Chapter 2

Insurance
and Risk
Agenda
i. Definition and Basic Characteristics of Insurance
ii. Characteristics of An Ideally Insurable Risk
iii. Adverse Selection and Insurance
iv. Insurance and Gambling Compared
v. Insurance and Hedging Compared
vi. Types of Insurance
vii. Benefits and Costs of Insurance to Society
Definition of Insurance
 Insurance is an economic device whereby an individual substitutes a
small certain cost (the premium) for a large uncertain financial loss (the
contingency insured against) that would exist if it were not for the
insurance.

 Insurance is the pooling of fortuitous losses by transfer of such risks to

insurers, who agree to indemnify insureds for such losses, to provide other
pecuniary benefits on their occurrence, or to render services connected with
the risk
Basic Characteristics of Insurance
1. Pooling of losses
 Pooling involves spreading losses incurred by the few over the entire
group
 Risk reduction is based on the Law of Large Numbers
 According to the Law of Large Numbers, the greater the number of
exposures, the more closely will the actual results approach the probable
results that are expected from an infinite number of exposures.
Basic Characteristics of Insurance
 Example of Pooling:
 Two business owners own identical buildings valued at $50,000
 There is a 10 percent chance each building will be destroyed by a peril in
any year
 Loss to either building is an independent event
 Expected value and standard deviation of the loss for each owner is:
Expected loss  0.90 * $0  0.10 * $50,000  $5,000

Standard deviation  0.90 0  $5,000  0.10 $50,000  $5,000

2 2

 $15,000
  Example, continued:
Basic Characteristics of Insurance
 If the owners instead pool (combine) their loss exposures, and each agrees to
pay an equal share of any loss that might occur:

Expected loss  0.81* $0  0.09 * $25,000  0.09 * $25,000  0.01* $50,000

 $5,000

Standard deviation  0.81 0  $5,000   (2)(0.09) $25,000  $5,000   0.01($50,000  $5,000) 2

2 2

 $10,607

 As additional individuals are added to the pool, the standard deviation

continues to decline while the expected value of the loss remains unchanged
Basic Characteristics of Insurance
2. Payment of fortuitous losses
 A fortuitous loss is one that is unforeseen, unexpected, and occur as a
result of chance
3. Risk transfer
 A pure risk is transferred from the insured to the insurer, who typically is
in a stronger financial position
4. Indemnification
 The insured is restored to his or her approximate financial position prior
to the occurrence of the loss
Characteristics of an Ideally
Insurable Risk
 Large number of exposure units
 to predict average loss based on the law of large numbers
 Accidental and unintentional loss
 to assure random occurrence of events
 To control Moral Hazards
 Determinable and measurable loss
 to determine how much should be paid – loss adjustment
 No catastrophic loss
 to allow the pooling technique to work
 exposures to catastrophic loss can be managed by using
 reinsurance, dispersing coverage over a large geographic area, or using
 financial instruments, such as catastrophe bonds
 Calculable chance of loss
 to establish a premium that is sufficient to pay all claims and expenses and
yields a profit during the policy period
Characteristics of an Ideally
Insurable Risk
 Economically feasible premium
 so people can afford to buy
 Premium must be substantially less than the face value of the policy
 Based on these requirements:
 Most personal, property and liability risks can be insured
 Market risks, financial risks, production risks and political risks are
difficult to insure
Adverse Selection and Insurance
 Adverse selection is the tendency of persons with a higher-than-average
chance of loss to seek insurance at standard rates
 If not controlled by underwriting, adverse selection results in higher-than-
expected loss levels
 Adverse selection can be controlled by:
 careful underwriting (selection and classification of applicants for
insurance)
 policy provisions (e.g., suicide clause in life insurance)
 Insurance vs. Gambling
Insurance Gambling

 Insurance is a technique for handing an  Gambling creates a new speculative risk

already existing pure risk  Gambling is not socially productive
 Insurance is always socially productive:  The winner’s gain comes at the
 both parties have a common interest expense of the loser
in the prevention of a loss
 Insurance vs. Hedging
Insurance

