CHAPTER THREE

NATURE OF INSURANCE
3.1. Definition of Insurance: Insurance can be defined from the
view point of any of several disciplines
Financial definition: - insurance is a financial arrangement that
redistributes the cost of unexpected losses.
Legal definition: - insurance is a contractual arrangement
whereby one party agrees to compensate another party for
losses.

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• According to Americal Risk and Insurance Association;

• “insurance is the pooling of fortuitous losses by

transfer of such a risk to insurers, who agree to indemnify insured’s for
such losses to provide
other pecuniary benefits on their occurrences or to render services
connected with the risk”.
• The party agreeing to pay for the losses is called insurer and the party
receiving the payment for a loss is called the insured.
• The payment the insurer receives is called a premium.

• The insurance contract is called the policy. The losses causing the
insurer to make payment to the insured result from the insured’s
exposure to loss. 2
• An insurance system is able to operate only when losses can be
predicted accurately before they occur.
• When losses can be predicted accurately, risk is reduced.
• Risk reduction is based on a mathematical principle called the
law of large numbers.
• The law of large number means that “the greater the numbers of
exposures, the more closely will the actual results approach the
probable results that are expected from an infinite number of
exposures

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3.2. Basic Characteristics of Insurance
Insurance has several unique characteristics.
These are:
a. pooling of losses
b. Payment of fortuitous losses
c. Risk transfer
d. Indemnification
A. 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”.
 Pooling involves the grouping of a large number of homogeneous
exposures units so that the law of large number can operate to provide a
substantially accurate prediction of future losses.

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 Pooling implies:

a. Sharing of losses by the entire group

b. Prediction of future losses with some accuracy based on the law of
large number
 by pooling the loss experience of a large number of units, an insurer
may be able to predict future losses with some accuracy

B. Payment of Fortuitous Losses

 A fortuitous loss is one that is unforeseen and unexpected and occurs as
a result of chance
 the loss must be accidental

 The law of large number is based on the assumption that losses are
accidental and occurs randomly 5
C. Risk Transfer: - means that the pure risk is transferred from the
insured to the insurer, who typically is in a strong financial position
to pay the loss than the insured.
Examples: The risk of premature death, Poor health, Disability,
Destruction and theft of property, a true insurance plan is always
involves risk transfers.
D. Indemnification: - means that the insured is restored to his/her
approximate financial position prior to the occurrence of the loss.
Examples of insurance which covers the loss are: Homeowner policy,
Automobile liability insurance policy, Disability income policy, Etc.

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3.3. Requirements of an Insurable Risk
 Insurers normally insure only pure risks

 However, not all pure risk are insurable, certain requirements

usually must be fulfilled before insure a pure risk
 The requirements of an insurable risk are;

a. There must be a large number of homogeneous exposure units

b. The loss must be accidental and unintentional

c. The loss must be determinable and measurable

d. The loss should not be the catastrophic

e. The chance of loss must be calculable

f. The premium must be economically feasible 7

a. There Must be a Large Number of Homogeneous Exposure
Units
 The purpose of this requirement is to enable the insurer to
predict losses based on the law of large number.
 If there are large number of homogeneous exposure units , the
insurer can accurately predict both the average frequency and
average severity of loss.
 The items in an insurance pool or the exposure units need to be
similar so that a fair premium can be calculated

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b. Accidental and Unintentional Loss
 This means that if an individual deliberately causes a loss, it
should not be paid.
 The requirement of an accidental and unintentional loss is
necessary for two reasons.
1. If intentional losses were paid, moral hazard would be
substantially increased and premiums would rises as a result.
 The substantial increase in premium could result in relatively
fewer persons purchasing the insurance.
2. The loss should be accidental because the law of large number is
based on the random occurrence of events.
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c. Determinable and Measurable Loss
• Loss must be definite, measurable and sufficient severity to
cause economic hardship.
• This means the loss must be definite as to cause, time, place and
amount. Life insurance in most cases meets this requirement
easily.
• The causes and time of death can be readily determined in most
cases.
• It is difficult to determine and measure the losses in some cases.

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d. No Catastrophic Loss: - means that ideally a large proportion of
exposure units should not incur losses at the same time.
• Insurers ideally wish to avoid all catastrophic losses but still
employ two approaches to handle this problem.
1. Reinsurance: - i.e. insurance companies are indemnified by re-
insurers for catastrophic losses. It is shifting of part or all of the
insurance originally written by one insurer to another
2. Dispersing coverage over a large geographical area: - is a
technique to reduce the burden of catastrophic losses by
dispersing the coverage area to different geographical locations

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e. Calculable Chance of Loss:
 the insurer must be able to calculate both the average frequency
and the average severity of future losses with some accuracy.
 This is necessary so that a proper premium can be charged i.e.
sufficient to pay all claims and expenses and yields a profit during
the policy periods.
f. Economically Feasible Premium: - the insured must be able to
afford to pay the premium. The premium should be substantially
less than the face value or the amount of the policy.

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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
exceeds the amount that the insurer must pay under the
contract.
Based on these requirements of insurable risk, most personal risk,
property risk and liability risk can be privately insured because
the requirement of an insurable risk generally can be met.
By contrast, most market risk, financial risk, and political risk are
normally uninsurable by private insurers.

