CHAPTER THREE

INSURANCE

3.1. Insurance Defined

There is no single definition of insurance. Insurance can be defined from the viewpoint of several
disciplines, including law, economics, history, actuarial science, risk theory, and sociology. But
each possible definition will not be examined at this point. Instead, we will examine those
common elements that are typically present in any insurance plan. However, before proceeding,
a working definition of insurance-one that captures the essential characteristics of a true
insurance plan-must be established.

After careful study, the commission on insurance terminology of the American risk and
insurance association has defined insurance as follows:

Insurance is the pooling of fortuitous losses by transfer of such risks to insurers, who agree to
indemnify insureds for such losses, to provide other pecuniary benefits on their occurrence, or to
render services connected with the risk. Although this definition may not be acceptable to all
insurance scholars, it is useful for analyzing the common elements of a true insurance plan.

Insurance can be defined from two points of view.

Insurance defined from the viewpoint of the individual.

Based on the preceding description, we may define insurance from the individual’s viewpoint as
follows:

From an individual view point, insurance is an economic device whereby the individual
substitutes a small certain cost (the premium) for a large uncertain financial loss (the
contingency insured against) that would exist if it were not for the insurance.

Insurance is the protection against financial loss provided by an insurer. The primary function of
insurance is the creation of the counterpart of risk, which is security. Insurance does not decrease
the uncertainty for the individual as to whether the event will occur, nor does it alter the
probability of occurrence, but it does reduce the probability of financial loss connected with the

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event. From the individual’s point of view, the purchase of an adequate amount of insurance on a
house eliminates the uncertainty regarding a financial loss in the event that the house should burn
down.

Some people seem to believe that they have somehow wasted their money in purchasing
insurance if a loss does not occur and indemnity is not received. Some even feel that if they have
not had a loss during the policy term, their premium should be returned. Both viewpoints
constitute the essence of ignorance. Relative to the first, we already know that the insurance
contract provides a valuable feature in the freedom from the burden of uncertainty. Even if a loss
is not sustained during the policy term, the insured has received something for the premium: the
promise of indemnification if a loss had occurred. With respect to the second, one must
appreciate the fact that the operation of the insurance principle is based upon the contribution of
the many paying the losses of the unfortunate few. If the premiums were returned to the many
who did not have losses, there would be no funds available to pay for the losses of the few who
did. Basically, then, the insurance device is a method if loss distribution. What would be a
devastating loss to an individual is spread in an equitable manner to all members of the group.

Insurance defined from the viewpoint of society.

From the social point of view, insurance is an economic device for reducing and
eliminating risk through the process of combining a sufficient number of homogeneous
exposures into a group to make the losses predictable for the group as a whole.

Insurance is 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. From the
view point of insured, insurance is a transfer device. From the view point of the insurer,
insurance is a retention and combination device. The distinctive feature of insurance as a transfer
device is that it involves some pooling of risks; i.e., the insurer combines the risks of many
insureds. Through this combination the insurer improve its ability its expected losses.

Insurance does not prevent losses, nor does it reduce the cost of losses to the economy as a
whole. As a matter of fact, it may very well have the opposite effect of causing losses and
increasing the cost of losses for the purpose of defrauding the insurer, and in addition, people are
less careful and may exert less effort to prevent losses than they might if the insurance did not
exist. Also, the economy incurs certain additional costs in the operation of the insurance

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mechanism. Not only must the cost of the losses be borne, but the expense of distributing the
losses on some equitable basis adds to this cost.

3.2. Basic Characteristics of Insurance

Based on the preceding definition, an insurance plan or arrangement typically includes the
following characteristics:

 Pooling of losses
 Payment of fortuitous losses
 Risk transfer
 Indemnification

Pooling of Losses

Pooling or the sharing of losses is the heart of insurance. Pooling is the spreading of losses
incurred by the few over the entire group, so that in the process, average loss is substituted for
actual loss. In addition, pooling involves the grouping of a large number of exposure units so
that the law of large numbers can operate to provide a substantially accurate prediction of future
losses. Ideally, there should be a large number of similar, but not necessarily identical, exposure
units that are subject to the same perils. Thus, pooling implies:

(1) The sharing of losses by the entire group, and

(2) Prediction of future losses with some accuracy based on the law of large numbers.

