.3.2 Secondary Functions

In addition to the aforementioned primary functions, insurance plays the following:

a. Prevention of loss. Insurance is primarily concerned with the financial consequences of

losses, but it would be fair to say that insurers have more than a passing interest in loss
control. It could be argued that insurers have no real interest in the complete control of loss, as
this would inevitably lead to an end to their business. This is a rather shortsighted view.
Insurers do have an interest in reducing the frequency and the severity of loss. In a practical
way, buyers of insurance will normally come into contact with the loss control services
offered by an insurer when they meet the surveyor. The surveyor may be employed by the
insurer, or indeed the insurance broker, and part of his job is to give advice on loss control.
Many insurers employ specialist surveyors in fire, security, liability and other types of risk;
others will employ people with broader, but less detailed, knowledge.

The surveyor will assess the extent of the risk to which the insurance company is exposed. In
doing so he will also offer advice, which could take the form of pre-loss control (minimizing
the chance that something will happen) or post-loss control (after an event has occurred).
Traditionally, the expertise of surveyors was concentrated on risks for which commercial
insurance was available. Increasingly, risk control surveyors employed by insurers and
insurance brokers have extended the services they offer to include identification and control
of all risks faced by organizations, as part of a wider risk management service.

The best time for a surveyor to be consulted is at the planning stage of a project. He can then
incorporate features which may minimize risk and control loss. A good example of this is the
installation of automatic fire-sprinkler systems. It is obviously far simpler and cheaper to
include a sprinkler system in the design of a building, rather than to alter a building once it
has been constructed to add sprinklers. Most builders are alert to the value of fire prevention
and control, but the same principle applies to safety and security.

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 The insurance assist financially to the fire brigade, educational institutions and other
organizations, which are engaged in preventing the losses. In short, the function of insurance
is not merely compensating those who suffered loss at the time the risk materializes.
However, insurance must make sure that adequate loss prevention and loss control
mechanisms were implemented by the insured to minimize the probability and severity of the
loss.

b. Providing Capital. Insurance companies have, at their disposal, large amounts of money. This
arises due to the fact that there is a time gap between the receipt of a premium and the
payment of a claim. A premium could be paid in January and a claim may not occur until
December, if it occurs at all. The insurer has this money and can invest it. In fact, the insurer
will have the accumulated premiums of all insureds, over a long period of time.

We have listed investment as one of the benefits of insurance in later discussions and the
benefit lies in the use to which the money is put. Insurers invest in a wide range of different
forms of investment. By having spread of investments, the insurance industry helps national
and international businesses in their borrowing. It also helps industry and commerce, b y
making various forms of loan and by taking up shares which are offered on the open market.
Insurers make up part of what are termed the institutional investors; the others include banks,
building societies and pension funds. Investment is also made in property.

3.4 SOCIAL AND ECONOMIC VALUES OF INSURANCE

Insurance is obviously desirable that we can enumerate several advantage or value to the social
well-being and economic development of a nation. Some of the advantages are discussed below.

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1. Risk transfer/Indemnification
The primary objective of insurance is to provide financial compensation to those insured who
suffered accidental losses. Indemnification is made out of the fund established by the members’
contribution or premium payment, who are exposed to the same risk. This means, the loss is
spread to all members on equitable basis and the financial burden of the unfortunate is reduced
and he is restored to his former financial position. By doing so, insurance helps stabilize the
financial situation of individuals, families and organizations.

2. Reduction of Uncertainty
Insurance reduces the physical and mental stress that insured's face concerning the risk of loss
and provides peace of mind. It is a psychological benefit that may not be quantified but still of
great importance. Insurance reduces worries and anxieties and help everyone work in a relaxed
manner, which can make every one to work more productive and perform his duties properly
without anxiety. This has direct implication on the society because the society will be secured
from unexpected loss and interruption of services from those who will face unexpected loss.

