CHAPTER THREE: INSURANCE

DEFINITIONS OF INSURANCE

There is no single definition of insurance. Insurance can be defined from the viewpoint of
individual, and social.

 From an individual point of view

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.

 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

Functional Definition

Insurance is a co-operative device to spread the loss caused by a particular risk over a number of
persons, who are exposed to it and who agree to insure themselves against the risk.

Contractual Definition

Insurance contract may be defined as a contract by which one party (the insurer/insurance
company) agrees to pay to the other party (the insured) or his beneficiary a certain sum up
on a given contingency (the risk) against which insurance is sought.

According to the Commission on Insurance Terminology of the American Risk and Insurance
Association, “Insurance is the pooling of fortuitous losses by transfer of such risks to insurers,
who agree to indemnify insured for such losses, to provide other pecuniary benefits on their
occurrence, or to render services connected with the risk".

A1though this definition may not be acceptable to all insurance scholars, it is useful for
analyzing the common elements of a true insurance plan.

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FUNCTIONS OF INSURANCE

The functions of insurance can be studied into two parts;

Primary functions
Secondary functions

PRIMARY FUNCTIONS

A. Insurance provides certainty

Insurance provides certainty of payment at the uncertainty of losses, the uncertainty of loss can
be reduced by better planning and administration. But, the insurance relieves the person from
such difficult task. There are different types of uncertainty in a risk. The risk will occur or not,
when will occur?, how much loss will be there?, in other words, there are uncertainty of
happening of time and amount of loss. Insurance removes all these uncertainty and the insured is
given certainty of payment of losses.

B. Insurance provides protection

The main function of the insurance is to provide protection against the probable chances of loss. The time
and amount of loss are uncertain and at the occurrence of risk, the person will suffer loss in the absence of
insurance. The insurance guarantees the payment of loss and thus protects the insured from sufferings.
The insurance cannot check /control the occurrence of risk but can provide protection for losses at the
happening of the risk.

C. Risk Sharing

The risk is uncertain and therefore, the loss arising from the risk is also uncertain. When risk
takes place, the loss is shared by all the persons who are exposed to the risk. The risk sharing in
ancient times was done only at the time of damage or death. But, today, on the basis of
Probability of risk, the share is obtained from each and every insured in the shape of premium
without which protection is not guaranteed by the insurer.

SECONDARY FUNCTIONS

A. Prevention of loss

The insurance joins hands with those institutions which are engaged in preventing the losses of
the society because the reduction in loss causes lesser payment to the insured and so more saving
is possible which will assist in reducing the premium. Lesser premium invites more business and
more business cause lesser share to the insured.

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Here, the insurance assist financially to health organizations, fire brigade, educational institutions
and other organizations which are engaged in preventing the losses of the masses from death and
damage.

B. It provides capital

The insurance provides capital to the society. The accumulated funds are invested in productive
channels. The shortage of capital of the society is minimized to a greater extent with the help of
investment of insurance. The industry, the business and the individual are benefited by the
investment and loans of the insurers.

C. It improves efficiency

The insurance eliminates worries and miseries of losses at death and destruction of property. The
carefree person can devote his body and soul together for better achievement. It improves not
only his efficiency, but the efficiencies of the masses are also advanced.

D. It helps economic progress

The insurance by protecting the society from huge losses of damage, destruction and death, provides an
initiative to work hard for the betterment of the masses. The next factor of economic progress, the capital,
is also immensely provided by the masses.

BASIC CHARACTERISTICS OF INSURANCE

Insurance has several distinct characteristics. They are:

 Pooling of losses
 Payment of accidental losses
 Risk transfer
 Indemnification

1) Pooling of losses

The other names for pooling are sharing, spreading or combination. "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
homogeneous exposure units so that the law of large numbers can operate to provide a
substantially accurate prediction of future losses.

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Homogeneous exposure unit means there is a large number of similar (e.g., houses), but not
necessarily identical exposure units that are exposed to the same perils. Thus pooling implies:

 The sharing of losses by the entire group and

 The prediction of future losses with some accuracy based on the law of large numbers.

a) Sharing of loss

The concept of loss sharing can be explained with an example. Assume that there are 10, 000
houses in Mekelle. All the10, 000 households agree that if anyone of the house is damaged or
destroyed by a fire, the other households will indemnify, or cover, the actual costs of the
household who has suffered a loss. Also assume that each home is valued at 100,000 birr, and,
on average, one house burns every year. In the absence of insurance, the maximum loss to each
household is 100,000 birr, if the house burns. However, by pooling the loss, it can be spread over
the entire group, and if one household has a total loss, the maximum amount that each household
would have to pay only 10 birr (100,000/ 10,000). Thus, the pooling technique results in the
substitution of an average loss of 10 birr for the actual loss of 100,000 birr.

b) Prediction of future losses

By pooling the loss experience of a large number of units, an insurer may be able to predict
future losses with some accuracy. From the viewpoint of the insurer if future losses can be
predict, objective risk is reduced. Thus, another characteristic of insurance is risk reduction based
on the law of large numbers.