By pooling or combining the loss experience of a large number of exposure units an insurer may
be able to predict future losses with some accuracy. From the viewpoint of the insurer, if future
losses can be predicted, objective risk is reduced. Thus, another characteristics often found in
many lines of insurance is risk reduction based on the law of large of numbers.

If there are a large number of exposure units, the actual loss experience of the past may be a
good appropriation of future losses. As the number of exposures increases, the relative variation
of actual loss from expected loss will decline. Thus, the insurer can predict future losses with a
greater degree of accuracy as the number of exposures increases. This concept is important since
an insurer must charge a premium that will be adequate for paying all losses and expenses during
the policy period. The lower the degree of objective risk, the more confidence an insurer has that

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the actual premium charged will be sufficient to pay all claims and expenses and provide a
margin for profit.

Payment of Fortuitous Losses

A second characteristic of private insurance is the payment of fortuitous losses. A fortuitous loss
is one that is unforeseen and unexpected and occurs as a result of chance. In other words, the
loss must be accidental. The law of large numbers is based on the assumption that losses are
accidental and occur randomly. For example, a person may slip on a muddy sidewalk and break a
leg. The loss would be fortuitous.

Risk Transfer

Risk transfer is another essential element of insurance. With the exception of self-insurance, a
true insurance plan always involves risk transfer. Risk transfer means that a pure risk is
transferred from the insured to the insurer, who typically is in a stronger financial position to
pay the loss than the insured. From the viewpoint of the individual, pure risks that are typically
transferred to insurers include the risk of premature death, poor health, disability, destruction and
theft of property, and liability lawsuits.

Indemnification

A final characteristic of insurance is indemnification for losses.

Indemnification means that the insured is restored to his or her approximate financial position
prior to the occurrence of the loss. Thus, if your house burns in a fire, the homeowner’s policy
will indemnify you or restore you to your previous position. If you are sued because of the
negligent operation of an automobile, your automobile liability insurance policy will pay those
sums that you are legally obligated to pay. Similarly, if you are seriously disabled, a disability-
income policy will restore at least part of the lost wages.

3.3. Fundamentals of Insurable Risk

In spite of the usefulness of insurance in many contexts, not all risks are commercially insurable.
Insurers normally insure only pure risks. However, not all pure risks are insurable. Certain
requirements usually must be fulfilled before a pure risk can be privately insured. The
characteristics of risks that make it feasible for private insurers to offer insurance for them are

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called the requisites of insurable risks. Requirements should not be considered as absolute, iron
rules but rather as guides or ideal standards that are not always completely attained in practice.
From the viewpoint of the insurer, there are ideally six requirements of an insurable risk.

 There must be a large number of exposure units

 The loss must be accidental and unintentional
 The loss must be determinable and measurable
 The loss should not be catastrophic
 The chance of loss must be calculable
 The premium must be economically feasible

Large Number of Exposure Units

There must be a sufficiently large number of homogenous exposure units to make the losses
reasonably predictable. Ideally, there should be a large group of roughly similar, but not
necessarily identical, exposure units that are subject to the same peril or group of perils.

Example

 A large number of frame dwellings in a city can be grouped together for purposes of
providing property insurance on the dwellings.

The purpose of this first requirement is to enable the insurer to predict loss based on the law of
large numbers. Loss data can be compiled over time, and losses for the group as a whole can be
predicted with some accuracy. The loss costs can then be spread over all insureds in the
underwriting class.

Accidental and Unintentional Loss

The loss must be accidental and unintentional. The loss must be the result of a contingency; that
is, it must be something that may or may not happen. It must not be something that is certain to
happen. Ideally, the loss should be fortuitous and outside the insured’s control. Thus, if an
individual deliberately causes a loss, he or she should not be indemnified for the loss.

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Example

 Depreciation, which is a certainty cannot be insured: it is provided for through a sinking

fund

The requirement of an accidental and unintentional loss is necessary for two reasons.

