CHAPTER THREE
INSURANCE
3.1 Definition of Insurance
Sometimes it is difficult to define certain terms. However, it is possible to describe them. Some
definition, though not comprehensive by themselves may provide reasonably sufficient
explanations about the term insurance. The following are some of the definitions given by
different scholars.
Insurance may be defined in economic, legal business, social, and mathematical point of view as
follows:
1. In economic sense:
sense: insurance is an important tool that provides certainty or predictability
aiming at reducing uncertainty in regard to pure risks. It accomplishes this result by
pooling or sharing of risk.
2. Legal point of view: insurance is a contract by which one party, in consideration of the
price paid to him adequate to the risk, becomes security to the other that he shall not
suffer loss, damage or prejudices by the happening of the perils specified in the policy.
Article 654(1) of the commercial code of Ethiopia states insurance as follows:
"A contract whereby a person called the insurer undertakes against payment of one or
more premiums to pay a person, called the beneficiary, sum of money where a specified
risk materializes.
From these definitions of law we can learn that insurance is contractual agreement
between two parties: the person (Insured) and Insurance companies. When a person buys
private insurance, she/he is entering into a contract with the insurer that entitles the
person (Insured) to certain advantages but also imposes certain responsibilities such as
payment of a premium and satisfying certain conditions specified in the policy.
3. Business Point of views: as a business institution, insurance has been defined as a plan by
which large number of people associate themselves and transfer risks of individuals to the
shoulders of all members of the policy.
4. Social View Point: insurance is defined as a social device for making payment for the
accumulation of fund to meet uncertain losses of capital which is carried out through the
transfer of risk of many individuals to one person or a group of persons. It is advice through
which few unfortunates are paid by many who are member of the policy.
5. Mathematical viewpoint: insurance is the application of actuarial (Insurance mathematics)
principles. Laws of probability and statistical techniques are used for achieve predictable
results.
Williams and Heins defines insurance as "a device by means of which the risks of two or
more persons or firms are combined through actual or promised contributions to a fund out of
which claimants are paid."
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Dinsdale and McMurdie also defined insurance as "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".
From the definitions, it can be learned that:
1) Insurance is a system used to transfer risk of individual for payment of premium.
The insured considers insurance as a transfer device where as from the point of view of
the insurer (Insurance Company),
Company), it is regarded as retention and combination device. Of
course, one may ask, "Why the insurer accepts risks that other people try to avoid?"
Insurance companies /Insurers accept the risks of others because, as compared to
individual insured’s:
insured’s:
i) They have the knowledge and the skill to apply various risk reduction and risk
control measures;
ii) Combination or pooling of similar risks will enable the insurer to predict the actual
loss experience with a reasonable accuracy.
iii) They have financial capacity to assume/ take risk
iv) They are in a position to enforce certain loss reduction and prevention measures
v) For losses that are beyond their capacity, insurers arrange a reinsurance mechanism.
From this we can say that risk in the business of insurance companies. The insured is
required to pay some amount of money in relation for the transfer of his/her risk to the
insurer. They do this because they want to remain secured financially and/or mentally.
2) It is a scheme (plan) that establishes a common fund out of which financial compensation
is made to those who faces accidental losses.
3) It is a pooling of risks of many people who are exposed to the same risk.
4) It is a device used to spread the loss suffered by an individual or firm to the members in
the group.
5) It is a method to provide security to the insured person against the probable loss.
3.2 Basic characteristics of insurance
There are four characteristics of an insurance plan/arrangement
1. Pooling of losses
2. Payment of fortuitous losses
3. Risk transfer
4. Indemnification
1. Pooling of losses
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.
Key mechanism is “law of large number”.
Future losses are predicted based on law of large number.
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Principal of loss pooling
“There should be a large number of similar, but not necessarily identical, exposure units that are
subject to the same peril”, which can be concluded as polling implies:
1. The sharing of losses by the entire group.
2. Prediction of future losses with some accuracy based on the law of large numbers
Ex: assume that 1,000 farmers in a village of Cheman Embecho (kebelle) agree that if any
farmer’s home is damaged or destroyed by a fire, the other members of the group will indemnify
the actual costs of the unlucky farmer who has a loss. Further assume that each home is worth
20,000 Birr, and, on average, one home burns every year.
