CHAPTER THREE: INTRODUCTION TO INSURANCE

3.1 Nature of Insurance

• Insurance is a complicated and intricate mechanism, and consequently
difficult to define.
• However, it has two fundamental characteristics:
• Transferring or shifting risk from one individual to a group,
• Sharing losses, on some equitable basis, by all members of the group.
• In economic sense: insurance is an important tool that provides
certainty or predictability aiming at reducing uncertainties in regard to
pure risks.
• It accomplishes this result by pooling or sharing of risk.
cont…
• 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 premium 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 (insurer).
• When a person buys private insurance she/he is entering into a
contract with the insurer that entitles the person to certain advantage
but also imposes certain responsibilities such as payment of premium
and satisfying certain conditions specified in the policy.
Cont…
• Business point of view: 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.
• Social point of view: insurance is defined as a social device through
which few unfortunates are paid by many who are member of the
policy.
• Mathematical point of view: insurance is the application of actuarial
(insurance mathematics), principles, laws of probability and statistical
techniques are used to achieve predictable results
• Dinsdale and Mcmurdie also defined insurance as “a device for
transfer of risks of individual entities, who agrees, for a consideration
(called the premium) to assume to a specified extent losses suffered by
the insured.”
4.2 Basic Characteristics of Insurance

• The basic characteristics of insurance are:-

1. Pooling of losses
2. Payment of fortuitous losses
3. Risk transfer
4. Indemnification
1. Pooling of losses
• Pooling of risks or the sharing of losses is the heart of insurance.
• Pooling of losses means 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 simple words, pooling in an insurance context implies two things:
Sharing of losses by the entire group, and
Using the law of large numbers to predict future losses.
Cont…
• The law of large numbers states that the greater the number of exposures,
the more closely will the actual results approach the probable results that
are expected from an infinite number of exposures.
2. Payment of fortuitous (accidental) losses
• The insurer should cover losses that are unforeseen and unexpected and
occurs as a result of chance.
3. Risk transfer
• In this, a pure risk is transferred from the insured to the insurer who
typically is in a stronger financial position and is willing to pay the loss than
the insured (example, the risk of premature death, poor health, destruction
or theft of property).
4. Indemnification
• Indemnification-means the insured is restored to his or her approximate
financial position prior to the occurrence of the loss.
 4.4 Requisites of Insurable Risks
• Insurers normally insure only pure risks. However, all pure risks are not
insurable.
1. There must be a large number of exposure units
• There must be a sufficiently large number of homogeneous exposure units to
make the losses reasonably predictable. Insurance is based on the operation of
the law of large numbers.
2. 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.
• If the insurance company knows that an event in the future is inevitable, it
also knows that it must collect a premium equal to the certain loss that it must
pay, plus an additional amount for the expenses of administering the claim and
operation. Depreciation, which is a certainty, cannot be insured
• The law of large numbers, in probability and statistics, states that as a sample
size grows, its mean gets closer to the average of the whole population.

• This is due to the sample being more representative of the population as the
sample become larger.

• In insurance the law of large numbers states that as the number of

policyholders increases, the more confident the insurance company is its
prediction will prove true.

