Unit 3

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
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 provide certainty or predictability
aiming at reducing uncertainty in regard to pure risks. It accomplishes this result by pooling
or sharing of risk.

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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.
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.

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 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 accept 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 Insurance, Gambling and Speculations
3.3.1 Insurance and Gambling
The essential feature about gambling is that it creates a risk where there existed none hitherto.
When a gambler buys a lottery ticket, for instance, or places a bet on a horse, he puts money at
risk that was not in jeopardy before. The difference between insurance and gambling can be
illustrated as follows.
 The man who gambles creates a risk, which did not exist previously whereas the man
who purchases insurance minimizes a risk which was already in being and which is
not in his power to avoid.

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  The gambler with hope of gain, goes out his way to bring a risk into being while the
man who insures, for the purpose of avoiding loss, goes out of his way to hedge
against a risk which already exists.
 The man who gambles accepts deliberately the risk of loss in exchange for the
possibility of profit: the man who insures accepts deliberately the certainty of a small
loss in exchange for the freedom from risk of devastating catastrophic loss.
 The gambler bears the risk while the insured transfers the risk.
Considering the many risks we are exposed to in our daily life, such as fire, motor accident, etc
there is certainly no complete escape from the hazards, and the man who gamble, by not insuring
against them is gambling against frightful odds. The man who insures pays a fixed, certain and
relatively small loss (the premium), and in doing so, doesn’t gamble which would have been
ruinous to his and his family.
3.3.2 Insurance and Speculation
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.
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.
1. Risk transfer/Indemnification

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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.
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

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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 essntial
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.

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3.5.1 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.
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 a 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.
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

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 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 penil 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 effected 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
Uninsurable 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.

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 4. Risk that are against public policy.
Functions and Organization of Insurers: - As part of the study of the insurance mechanism
and the way in which it works, it will be helpful to examine some the unique facets of insurance
company operations. 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:
 Production (Selling)
 Underwriting (Selection of Risks)
 Rate Making
 Managing Claims
 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.
 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.
 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
from 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

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 performed by home office personnel whose scrutinize 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 avoid 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:
I. 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.
II. 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 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.
III. 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

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 which neighbors say he used them). All the information is pertinent in the decision to accept
or reject the application.
IV. 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 medical 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.
 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 insured’s 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
statutory restraints on insurance rates. These laws require that insurance rates must be not 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.

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  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.
 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 insured’s. 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.
 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”.
 Investment Function: - 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,

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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 fir
insurance of life insurance only. All-line organization refers to that type f 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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