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These risks are uninsurable for the following reasons:
a. These risk are speculative risk and so difficult to insure privately
b. The potential of each to produce a catastrophic loss is great; this
is particularly true for political risks such as the risk of war.
c. 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 The insurer and insured have a
common interest in the prevention or non-occurrence of loss and
the insurer indemnifies the losses incurred by the insured.

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Whereas gambling transaction never restores the losses to his or
her earlier financial position, but insurance financially restores
the insured in whole or in part if a loss occurs
• Generally, there are two important differences between them:
✓ Gambling creates new speculative risk that did not exist
before, while insurance is a technique for handling an already
existing pure risk. For example, if you bet Birr 400 on pool match,
a speculative risk is created, but if you pay Birr 400 to an insurer
for fir 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.
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✓ Gambling is socially unproductive because the winner gain comes
at the expenses of the loser. In contrast, insurance is always
socially productive because neither insurer nor the insured is
placed in a position where gain of the winner comes at the
expenses of the loser.
3.5. Insurance and Speculation
• Speculation – is a transaction under which one part, agrees to
assume certain risks, usually in connection with a business
venture.
• Speculation is found in the practice known as hedging. Hedging
involves the transfer of a speculation risk. 16
It is a business transaction in which the risk of price fluctuations is
transferred to a third party known as speculator. Although both are
similar in that risk is transferred by a contract and no new risk is
created.

There are some important differences between them:

✓ An Insurance transaction normally involves the transfer of risks
that are insurable since the requirements of an insurable risk
generally can be met.

However, speculation is a technique for handling risks that typically

uninsurable risk such as protection against a decline in the price of
agricultural production and raw materials. 17
✓ Insurance can reduce the objective risk of an insurer by
application of the law of large number
Speculation only involves transfer of risks but not reduction of risks.
The risk of adverse price fluctuations is transferred to speculators
who believe they can make a profit because of superior
knowledge of market conditions. The risk is transferred, not
reduced; the loss cannot be predicted based on the law of large
number.

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3.6. Benefits and Costs of Insurance to the Society
A. Benefits of Insurance to the Society
The major social and economic benefits of insurance including the
following:
1. Indemnification of losses
2. Less worry and fear
3. Sources of investment fund
4. Loss prevention
5. Enhancement of credit
1. Indemnification of Losses The indemnification function
contributes greatly to family and business stability and therefore
is one of the most important social and economic benefits of
insurance.
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To individuals and families
• Permits individuals and families to be restored to their former financial
position after a loss occur
• The families maintain their economic security

• They are less likely to apply for public assistance or welfare

• They are less likely to seek financial assistance from relatives and friends

To business firms
• Permits the firm to remain in business even after the loss occurs

• Employees of the firm would be able to keep their jobs

• Supplier continue to receive orders

• Customers can still receives the goods and services

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2. Less Worry and Fear
❖ Persons insured their life in the event of their premature death
less worry about financial security of their dependents
❖ Persons insured for long term disability do not worry about
the replacement of their earnings, if a serious illness or accident
occurs
❖ 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’s know that they have insurance that will pay for the loss.

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3. Sources of Investment Fund
• Insurance provides funds for capital investment and accumulation.
• Premiums are collected in advance of the losses and funds not
need to meet the immediate losses and expense but also uses for
investment.
• These investments are:
✓ Increase society’s stock of capital goods
✓ Promote economic growth
✓ Promote full employment
✓ Reduces cost of borrowing of business firms

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4. Loss Prevention
Insurance companies are actively involved in numerous loss prevention
programs and also employ a wide variety of loss prevention
personnel.
Some the loss prevention activities are:
➢ High way safety and reduction of automobile death
➢ Fire prevention
➢ Reduction of work related disability
➢ Prevention of automobile theft
➢ Prevention and detection of arson losses
➢ Prevention of defective products that could be injure the users
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5. Enhancement of Credit
• Insurance makes a borrower a better credit risk because it gives
greater assurance that the loan will be repaid.
Example:
✓ Property insurance is obtained while lending for purchase of
houses. Property insurance protects the lenders financial interest if
the property is damaged or destroyed.
✓ Temporary loan may be obtained by insuring inventories of the
business firms.
✓ Insurance on automobile is required to get a loan for purchasing
any new automobile thus insurance can enhance a person’s credit
worthiness. 24
B. Costs of Insurance to the Society
 No institution can operate without certain costs, so that one can
obtain an impartial view of the insurance institution as a social
device.
 The major social costs of insurance are the following:

1. Cost of doing the business

2. Fraudulent claims
3. Inflated claims
1. Cost of doing the business: - the main social cost of insurance lies
in the use of scarce of economic resources that are land, labor,
capital and organization to operate the business. 25
In financial terms an expenses loading must be added to the pure
premium to cover the expenses incurred by insurance
companies.
An expenses loading is the amount needed to pay all expenses
including commissions, general administrative expenses and
state premium taxes acquisition expenses and an allowance for
contingencies and profit.
2. Fraudulent claims: - are the claims made against the losses that
one caused intentionally by peoples in order to collect on their
policies. There is always exist moral hazards in all forms of
insurance.
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3. Inflated claims: - is a situation where the tendency of the insured
to exaggerate the extent of damage that result from purely
unintentional loss occurrences.
• Examples of inflated claims includes the followings:
✓ Attorney for plaintiff may seek high liability judgments –
liability insurance
✓ Physicians may charge above average fees – health insurance
• ✓ Disabled persons may malinger to collect disability income
benefits for a longer duration.

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