In the absence of insurance, the maximum loss to each farmer is 20,000 Birr, if the home should
burn. With the pooling of loss, the maximum loss for each farmer is 20 Birr for the actual loss of
20,000 Birr.
In reality, the actuary seldom knows the true probability and severity of loss. Therefore,
estimates of both the average frequency and the average severity of loss must be based on
previous loss experience (objective risk). As the number of exposures increases, the relative
variation of actual loss from expected loss will decline.
Note:
1. Pooling of loss 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.
2. The primary purpose of pooling, or then sharing of losses, is to reduce the variation in possible
outcomes as measured by the standard deviation or some other measure of dispersion, which
reduces risk
Assume two business owners each own an identical storage building valued at Birr 50,000.
Assume there is a 10% chance in any year that each building will be destroyed by a peril, and
that a loss to either building is an independent event. If the two owners decide to pool their loss
agreeing to pay an equal share of any loss that might occur. Do risk pooling help reduce risk of
the two owners?
From the last problem, if there is another owner joins the pool, what is the level of risk?
2. Payment of fortuitous losses
A fortuitous loss is one that is unforeseen and unexpected and occurs as a result of chance.
Law of large number is based on the assumption that losses are accidental and occur randomly.
Insurance policies do not cover intentional losses.
3. Risk Transfer
Risk transfer means that a pure risk is transferred from the insured to the insurer, who typically is
in a stronger financial position to pay the loss than the insured.
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4. Indemnification
Indemnification means that the insured is restored to his or her approximate financial position
prior to the occurrence of the loss.
3.3 Fundamentals of insurable risk
Insurance is clearly a useful device for handling risk, but some risks cannot safely be handled by
insurance. It is a device used to deal with pure risks only. Even not all pure risks are insurable.
That means, insurance does not provide protection against a wide range of risks. It has a limited
application. We may question a: what types of risks are insurable? To give an answer, it is
necessary to discuss the characteristics of insurable risks. In other words, for insurance to be
used as a risk transfer mechanism the following conditions must be met to identify the insurable
risks from those which cannot be commercially insurable.
1. A large number of independent units should be exposed to the same risk. This requirement
follows from the law of large numbers, a mathematical principle which states that a risk that
is not predictable for one person can be forecasted accurately for a sufficiently large groups
of people with similar characteristics. Insurance operation is safe only when the insurer is
able to predict fairly and accurately its expected losses. If the pool of policy holders is small,
volatility in number of claims can lead to unexpected increase in claim and hence bankrupt
the plan the insurance company.
Therefore, there must be a sufficiently large number of risks of a similar class being insured
so as to predict accurately the average loss experience.
2. It must be possible to calculate/measure the chance of loss in monetary terms.
3. The loss should be definite, in time, place, cause and amount; otherwise claim adjustment
will be difficult.
4. The loss should be accidental from the view point of the insured as distinguished from the
expected loss. For example, losses on account of depreciation cannot be insured, as there is
nothing accidental about their occurrence.
5. The possible loss must not be catastrophic. The risks covered by insurance should affect only
a relatively small portion of the total insured population at a given time. If a risk is likely to
cause similar damage to a large proportion of policy holders at the same time, a single
occurrence of the risk would bankrupt the insurance companies. Therefore, with certain
exceptions, it is usual to find exclusions regarding fundamental risks such as war and
earthquake in all insurance contracts.
6. There must be an insurable interest. An insurance contract provides security against the
consequences of a loss and is basically concerned with preserving the interest of the insured,
one who possesses insurable interest (financial relationship) in the subject matter of
insurance can avail the insurance protection.
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7. The potential loss must be large. The risk should not be very minor one and the penil must be
capable of causing a loss so large that the insured cannot bear it himself without economic
distress.
