Chapter Three

Insurance
3.1. 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”.

Insurance defined from Economic perspective:

Insurance is a financial intermediation function by which individual exposed to a specific

Insurance is an agreement by which one party, the policy holder or insured, pays a stipulated
consideration called the premium to the other party called the insurer in return for which the
insurer agrees to pay a defined amount of money or provide a defined service if a covered event
occurs during the currency of the policy.
3.2. Basic Characteristics of Insurance
Based on the preceding definition, an insurance plan or arrangement typically includes the following
characteristics.
A. Pooling of Losses B. Payment of Accidental Losses C. Risk Transfer D. Indemnification
A. 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 number of similar, but not necessarily identical, exposure units that are subject to the
same perils. Thus, pooling implies (1) the sharing of loss 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 technique results in the
substitution of an average loss of $100 for the actual loss of $100,000.
By pooling or combining the loss experience of a large number of exposure units, an insurer may be
able to predict future losses with some accuracy. From the view point of insurer, if future losses can be

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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. If there are a large number of exposure units, the
actual loss experience of the past may be a good approximation of future losses. As the number of
exposures increases, the relative variation of actual loss from expected loss will decline. Thus, the
insurer can predict future losses with a greater degree of accuracy as the number of exposures
increases. This concept is important since an insurer must charge a premium that will be adequate for
paying all losses and expenses during the policy period. The lower the degree of objective risk, the
more confidence an insurer has that the actual premium charged will be sufficient to pay all claims and
expenses and provide a margin of profit.
B. Payment of fortuitous losses:
A fortuitous loss is 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 sidewalk and break a leg.
The loss would be fortuitous. The loss would be accidental insurance policies do not cover intentional
losses.
C. Risk transfer:
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 strong
financial position and is willing to pay the loss than the insured. From the view point 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.
D. Indemnification:
Indemnification means that the insured is restored to his or her approximate financial position prior to
the occurrence of the loss. Thus, if your house burns in a fire, the 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 liability insurance policy will pay those sums that you are legally obligated to pay.
Similarly, if you are seriously disabled, a disability-income policy will restore at least part of the lost
wages.
3.1. Requisites of Insurable Risks
In spite of the usefulness of insurance in many contexts, not all risks are commercially insurable.
Insurers normally insure only pure risks. However, not all risks are insurable. Certain requirements
usually must be fulfilled before a pure risk can be privately insured. The characteristics of risks that
make it feasible for private insurers to offer insurance for them are called the requisites of insurable
risks. For practical reasons, insurers are not willing to accept all the risks that others may wish to
transfer to them. To be considered a proper subject for insurance, certain characteristics should be
present. These requirements should not be considered as absolute, iron rules but rather as guides or
ideal standards that are not always completely attained in practice.
A risk could be considered an ideally insurable risk if it satisfies the following conditions:
A. There must be a large number of exposure units:

There must be a sufficient 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,
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exposure units that are subject to the same peril or group of perils. Insurance, as we have seen is based
on the operation of the law of large numbers. A large number of exposure units enhance the operation
of an insurance plan by making estimates of future losses more accurate. The purpose of this 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 insureds in the underwriting class. B. The loss must be
accidental and unintentional:
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. If the insurance company knows that an event in the
future is inevitable, it also knows that it must collect a premium equal to the certain loss that it must
pay, plus an additional amount for the expenses of administering the operation. Depreciation, which is
a certainty, cannot be insured; it is provided for through a sinking fund. Furthermore, the loss should be
beyond the control of the insured. This means that if an individual deliberately causes a loss, he or she
should not be indemnified for the loss. The requirement for 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 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. A deliberately caused loss is not a random
event since 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. The law of large numbers
is useful in making predictions only if we can reasonably assume that future occurrences will
approximate past experience. Since we assume that past experience was a result of chance happening,
the predictions concerning the future will be valid only if future happenings are also a result of chance.
C. The loss must be determinable and measurable:
The loss produced by the risk must be determinable and measurable. This means the loss should be
definite as to cause, time, place and amount. We must be able to tell when a loss has taken place, and
we must be able to set some value on the extent of it. 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 a monthly benefit to the disabled person if the definition of disability stated in
the policy is satisfied. Some dishonest claimants may deliberately fake sickness or injury in order 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. Sickness and disability are highly
subjective, and the same event can affect two persons quite differently.
For example, two accountants who are insured under separate disability income contracts may be
injured in an automobile accident, and both may be classified as totally disabled. One accountant,
however, may be stronger willed and more determined to return to work. If that accountant undergoes
rehabilitation and returns to work, the disability-income benefits will terminate. Meanwhile, the other
accountant would still continue to receive disability-income benefits according to the terms of the
policy.
In short, it is difficult to determine when a person is actually disabled. However, all losses ideally
should be both determinable and measurable. Before the burden of risk can be easily assumed, the
insurer must set up procedures to determine whether loss has actually occurred and if so, its size. The
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basic purpose of this requirement is to enable the insurer to determine if the loss is covered under the
policy, and if it is covered, how much should be paid. For example, assume that Shannon has an
expensive fur coat that is insured under a homeowner’s policy. It makes a great deal of difference to
the insurer if a thief breaks into her home and steals the coat, or coat is missing because her husband
stored it in a dry-cleaning establishment but forgot to tell her. The loss is covered in the first example
but not in the second.
D. The loss should not be catastrophic:
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. 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, then 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 losses of the
few are spread over the entire group. Insurers ideally wish to avoid all catastrophic losses. In reality,
however, this is impossible, because catastrophic losses periodically result from floods, 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 problem of a catastrophic loss.
First, reinsurance can be used by which insurance companies are indemnified by reinsurers for
catastrophic losses. Reinsurance is an arrangement by which the primary insurer that initially writes the
insurance transfers to another insurer (called the reinsurer) part or all of the potential losses associated
with sub insurance. In other words, 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 frequent
floods, earthquakes, hurricanes, or other natural disasters can result in periodic catastrophic losses. If
the loss exposures are geographically dispersed, the possibility of a catastrophic loss is reduced.
Finally, financial instruments are now available for dealing with catastrophic losses. These instruments
include catastrophic bonds, which are designed to pay for a catastrophic loss. E. The chance of loss
must 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 all 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.
F. The premium must be economically feasible:
The cost of the insurance must not be high in relation to the possible loss. The insurance must be
economically feasible. The insured must able to pay the premium. In addition, for the insurance to be
an attractive purchase, the premium paid must be substantially less than the face value, or amount, of
the policy. 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