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. For example, if you flip a balanced coin into the air, the chance of getting a head is
0.5. If you flip the coin only 10 times, you may get a head 8 times. Although, the observed
probability is 0.8, the true probability still 0.5. If the coin were flipped 1 million times, however,
the actual number of heads would be approximately 500,000. Thus, as the number of random
tosses increases, the actual results approach the expected results.

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2) Payment of accidental losses

An accidental loss is one that is unforeseen and unexpected and occurs as a result of chance. In
other words, the loss must be accidental. For example, a person may slip on an icy sidewalk and
break his or her leg. The loss would be accidental.

3) 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." Examples: Premature death,
Poor health, Disability, Destruction, Theft of property, etc. With the exception of self insurance,
a true insurance plan always involves risk transfer.

4) Indemnification

Indemnification means that the insured is restored to his or her approximate financial position
prior to the occurrence of the loss. Examples of insurance which cover the loss are, Home
owners policy, Automobile liability insurance policy, Disability income policy, etc.

ELEMENTS OR REQUIREMENTS OF AN INSURABLE RISK

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. From the view
point of the insurer, there are ideally six requirements of an insurable risk.

1. There must be a large number of homogeneous exposure units

2. The loss must be accidental and unintentional
3. The loss must be determinable and measurable.
4. The loss should not be the catastrophic
5. The chance of loss must be calculable
6. The premium must be economically feasible

1. Large number of Homogeneous Exposure units

The purpose of the first requirement is to enable the insurers to predict losses based on the law of
large numbers. If a sufficiently large number of homogeneous exposure units are present within a
class, the insurer can accurately predict both the average frequency and the average severity of
loss.

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The items in an insurance pool, or the exposure units, need to be similar so that a fair premium
can be calculated. The fire damage done to brick homes will ordinarily be less than that of
suffered by wooden homes. It would be unfair to combine them in the same insurance pool and
charge each insured the same premium rate based on the combined losses of the pool. If such an
attempt were made, the rate developed would cause the owners of brick home (less susceptible to
loss) to pay too high a premium and the owners of wooden structures (more susceptible to loss)
to pay too low a premium.

2. Accidental and unintentional loss

The second requirement is that the loss should be accidental and unintentional; ideally, the loss
should be accidental and outside the insured’s control. Thus, if an individual deliberately causes
a loss, he or she should not be indemnified for the loss.

The requirement of an accidental and unintentional loss is necessary for two reasons. First, if
intentional losses were paid, moral hazard would be substantially increased, and premiums
would rise as a result. The substantial increase in premium 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.

3. Determinable and Measurable loss

Loss must be definite, measurable and of sufficient severity to cause economic hardship. This
means the loss must be definite to cause, time, place, and amount. Life insurance in most cases
meets this requirement easily. The cause and time of death can be readily determined in most
cases. It is difficult to determine and measure the losses in some cases. E.g. Disability income
policy; there are chances of dishonest claims, taking an illness or injury and collecting the
insurance payment.

It is also important that the losses insured against be measurable. The company must determine
whether the insured satisfies the definition of disability as stated in the policy, because sickness
and disability are highly subjective. The basic purpose of this requirement is that the insurers
must be able to determine if the loss is covered under the policy, and if it is covered, how much
the company will pay.

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4. No Catastrophic Loss

This means that ideally a large proportion of exposure units should not incur losses at the same
time. The pooling technique breaks down if most or all of the exposure units in a certain class
simultaneously incur a loss. Examples of catastrophic losses include, flood, storms, earth quakes,
wild fire, tsunami etc. Insurers ideally wish to avoid all catastrophic losses, but still employ two
approaches to handle this problem.

Reinsurance: Insurance companies are indemnified by re-insurers for catastrophic losses. It

is shifting of part or all of the insurance originally written by one insurer to another.
Dispersing coverage over a large geographical area: This is a technique to reduce the
burden of catastrophic losses by dispersing the coverage area to different geographic
locations.

5. 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 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. Certain
catastrophic losses, however, are difficult to insure because of the chance of loss cannot be
accurately estimated.

6. Economically Feasible Premium

The insured must be able to afford to pay the premium. Premium should be substantially less
than the face value, or amount, of the policy.

INSURANCE AND GAMBLING

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

Insurance Gambling
A technique for handling an already existing Creates new speculative risk that did not exist
pure risk before
Socially productive. since neither the insurer Socially unproductive. Since the winners gain
nor the insured is placed in a position where comes at the expense of the loser
gain of the winner comes at the expense of the
loser

The insurer and the insured have a common interest in the prevention or non occurrence of loss and the
insurer indemnify the losses incurred by the insured. Whereas gambling transaction never restores the

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losses to his or her earlier financial position. A gambler presumably enjoys the risk of gambling and
therefore would be unlikely to pay the premium needed for transferring the risk being enjoyed.

