Risk Management & Insurance Chapter -3- Insurance

CHAPTER 3

INSURANCE

“Insurance: An ingenious modern game of chance in which the player is permitted to enjoy the

comfortable conviction that he is beating the man who keeps the table” Ambrose Bierce.

3.1. Insurance Defined

Insurance is an important part of risk management programs for organizations and individuals.

Insurance is a risk financing transfer under which an insurer agrees to accept financial burdens

arising from loss. More formally, insurance can be defined as a contractual agreement between two

parties: the insurer and the insured. Under the agreement, the insurer agrees to reimburse loss (as

defined in the insurance contract) in return for the insured's premium payment

Before considering some of the definitions of insurance, it might be useful to consider the following

explanations about insurance.

Insurance is a system used to handle risk, or transfer risk.

Insurance is a scheme that establishes a common fund out of which financial compensation is

made to the unfortunates who suffered losses by accidental misfortune.

Insurance refers to a pooling of risk of many people who are exposed to the same risk.

Insurance is a device used to spread the loss suffered by an individual or firm to the members in

the group.

Each of the above explanations provides an insight as to what insurance is. In fact, it is rather

difficult to give a comprehensive explanation of the term. Some definitions, though not

comprehensive by themselves, may provide reasonably sufficient expositions about the term.

Consider the following definitions:

 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.

 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.

Page 1 of 9
Risk Management & Insurance Chapter -3- Insurance

 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.

 An insurance policy is a contract whereby a person called the insured undertakes against

payment of one or more premiums to pay to a person, called the beneficiary, a sum of money

where a specified risk materializes (Article 654 (1) of the Commercial Code of Ethiopia)

The following points are worth considering regarding insurance contracts:

1. There are usually two parties in the contract: the insurer and the insured. In some types of

insurance policies three parties are involved, for example, fidelity guarantee policy.

2. The insured transfers his risk to the insurer. To this effect, he will have to pay the price, which in

insurance terminology is called the premium.

3. If the specified risk materializes (happened to the insurance), within a specified period, the

insurer will make financial compensation to the insured or his beneficiary. The insured is

restored to his former position which in insurance terminology is called Indemnification.

3.2. Basic characteristics of insurance

An insurance plan or arrangement typically has certain characteristics.

Pooling of losses

Payment of fortuitous losses

Risk transfer

Indemnification

I) 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 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.

Page 2 of 9
Risk Management & Insurance Chapter -3- Insurance

II) Payment of fortuitous losses

A fortuitous loss is the 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 side walk

and break a leg. The loss would be fortuitous.

III) Risk transfer

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 view point of individual, pure

risk that are typically transferred to insurers include the risk of premature death, poor health,

disability, destruction, and theft of property and liability lawsuits.

IV)Indemnification

Indemnification means that the insured is restored to his/her approximate financial position by the

insurer. Thus, if your house burn in a fire, the house owners’ policy will indemnify you or restore

you to your previous position.

3.3.Fundamentals of insurable risks

In spite of 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. These

requirements should not be taken as absolute, iron rule but rather as guides or ideal standards that

are not always completely attained in practice.

A risk could be considered an ideally insurable risk if it satisfies the six conditions below.

 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

Page 3 of 9
Risk Management & Insurance Chapter -3- Insurance

Large number of exposure units

There must be a sufficiently large number of homogeneous exposure units to make the losses

reasonably predictable. Ideally, there should be a large group of roughly similar, but not necessarily

identical, exposures units that are subject to the same peril or group of perils. A large number of

exposure units enhance the operation of an insurance plan by making estimates of future losses

more accurate. The purpose of the 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 insured’s in the

underwriting class.

Accidental and unintentional loss

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. The requirement of an accidental and

unintentional loss is necessary for two reasons. First, if intentional losses were not paid, moral

hazard would be substantially increased and premiums would rise as 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.

Determinable and measurable loss

The loss produced by risk must be definite and measurable. This means the loss should definite as

to cause, time, place, and amount. Life insurance in most cases meets this requirement easily. So

before the burden of 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.

Page 4 of 9
Risk Management & Insurance Chapter -3- Insurance

No catastrophic loss

This means that a large proportion of exposure units should not incur losses at the same time. The

insurance principle is based on a notion of sharing losses, and inherent in this idea is the

assumption that only a small percentage of the group will suffer loss at any one time.

Insurers ideally wish to avoid all catastrophic losses, but in the real world, this is impossible, since

catastrophic losses occur periodically from earth quakes, floods, forest fires and other natural

disasters. Fortunately there are two approaches for meeting the problem of catastrophic loss. First,

reinsurance can be used by which insurance companies are indemnified by reinsurers for

catastrophic losses. 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. 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.

Calculable chance of loss

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 claims and expenses and yield a profit during the policy period.

Economically feasible premium

The cost of insurance must not be high in relation to the possible loss. The insurance must be

economically feasible. For the Insurance to be attractive purchase, the premium paid must be less

than the face value or amount of the policy.