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becomes prohibitive. At this point, insurance is no longer feasible because the insured will not be
willing to pay the necessary premium.
In order to have an economically feasible premium, the probability of loss must be relatively low. If
the probability of loss is too high, the cost of the policy will exceed the amount that the insurer must
pay under the contract. For example, an insurer could issue a Birr 1,000 life insurance on a man age
99, but the pure premium would be about Birr 980, and an additional amount for the 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, since the
requirements of an insurable risk generally can be met. In contrast, most market risks, financial risks,
and political risks are normally uninsurable by private insurers. These risks are uninsurable for
several reasons.
First, these risks are speculative and so are difficult to insure privately. Second, the potential of each to
produce a catastrophic loss is great; this is particularly true for political risks, such as the risk of war.
Finally, calculation of the proper premium for such risks may be difficult because the probability of
loss cannot be accurately determined.
For example, insurance that protects a retailer against loss because of a change in consumer tastes,
such as a style change, generally is not available. Accurate loss data are not available, and there is no
accurate way to calculate a premium. The premium charged may or may not be adequate to pay all
losses and expenses. Since private insurers are in business to make a profit, certain risks are
uninsurable because of the possibility of substantial losses.
3.2. Insurance and Gambling Compared
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. If 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 restores the insured financially in whole or in part if a loss occurs.
Insurance and Speculation compared
o Speculation is the business transaction in which the risk of price fluctuation is transferred to a third
party known as a speculator.
Similarities between speculation and insurance:
i. Risk is transferred by a contract
ii. No new risk is created
Differences between speculation and insurance:
1) An insurance transaction involves the transfer of insurable risks. However, speculation is a
technique for handling risks that are typically uninsurable, such as protection against a decline in
the price of agricultural products and raw materials.
2) Insurance can reduce the objective risk of an insurer by application of the law of large numbers.
However, speculation involves only risk transfer, not risk reduction.

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 3.3. Terms in Insurance
 Insurance policy: a written or printed document formally setting out particulars of the concluded
and contract which has been made between the insured and insurer.
 Insured: the first party which transferring the risk; being either person or organization.
 Insurer: the second party is the one accepting the risk or the one to whom the risk is transferred. 
Premium: when an insured transfers his /her risk to the insurer, there is a price to be paid.
 Pool: the premiums insurer collects to create a ‘fund’
 Pooling: sharing of total loss to the group
3.4. Benefits and Costs of Insurance
Insurance has peculiar advantages as a device to handle risk and so ought to be used to bring about the
greatest economic advantage to society.
3.4.1. Benefits of Insurance to Society
The existence of insurance results in great benefits to society. The major social and economic benefits
of insurance include the following:
i. Indemnification for loss:
Indemnification permits individuals, families, and business firm to be restored to their former financial
position after a loss occurs. As a result, they can maintain their financial security. Since they are
restored either in part or in whole after a loss occurs, they are less likely to seek financial assistant from
relatives and friends. Indemnification to business firms also permits firms to remain in business and
employees to keep their jobs. Suppliers continue to receive orders, and customers can still receive the
goods or services they desire. The community also benefits because its tax base is not eroded.
Businesses and families who suffer unexpected losses are restored or at least moved closer to their
former economic position. The advantage to these individuals is obvious. Society also gains because
these persons are restored to production and tax revenues are increased. In short, the indemnification
function contributes greatly to family and business stability and therefore is one of the most important
social and economic benefits of insurance.
ii. Less worry and fear:
The 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 serious illness or accident
occurs; and property owners who are insured enjoy greater peace of mind since they know they are
covered if a loss occurs. Worry and fear are also reduced after a loss occurs, since the insured know
that they have insurance that will pay for the loss.
iii. Source of investment fund:
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 factories, housing and
urban developments, and new machinery and equipment. The investments increase society`s stock of
capital goods, and promote economic growth. Insurer also invests in social investment and economic
development projects. The insurance mechanism encourages new investment. For example, if an
individual knows that his or her family will be protected by life insurance in the event of premature
death, the insured may be more willing to invest savings in a long-desired project, such as a business

