208 BANKING AND INSURANCE

Insurance and Risk

Ravi Kiran and Kabita graduated from a government college. They
married after graduation. Then they started to stay at New Baneshwor.
They wanted to save money for a down payment on a house. Shortly, after
they moved into a rented apartment, a burglar broke into their apartment
and stole a new television set, stereo, camera, jewelry, silverware, and
cash stashed in a jewelry box. The loss totaled Rs. 800,000. They had no
insurance. As a result their dream of buying a new house was shattered.
What went wrong? The couple made the common mistake of paying
inadequate attention to risk and insurance in their financial plan.
In previous chapter we identified major risks that cause financial
insecurity. For most people, insurance is the most important technique for
handling risk. Consequently, we should understand and realize how
insurance works. In this chapter we discuss the basic characteristics of
insurance requirements of an insurable risk, major types of insurance and
social benefits and social value of insurance.

INSU RA NC E AND RISK

Learning Objectives
After studying this chapter, you should be able to understand:
Define insurance and explain the basic characteristics of insurance.
Explain the law of large number.
Describe the requirements of an insurable risk from the viewpoint of a
private insurer.
Identify the major insurable and uninsurable risk in our society.
Describe the major types of insurance.
Explain the social benefits and social costs of insurance.
“An ingenious modern game of chance in which the player is
permitted to enjoy the comfortable conviction that he is beating the
man who keeps the table.” • Ambrose Bierce
DEFINITION OF INSURANCE
In the 21st century human kind is facing with different kind of problems.
There are many types of problems in our life death of house holder at
improper time, sudden stealing of goods loan house, loss of property by fire,
loss of goods and valuable things kept in ship because of unexpected
hurricane etc. are different pictures of problems. Human kind is always alert
and terrified with these problems. It is difficult to predict the time of escort
problems and so these types of problems can not be declared that where,
when, to whom and how occurs. And we are unable to guess the loss of
valuable things. Thus, whole human kind is always uncertain with the
consequences of loss. Insurance gives priority to uncertainty and it changes
uncertainty to certainty by giving economical security. In broader sense
insurance gives security against future risk changing uncertainty to certainty
instead of less insured money.
In the 21st century scope of insurance has been broaden and has captured
greater meaning of life. Insurance can give stronger economical security
against any kind of future risk. Thus, before to study about insurance it is
necessary to understand definition of insurance clearly.
There is no single and universal definition of insurance. Insurance can be
defined from the view point of several disciplines, including law, economics,
history, actuarial science, risk theory and sociology. But each possible
definition will not be examined at this point. Instead, we will examine these
common elements that are typically present in any insurance plan. The
definition of insurance can be made from two points:
 INSURANCE AND RISK 209
Figure 1
Definitions of
Insurance.
Definitions of Insurance
Functional Definition Contractual Definition
1. Functional Concept
Insurance is a co-operative device to spread the loss caused by a particular
risk over a number of persons, who are exposed to it and who agree to insure
themselves against the risk. Thus, the insurance is
• A co-operative device to spread the risk;
• The system to spread the risk over a number of persons who are insured
against the risk;
• The principle to share the loss of each member of the society on the basis
of probability of loss to their risk; and
• The method to provide security against losses to the insured.
Similarly another definition can be given. Insurance is a co-operative device
of distributing losses, falling on an individual or his family over a large
number of persons, each bearing a nominal expenditure and felling secure
against heavy loss. Different Scholars have different attitudes about this
concept.
According to Mehr, Robert, “Insurance is a social device for reducing risk by
combining a sufficient number of exposures, units to make their individual losses
collectively predictable. The predictable loss is then shared proportionally by all those
in the combination.”
According to J.H. Mayee, "Insurance has been defined as a plan by which a large
number of people associated themselves and transfer, to shoulders of all risk to attach
individuals."
Accordingly to D.S. Hansell, "Insurance may be defined as a social device
providing compensation for the effects of misfortune, the payment being made from
accumulated contribution of all parties participating in the scheme."
2. Contractual Concept
Insurance has been defined to be that in which a sum of money as a premium
is paid in consideration of the insurer’s incurring the risk of paying a large
sum upon a given contingency. The insurance, thus, is a contract whereby
• Certain sum, called premium, is charged in consideration,
• Against the said consideration, a large sum is guaranteed to be paid by
the insurer who received the premium,
210 BANKING AND INSURANCE
• The payment will be made in a certain definite sum, i.e., the loss or the
policy amount whichever may be , and
• The payment is made only upon a contingency. More specific definition
can be given as follows- Insurance may be defined as a consisting one
party (the insurer) agrees to pay to the other party (the insured) or his
beneficiary, a certain sum upon a given contingency (the risk) against
which insurance is sought.
According to Chief Justice Tindal, "Insurance is a contract in which a sum of
money is paid by insured in consideration of the insurer's incurring the risk of
paying a larger sum when the given contingency arises."
According to A.H. Mowbray and R.H. Blankchard, "Insurance is promise by
an insurer to an insured protection or service."
According to Edwin W. Petterson, "Insurance is contract by which one party for
a compensation called premium assume particular risk of the other party and premise
to pay to him or his nominee a certain sum of money on a specified contingency."
BASIC CHARACTERISTICS OF INSURANCE
Based on the preceding definition, an insurance plan or arrangement
typically includes the following characteristics.
Figure 2
Basic
Basic Characteristics of Insurance
characteristics of
Insurance.
Pooling of Losses Payments of Risk Transfer Indemnification
Fortuitous Losses
a. The sharing of losses by the entire group
b. The law of large numbers
1. Pooling of Losses
First basic characteristic of private insurance is the pooling of losses. Pooling
of few losses or the sharing of losses is the heart of insurance. Pooling is the
spreading of few losses 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 numbers which can operate to provide a substantially accurate
prediction of future losses. Ideally, there should be a large number of similar,
but not necessarily identical, exposure units that are subject to the same
perils. Thus, pooling is implied in two ways:
a. The sharing of losses by the entire group: With respect to this concept,
let's consider this simple example. Assume that 1000 farmers in Bhaktapur
agree that if any farmer's house is damaged or destroyed by a fire the other
 INSURANCE AND RISK 211 212 BANKING AND INSURANCE