 Risk is transferred by a contract Hedging

 Insurance involves the transfer of pure
 Risk is transferred by a contract
(insurable) risks
 Insurance can reduce the objective risk  Hedging involves risks that are
of an insurer typically uninsurable
 through the Law of Large Numbers  Hedging does not result in reduced
risk
Types of Private Insurance
Life and Health
Life insurance pays death benefits to beneficiaries when
the insured dies
Health insurance covers medical expenses because of
sickness or injury
Disability plans pay income benefits
Types of Private Insurance
Property and Liability
Property insurance indemnifies property owners
against the loss or damage of real or personal property
Liability insurance covers the insured’s legal liability
arising out of property damage or bodily injury to
others
Casualty insurance refers to insurance that covers
whatever is not covered by fire, marine, and life
insurance
Types of Private Insurance
 Private insurance coverage can be grouped into two major categories
 Personal lines: coverage that insure the real estate and personal property
of individuals and families or provide protection against legal liability
 Commercial lines: coverage for business firms, nonprofit organizations,
and government agencies
Classifications of Insurance

19
Types of Government
Insurance
 Social Insurance Programs
 Financed entirely or in large part by contributions from employers and/or
employees
 Benefits are heavily weighted in favor of low-income groups
 Eligibility and benefits are prescribed by statute
 Examples: Social Security, Unemployment, Workers Comp
 Other Government Insurance Programs
 Found at both the federal and state level
 Examples: Federal flood insurance, state health insurance pools
Social Benefits of Insurance
 Indemnification for Loss
 Contributes to family and business stability
 Reduction of Worry and Fear
 Insured's are less worried about losses
 Source of Investment Funds
 Premiums may be invested, promoting economic growth
 Loss Prevention
 Insurers support loss-prevention activities that reduce direct and indirect
losses
 Enhancement of Credit
 Insured individuals are better credit risks than individuals without
insurance
Social Benefits of Insurance
 Insurance Companies Act as Guardians in number of Ways:
 Risk cover for Large Industry, Trade & Property are offered in Compliance to
Law
 Environmental Risks get reduced
 Hit – and – Run Compensations
 Innovations - Crop Insurance for Covering Risk of Nature – Poor Rainfall etc.
 Socio Responsibilities Burden shared
 Education
 Medical
 Health
 Accident
Social Costs of Insurance
 Cost of Doing Business
 Insurers consume resources in providing insurance to society
 An expense loading is the amount needed to pay all expenses, including
commissions, general administrative expenses, state premium taxes,
acquisition expenses, and an allowance for contingencies and profit
 Fraudulent and Inflated Claims
 Payment of fraudulent or inflated claims results in higher premiums to all
insured's, thus reducing disposable income and consumption of other
goods and services
BENEFITS OF INSURANCE
Benefits to Economy
Rapid investment
Improve Quality to Life (New risk covers)
Competition will bring Consumer Friendly Products
Large Scale Mobilization of Funds
Insurance & Reinsurance Facilities to Major Projects
Export Projects covered at Home
 
Benefits to Government
Long Term Funds for Infrastructure
Long Term Debt Market Instruments Available
Increased Employment Opportunities & Compensation
Reduced Financial Burden of - Rural, Social & Backward Classes
Contributions in Calamities (Sharing of Social Responsibilities)
BENEFITS OF INSURANCE
Benefits to Industry
Transfer of Technical Expertise
Innovative Products and Pricing Options
Improved Prospects for National Cos.
Domestic Industry will Utilize Technology and Service Customer with Loyalty
Market Driven Economy will Benefit Customer the most.

