CHAPTER-THREE

INSURANCE
Definition of Insurance
There is no single definition of insurance. Insurance can be
defined from the viewpoint of several disciplines, including
law, economics, history, actuarial science, risk theory, and
sociology. The commission of Insurance Terminology of
the American Risk and Insurance Association has defined
insurance as follows.
“Insurance is the pooling of accidental losses by transfer
of such risks to insurers, who agree to indemnify insureds
for such losses, to provide other financial benefits on
their occurrence, or to render services connected with the
risk”.
Basic Characteristics of Insurance
Based on the preceding definition, an insurance plan or
arrangement typically includes the following
characteristics.
 Pooling of Losses  Risk Transfer
 Payment of Accidental  Indemnification
Losses
Pooling of Losses

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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 actuarial. In addition, pooling involves the
grouping of a large number of exposure units so that the
law of large numbers can operate to prove a substantially
accurate prediction of future losses. Ideally, there should
be large 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.
With respect to the first concept-loss sharing-consider this
simple example. Assume that 1000 farmer in southeastern
Kanas agree that if any farmer’s home is damaged or
destroyed by a fire, the other members of the group will
indemnify, or cover, the actual costs of the unlucky farmer
who has a loss. Assume also that each home is worth
$100,000 and one average, one home burns each year. In
the absence of insurance, the maximum loss to each farmer
is $100,000 if the home should burn. However, by pooling
the loss, it can be spread over the entire group, and if one
farmer has a total loss, the maximum amount that each

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farmer must pay is only $100 ($100,000/1000). In effect,
the pooling technique results in the substitution of an
average loss of $100 for the actual loss of $100,000.
In addition, by pooling or combining the loss experience of
a large number of exposure units, an insurer may be able to
predict future losses with greater accuracy. From the
viewpoint of the insurer, if future losses can be predicted,
objective risk is reduced. Thus, another characteristic often
found in many lines of insurance is risk reduction based on
the law of large numbers.
Payment of Accidental Losses
A second characteristic of private insurance is the payment
of accidental losses. An accidental loss is one that the
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 an icy sidewalk and bread a leg. The loss
would be accidental insurance policies do not cover
intentional losses.
Risk Transfer

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Risk transfer is another essential element of insurance.
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 viewpoint of the individual,
pure risks that are typically transferred to insurers include
the risk of premature death, poor health, disability,
destruction and theft of property, and liability lawsuits.
Indemnification
A final characteristic of insurance is indemnification for
losses. Indemnification means that the insured is restored
to his or her approximate financial position prior to the
occurrence of the loss. Thus, if your home burns in a fire, a
homeowner’s policy will indemnify you or restore you to
your previous position. If you are sued because of the
negligent operation of an automobile, your auto liability
insurance policy will pay those sums that you are legally
obligated to pay. Similarly, if you become seriously
disabled, a disability income insurance policy will restore
at least part of the lost wages.

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Requirements of an Insurance 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 viewpoint of the insurer, there are ideally six
requirements of an insurable risk.
Requirements
 Large Number of  No Catastrophic Loss
Exposure Units  Calculable Chance of
 Accidental and Loss
Unintentional Loss  Economically Feasible
 Determinable and Premium
Measurable Loss
Large Number of Exposure Units
The first requirement of an insurable risk is a large number
of exposure units. Ideally, there should be a large group of
roughly similar, but not necessarily identical, exposure
units that are subject to the same peril or group of perils.

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For example, a large number of frame dwellings in a city
can be grouped together for purposes of providing property
insurance on the dwellings.
The purpose of this first requirement is to enable the insurer
to predict loss based on the law 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 the spread over all insureds in the underwriting
class.
Accidental and Unintentional Loss
A 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.
Determinable and Measurable Loss
A third requirement is that the loss should be both
determinable and measurable. This means the loss should
be definite as 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

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cases, and if the person is insured, the face amount of the
life insurance policy is the amount paid.
Some losses, however, are difficult to determine and
measure. For example, under a disability-income policy,
the insurer promises to pay monthly benefit to the disable
person if the definition of disability stated in the policy is
satisfied. Some dishonest claimants may deliberately fake
sickness or injury to collect from the insurer. Even if the
claim is legitimate, the insurer must still determine whether
the insured satisfies the definition of disability stated in the
policy. 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.
No Catastrophic Loss
The fourth requirement is that ideally the loss should not be
catastrophic. This means that large proportion of exposure
units should not incur losses at the same time. As we stated
earlier, pooling is the essence of insurance. If most or all of
the exposure units in a certain class simultaneously incur a
loss, them the pooling technique breaks down and becomes
unworkable. Premiums must be increased to prohibitive
levels, and the insurance technique is no longer a viable

