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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.
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
Insurance is a scheme that establishes a common fund out of which financial compensation is
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.
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
A device by means of which the risks of two or more persons or firms are combined through
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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)
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
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
Pooling of 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
(2) Prediction of future losses with some accuracy based on the law of large numbers.
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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
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,
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
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
A risk could be considered an ideally insurable risk if it satisfies the six conditions below.
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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.
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.
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.
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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
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.
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
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
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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,
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
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.
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Benefits of Insurance
Insurance provides several advantages to individuals, organizations and the society as a whole.
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
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
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
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.
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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
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
Fraudulent claims
Inflated claims
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,
Fraudulent Claims
A second cost of insurance comes from the submission of fraudulent claims. Examples of fraudulent
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Dishonest policyholders take out life insurance policies on unsuspecting insureds and
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
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.
- 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
- 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
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