Benefits to Consumer
Superior Quality at Lower Prices
Wider Choice of Products
World Class Service to the Consumer
Increased Penetration of Insurance
BENEFITS OF INSURANCE
Benefits to Employee
Human Resource Development
Exposure to ‘State of the Art Practices”
Greater Job Opportunities
Higher Remuneration
Professional Management Practices
 PRINCIPLES OF INSURANCE
The principles will act as a guideline both to person(s)
who may want to persuade an insurance company to
bear on his or their own behalf the loss that may be
incurred by a given risk and to the insurance
company that would as a result undertake the cover.
The following is an outline of these principles:
1. INSURABLE INTEREST
 A contract of insurance affected without
insurable interest is void.
 It means that the insured must have an actual
pecuniary interest and not a mere anxiety or
sentimental interest in the subject matter of
insurance.
 The insured must be so situated with regard to
the thing insured that he would have benefit by its
existence and loss from its destruction.
It is the existence of insurable interest in a contract of
insurance, which distinguishes it from mere wagering
equipment.
In relation to insurance the law the principle of
insurable interest prevents people taking out an
insurable contract on someone else’s life (or someone
else’s property) unless they have an insurable interest
in that life.
Valid forms of insurable interest include being a
spouse being financially dependent on the person or
situations where there is joint ownership of real
property or a business.
 The concept of insurable interest was established to
prevent:
Gambling (on the lives of others), under the pretense
of insurance.
The moral hazard of the people taking out insurance
on someone’s life, and then “arranging” for that
person to die- so that they can claim on the policy.
WAYS IN WHICH INSURABLE INTEREST CAN
ARISE
a) One’s own life;
Life is the most valuable possession one could have.
It’s priceless and therefore its value can’t be
quantified in monetary terms. There is therefore no
financial limit to the insurable interest that a person
has in his life.
b) Husband-wife relationship
c) Creditor-debtor relationship
d) Partnership relationship
e) Ownership
f) Joint ownership
g) Bailee
h) Administrators, trustees and executors
i) Potential liability
2.INDEMNITY
 A contract of insurance where the insurable
interest is limited and can be valued in financial terms
is a contract of indemnity.
 The object of every contract of insurance is to place
the insured in the same financial position as nearly as
possible after the loss as if the loss had not taken place
at all.
 This means then that the insured in case of loss
against which the policy has been insured shall be paid
the actual amount of loss he has suffered as a result of
the operation of the insured risk but not exceeding the
amount of the sum insured in the policy.
 Indemnity therefore simply means what the
insured has actually lost is what he or she gets
nothing more nothing less.
 Why is it not advisable to allow the insured to obtain
from the insurer a value that is greater than what he or
she has actually lost?
 The principle of indemnity does not apply to life
assurance contracts and personal accident insurances
where the insurable interest is unlimited and cannot be
valued in monetary terms.
 It will however apply to life assurance contracts where
the insurable interest is limited and can be valued
financially such in the case of a creditor insuring the life
of his debtor.
METHODS OF PROVIDING INDEMNIFICATION
i) Cash payments;
When the insurer pays for the cash value of the item
lost or the cash value of the assessed reduction in the
value of an item as a result of the occurrence of the
insured peril. This is the most common method of
providing indemnity.
 ii) Replacement;
In this case the insurer replaces the items lost by
providing the insured with another item of similar
financial value. This method is mostly used where the
items was still brand new or doesn’t depreciate in
value over a period of time. For example; jewelry like
gold ring, diamond etc.
iii) Repairs;
This method is mostly used in motor vehicle
insurance where the insurer arranges for the damaged
vehicle to be repaired and pays for the cost of repairs
with the garage concerned. Adequate repairs
constitute indemnity.
 iv) Re-instatement;
This method is mostly used in fire insurance policies.
The insurer rebuilds the premises which have been
damaged by fire.
 In ordinary circumstances the insurer prefers to pay
cash to the insured for the damaged premises so that
the insured himself will undertake the building.
 CIRCUMSTANCES THAT HINDER FULL
INDEMNITY