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arrangement by which loses of the few are spread over the
entire group.
Insurers ideally which to avoid all catastrophic loses. In
reality, however, this is impossible, because catastrophic
losses periodically result from the foods, hurricanes,
tornadoes, earthquakes, forest fires, and other natural
disasters. Catastrophic losses can also result from acts of
terrorism.
Several approaches are available for meeting the problems
of catastrophic loss. First, reinsurance can be used by
which insurance companies are indemnified by reinsures
for catastrophic losses. Reinsurance is the shifting of part
or all of the insurance originally written by one insurer to
another. Second, insurers can avoid the concentration of
risk by dispersing their coverage over a large geographical
area. The concentration of loss exposures in a geographic
area exposed to frequent floods, earthquakes, hurricanes, or
the natural disasters can result in periodic catastrophic
losses. If the loss exposures are geographically disperses,
the possibility of a catastrophic loss is reduced.
Finally, new financial instruments are now available for
dealing with catastrophic losses. These instruments include

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catastrophe bonds, which are designed to pay for a
catastrophic loss.
Calculable Chance of Loss
A fifth requirement is that the chance of loss should be
calculable. 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 al
claims and expenses and yield a profit during the policy
period. Certain losses, however, are difficult to insure
because the chance of loss cannot be accurately estimated,
and the potential for a catastrophic loss is present. For
example, floods, wars and cyclical Unemployment occur
on an irregular basis, and prediction of the average
frequency and the severity of losses are difficult. Thus,
without government assistance, these losses are difficult for
private carriers to insure.
Economically Feasible Premium
A final requirement is that the premium should be
economically feasible. The insured must be able to pay the
premium. In addition, for the insurance to be an attractive
purchase, the premiums paid must be substantially less than

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the face value, or amount, of the policy. To have an
economically feasible premium, the chance of loss must be
relatively low. One view is that if the chance of loss
exceeds 40%, the cost of the policy will exceed the amount
that the insurer must pay under the contract. For example,
an insurer could issue a $1,000 life insurance policy on a
man age 99, but the pure premium would be about $980,
and an additional amount for expenses would have to be
added. The total premium would exceed the face amount
of the insurance.
Based on these requirements, personal risks, property risks
and liability risks can be privately insured, because the
requirements of an insurable risk generally can be met. By
contrast, most market risks, financial risks, production risks
and political risks are usually uninsurable by private
insurers. These risks are uninsurable for several reasons.
Insurance and Gambling Compared (Speculation)
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.
This, the bet $300 on a horse race, a new speculative risk is

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created, but if you pay $300 to an insurer for fire insurance,
the risk of fire is already present and is transferred to the
insurer by a contract. No new risk is created by the
transaction.
The second difference between insurance and gambling is
that gambling is socially unproductive, because the
winner’s gain comes at the expense of the loser. In
contrast, insurance is always socially productive, because
neither the insurer nor the insured is placed in a position
where the gain of the winner comes at the expense of the
loser. The insurer and the insured both have a common
interest in the prevention of a loss. Both parties win if the
loss does not incur. Moreover, consistent gambling
transactions generally never restore the loser to the former
financial position. In contrast, insurable contract restore
the insured financially in whole or in part if a loss occurs.
Benefits of Insurance to Society
The major social and economic benefits of insurance
include the following:
Indemnification: Indemnification permits individuals, and
families to be restores to their former financial position
after a loss occurs. As a result, they can maintain their

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financial security. Because insureds are restored either in
part or in whole after a loss occurs, they are less likely to
apply for public assistance or welfare benefits, or to seek
financial assistance form relative and friends.
Less 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
even of premature death; persons insured for long-term
disability to not have to worry about the loss of earnings if
a serious 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.
Source of Investment Funds: The insurance industry is an
important source of funds for capital investment and
accumulation. Premiums are collected in advance of the
loss, and funds not needed to pay immediate losses and
expenses can be loaned to business firms. These funds
typically are invested in shopping centers, hospitals,
factories, housing developments, and new machinery and
equipment. The investments increase society’s stock of
capital goods, and promote economic growth and full
employment. Insurers also invest in social investments,
such as housing, nursing homes and economic development
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projects. In addition, because the total supply of loanable
funds is increased by the advance payment of insurance
premiums, the cost of capital to business firms that borrow
is lower than it would be in the absence of insurance.
Loss Prevention: Insurance companies are actively
involved in numerous loss prevention programs and also
employ a wide variety of loss prevention personnel,
including safety engineers and specialists in fire prevention,
occupational safety and health, and products liability. For
example, Highway safety and reduction of automobile
deaths, Fire prevention, Reduction of work related
disabilities, Prevention of auto thefts, Prevention and
detection of arson losses and ect.,
Enhancement of Credit: A final benefit is that 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 give 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.
Costs of Insurance to Society
Although the insurance industry provides enormous social
and economic benefits to society, the social costs of