 First, if intentional loss were paid, moral hazard would be substantially increased, and
premiums would raise a result. The substantial increase in premiums could result in
relatively fewer persons purchasing the insurance, and the insurer might not have a
sufficient number of exposure units to predict future losses.
 Second, the loss should be accidental because the law of large numbers is based on the
random occurrence of events. A deliberately caused loss is not a random event because
the insured knows when the loss will occur. Thus, prediction of future experience may be
highly inaccurate if a large number of intentional or nonrandom losses occur. The law of
large numbers is useful in making predictions only if we can reasonably assume that
future occurrences will approximate past experience. Since we assume that a past
experience was a result of chance happening, the predictions concerning the future will
be valid only if future happenings are also a result of chance.

Determinable and Measurable Loss

The loss should both determinable and measurable. This means the loss should be definite as to
cause, time, place, and amount. We must be able to tell when a loss has taken place, and we must
be able to set some value on the extent of it. Life insurance in most cases meets this requirement
easily. The cause and time of death can be readily determined in most cases, and if the person is
insured, the face amount of the life insurance policy is the amount paid.

Some losses however, are difficult to determine and measure. For example, under a disability-
income policy, the insurer promises to pay a monthly benefit to the disabled person if the
definition of disability stated in the policy is satisfied. Some dishonest claimants may
deliberately fake sickness or injury in order to collect from the insurer. Even if the claim is
legitimate, the insurer must still determine whether the insured satisfies the definition of
disability stated in the policy. Sickness and disability are highly subjective, and the same event
can affect two persons quite differently.

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  For example, two accountants who are insured under separate disability income contracts
may be injured in an automobile accident, and both may be classified as totally disabled.
Once accountant, however, may be stronger willed and more determined to return to
work. If that accountant undergoes rehabilitation and returns to work, the disability-
income benefits will terminate. Meanwhile, the other accountant would still continue to
receive disability-income benefits according to the terms of the policy. In short, it is
difficult to determine when a person is actually disabled. However, all losses ideally
should be both determinable and measurable.

Before the burden of the risk can be safely assumed, the insurer must set up procedures to
determine whether loss has actually occurred and, if so, its size. The basic purpose of this
requirement is to enable an insurer to determine if the loss is covered under the policy, and if it is
covered, how much should be paid.

 For example, Shannon has an expensive fir coat that is insured under a home-owners
policy. It makes a great deal of difference to the insurer if a thief breaks into her home
and steals the coat, or the coat is missing because her husband stored it in a dirty-cleaning
establishment but forgot to tell her. The loss is covered in the first example but not in the
second.

No Catastrophic Loss

The loss should not be catastrophic. This mean that a large proportion of exposure units should
not be incur losses at the same time. As we stated earlier, pooling is the essence of insurance. If
most or all of the exposure units in a certain class simultaneously incur a loss, then the pooling
technique breaks down and becomes unworkable. Premiums must be increased to prohibitive
levels, and the insurance technique is no longer a viable arrangement by which losses of the few
are spread over the entire group.

Insurers ideally wish to avoid all catastrophic losses, but in the real world, this is impossible,
since catastrophic losses, periodically result from floods, earthquakes, forest fires, and other
natural disasters. Fortunately, several approaches are available for meeting the problem of a
catastrophic loss. First, reinsurances can be used by which insurance companies are indemnified
by reinsures for catastrophic losses.

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Reinsurance is the shifting of part or all of the insurance originally written by one insurer to
another insurer. The reinsurer is then responsible for the payment of its share of the loss.
Reinsurance is discussed in greater detail in chapter seven.

Second, insurers can avoid the concentration of risk by dispersing their coverage over a large
geographical area. The concentration of loss exposures in a geographical area exposed to floods
or other natural disasters can result in periodic catastrophic losses. If the loss exposures are
geographically dispersed, the possibility of a catastrophic loss is reduced.

Finally, financial instruments are now available for dealing with catastrophic losses. These
instruments include catastrophe bonds, which are designed to pay for a catastrophic loss.

