Chapter Three

INSURANCE
Definition of Insurance:
There is not 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”.
BASIC CHARACTERISTICS OF INSURANCE:
Based on the preceding definition, 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 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 actuarial. 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.
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.
In addition, by pooling or combining the loss experience of a
large number of exposure units, an insurer may be able to

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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 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 an icy sidewalk and bread 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 pur

e 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.
Indemnification:
A final characteristic of insurance is indemnification for losses.
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.

REQUIREMENTS OF AN INSURANCE 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

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 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 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 the spread
over all insureds 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.

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 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, them the pooling technique
breaks down and becomes unworkable. Premiums must be increased

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to prohibitive levels, and the insurance technique is no longer a viable
arrangement by which loses of the few are spread over the entire
group.
Insurers ideally which to avoid all catastrophic loses. In reality,
however, this is impossible, because catastrophic losses periodically
result from the foods, 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.

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 al 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

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$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.

INSURANCE AND GAMBLING COMPARED (SPECULATION):

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, the 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 restore the insured financially
in whole or in part if a loss occurs.

BENEFITS OF INSURANCE TO SOCIETY

The major social and economic benefits of insurance include
the following:
Indemnification: Indemnification permits individuals, and
families to be restores to their former financial position after a loss
occurs. As a result, they can maintain their financial security. Because
insureds 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 form 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

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dependents in the even 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 ect.,
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.

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

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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 tout life insurance policies on insured who are later
reported as having dies.
The payments 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.

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 ect.,
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.
FUNCTIONS AND ORGANIZATION OF INSURERS
As part of the study of the insurance mechanism and the way
in which it works, it will he 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.

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

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 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 form 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\e
applications for coverage and make decisions as to whether they will
be accepted, and by agents who produce the applications initially in
the field.
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
a void 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

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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 form 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 supply the insurer with medial
reports after a physical examination; this report is a very important
source of underwriting information. In the field of property and liability
insurance, the equalivalent 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.

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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 not known
when the contract is sold, and will not be known until some time 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
insureds 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 al 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.

Make up 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 fir insurance
the rate applies toe ach 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. 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, computer as follows:
Expected Loss 100,000 Birr

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Pure Premium = ------------------------- = ---------------------- = 100
Birr
Exposure Units 1,000
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. In property – liability insurance, a typical
loading might be 0.3333. The general formula for the gross premium,
the amount charged the consumer, is
Pure Premium
Gross Premium = -----------------------------
1 – Loading Percentage
In above example, where 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: Two basic approaches to rate making,

class and individual rating are discusses 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 judgement of the
person setting the rate. This rating is supplemented by whatever
statistical data are available and by knowledge of the premiums
charged similar insureds. 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 losses as “claims representatives,” or
“benefit representatives”. Employees of the claims department in the
field of property and liability insurance are called “Adjusters”.

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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.

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 bases,
such as territorial, are 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 fir
insurance of life insurance only. All-line organization refers to that
type f 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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