CHAPTER THREE

INSURANCE
Definition of Insurance:
There is not 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
Payment of Accidental Losses
Risk Transfer
Indemnification

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 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 farmer must pay is only $100 ($100,000/1000). In effect, the pooling

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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 break a
leg, the loss would be accidental. Insurance policies do not cover intentional
losses.

Risk Transfer:
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 Exposure Units
Accidental and Unintentional Loss
Determinable and Measurable Loss
No Catastrophic Loss
Calculable Chance of Loss
Economically Feasible Premium

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. 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 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

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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
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 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

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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 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, you bet $300 on a horse race, a new speculative risk is 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.

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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 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 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

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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 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.
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.

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FUNCTIONS AND ORGANIZATION OF INSURERS
As part of the study of the insurance mechanism and the way in which
it works, it will 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

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against adverse selection. Underwriting is performed by home office personnel
who 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.
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 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.

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

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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. 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 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 all 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.
Make-up 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

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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
fire insurance the rate applies to each 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 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 331/3%. The general formula for
the gross premium, the amount charged the consumer, is
Pure Premium
Gross Premium = -----------------------------
1 – Loading Percentage
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

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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, 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 fire insurance or life insurance only. All-line organization
refers to that type of 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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