Calculable Chance of Loss

The chance of loss should be calculable. The insurer must be able to calculate both the average
frequency and the average severity of future losses with some accuracy. This requirement is
necessary so that a proper premium can be charged that is sufficient to pay all claim and
expenses and yield a profit during the policy period.

Certain losses, however, are difficult to insure because the chance of loss cannot be accurately
estimated, and the potential for a catastrophic loss is present. For example, floods and wars occur
on an irregular basis, and prediction of the average frequency and the severity of losses is
difficult. Thus, without government assistance, these losses are difficult for private carriers to
insure.

Economically Feasible Premium

The premium should be economically feasible. The insured must be able to pay the premium. In
addition, for the insurance to be an attractive purchase, the premium paid must be substantially
less than the face value, or amount, of the policy.

To have an economically feasible premium, the chance of loss must be relatively low. One view
is that if the chance of loss exceeds 40 percent, the cost of the policy will exceed the amount that
the insurer must pay under the contract. For example, an insurer could issue a $ 10000 life
insurance policy on a man age 99, but the pure premium would be about $980, and an additional
amount for expenses would have to be added. The total premium would exceed the face amount
of the insurance.

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Based on the preceding requirements, most personal, liability, and property risks can be privately
insured, because the requirements of an insurable risk generally can be met. In contrast, most
market risks, financial risks, production risks, and political risks are difficult to insure by private
insurers. These risks are speculative, and the requirements of an insurable risk discussed earlier
are not easily met. In addition, the potential of each risk to produce a catastrophic loss is great;
this is especially true for political risks, such as the risk of war.

Finally, calculation of proper premium may be difficult because the chance of loss cannot be
accurately estimated. For example, insurance that protects a retailer against loss because of a
change in consumer tastes, such as a style change, generally is not available. Accurate loss data
are not available, and there is no accurate way to calculate a premium. The premium charged
may or may not be adequate to pay all losses and expenses. Since private insurers are in business
to make a profit, certain risks are difficult to insure because of the possibility of substantial
losses.

3.4. Insurance and Gambling Compared

Insurance is often erroneously confused with gambling. There are two important differences
between them.

First, gambling creates a new speculative risk, while insurance is a technique for handling an
already existing pure risk. Thus, if you bet $300 on a horse race, a new speculative risk is
created, but if you pay $300 to an insurer for fire insurance, the risk of fire is already present and
is transferred to the insurer by a contract. No new risk is created by the transaction.

The second difference between insurance and gambling is that gambling is socially
unproductive, because the winner’s gain comes at the expense of the loser. In contrast, insurance
is always socially productive, because neither the insurer nor the insured is placed in a position
where the gain of the winner comes at the expense of the loser. The insurer and the insured both
have a common interest in the prevention of a loss. Both parties win if the loss does not occur.
Moreover, frequent gambling transactions generally never restore the losers to their former
financial position. In contrast, insurance contracts restore the insureds financially in whole or in
part if a loss occurs.

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 3.5. Insurance and Speculation Compared

Speculation on the other hand involves doing some kind of activity with the expectation of profit
in the future. For instance, a businessman who purchases and sells goods, stocks and shares, etc
with the risk of loss and hope of profit through changes in their market value is a clear case of
speculation. Through speculation individuals create a risk deliberately in the anticipation of
profits. However, an insurance transaction normally involves the transfer of risks that are
insurable, since the requirements of an insurable risk generally can be met. On the contrary,
speculation is a technique for handling risks that are typically uninsurable, such as protection
against a substantial decline in the price of agricultural products and raw material.

The other difference between the two is that insurance can reduce the objective risk of an
insurer by application of the law of large numbers. In contrast, speculation typically involves
only risk transfer, not risk reduction. The risk of an adverse price fluctuation is transferred to a
speculator who feels he or she can make a profit because of superior knowledge of forces that
affect market price. The risk is transferred, not reduced, and the speculator’s prediction of loss
generally is not based on the law of large numbers.

At this point, we may ask ourselves if insurance is a charity. Is insurance a charity?