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insurance must also be recognized. The major social costs
of insurance include the following:
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 expense incurred by insurance companies in their
daily operations. An expense loading is the amount needed
to pay all expense, including commissions, general
administrative expenses, state premium taxes, acquisition
expense, 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, Phony burglaries, thefts, or acts
of vandalism are reported to insurers, False health
insurance claims are submitted to collect benefits,
Dishonest policy owners take tout life insurance policies on
insured who are later reported as having dies.

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The payments of such fraudulent claims results in higher
premiums to all insureds. The existence of insurance also
prompts some insureds to deliberately cause a loss so as 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, Insured
inflated the amount of damage in auto mobile collision
claims so that the insurance payments will cover the
collision deductible, Disabled persons often maligner to
collect disability income benefits for a longer duration and
ect.,
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.
Functions and Organization of Insurers

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As part of the study of the insurance mechanism and the
way in which it works, it will he 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) Rate Making
Underwriting Managing Claims
(Selection of Risks) 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.

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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 form
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 performed by home office personnel whose

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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 a void 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.

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There are four sources from which the underwriter obtains
information regarding the hazards inherent in an exposure:
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.
Information form 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.
Investigations: In some cases the underwriter will request
a report from an inspection organization that specializes in
the investigation of personal matters. This inspection

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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 which neighbors say he used
them). All the information is pertinent in the decision to
accept or reject the application.
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 medial reports after a physical examination; this report
is a very important source of underwriting information. In
the field of property and liability insurance, the
equalivalent of the physical examination in life insurance is
the inspection of the premises. 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

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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 some time 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 insureds 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.

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At the same time, rates should be sufficiently responsive to
changing conditions to avoid inadequacies in the event of
deteriorating loss experience.
Makeup of the Premiums
A rate is the price charged for each unit of protection or
exposure and should be distinguished from a “Premium”,
which is determined by multiplying the rate by the number
of units of protection purchased. The unit of protection to
which a rate applies differs for the various lines of
insurance. In life insurance, for example, rates are
computed for each 1,000 birr in protection; in fir insurance
the rate applies toe ach 100 birr coverage.
The insurance rate is the amount charged per unit of
exposure. The premium is the product of the insurance rate
and the number of units of exposure. Thus, in life
insurance, if the rate is 25 birr per 1,000 birr of face amount
of insurance, the premium for a 10,000 birr policy is 250
birr.
The premium is designed to cover two major costs: (I) The
expected loss and (II) The cost of doing business. These
are known as the pure premium and the loading,
respectively. The pure premium is determined by dividing

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the total expected loss by the number of exposures. In
automobile insurance, for example, if an insurer expects to
pay 100,000 birr of collision loss claims in a given
territory, and there are 1,000 autos in the sued group, the
pure premium for collision will be 100 birr per car,
computer as follows:
Expected Loss 100,000 Birr
Pure Premium = ------------------------- =----------------------
= 100 Birr
Exposure Units 1,000
The loading is made up of such items as agents’
commissions, general company expenses, taxes and fees,
and allowances for profit. The sum of the pure premium
and loading is termed as the gross premium. Usually the
loading is expressed as a percentage of the expected gross
premium. In property-liability insurance, a typical loading
might be 33.33%. The general formula for the gross
premium, the amount charged the consumer, is
Pure Premium
Gross Premium = -----------------------------
1 – Loading Percentage

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In above example, where the pure premium was birr 100
per car, the gross premium would be calculated as
Gross Premium = 100 Birr / 1-0.3333 = 150 Birr.
Rate-Making Methods: Two basic approaches to rate
making, class and individual rating are discusses below.
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
judgement of the person setting the rate. This rating is
supplemented by whatever statistical data are available and
by knowledge of the premiums charged similar insureds. 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

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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

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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, 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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