CHAPTER – 3

INSURANCE
Definition: Insurance can be defined from: -
 economic,
 legal,
 business,
 social point of views.
A) In economic sense: for instance,
A.Insurance is a mechanism of providing certainty or predictability of loss with
regard to pure risk.
By reducing uncertainty in the business environment,
 it will create peace of mind that enables businessmen focus on their primary
activities instead of worrying about the existence of possibility of loss so that
societies can grow more economically.
B) From legal point of view:

Insurance is a contract whereby, a consideration (price) paid to a

party adequate to the risk, becomes security to the other that he
shall not suffer loss, damage or prejudice by the happening of
risks specified in the contract for which he may be exposed to.

The contracting parties are the insured, who is responsible to pay

the price(premium) for obtaining the security, and the insurer,
who will assume the risk is transferred to.

This makes insurance a means of transferring risk for a premium

(price) from one party known as the insured to another called
insurer.
C) From business perspective:
Insurance is defined as a cooperative device to spread the loss caused
by a particular risk over a number of persons who are exposed to and
who agree to ensure themselves against that risk.
The function of insurance: -
 Spread the loss over a large number of persons who agreed to
cooperate each other at the time of loss.
 Risk cannot be averted/removed but loss occurring due to a certain
peril can be distributed amongst the agreed persons.
 They agree to share the loss because the chance of loss, i.e., the time
and amount, to a person is not known.

nsurance does not decrease the uncertainty for the individual as to

whether the event will occur, nor does it alter the probability of
occurrence, but it does reduce the probability of financial loss connected
with the event.
 Any of the insured may suffer loss to a given risk; so, the rest of the
persons who have agreed will share the loss.
 The larger the number of such persons, the easier the process of
distribution of loss.

D) From the social point of view

Insurance is defined as a device to accumulate funds to meet uncertain

losses of capital, which is carried at through the transfer of the risk
of many individual to one person or, to a group of persons.

From the view point of the insured, insurance is a transfer

device. From the view point of the insurer, insurance is a
retention or combination device.
Insurance does not prevent losses, nor does it reduce the cost of losses
to the economy as a whole.
As a matter of fact, it may very well have the opposite effect of causing
losses and increasing the cost of losses for the economy as a whole.

The existence of insurance encourages some losses for the purpose of

defrauding the insurer, and in addition, people are less careful and
may exert less effort to prevent losses than they might if the
insurance did not exist.
 Basic Characteristics of Insurance
 An insurance plan or arrangement typically has certain
characteristics. They include the following:
A)Pooling of loss:
 Pooling or the sharing of losses is the heart of insurance.
 It is spreading of loss incurred by the few over the entire
group, so that, in the process, average loss is substituted for
actual loss.
 It implies: -
1) the sharing of loss by the entire group and
2) prediction of future losses with same accuracy based on
the law of large numbers.
 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
predicted, objective risk is reduced.
Basic Characteristics of Insurance (Cont’d)
B) Payment of fortuitous losses: (occurring by chance)
 A fortuitous loss (payment) is one that is unforeseen and unexpected
and occurs as a result of chance. In other words, the loss must be
accidental.
C) 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.
Speculative risks: refer to ‘‘the situation characterized by a possibility of either a loss or a
gain’’.
 It provide favorable or unfavorable consequences.
Pure risks: refer to the situation in which only a loss or no loss would occur.
 There are only two distinct outcomes; loss or no loss.
 Most pure risks are insurable.
Basic Characteristics of Insurance (Cont’d)
D) Indemnification: (Compensation /Reimbursement for loss, or
damage )
 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 insurance 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.
 3.3. Requisites/requirements of Insurable Risks
 not all risks are commercially insurable.
 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.
 The characteristics of risks that make it feasible for private
insurers to offer insurance for them are called the
requisites of insurable risks.
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.
 A large number of exposure units enhance the operation of
an insurance plan by making estimates of future losses
more accurate.
 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(possible but not
certain to occur); 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.
 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/compensated 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.
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.

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/fact 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.
 pooling is the essence of insurance.
 Insurers ideally wish to avoid all catastrophic losses.
 In reality, however, this is impossible, because catastrophic
losses periodically result from :-
 floods, hurricanes, tornadoes/destructive windstorm,
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.
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.
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.
 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.
 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.
 Functions of insurance
Primary Functions
 Providing certainty. Insurance provides certainty of
payment at the uncertainty of loss. assurance is given to
payment of compensation at the time of loss.
 Protection. The main function of insurance is to provide
protection against the probable chances of loss.
 Risk-sharing. When the risk takes place, all the persons
who are exposed to the risk share the loss.
Secondary Functions
 Prevention of loss. Primarily concerned with the financial
consequences of losses. Insurers do have an interest in reducing the
frequency and the severity of loss.
 In short, the function of insurance is not merely compensating those
who suffered loss at the time the risk materializes.
 However, insurance must make sure that adequate loss prevention
and loss control mechanisms were implemented by the insured to
minimize the probability and severity of the loss.
Secondary Functions
Providing Capital. Insurance companies have, at their
disposal, large amounts of money.
This arises due to the fact that there is a time gap between
the receipt of a premium and the payment of a claim.
 Insurers invest in a wide range of different forms of
investment.
 By having spread of investments, the insurance industry
helps national and international businesses in their
borrowing.
 