Charity is given without consideration but insurance is not possible without premium. Insurance
is a profession of providing certainty and predictability and safety to the individual, business or
society. It provides adequate finance at the time of damage only by charging a normal premium
for the service.
3.6. Benefits and Costs of Insurance

Insurance has peculiar advantages as a device to handle risk and so ought to be used to bring
about the greatest economic advantage to the society

3.6.1. Benefits of Insurance to the Society

The existence of insurance results in great benefits to society. The major social and economic
benefits of insurance include the following:

 Indemnification for loss

 Reduction of worry and fear
 Source of investment funds
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  Loss prevention
 Enhancement of credit

Indemnification for Loss

Indemnification permits individuals and families to be restored to their former financial position
after a loss occurs. As a result, they can maintain their financial security. Because insureds are
restored either in part or in whole after a loss occurs, they are less likely to apply for public
assistance or welfare benefits, or to seek financial assistance from relatives and friends.

Indemnification to business firms also permits firms to remain in business and employees to keep
their jobs. Suppliers continue to receive orders, and customers can still receive the goods and
services they desire. The community also benefits because its tax base is not eroded. Business
and families who suffer unexpected losses are restored or at least moved closer to their former
economic position. The advantage to these individuals is obvious. Society also gains because
these persons are restored to production and tax revenues are increased. In short, the
indemnification function contributes greatly to family and business stability and therefore is one
of the most important social and economic benefits of insurance.

Reduction of Worry and Fear

A second benefit of insurance is that worry and fear are reduced. This is true before and after a
loss. For example, if family heads have adequate amounts of life insurance, they are less likely to
worry about the financial security of their dependents in the event of premature death; persons
insured for long-term disability do not have to worry about the loss of earnings if a serious
illness or accident occurs, and property owners who are insured enjoy greater peace of mind
because they know they are covered if a loss occurs. Worry and fear are also reduced after a loss
occurs, because the insureds know that they have insurance that will pay for the loss.

Source of Investment Funds

The insurance industry is an important source of funds for capital investment and accumulation.
Premiums are collected in advance of the loss, and funds not needed to pay immediate losses and
expenses can be loaned to business firms. These funds typically are invested in shopping centers,
hospitals, factories, housing developments, and new machinery and equipment. The investments
increase society’s stock of capital goods, and promote economic growth and full employment.

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Insurers also invest in social investments, such as housing, nursing homes, and economic
development projects. In addition, because the total supply of loanable funds is increased by the
advance payment of insurance premiums, the cost of capital to business firms that borrow is
lower than it would be in the absence of insurance.

Loss Prevention

Insurance companies are actively involved in numerous loss-prevention programs and also
employ a wide variety of loss-prevention personnel, including safety engineers and specialists in
fire prevention, occupational safety and health, and products liability. Some important loss-
prevention activities that property and liability insurers strongly support include the following:

 Highway safety and reduction of automobile deaths

 Fire prevention
 Reduction of work-related disabilities
 Prevention of auto thefts
 Prevention and detection of arson losses
 Prevention of defective products that could injure the user
 Prevention of boiler explosion
 Educational programs on loss prevention

The loss-prevention activities reduce both direct and indirect, or consequential, losses. Society
benefits, since both types of losses are reduced.

Enhancement of Credit

A final benefit is that insurance enhances a person’s credit. Insurance makes a borrower a better
credit risk because it guarantees the value of the borrower’s collateral or gives greater assurance
that the loan will be rapid. For example, when a house is purchased, the lending institution
normally requires property insurance on the house before the mortgage loan is granted. The
property insurance protects the lender’s financial interest if the property is damaged or destroyed.
Similarly, a business firm seeking a temporary loan for holidays or seasonal business may be
required to insure its inventories before the loan is made. If a new car is purchased and financed
by a bank or other lending institution, physical damage insurance on the car may be required
before the loan is made. Thus, insurance can enhance a person’s credit.

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 3.6.2. Cost of Insurance to the Society

Although the insurance industry provides enormous social and economic benefits to society, the
social cost of insurance must also be recognized. The major social costs of insurance include the
following:

 Cost of doing business

 Fraudulent claims
 Inflated claims

Cost of Doing Business

One important cost is the cost of doing business. Insurers consume scare economic resource-
land, labor, capital, and business enterprise-in providing insurance to society. In financial terms,
an expense loading must be added to the pure premium to cover the expenses incurred by
insurance companies in their daily operations. For example, assume that a small country with no
property insurance has an average of $100 million of fire losses each year. Also assume that
property insurance later becomes available, and the expense loading is 35 percent of losses.
Thus, total costs to this country are increased to $135 million.