INSURANCE AND SPECULATION

Both are similar in that risk is transferred by a contract and no new risk is created. The main
difference between insurance and speculation lies in the type that each is designed to handle, and
in the resulting differences in contractual arrangements. The main similarity lies in the central
purpose behind each transaction. However, there are some important differences exist between
them.

Insurance transaction normally involves the transfer of risks that are insurable since the
requirements of an insurable risk generally can be met. While speculation is a technique for
handling risks that are typically uninsurable. Insurance can reduce the objective risk of an insurer
by application of the law of large numbers, but speculation only involves transfer of risks & not
reduction of risk. The losses cannot be predicted based on the law of large numbers

BENEFITS OF INSURANCE TO THE SOCIETY

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

Indemnification of losses
Less worry & fear
Source of investment fund
Loss prevention
Enhancement of credit

1) Indemnification for loss

The indemnification function contributes greatly to family and business stability and therefore is
one of the most important social & economic benefits of insurance. The following table lists the
benefits to individuals and families and also to business firms through the indemnification
function of insurance.

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To individuals and families To business firms
Permits individuals & families to be restored to Permits the firm to remain in business even
their former financial position that existed prior after the loss occurs
to the loss occur.
The families maintain their economic security. Employees of the firm would be able to keep
their jobs
They are less likely to apply for public Suppliers continue to receive orders
assistance or welfare.
They are less likely to seek financial assistance Customers can still receive the goods and
from relatives & friends. services

2) Reduction of Worry and Fear

A second benefit of insurance is that worry and fear are reduced. This is true both 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 series
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 insured know that they have insurance that will pay for the loss.

3) Source of Investment funds

Insurance provide funds for capital investment and accumulation. Premiums are collected in
advance of the losses and funds not needed to meet the immediate losses can be loaned to
business firms. These investments:

increases society's stock of capital goods

promote economic growth
promote full employment
reduce cost of borrowings of business firm

4) Loss prevention

Insurance companies are actively involved in numerous loss prevention programs and also
employ a wide variety of loss prevention personnel. (E.g. Safety Engineers, Specialists in fire
prevention, Occupational Safety and Health, etc.) Some of the loss prevention activities are:

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 High way safety & reduction of automobile death'
Fire prevention
Reduction of work related disabilities
Prevention of automobile thefts
Prevention and detection of arson losses
Prevention of defective products that could injure the users
Prevention of boiler explosions
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.

5) Enhancement of Credit

Insurance makes a borrower a better credit risk, because its gives greater assurance that the loan
will be repaid. For example,

Property insurance is obtained while lending for purchase of houses. Property insurance
protects the lender's financial interest if the property is damaged or destroyed.
Temporary loan may obtained by insuring inventories of business firms.
Insurance on automobile)s required to get a loan for purchasing any new automobile

Thus, insurance can enhance a person's credit worthiness

COST OF INSURANCE TO SOCIETY

No institution can operate without certain costs. These are listed below so that one can obtain an
impartial view of the insurance institution as a social device. The major social costs of insurance
include the following:

 Cost of doing business

 Fraudulent claims
 Inflated claims

1) Cost of doing the business

The main social cost of insurance lies in the use of scarce of economic resources land, labor,
capital, and organization to operate the business. In financial terms, an expense loading must be
added to the pure premium to cover the expenses incurred by insurance companies. 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. The cost is justified from the insured's view point as follows:

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  Uncertainty concerning the payment of a covered loss is reduced because of insurance.
 The cost of doing business is not necessarily wasteful, because insurers engage in a wide
variety of loss prevention activities.
 The insurance industry provides jobs to millions of workers.

However, because economic resources are used up in providing insurance, a real economic cost
is incurred.

2) Fraudulent claims

These are the claims made against the losses that one caused intentionally by people in order to
collect on their policies. There always exists moral hazard in all forms of insurance. Arson losses
are on the increase. Fraud and vandalisms are the most common motives for arson. Fraudulent
claims are made against thefts of valuable property, such as diamond ring or fur coat, and ask for
reimbursement. These claims results in higher premiums to all insured. These social costs fall
directly on society.

3) Inflated claims

It is a situation where, the tendency of the insured to exaggerate the extent of damages that result
from purely unintentional loss occurrences. Examples of inflated claims include the following.

a) Attorney for plaintiffs may seek high liability judgments - Liability insurance

b) Physicians may charge above average fees – health insurance

c) Disabled persons may malinger to collect disability income benefits for a longer duration.

These inflated claims must be recognized as an important social cost of insurance. Premiums
must be increased to cover the losses, and disposable income that could be used for the
consumption of other goods or services is thereby reduced.

The social costs of insurance can be viewed as the sacrifice that society must make to obtain the
social benefits of insurance.

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