• In insurance, with a large number of policyholders, the actual loss per event
will equal the expected loss per event.
Cont…
3. The loss must be determinable and measurable
• The loss produced by the risk must be definite and measurable. This
means the loss should be definite as to cause, time, place and amount.
• 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.
4. The loss should not be catastrophic.
• Ideally, the loss should not be catastrophic (i.e., affecting a large number
of exposure units at the same time).
• Because most catastrophic losses, such as floods, earthquakes, and war,
occur erratically and usually with great destruction, both the frequency
of occurrence and the severity of losses cannot be accurately forecasted,
and, thus, catastrophic losses are usually not insured by private
companies.
Cont…
• Insurers can deal with the problem of a catastrophe loss by (1)
Reinsurance,
• Reinsurance is the shifting of part or all of the insurance originally
written by one insurer to another. (2) Avoiding the concentration of risk
by dispersing coverage over a large geographical area.
5. The chance of loss must be calculable
• It should be possible for the insurer to calculate the chance of loss with a
reasonable degree of accuracy, as this is a major consideration in
determining premium.
6. The premium must be economically feasible
• Several requirements must be satisfied for an insurance company to be
able to offer affordable premiums. First, the premium for the insurance
must be affordable; otherwise few people would buy it, thereby
spreading the risk among fewer people.
Cont…
• With fewer people insured, the objective risk of the pool would be
higher, because actual losses would be less predictable. Therefore,
higher premiums would have to be charged to cover the increased
objective risk.
• Secondly, the premium must be considerably less than the policy
coverage; otherwise, people would simply self-insure.
7. The risk must be consistent with the public policy. The insurance
contract should not be against the public policies, for insurance effected
by terrorists for fines imposed for the offences.
8. 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.
Insurance versus Gambling
• Gambling creates a new speculative risk that did not exist before, while insurance is a
technique for handling an already existing pure risk.
• Gambling is socially unproductive, since the winner’s gain comes at the expense of the
loser. Insurance is always socially productive, since both the insured and insurer win if
the loss does not occur.
• Gambling transactions never restore the losers to their former financial position. In
contrast, insurance contracts restore the position of insured financially in whole or in
part if a loss occurs.
Insurance versus Speculation
• Both insurance and speculation techniques are similar in that risk is transferred by a
contract, and no new risk is created.
• Insurance differs from speculation:
• Insurance transaction usually involves the transfer of risks that are insurable. However,
speculation is a technique for handling risks that are typically uninsurable, such as
protection against a substantial decline in the price of commodities.
• Insurance reduce objective risk by applying of the law of large numbers. In contrast,
speculation typically involves only risk transfer, not risk reduction.
 Benefits and Costs of Insurance to Society
4.5.1 Benefits of Insurance to Society
• The major social and economic benefits of insurance are:
A. Stability in family
• Insurance prevents families from experiencing the great hardships caused by
unexpected losses of property or the premature death of the family income
provider.
B. Indemnification for Loss
• Indemnification helps individuals and families to restore to their former financial
position after a loss occurs. As a result, they can maintain their financial security.
C. Source of investment funds
• The insurance industry is an important source of funds for capital investment and
accumulation. Premiums are collected in advance, and funds not needed to pay
immediate losses and expenses can be loaned to business firms.
Cont…
D. Reduce worry and fear
• The other benefit on insurance is it helps to remove various types of fear
from the mind of the people. Insurance creates the confidence and sense of
security among the policyholder. This is true both before and after a loss.
• That is, if family heads have adequate amount of life insurance, they are
less likely to worry about the financial security of their dependents in the
event of premature death.
• Worry and fear are also reduced after a loss occurs, since the insured know
that they have insurance that will pay for the loss.
E. Promotion of Loss control systems
• Another social and economic value of insurance lays in its loss control or
loss prevention activities. Although the main function of insurance is not
to reduce loss, insurers are vitally interested in keeping losses at a
minimum.
 Cont…
F. Enhancement of credit
• 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 repaid.
• 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, if a new automobile purchased and
financed by a bank or other lending institution, physical damage insurance on
the automobile may be required before the loan is made.
• A life insurance policy increases the credit worthiness of the assured person
because it can provide funds for repayment if he/she dies. Thus, insurance
enhance a personal credit.
Cont…
G. Promotion of saving
• Insurance policy is often very suitable way of providing fund for the
future. This type of policy is found particularly in life insurance.
H. 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.
I. 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 certain region.
Cont…
• Insurance also provide or at least minimizes production stoppage that
produce an economic wastage, and result 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 the risk.
4.5.2 Costs of Insurance to Society
A. Costs of doing business/operating expenses
• One important cost is the cost of doing business. An expense loading
(the amount needed to pay all expenses, including commissions, general
administrative expenses and an allowance for contingencies and profit
must be added to the pure premium to cover the expenses incurred by
companies in their daily operations.
• However, these additional costs can be justified from the insured's view-
point of engaging in a wide variety of loss prevention activities. And
from the industry view-point, it provides jobs to millions of workers.
 Cont…
B. Fraudulent Claims: A second cost of insurance encourages moral hazard like:
• Faked auto accidents, Fake slip and fall accidents, Phony burglaries, thefts, vandalism,
False health insurance claims, Murders, etc.
• These social costs fall directly on society.
C. Inflated Claims: Submission of inflated or 'padded' claims though loss is not
intentionally caused by the insured like:
• Attorneys for plaintiffs sue for high liability judgments than the true economic loss of
the victim.
• Inflate the amount of damage in automobile collision claims.
• Disabled persons often manage to collect disability income benefits for a larger
duration.
In summary the social and economic benefits of insurance generally outweigh the social
costs.
Insurance reduces worry and fear; it contributes its service to economic and social
stability and provides financial security to individuals and firms.