8. The cost of insurance should not be prohibitive. The cost of insuring (premium) must be
economically feasible and within the reach of nearly everyone; otherwise it will be confined
to a very small section of the society. For instance, who would be willing to pay Birr 1,000 or
2,000 to insure the risk of losing a 100 Birr property? If you are rational person, the answer is
definitely "no" The premium should be reasonable.
9. The risk must be consistent with public policy. The insurance contract should not be against
the public policies, for example, insurance effected by terrorists for fines imposed for the
offences.
10. The insured must be subject to real risk whatever may be the subject matter of insurance for
which the insured seeks protection, the subject matter must be adversely affected on the
happening of the event, i.e., the subject matter must be potentially exposed to the risk.
Insurable Risk
The following are generally insurable risk.
1. Pure risks: property (direct and indirect losses; personal and legal liability.
2. Non-catastrophic losses
3. Risk with low probability of occurrence
Un insurable risks
1. Speculative risks such as market risks,
2. Fundamental risks (war, earthquake, political and economic losses).
3. Wear and tear of goods, eg. Depreciation.
4. Risk that are against public policy.
3.4 Insurance and gambling compared
The essential feature about gambling is that it creates a risk where there existed none hitherto.
When a gambler buys a lottery ticket, for instance, or places a bet on a horse, he puts money at
risk that was not in jeopardy before. The difference between insurance and gambling can be
illustrated as follows.
The man who gambles creates a risk, which did not exist previously whereas the man
who purchases insurance minimizes a risk which was already in being and which is
not in his power to avoid.
The gambler with hope of gain, goes out his way to bring a risk into being while the
man who insures, for the purpose of avoiding loss, goes out of his way to hedge
against a risk which already exists.
The man who gambles accepts deliberately the risk of loss in exchange for the
possibility of profit: the man who insures accepts deliberately the certainty of a small
loss in exchange for the freedom from risk of devastating catastrophic loss.
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The gambler bears the risk while the insured transfers the risk.
Considering the many risks we are exposed to in our daily life, such as fire, motor accident, etc
there is certainly no complete escape from the hazards, and the man who gamble, by not insuring
against them is gambling against frightful odds. The man who insures pays a fixed, certain and
relatively small loss (the premium), and in doing so, doesn’t gamble which would have been
ruinous to his and his family.
3.5 Insurance and speculation compared
Speculation on the other hand involves doing some kind of activity with the expectation of profit
in the future. For instance, a businessman who purchases and sells goods, stocks and shares, etc
with the risk of loss and hope of profit through changes in their market value is a clear case of
speculation. Through speculation individuals create a risk deliberately in the anticipation of
profits. However, an insurance transaction normally involves the transfer of risks that are
insurable, since the requirements of an insurable risk generally can be met. On the contrary,
speculation is a technique for handling risks that are typically uninsurable, such as protection
against a substantial decline in the price of agricultural products and raw material.
The other difference between the two is that insurance can reduce the objective risk of an insurer
by application of the law of large numbers. In contrast,
contrast, speculation typically involves only risk
transfer, not risk reduction. The risk of an adverse price fluctuation is transferred to a speculator
who feels he or she can make a profit because of superior knowledge of forces that affect market
price. The risk is transferred, not reduced, and the speculator’s prediction of loss generally is not
based on the law of large numbers.
3.6 Benefits and costs of insurance
3.6.1 Benefits of insurance
Insurance is obviously desirable that we can enumerate several advantage or value to the social
well-being and economic development of a nation. Some of the advantages are discussed below.
1. Risk transfer/Indemnification
The primary objective of insurance is to provide financial compensation to those insured who
suffered accidental losses. Indemnification is made out of the fund established by the members
contribution or premium payment, who are exposed to the same risk. This means, the loss is
spread to all members on equitable basis and the financial burden of the unfortunate is reduced
and he is restored to his former financial position. By doing so insurance helps stabilize the
financial situation of individuals, families and organizations.