In practice it is sometimes possible that a person who

has suffered financial loss as a result of an insured
peril may not be taken to the same financial position
he was in immediately before the loss occurred.
The following circumstances may operate to prevent
the insured from obtaining full indemnity.
 i) Sum insured
The maximum liability of the insurer in a contract of
insurance is the sum insured.
 There is no obligation on the part of the insurer to
pay for sum which exceeds the sum insured.
Therefore in a situation where the insured, insured
his property for a sum which is less than the market
value or the financial value of the property insured he
may not be fully indemnified when a loss occurs as
the insurer will only pay the sum insured which will
be less than the financial value of the loss.
ii) Where the insurance policy is subject to average;
Where the property is insured on the understanding
that the sum insured is the financial value of the
property insured, the policy will become subject to
average if it turns out that the property was actually
more than the sum insured.
 It will be understood that in such circumstances the
insured did not transfer the whole risk to the insurance
company.
 The insured therefore retains part of the risk and if the
loss occurs the insurer will only compensate for the
proportion of the loss that was transferred to him. They
therefore share the loss with the insured person.
iii) Policy Excess;
This is a statement or a clause in motor vehicle
insurance policy which states that; if a loss occurs and
the insured want to make a claim for compensation
he will pay a specified sum of money to the insurer
before his claim can be processed and paid.
 This clause serves to prevent the insured from
launching what is called petty or trivial claims. It
results in less than the indemnity being paid.
iv) Policy Franchise;
A franchise policy is similar to the policy excess in
that they serve the same purpose of eliminating trivial
or petty claims.
The difference is only that in a franchise there is a
clause stating that the insurer will only compensate
for a loss if total value exceeds a specified sum of
money.
Compensation can only be paid where the value of
the loss is greater than the franchise amount.
3 CONTRIBUTION
Contribution is the right of an insurer to call upon
other insurers who have insured the same risk to
share in the cost of an indemnity payment.
Where there are two or more insurers on one risk, the
principle of contribution comes into play. The aim
of contribution is to prevent the insured from
making a profit by claiming in full from all insurers
against the same loss
It achieves this by distributing the actual amount of
loss among the different insurers who are liable for
the same risk under different policies in respect of the
same subject matter.
Any one insurer may pay to the insured the full
amount of the loss covered by the policy and then
become entitled to contribution from his co-insurers
in proportion to the amount which each has
undertaken to pay in case of the same subject matter.
The following conditions are necessary for
contribution to apply.
There must be at least two or more policies of
indemnity existing.
The two or more policies of indemnity must cover the
same peril or risk.
The two or more polices of indemnity must cover the
same subject matter of insurance.
They must cover the same interest of the same insured.
They must be in force at the time of loss.
METHODS OF CALCULATING CONTRIBUTIONS
a)Sums insured method
sum insured by individual insurer X Loss sustained
Total of loss insured

a)Independent liability method

Sum insured by individual insurer X Loss sustained
Market or financial value of the property insured
4 . SUBROGATION
 In insurance subrogation is the right of an insurer
to stand in the place of the insured and to avail to
himself all the rights and remedies available to the
insured, whether such rights have been exercised or
not.
 It is a corollary to the principle of indemnity and
applies only to contracts of indemnity.
 It operates to prevent the insured from making a
profit out of a contract of insurance by claiming
twice.
Where the insured property is lost or damaged
through the negligence of say a third party, the
insured can make a profit by claiming in full from
both his insurer and the third party.
 This would be contrary to the requirements of
the principle of indemnity which prohibits parties
from making profits out of contracts of insurance.
 Subrogation only applies to contracts of
indemnity where the insurable interest is limited and
can be valued financially.
 It does not apply to those life assurance contracts
and personal accident insurances where the insurable
interest is unlimited and cannot be valued in
monetary terms.
Subrogation is the same name given to the legal
technique under the common law by which one party
(P) steps into the shoes of another party (X), so as to
have the benefit X’s rights and remedies against the
third party (D).
subrogation is similar in effect to assignment, but
unlike assignment subrogation can occur with any
agreement between P and X to transfer X’s rights.
Subrogation most commonly arise in relation to
policies of insurance but the legal technique is more
of general application.
Using the designations above, P (the party seeking to
enforce the rights of another) is called subrogee. X
(the party whose rights the subrogee is enforcing) is
called the subrogor.
Subrogation requires that when an insured has
received full indemnity in respect of his loss, all rights
and remedies which he has against any third person
will pass on to the insurer and will be exercised for his
benefit until he (the insurer) recoups the amount he
has paid for the loss for which he is liable under the
policy and this right extend only to the rights and
remedies available to the insured in respect of the
thing to which the contract of the insurance relates.
In each case because P pays money to X which
otherwise D would have had to pay, the law permits P
to enforce X’s rights against D to recover some or all
of what P has paid out. A very simple (and common)
example of subrogation would be as follows:
D drives a car negligently and damages X’s car as a
result.
X, the insured party has comprehensive insurance
and claims (ie asks for payment) under the policy
against P, his insurer.
P pays in full to have X’s car repaired.
P then sues D for negligence to recoup some or all of
the sums paid out to X.
 P receives the full amount of any amounts recovered in the action
against D up to the amount to which P indemnified X. X retains non
of the proceeds of the action against D except to the extent that they
exceed the amount P paid to X.
 Subrogation is an equitable remedy and is subject to all the usual
limitations which apply to equitable remedies.
Types of subrogation
Although the classes of subrogation rights are not
fixed (or closed) types of subrogation are normally
divided into the following categories:
 