. BENEFITS OF INSURANCE
 The major social and economic benefits of insurance include:
i. Indemnification for loss:
 Indemnification permits individuals, families, and business firms to
be restored to their former financial position after a loss occurs.

ii. Less worry and fear:

 Worry and fear are reduced for a family and property owner both
before and after a loss.
 Because the insured know that they have insurance that will pay for
the loss.
BENEFITS OF INSURANCE………..(Cont’d)
iii. Source of investment fund:
 The insurance industry is an important source of fund
for capital investment and accumulation.
 Insurers also invests in social investments, such as
housing and economic development for the benefit of
the general public.
iv. Encourage confidence to undertake new venture:

 Venture: an undertaking activities involving a chance of risk, or

danger especially : a speculative business enterprise.

 Many business would not be started, and much research and

development would not be embarked upon or started, unless the
people concerned had confidence in the protection against losses
from risks provided by insurance.
 BENEFITS OF INSURANCE………..(Cont’d)
v. Loss prevention:
 Society benefits with the involvement of insurance companies
directly and indirectly in the loss prevention activities.
 Such as; reduction of automobile deaths, fire prevention, and
reduction of wok related disabilities and etc..

vi. Reduces cost of capital

 Cost of capital represents the return a company needs to
achieve in order to justify the cost of a capital project, such as
purchasing new equipment or constructing a new factory. Cost of
capital encompasses the cost of both equity and debt, weighted
according to the company's preferred or existing capital structure.
vii. Enhancement of credit
 Those insured assets are easily acceptable collateral for credit.
The Role & Importance of insurance
The role and importance of insurance can be discussed in three phases:

individuals, business, & society

1) Uses to an individual (The insured person)

 Insurance provides security and safety.
 Insurance reduces the physical and mental stress that insured faces.
 Insurance affords peace of mind for the insured.
 Insurance protects the loss of mortgaged property.

2)Uses to Business
 Reduction of uncertainty of payment due to the occurred losses.
 Increasing business efficiency.
 Capital source for investment (if the capital source is not only internal)
 Improve Credit Standing/Insured assets are easily accepted as security.
The Role & Importance of insurance
3)Uses to society
 Wealth protection:
 With the advancement of the society, the wealth or the property of the society
attracts more hazards resulting in the creation of new types of insurance
invention to protect them against the possible losses.
 Through prevention of losses, insurance protects the society against
degradation of resources and ensure stabilization and expansion of business
and industry.
The Role & Importance of insurance……cont’d
 Economic growth
 Insurance provides strong hand & mind and protection against loss of property.
 In addition to these, insurance companies accumulate large sum of money
available for investment purpose that will enhance the economic development
of nations.
 Capital Formation/mobilize saving of the people and invest.
 Generating Employment Opportunities :
 
Generally
 The fact that the owner of a business has the opportunity to recover
from a loss provides the stimulus to business activity that we noted
earlier.
 It also means that jobs may not be lost and goods or services can still
be sold.
 The social benefit of this is that people keep their jobs, their sources
of income are maintained and they can continue to contribute to the
national economy.
We all know the effects on a community when:-
 a large employer moves or ceases operation;
 the area runs the risk of being depressed(suffering the damaging
effects of a lack of demand or employment),
 people have less money to spend and the consequences of this can
be far reaching.
TERMS IN INSURANCE.

i. Insurance policy : A written or printed document, formally

setting-out particulars/details of the contract which has been made
between the insured and insurer.

ii. Insured : The first party, which is transferring the risk; being either
person or organization.
iv. Insurer : The second party, which is the one accepting the risk or
the one to whom the risk is transferred.
v. Premium : is a price to be paid by the insured to the insurer.
vi. Pooling : Sharing of total loss to the group within the same
exposure unit.

vii. Pool : The premium insurers collects to create a ‘fund’ to protect

the group of insurers themselves.
 Pool- A group of insurers or reinsurers through which particular
types of risks (often of unexpected in its nature) are
underwritten , with premiums, losses, and expenses shared in
agreed ratios.
viii. Underwriting: the process insurers use to determine the risks
of insuring your property. It involves the insurance company
determining whether your firm poses an acceptable risk and, if it
does, calculating a fair premium price for your coverage.
 3.5. Insurance and Gambling Compared
Insurance is often erroneously confused with gambling.
There are three important differences between them.
 First, gambling creates a new speculative risk, while
insurance is a technique for handling an already existing
pure risk. Thus, if you bet $500 on a horse race, a new
speculative risk is created, but if you pay $500 to an insurer
for a homeowner’s insurance policy that includes coverage
for a fire, the risk of fire is already present. No new risk is
created by the transaction.
Second, gambling is socially unproductive since the winner`s
gain comes at the expense of the loser. In contrast, insurance
is always socially productive, since 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
occur.

Third, gambling transactions never restore the losers to their

former financial position. In contrast, insurance contracts
restore the insured financially in whole or in part if a loss
occurs.
 Both the insured and the gambler may collect more money
than they payout, the outcome being determined by some
chance event.

 However, through the purchase of insurance, the insured

transfers an existing pure risk.

A gambler creates a speculative risk.

 Gambler bear risk, while insured transfer risk.

 Gambler prefers uncertainty to certainty, while the insured

prefers certainty to uncertainty.
Insurance Vs gambling

Generally:-
Gambling
 Creates new speculative risk.
 Socially unproductive because the winners gain comes at
the expense of the loser.
 Never restore the losers to their former financial position.
 Gambler bear risk.
 Gambler prefers uncertainty to certainty.
Insurance
 Handling an already existing pure risk.
 Socially productive.
 Restore the position of insured financially in whole or in
part if a loss occurs.
 Insured transfer risk.
 Insured prefers certainty to uncertainty.