3. Encourages Savings
Insurance is a contractual agreement between the insurer and the insured, where the insured is
expected to pay a premium for the risk he/she transferred to the insurer. This compulsory
premium payments are a form of encouragement of the insured to make systematic saving.
Particularly, this is possible in certain life insurance policies that have dual purpose, i.e.,
protection in the event of death and savings in the event of survival.

4. Help Businesses Continue Without Interruption of Operation

The insured firm will not be knocked out of business by fire or liability or other insurable risks.
The insurer indemnifies the losses and restores the firm to its former position. This is also
advantageous to the society because they can get uninterrupted services and goods of the firm.
Moreover, insurance helps small businesses since they cannot bear all the risks by themselves.
By transferring their risk, they can safely perform their operation and compete with larger firms.

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5. Provide Funds for Investment
Premiums collected by insurance companies are not left stagnant. They are used to provide a big
source long-term investment capital for the national economy. The loan is made available to
investors through banks and it serve as a stimulant for the national economy to be healthier.

6. Keeps Families Together

Family can continue to live together after disastrous adversaries. For example, if a husband with
life insurance dies, it may not force his family to disintegrate due to lack of income because they
can receive the compensation from the insurer and can earn their live as it was before at least to
some extent

It relieves pressure on social welfare system, thereby reserving government resources for
essential social security activities.

7. Provides a Basis for Credit

Insurance policies are used as a guarantee for personal and business bank loans. This days banks
lend money on the basis of the collateral security of insurance.

8. Promotes Loss Control Systems

In order to minimize their losses, insurance companies have tried and are continuing to introduce
several kinds of loss reduction and prevention schemes. For example, health education,
inspection, of elevators, and boilers, installation of fire extinguishers, burglar alarms, on vehicles
or houses are risk control mechanisms developed and applied by insurance companies at
different times. The introduction of this loss control programs can reduce losses to businesses
and individuals and complement good risk management thereby benefiting society as a whole.

9. It provides Financial Stability to the Community

Insurance makes a remarkable contribution to the society as a whole. It creates certainty in the
environment thereby stimulating competition among business enterprises in a certain region. Fair
competition is a greater advantage to the society since it reduces price, encourage efficient
utilization of scarce resources and produce quality products. Insurance also avoids or at least
minimizes production stoppage that produces an economic wastage, and results in loss of profit
to the insured, unemployment and loss of trade and services to the business community. So,
insurance can minimize all these and other consequences of risk.

10. Stimulates International Trade and Commerce

Goods traded at the international market are highly vulnerable to risk of loss due to large number
of perils. As a result it is difficult to think of international trade with out insurance. Insurance
coverage may be a condition for engaging in international trade and commerce. Insurance serves
as a "lubricant of trade", without it trade and commerce may stifle.

3.5 COSTS AND LIMITATIONS OF INSURANCE

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Disadvantages/ Costs of Insurance
Insurance is not without some problems. It has the following major problems:
1. It encourages fraud to collect dishonest claims (moral hazard problems). When
individuals are insured against a particular risk, they may intentionally increase the
chance of loss, or exaggerate the claim.
2. Increases carelessness in life (morale hazard problem): it is a condition that causes to
be less careful than they would otherwise be. Some individuals do not consciously seek
to bring about a loss, but the fact that they have insurance causes them to take more risks
than they would if they had no insurance coverage. This manner may result in excessive
losses in the community.
3. Cost of Insurance: insurers incur operating expenses such as loss control costs, loss
adjustment expenses, expense involved in acquiring insured, (advertisement cost), state
premium taxes, and general administrative costs. In addition to these expenses, the
insured is expected to cover a reasonable amount for profit and contingencies.

Limitations of Insurance
Insurance is clearly a useful device for handling risk, but some risks cannot safely be handled by
insurance. It is a device used to deal with pure risks only. Even not all pure risks are insurable.
That means, insurance does not provide protection against a wide range of risks. It has a limited
application. You may question: what types of risks are insurable? To give an answer to this
question, it is necessary to discuss the characteristics of insurable risks. In other words, for
insurance to be used as a risk transfer mechanism the following conditions must be met to
identify the insurable risks from those which cannot be commercially insurable.