Insurers incur expenses such as loss-control costs, loss-adjustment expenses, expenses involved
in underwriting coverage, premium taxes, and general administrative expenses. These expenses,
plus a reasonable amount of profit and contingencies, must be covered by the premium charged.
In real terms, workers and other resources that might have been committed to other uses are
required by the insurance industry.

However, these additional costs can be justified for several reasons.

 First, from the insured’s view point, uncertainty concerning the payment of a covered loss
is reduced because of insurance.
 Second, the costs of doing business are not necessarily wasteful, because insurers engage
in a wide variety of loss prevention activities.
 Finally, the insurance industry provides jobs opportunities to a large number of workers.
However, because economic resources are used up in providing insurance to society, a real
economic cost is incurred.

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Fraudulent Claims
A second cost of insurance comes from the submission of fraudulent claims. Examples of
fraudulent claims include the following:

 Auto accidents are faked or staged to collect benefits

 Dishonest claimants fake slip-and-fall accidents
 Phony burglaries, thefts, or acts of vandalism are reported to insurers
 False health insurance claims are submitted to collect benefits
 Dishonest policy owners take out life insurance policies on insureds who are later
reported as having died.

The payments of such fraudulent claims results in higher premiums to all insureds. The existence
of insurance also prompts some insureds to deliberately cause a loss so as to profit from
insurance. These social costs fall directly on society.

Some types of insurance fraud are especially outrageous. The coalition against insurance fraud
has established a “hall of shame” for insurance scams that are strictly large, brazen, vicious, and
in some case stupid.

Inflated Claims

Another cost of insurance relates to the submission of inflated or “padded” claims. Although the
loss is not intentionally caused by the insured, the dollar amount of the claims may exceed the
actual financial loss. Examples of inflated claims include the following:

 Attorney’s fir plaintiffs sue for high-liability judgments that exceed the true economic
loss of the victim.
 Insureds inflate the amount of damage in auto-mobile collision claims so that the
insurance payments will cover the collision deductible
 Disabled persons often malinger to collect disability-income benefits for a longer
duration
 Insureds exaggerate the amount and value of property stolen from a home or business.

Inflated claims must be recognized as an important social cost of insurance. Premiums must be
increased to pay the additional losses. As a result, disposable income and the consumption of
other goods and services are reduced.

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In summary, the social and economic benefits of insurance generally out weight the social costs.
Insurance reduces worry and fear; the indemnification function contributes greatly to social and
economic stability; financial security of individuals and firms is preserved; and from the
viewpoint of insurers, objective risk in the economy is reduced. The social costs of insurance can
be viewed as the sacrifice that society must make to obtain these benefits.

3.7 FUNCTIONS AND ORGANIZATION OF INSURERS

In general, insurers operate in much the same manner as other firms; however, the nature of the
insurance transaction requires certain specialized functions which require a suitable organization
structure. In this section, we will examine some of specialized activities of insurance companies
and the general forms of organization structure.

Functions of Insurers:
Although there are definite operational differences between life insurance companies, and
property and liability insurers, the major activities of all insurers may be classified as follows:
A. Production (Selling)
B. Underwriting (Selection of Risks)
C. Rate Making
D. Managing Claims
E. Investment
These functions are normally the responsibility of definite departments or divisions within the
firms. In addition to these functions there are various other activities common to most business
firms such as accounting, personnel management, market research and so on.
A. Production
One of the most vital functions of an insurance firm is securing a sufficient number of applicants
for insurance to enable the company to operate. This function, usually called production in an
insurance company, corresponds to the sales function in an industrial firm. The term is a proper
one for insurance because the act of selling is production in its true sense. Insurance in an
intangible item and does not exist until a policy is sold. The production department of any
insurer supervises the relationships with agents in the field. In firms such as direct writers,
where a high degree of control over field activities is maintained, the production department
recruits, trains and supervises the agents or salespersons.