Indemnify insurer’s subrogation rights
Surety’s subrogation rights
Subrogation rights of business creditors
Lender’s subrogation rights
Banker’s subrogation rights
5. UTMOST GOOD FAITH
Since insurance shifts risk from one party to
another, it is essential that there must be utmost
good faith and mutual confidence between the
insured and the insurer.
In a contract of insurance the insured knows more
about the subject matter of the contract than the
insurer.
Consequently he is duty bound to disclose
accurately all materials facts and nothing should be
withheld or concealed.
 Any fact is material which goes to the root of the
contract of insurance and has a bearing on the risk
involved.
It is only when the insurer knows the whole truth that
he is in a position to judge if he should accept the risk
and what premium he should charge.
Examples of material facts include:
The fact that a life proposed for insurance has been
hospitalized for several times before or suffers from
known serious infection is regarded as a material fact.
In motor insurance the fact that the motor vehicle
that is proposed for insurance will be driven on a
regular basis by someone else rather than the insured
driver is regarded as a material fact.
Examples of non-material facts include:
Facts which the proposer does not know and which
he cannot reasonably be expected to know. In
determining this, the level of education, the
professional qualification and the experience of the
proposer will be taken into account.
Facts of law: Everyone is presumed to know the law
and ignorance of the law is no defense. The insurer is
therefore expected to be aware of all legal provisions
affecting the insurance operations.

 
6. PROXIMATE CAUSE
 The rule of proximate cause means that the cause
of the loss must be proximate or immediate and not
remote.
 If the proximate cause of the loss is a peril insured
against, the insured can recover.
 When a loss has been brought about by two or
more causes, the question arises as to which is the
proximate cause, although the result could not have
happened without the remote cause.
 But if the loss is brought about by any cause
attributed to the misconduct of the insured, the
insurer is not liable.
Proximate cause
The legal definition of ‘proximate cause’ is contained
with the case Pawsey v Scottish Union & National
(1908):
“Proximate cause means the active, efficient motion
that sets in motion a train of events, which brings
about a result, without the intervention of any force
started and working actively from a new and
independent source”
Proximate cause is the dominant cause-it does not have to
be first.
Life itself is full of events, sometimes occurring
independently of each other or as a result of another. The
principle, proximate cause identifies for insurance
purposes, which event is the probable cause of a
particular event, leading to a loss and whether this event
is insured.
Usually, the first and last event can be easily identified
but it is any intermediate events and causes, which
happen, that may be trickier to determine.
The event chain must be carefully considered at each
stage, questions as to whether that particular chain was
broken by a new and intervening cause, using logic.
Remote causes
These are when an original event has occurred and
started the motion towards loss, when another new
and independent cause occurs and the loss happens.
Usually a period of time elapses between the original
causes of the remote cause.
Perils Relevant to Proximate Cause
There are three types of relevant perils, which are as
follows:
i) Insured Perils
Those which are stated in the policy as insured, such
as fire and lighting
ii) Exempted or Excluded perils
hose stated in the policy as excluded either as causes of
insured perils, such as riot or earthquake or as a result
of insured perils
iii) Uninsured or Other Perils
Those not mentioned in the policy at all. Storm, smoke
and water are not excluded nor mentioned as insured
in a fire policy. It is possible for water damage claim to
be covered under fire policy, if for example a fire
occurs and the fire brigade extinguishes it with water.
iv) Indirect Causes
Some policies sometimes exclude a peril if it caused
directly or indirectly by another one.
v) Concurrent Causes
These are losses whereby it is clear that more than
one event has occurred at the same time, contributing
to the loss.
 If there is no expected peril involved and the causes
cannot be identified or the parts of the loss separated,
then all the damage will be insured.
 If the losses can be filtered, then the appropriate
settlements will be made, if insured.
 If an expected peril is involved in loss involving
concurrent causes and the damage cannot be
separated then none of the loss is insured. If it can
then only the insured part of the damaged is insured.