3.6. Characteristics of Insurable Risks

1. A large number of independent units should be exposed to the same risk. This requirement
follows from the law of large numbers, a mathematical principle which states that a risk that
is not predictable for one person can be forecasted accurately for sufficiently large groups of
people with similar characteristics. Insurance operation is safe only when the insurer is able
to predict fairly and accurately its expected losses. If the pool of policy holders is small,
volatility in number of claims can lead to unexpected increase in claim and hence bankrupt
the plan the insurance company.

Therefore, there must be a sufficiently large number of risks of a similar class being insured
so as to predict accurately the average loss experience.
2. It must be possible to calculate/measure the chance of loss in monetary terms.
3. The loss should be definite, in time, place, cause and amount; otherwise claim adjustment
will be difficult.
4. The loss should be accidental from the view point of the insured as distinguished from the
expected loss. For example, losses on account of depreciation cannot be insured, as there is
nothing accidental about their occurrence.
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5. The possible loss must not be catastrophic. The risks covered by insurance should affect only
a relatively small portion of the total insured population at a given time. If a risk is likely to
cause similar damage to a large proportion of policy holders at the same time, a single
occurrence of the risk would bankrupt the insurance companies. Therefore, with certain
exceptions, it is usual to find exclusions regarding fundamental risks such as war and
earthquake in all insurance contracts.
6. There must be an insurable interest. An insurance contract provides security against the
consequences of a loss and is basically concerned with preserving the interest of the insured,
one who possesses insurable interest (financial relationship) in the subject matter of
insurance can avail the insurance protection.
7. The potential loss must be large. The risk should not be very minor one and the peril must be
capable of causing a loss so large that the insured cannot bear it himself without economic
distress.
8. The cost of insurance should not be prohibitive. The cost of insuring (premium) must be
economically feasible and within the reach of nearly everyone; otherwise it will be confined
to a very small section of the society. For instance, who would be willing to pay Birr 1,000 or
2,000 to insure the risk of losing a 100 Birr property? If you are rational person, the answer is
definitely “no" the premium should be reasonable.
9. The risk must be consistent with public policy. The insurance contract should not be against
the public policies, for example, insurance affected by terrorists for fines imposed for the
offences.
10. The insured must be subject to real risk whatever may be the subject matter of insurance for
which the insured seeks protection, the subject matter must be adversely affected on the
happening of the event, i.e., the subject matter must be potentially exposed to the risk.

Insurable Risk
The following are generally insurable risks.
1. Pure risks: property (direct and indirect property losses; personal and legal liability
losses).
2. Non-catastrophic losses
3. Risk with low probability of occurrence

Un insurable risks
1. Speculative risks such as market risks,
2. Fundamental risks (war, earthquake, political and economic losses).
3. Wear and tear of goods, eg. Depreciation.
4. Risk that are against public policy.

3.7 INSURANCE CONTRACTS

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Understanding of the legal interpretation of Insurance Contract can be important to a risk
manager, for several reasons. One reason in fundamental in deciding whether to use insurance or
some other risk management tools, the insured or the risk manager should know what the insurer
promises to do under the contract. The risk manger also should understand the rights and
responsibilities of the insurer and the insured under the contract.

Insurance contracts are subject to the same basic law that govern all types of contracts. But
insurance contracts have many characteristics not found in most other contracts. A set of special
features discussed below applies to insurance contracts.

Insurance contracts are agreements between the insurance companies and the insured for the
purpose of transferring from the insured to the insurer part of the risk or loss arising out of
contingent events. The contract serves the following functions:

i) Define the risk to be transferred

ii) State the conditions under which the contract parties should know such as premium and
performance of certain acts.
iii) Explain the procedures for selling loss claims.
A feature discussed below tends to distinguish insurance from other contracts.