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 B. Underwriting
Underwriting is the process of selecting risks offered to the insurer. It is an essential element in
the operation of any insurance program, for unless the company selects form among its
applicants, the inevitable result will be adverse to the company. Hence, the main responsibility
of the underwriter is to guard against adverse selection. Underwriting is performed by home
office personnel whose scrutinize\e applications for coverage and make decisions as to whether
they will be accepted, and by agents who produce the applications initially in the field.

It is important to understand that underwriting does not have as its goal the selection of risks that
will not have losses, but merely to a void a disproportionate number of bad risks, thereby
equalizing the actual losses with the expected ones. While attempting to avoid adverse selection
through rejection of undesirable risks, the underwriter must secure an adequate volume of
exposures in each class. In addition, he must guard against congestion or concentration of
exposures that might result in a catastrophe.

Process of Underwriting:
The underwriter must obtain as much information about the subject of the insurance as possible
within the limitations imposed by time and the cost obtaining additional data. The desk
underwriter must rule on the exposure submitted by the agents, accepting some and rejecting
others that do not meet the company’s underwriting requirements or policies. When a risk is
rejected, it is because the under writer feels that the hazards connected with it are excessive in
relation to the rate.

There are four sources from which the underwriter obtains information regarding the hazards
inherent in an exposure:

1. The Application: The basic source of underwriting information is the application, which
varies from each line if insurance and for each type of coverage. The broader and more
liberal the contract, usually the more detailed the information required in the application.
The questions on the application are designed to give the underwriter the information
needed to decide if he would accept the exposure, reject it, or seek additional
information.
2. Information from Agent or Broker: In many cases underwriter places much weight on
the recommendations of the agent or broker. This varies, of course, with the experience

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 the underwriter has had with the particular agent in question. In certain cases the
underwriter will agree to accept an exposure that does not meet the underwriting
requirements of the company. Such exposures are referred to as “accommodation risk,”
because they are accepted to accommodate a value client or agent.
3. Investigations: In some cases the underwriter will request a report from an inspection
organization that specializes in the investigation of personal matters. This inspection
report may deal with a wide range of personal characteristics of the applicant, including
financial status, occupation, character, and the extent to which he uses alcoholic
beverages (or to which neighbors say he used them). All the information is pertinent in
the decision to accept or reject the application.
4. Physical Examinations or Inspections: In life insurance, the primary focus is on the
health of the applicant. The medical director of the company lays down principles to
guide the agents and desk writer in the selection of risks, and one the most critical pieces
of intelligence is the report of the physician. Physicians selected by the insurance
company or recognized medical centers supply the insurer with medial reports after a
physical examination; this report is a very important source of underwriting information.
In the field of property and liability insurance, the equivalent of the physical examination
in life insurance is the inspection of the premises. Although such inspections are not
always conducted, the practice is increasing. In some instances this inspection is
performed by the agent, who sends a report to the company with photographs of the
property. In other cases a company representative conducts the inspection.
C. Rate Making
An insurance rate is the price per unit of insurance. Like any other price, it is a function of the
cost of production. However, in insurance unlike other industries the cost of production is now
known when the contract is sold, and will not be known until sometime in the future, when the
policy has expired. One of the fundamental differences between insurance pricing and the
pricing function in other industries is that the price for insurance must be based on the prediction.
The process of predicting future losses and future expenses, and allocating these costs among the
various classes of insureds is called rate making.
A second important difference between the pricing of insurance and pricing another industry
arises from the fact that insurance rates area subject to government regulation. Because
insurance is considered to be vested in the public interest al nations have enacted law imposing

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statutory restraints on insurance rates. These laws require that insurance rates must be no t be
excessive, must be adequate, and may not be unfairly discriminatory.

Other characteristics considered desirable are that rates would be relatively stable over time, so
that the public is not subjected to wide variations in cost from year to year. At the same time,
rates should be sufficiently responsive to changing conditions to avoid inadequacies in the event
of deteriorating loss experience.