The probability of loss must be reasonable, or else the cost of risk transfer will be excessive. The

more probable the loss, the greater the premium will be. And a point ultimately is reached when

the loss becomes so certain that when the insurer’s expenses are added on, the cost of the premium

becomes prohibitive. At this point, insurance is no longer feasible because the insured will not be

willing to pay the necessary premium.

Page 5 of 9
Risk Management & Insurance Chapter -3- Insurance

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. Gambling creates a new risk where none existed before,

whereas insurance is a method of eliminating or greatly reducing an already existing risk.

The second difference between insurance and gambling is that gambling is socially unproductive,

since the winner’s gain comes at the expense of the loser. In contrast insurance is always socially

productive, since neither the insurer nor the insured is placed in a position where gain of the

winner comes at the expense of the loser. Both the insurer and the insured have common interest in

the prevention of a loss. Both parties win if the loss does not occur. Moreover, the gambling

transactions never restore the loser to their former financial position. In contrast, the insurance

contracts restore the insureds financially in whole or in part if a loss occurs.

3.5.Insurance and Speculation Compared

Speculation is a transaction under which one party agrees to assume certain risks, usually in

connection with business venture. A good example of speculation found in the practice known as

hedging. Hedging involves a transfer of speculative risk. It is a business transaction in which the

risk of price fluctuation transferred to third party known as speculator. An insurance contract

however is not the same thing as speculation. Although both techniques are similar in that risk is

transferred by contract and no new risk is created, there are some important differences between

them. First, an insurance transaction involves the transfer of insurable risks, since the requirements

of an insurable risk generally can be met. However, speculation is a technique of handling risks that

are typically uninsurable, such as protection against a decline in price of agricultural products and

raw materials.

A second difference 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 adverse price fluctuations is transferred to speculators who believe they can

make a profit because of superior knowledge of market conditions. The risk is transferred, not

reduced, and the speculator’s prediction of loss generally is not based on the law of large numbers.

Page 6 of 9
Risk Management & Insurance Chapter -3- Insurance

3.6.Benefits and Costs of Insurance

Benefits of Insurance

Insurance provides several advantages to individuals, organizations and the society as a whole.

Some of the advantages are discussed below.

 Financial Compensation: The primary task of insurance is to provide financial compensation to

those insured who suffered losses due to accidental misfortune. Compensation is made out of

the funds. (Premiums) collected from the members in the group who are exposed to the same

risk. The loss is spread to all members on an equitable basis. Thus, the financial burden of the

loser is reduced, and he is restored to his former financial position.

 Provision of funds for Investment: Insurance, particularly life insurance, accumulate large sum

of money available for investment. In life insurance, there is a constant inflow of money in the

form of premium payments. Since claim payments during the initial period of life insurance are

very low, the accumulated premiums constitute an insurance fund that is available for

investment by the insurer or lending to other investors.

 Reduction of Worry: Insurance reduces the physical and mental stress that insured’s face

concerning the possibility or financial loss. Insured’s, through transfer of their risk to the

insurer, reduce their worry about any financial loss they may face due to accidental misfortune.

This means that insured’s are to a large extent certain that the loss, if at all occurs, can be

recovered from the insurer.

 Encourages Saving: In life insurance, certain policies have dual advantages: Financial protection

in the event of death, and saving in the event of survival. Consequently, insured’s under such

policies are systematically saving money while their main objective in purchasing life insurance

is protection of their dependants from financial losses in the event of death. Compulsory

premium payments are a form of encouragement of the insured to make systematic saving.

Page 7 of 9
Risk Management & Insurance Chapter -3- Insurance

 Enhances Efficient Utilization of Resources:

Insurance makes a remarkable contribution to society as a whole. It creates certainty in the

business firms. Insurers induce firms to set-up loss prevention and reduction measures to

prevent and minimize losses. Inefficiencies tend to disappear because adverse reaction to risk by

individuals or firms is eliminated or reduced. The risks are pooled and managed by the insurer

who have specialized knowledge in the field. All these measures in the final analysis lead to

efficient utilization of resources in the society.

Limitations of Insurance

Basically, insurance is a device used to deal with pure risks only. Even then, not all pure risks are

insurable. A clear example is fundamental risks such as Flood, earthquake, etc. Such risks are

normally tackled by the society. Also speculative risks are not insurable. It is, therefore, clear that

insurance doesn’t provide protection against a wide range of risks.

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 scarce economic resources—

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. An expense loading is the amount needed to

pay all expenses, including commissions, general administrative expenses, state premium taxes,

acquisition expenses, and an allowance for contingencies and profit.

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.

Page 8 of 9
Risk Management & Insurance Chapter -3- Insurance

False health insurance claims are submitted to collect benefits.

Dishonest policyholders take out life insurance policies on unsuspecting insureds and

later arrange to have them killed.

The payment of such fraudulent claims results in higher premiums to all insureds. The existence of

insurance also prompts some insureds to deliberately cause a loss to profit from insurance. These

social costs fall directly on society.

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 claim may exceed the actual

financial loss.

Examples of inflated claims include the following:

- Attorneys for plaintiffs sue for high-liability judgments that exceed the true economic loss of the

victim.

- Insureds inflate the amount of damage in auto 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.

Page 9 of 9