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2. Reduction of Uncertainty
Insurance reduces the physical and mental stress that insured's face concerning the risk of loss
and provides peace of mind. It is a psychological benefit that may not be quantified but still of
great importance. Insurance reduces worries and anxieties and help everyone work in a relaxed
manner, which can make every one to work more productive and perform his duties properly
without anxiety. This has direct implication on the society because the society will be secured
from unexpected loss and interruption of services from those who will face unexpected loss.
3. Encourages Savings
Insurance is a contractual agreement between the insurer and the insured, where the insured is
expected to pay a premium for the risk he/she transferred to the insurer. This compulsory
premium payments are a form of encouragement of the insured to make systematic saving.
Particularly, this is possible in certain life insurance policies that have dual purpose, i.e.,
protection in the event of death and savings in the event of survival.
4. Help Businesses Continue Without Interruption of Operation
The insured firm will not be knocked out of business by fire or liability or other insurable risks.
The insurer indemnifies the losses and restores the firm to its former position. This is also
advantageous to the society because they can get uninterrupted services and goods of the firm.
Moreover, insurance helps small businesses since they cannot bear all the risks by themselves.
By transferring their risk, they can safely perform their operation and compete with larger firms.
5. Provide Funds for Investment
Premiums collected by insurance companies are not left stagnant. They are used to provide a big
source long-term investment capital for the national economy. The loan is made available to
investors through banks and it serve as a stimulant for the national economy to be healthier.
6. Keeps Families Together
Family can continue to live together after disastrous adversaries. For example, if a husband with
life insurance dies, it may not force his family to disintegrate due to lack of income because they
can receive the compensation from the insurer and can earn their live as it was before at least to
some extent.
It relieves pressure on social welfare system, thereby reserving government resources for
essential social security.
7. Provides a Basis for Credit
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Insurance policies are used as a guarantee for personal and business bank loans. This days banks
lend money on the basis of the collateral security of insurance.
8. Promotes Loss Control Systems
In order to minimize their losses, insurance companies have tried and are continuing to introduce
several kinds of loss reduction and prevention schemes. For example, health education,
inspection, of elevators, and boilers, installation of fire extinguishers, burglar alarms, on vehicles
or houses are risk control mechanisms developed and applied by insurance companies at
different times. The introduction of this loss control programs can reduce losses to businesses
and individuals and complement good risk management thereby benefiting society as a whole.
9. It provides Financial Stability to the Community
Insurance makes a remarkable contribution to the society as a whole. It creates certainty in the
environment thereby stimulating competition among business enterprises in a certain region. Fair
competition is a greater advantage to the society since it reduces price, encourage efficient
utilization of scarce resources and produce quality products. Insurance also avoids or at least
minimizes production stoppage that produces an economic wastage, and results in loss of profit
to the insured, unemployment and loss of trade and services to the business community. So,
insurance can minimize all these and other consequences of risk.
10. Stimulates International Trade and Commerce
Goods traded at the international market are highly vulnerable to risk of loss due
to large number of perils. As a result it is difficult to think of international trade
without insurance. Insurance coverage may be a condition for engaging in
international trade and commerce. Insurance serves as a "lubricant of trade",
without it trade and commerce may stifle.
3.6.2 Cost of insurance to society
Insurance is not without some problems. It has the following major problems:
1. It encourages fraud to collect dishonest claims (moral hazard problems). When
individuals are insured against a particular risk, they may intentionally increase the
chance of loss, or exaggerate the claim.
2. Increases carelessness in life (morale hazard problem): it is a condition that causes to be
less careful than they would otherwise be. Some individuals do not consciously seek to
bring about a loss, but the fact that they have insurance causes them to take more risks
than they would if they had no insurance coverage. This manner may result in excessive
losses in the community.
3. Cost of Insurance: insurers incur operating expenses such as loss control costs, loss
adjustment expenses, expense involved in acquiring insured, (advertisement cost), state
premium taxes, and general administrative costs. In addition to these expenses, the
insured is expected to cover a reasonable amount for profit and contingencies.
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