CHAPTER THREE

INSURANCE

3.1. DEFINITION OF INSURANCE

Insurance is complex and difficult to define. 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 insured for such losses, to provide other financial
benefits on their occurrence, or to render services connected with the risk”. In its simplest aspect
insurance has two fundamental characteristics:

 Transferring or shifting risk from one individual to a group

 Sharing losses on some equitable basis by all members of the group

To simplify the definition and nature of insurance assume there are 100 persons in Wolaita Sodo
town who own car acquired at birr 150,000 each. If the car of one individual collude and become
completely out of use, he/she will lose birr 150,000. But if all these 100 car owners form group
and agree to share the cost whenever there is loss, each of the 100 individuals will contribute birr
1,500 and indemnify the sufferer. Hence, the risk is now shared among the group, rather than
fully assumed by the individual. In effect, this mechanism results in the substitution of an
average loss of $1,500 for the actual loss of $150,000.

From the individual point of view, insurance can be defined as an economic device where by the
individual substitutes a small certain cost (called premium) for a larger uncertain financial loss
that would exist if it were not for the insurance. It is a protection against financial loss provided
by an insurer. The primary function of insurance is creation of security. It does not reduce or
prevent the incident of the occurrence of the loss; rather it reduces the probability of the financial
loss connected with the event.

Likewise from the societal point of view insurance is an economic device for reducing and
eliminating risk through the process of combining a sufficient number of homogeneous
exposures in to a group to make the losses predictable for the group as a whole. It is advice by
means of which the risks of two or more persons or firms are combined through the actual or
promised contributions to a fund out of which applicants are paid.

From the view point of the insurer, insurance is a transfer, a combination and a retention device
that it involves some pooling of risks: the insurer combines the risks of many insured. And
through this combination the insurer approves its ability to predict its expected losses.

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3.2. BASIC CHARACTERISTICS OF INSURANCE

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 sharing of losses is the corner stone 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 losses. 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.

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 unanticipated 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.

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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 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.

3.3. REQUIREMENTS OF AN INSURABLE 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 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 to all insured 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.

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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 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 it is 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
feasible arrangement by which loses 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 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.

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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 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.

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.

First the risks are speculative and are so difficult to insure privately. Second the potential of each
to produce a catastrophic loss is great 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.

3.4. 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. This, if you put $500 on a horse race, a new speculative
risk is created, but if you pay $500 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 this transaction.

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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.

3.5. BENEFITS OF INSURANCE TO THE SOCIETY

The major social and economic benefits of insurance include the following:

Indemnification: Indemnification permits individuals, and families to be restored to their former

financial position after a loss occurs. As a result, they can maintain their financial security.
Because insured 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 from 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
event 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
etc.

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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.

3.6. 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 out life insurance policies on insured who are later
reported as having dies.

The payments of such fraudulent claims results in higher premiums to all insured. The existence
of insurance also prompts some insured 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 etc.

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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3.7. FUNCTIONS AND ORGANIZATION OF INSURERS

As part of the study of the insurance mechanism and the way in which it works, it will be 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.

3.7.1. 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 against adverse selection. Underwriting is performed by home
office personnel whose 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.

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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 avoid 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 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
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supply the insurer with medical reports after a physical examination; this report is a very
important source of underwriting information. In the field of property and liability insurance, the
equivalent 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 sometime 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 insured 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.

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 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.

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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, computed as follows:

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.
The general formula for the gross premium, the amount charged the consumer, is

In above example, if 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

The two basic approaches to rate making; class and individual rating, are discussed 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 judgment of the person setting the rate. This rating is supplemented by
whatever statistical data are available and by knowledge of the premiums charged similar
insured. 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

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
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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.

3.7.2. 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 basis, such as territorial, is
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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