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venture, without feeling that the family is being robbed of its basic income security. In this way a better
allocation of economic resources is achieved.
iv. Encourage confidence to undertake new venture:
Many businesses would not be started, and much research and development would not be embarked
upon, unless the people concerned had confidence in the protection against losses from risks provided
by insurance.
v. Reduced cost of capital:
Because the supply of investable funds is greater than it would be with insurance, capital is available at
a lower cost than would otherwise be possible. Since the total supply of loanable funds is increased by
the advance payment of insurance premiums, the costs of capital to business firms that borrow is lower
than it would be in the absence of insurance. This result brings about a higher standard of living
because increased investment itself will raise production and cause lower prices than would otherwise
be the case. Also, because insurance is an efficient device to reduce risk, investors may be willing to
enter fields they would otherwise reject as too risky. Thus, society benefits by increased services and
new products, the hallmarks of increased living standards.
vi. Loss control:
Another social and economic benefit of insurance lays in its loss control or loss prevention activities.
Although the main function of insurance is not to reduce loss but merely to spread losses among
members of the insured group, insurers are nevertheless virtually interested in keeping losses at a
minimum. Insurers know that if no effort is made in this regard, losses and premiums would have a
tendency to rise. It is a human nature to relax vigilance when it is known that the loss will be fully paid
by the insurer. Furthermore, in any given year, a risk in loss payments reduces the profit to the insurer,
and so loss prevention provides a direct avenue of increased profit.
A few illustrations of loss prevention and control in the field of property and casualty/liability
insurers strongly support include the following: (1) investigation of fraudulent insurance claims, (2)
recovery of stolen properties, (3) development of fire safety standards and public education programs,
(4) highway safety and reduction of automobile deaths, (5) reduction of work-related injuries and
disease, (6) prevention of auto thefts, (7) prevention of defective products that could injure the user,
(8) prevention of boiler explosions. In the life and health insurance industry, support can be given by
private insurers to programs aimed at reducing loss by premature death, sickness, and accidents.
vii. Enhancement of credit:
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 gives 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. The property insurance protects the lenders
financial interest if the property is damaged or destroyed. Similarly, if a new automobile is purchased
and financed by a bank or other lending institution, physical damage insurance on the automobile may
be required before the loan is made. Thus, insurance can enhance a person`s credit.
viii. Aid to small business:
Insurance encourages competition because without an insurance industry, small business would be a
less effective competitor against big business. Big business may safely retain some of the risks that, if
they resulted in loss, would destroy most small businesses. Without insurance, small business would
involve more risks and would be a less attractive outlet for funds and energies.

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 3.4.2. 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:
i. Operating expenses (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 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, acquisition expenses, and an allowance for
contingencies and profit. In other words, insurer incur expenses such as loss-control costs,
lossadjustment expenses, expenses involved in underwriting coverage, premium taxes, and general
administrative expenses. These expenses, plus a reasonable amount of profit and contingencies, must
be covered by the premium charged.
In real terms, workers and other resources that might have been committed to other uses are required
by the insurance industry. However, these additional costs are justified for several reasons. First,
from the insured`s viewpoint, uncertainty concerning the payment of a covered loss is reduced because
of insurance. Second, the costs of doing business are not necessarily wasteful, since insurers engage in
a wide variety of loss prevention activities. Finally, the insurance industry provides job opportunity to
a large number of workers. However, because economic resources are used up in providing insurance
to society, a real economic cost is incurred.
ii. Losses that are intentionally caused (i.e., fraudulent claims):
A second cost of insurance comes from the submission of fraudulent claims. Some
unscrupulous/dishonest persons can make, or believe that they can make, a profit by bringing about a
loss. 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 out life insurance policies on insureds who are later reported as
having died.
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 so as to profit from insurance. These
social costs fall directly on society. iii. Inflated claims:
Another cost of insurance relates to the submission of inflated or “padded” claims. Many claims are
inflated because of insurance. 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.
 Insureds inflate the amount of damage in auto collision claims so that the insurance payments
will cover the collision deductible.
 Physicians may charge higher fees for surgical procedures covered by major medical health
insurance.
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 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.
These 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 or services are reduced.

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