Makeup of the Premiums

A rate is the price charged for each unit of protection or exposure and should be distinguished
from a “Premium”, which is determined by multiplying the rate by the number of units of
protection purchased. The unit of protection to which a rate applies differs for the various lines
of insurance. In life insurance, for example, rates are computed for each 1,000 birr in protection;
in fire insurance, the rate applies to each 100 birr coverage. The insurance rate is the amount
charged per unit of exposure. The premium is the product of the insurance rate and the number
of units of exposure. Thus, in life insurance, if the rate is 25 birr per 1,000 birr of face amount of
insurance, the premium for a 10,000 birr policy is 250 birr.

The premium is designed to cover two major costs: (I) The expected loss and (II) The cost of
doing business. These are known as the pure premium and the loading, respectively. The pure
premium is determined by dividing the total expected loss by the number of exposures. In
automobile insurance, for example, if an insurer expects to pay 100,000 birr of collision loss
claims in a given territory, and there are 1,000 autos in the sued group, the pure premium for
collision will be 100 birr per car, computer as follows:
Expected Loss 100,000 Birr
Pure Premium = ------------------------- = ---------------------- = 100 Birr
Exposure Units 1,000

The loading is made up of such items as agents’ commissions, general company expenses, taxes
and fees, and allowances for profit. The sum of the pure premium and loading is termed as the
gross premium. Usually the loading is expressed as a percentage of the expected gross premium.
In property – liability insurance, a typical loading might be 331/3%. The general formula for the
gross premium, the amount charged the consumer, is

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 Pure Premium
Gross Premium = -----------------------------
1 – Loading Percentage
In the above example, where the pure premium was birr 100 per car, the gross premium would
be calculated as
Gross Premium = 100 Birr / 1-0.3333 = 150 Birr.

Rate – Making Methods: Two basic approaches to ratemaking, class and individual rating
are discusses below.

1. Manual Or Class Rating: The manual or class rating method sets rates that apply
uniformly to each exposure unit falling within some predetermined class or group.
Everyone falling within a given class is charged the same rate.

2. Individual Rating: Under individual rating, each insured is charged a unique premium
based largely upon the judgment of the person setting the rate. This rating is
supplemented by whatever statistical data are available and by knowledge of the
premiums charged similar insureds. It takes into account all known factors affecting the
exposure, including competition from other insurers. If the characteristics of the units to
be insured vary so widely it is desirable to calculate rates for each unit depending on its
loss producing characteristics.

D. Managing Claims / Loss Adjustment

The basic purpose of insurance is to provide indemnity to the members of the group who suffer
losses. This is accomplished on the loss settlement process, but it is sometimes more
complicated than just passing out money. The payment of losses that have occurred is the
function of the claims department. Life insurance companies refer to those employees who settle
losses as “claims representatives,” or “benefit representatives”. Employees of the claims
department in the field of property and liability insurance are called “Adjusters”.

E. Investment Function

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When an insurance policy is written, the premium is generally paid in advance for periods
varying from six months to five or more years. This advance payment of premiums gives rise to
funds held for policyholders by the insurer, funds that must be invested in some manner. When
these are added to the funds of the companies themselves, the assets would add up to huge
amounts. These funds should not remain idle, and it is the responsibility of finance department
or a finance committee of the company to see that they are properly invested.
Not all the money collected by the insurer is to be invested. A certain proportion of it should be
kept aside to meet future claims. However, the need for liquidity may vary from one state to
another.

Organization of Insurers
The type of organization used by a given insurer and the types of departments created depend
upon the particular problems it faces. The most common basis is a centralized management with
departments organized on a functional basis. However, other bases, such as territorial, are
commonly used, often concurrently with the functional type. Thus, the form the organization
adopted depends on the scope of the line of business and the activities performed by the
insurance organization. Based on the line of business, there are two basic forms of organization
of insurers; single line or product organization and all-line organization. Single line insurance
organizations are those who deal only with the type business, say fire insurance of life insurance
only. All-line organization refers to that type of arrangement by which an insurer my write
literally all lines of insurance under one administrative frame work of a single organization,
example, the Ethiopian Insurance Corporation (EIC).

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