1. Personal Contract
Insurance contracts are personal contracts. Although the subject of a property insurance contract
is an item of property, the contract insures the legal interest of a person or an entity not the
property itself. If the owner of a car (Mr. Y) sells the car to Mr. X, the new owner Mr. X is not
insured under the contract unless the insurer agrees to assignment of the insured’s (Mr. Y’s)
rights to the new owner (Mr. X).

2. Unilateral Contract
Insurance contracts are commonly unilateral contracts. After the insured has paid the premium
and the contract has gone into effect, only the insurer can be forced to perform, because the
insured has fulfilled his/her promise to pay the premium. The term "unilateral" means that courts
will enforce the contract in one direction only: against one of the parties: in this case, the insurer.
A typical contract other than insurance is bilateral. However, in some cases the insured may
promise to pay premium during the contract period. In this situation, the contract becomes
bilateral.

3. Conditional Contract
Insurance contracts are conditional contracts. Although only the insurer can be forced to perform
after the contract is effective, the insurer can refuse to perform if the insured does not satisfy
certain conditions contained in the contract. For instance, the insurer need not pay a claim if the
insured has increased the chance of loss in some manner prohibited under the contract or has
failed to submit a proof of loss within a specified period.
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4. Aleatory Contract
Insurance contract are aleatory contracts, i.e., the obligation of at least one of the parties to
perform is dependent upon chance. If the event insured against occurs, the insurer will probably
pay the insured a sum of money much larger than the premium. If the event does not occur, the
Insurer will pay nothing.

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5. Contract of Adhesion
Insurance contract is usually contracts of adhesion. The insured seldom participates in the
drafting of the contract. Usually the insurer offers the Insured a printed document on a take-it or-
leave -it -basis. Courts frequently refer to this characteristic of insurance contracts when they
interpret ambiguous provisions in favor of the insured and interpreted for the benefit of the
insured.

6. Contracts of Uberrimae Fidei

The literal meaning of "Uberrimae Fidei" is utmost good faith that can be restated as the highest
standard honesty.
Insurance contracts are contracts of the utmost good faith. Both parties to the contract are bound
to disclose all the facts relevant to the transaction. Neither party is to take advantage of the
other's lack of information.

7. Contract of Indemnity
Property and liability insurance contracts are contracts of indemnity. The person insured should
not benefit financially from the happening of the event insured against. Because insurance do not
allow insured's to make profit from happening of a particular risk. Life and frequently health
insurance contracts are not contracts of indemnity.

3.6.2 Requirements for a Valid Contract

According to the law of contracts, a contract must satisfy some conditions before it is legally
enforceable. Some of these are:

1. The contract must serve a legal purpose.

2. One party must make a definite offer and a second party must accept the offer.
3. Each party to the contract must be required to make some consideration on behalf of the
other party. The contract is not enforceable unless one party gives up a right, power, or
privilege that he/she already has in exchange for an equivalent renouncement by the
other.
4. The parties to the contract must be legally competent. Insane, minors or intoxicated
persons are not considered competent. For instance, Minors may void a contract to which
they are a party, except a contract of "necessities" (food, clothing and shelter etc).
5. The purpose of the contract should not be contrary to public interest.

3.6.3 Valid Elements Common to Insurance Contracts

A valid insurance contract includes the following documents and conditions. They are:
 Application
 Binders
 Policy forms

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  Endorsement

1. Application: is an offer to enter into a contract. The prospective insured sets forth the facts
and figures required by the insurance company. Application may take oral or written from.
2. Binders: Is a temporary document, which remains in force for few days for not more than
10 days.
3. Policy forms: policy form is a formal written contract of insurance. The common
provisions included in this document are:
i. Declarations: This identifies the insured, describes the property, activity
or life being insured, states the types of coverage purchased, terms of
coverage, and indicates the premium paid. The purpose of declaration is to
give sufficient information needed for the insured.
ii. Insuring agreements: this part states what the insurer promises to do.
iii. Exclusions: the contract may exclude certain perils, property, sources of
liability, persons, losses, locations or time periods.
iv. Conditions: These prescribe certain conditions that should be met by the
insured.
4. Endorsement: is a form that is used to modify the policy contract.

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