members of the group will indemnify or cover the actual costs of the unlucky and occurs as a result of chance. In other words, the loss must be accidental.
farmers who has a loss. Assume also that each home is worth $100,000, and The rules and regulation of large numbers is based on the assumption that
on average, one home burns each year. In the absence of insurance, the losses are accidental and occur randomly. For example, a person may slip on
maximum loss to each farmer is $100,000 if the house is burn. However, by an icy side walk and break a leg. The loss would be fortuitous. Insurance
pooling the loss, it can be spread over the entire group, and if one farmer has policies do not cover intentional losses.
a total loss, the maximum amount that each farmer must pay is only $100
($100,000/1,000). In effect, the pooling technique results in the substitution of 3. Risk transfer
an average loss of $100 for the actual loss of $100,000. The third basic characteristic of private insurance is the risk transfer. With the
In addition, by pooling or combining the loss of a large number of exposure exception of self insurance, a true insurance plan always involves risk
units, an insurer is able to predict future losses with greater accuracy. From transfer. We can say that risk transfer means that a pure risk is transferred
the viewpoint of the insurer, if future losses can be predicted, objective can be from the insured to the insurer, who typically is in a stronger financial
reduced. Thus, another characteristic often found in many lines of insurance position to pay the loss than the insured. From the viewpoint of the
is risk reduction based on the law of large numbers. individual, pure risks that are typically transferred to insurers include the
b. The law of large numbers: The law of large numbers states that the risk of premature death, poor health, disability, and destruction, theft of
greater the number of exposures, the more closely will the actual results property and liability lawsuits.
approach the probable results that are expected from an infinite number of
exposures. For example, if we toss a balanced coin into the air, probability of 4. Indemnification
getting a head (trishul) is 0.5 or 1/2. If we toss the coin only 10 times, we may The final basic characteristic of insurance is indemnification for losses.
get a head (trishul) eight times. Although the observed probability of getting Indemnification means that the insured is restored to his or her appropriate
a head is 0.8, the true probability is still 0.5. If the coin were flipped one financial position prior to the occurrence of the loss. As for example, if your
million times, however, the actual number of head would be approximately house burns in a fire, a home-owners policy will indemnify you or restore
500,000. Thus, as the number of random tosses increases, the actual results you to your previous position. If you are sued because of the negligent
approach the expected results. operation of an automobile, your auto liability insurance policy will pay the
However, for most insurance lines, the actuary seldom knows the true sums that you are legally obligated to pay. Similarly, if you become seriously
probability and severity of loss. Therefore, estimates of both the average disabled, a disability- income insurance policy will restore at least part of the
frequency and the average severity of loss must be based on previous loss lost wages.
experience. If there are a large number of exposure units, the actual loss
experience of the past may be a good approximation of future losses. As REQUIREMENTS OF AN INSURABLE RISK
noted in chapter- 8, objective risk varies inversely with the square root of the
Insurance always insure only pure risk. But all pure risks are not insurable.
number of cases under observation: as the number of exposures increases,
Before insurance of pure risk some certain requirements should be completed
the relative variation of actual loss from expected loss will decline. Thus, the
or fulfilled. Here, we discuss six requirements of an insurable risk from the
insurer can predict future losses with a greater degree of accuracy as the
view point of insurer (insurance company).
number of exposures increases.
This concept is important because an insurer must charge a premium that Figure 3
will be adequate for paying all losses and expenses during the policy period. Requirements of an
Insurable Risk Requirements of an Insurable Risk
The lower the degree of objective risk, the more confidence an insurer has
that actual premium charged will be sufficient to pay all claims and expenses
and provide a margin for profit. Large Accidental Determinable No Calculable Economically
Number of and Un- and Catastrophic Chance of Feasible
Exposure intentional Measurable Loss Loss Premium
2. Payments of Fortuitous Losses Units
The second basic characteristic of private insurance is the payment of
fortuitous losses. A fortuitous loss is one that is unforeseen and unexpected
1. Large Number of Exposure Units
 INSURANCE AND RISK 213
The first requirement of an insurable risk is a large number of exposure units.
Ideally, it may not be similar but there should be a large group of roughly
similar which are under the 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 first requirement is to enable the insurer to predict loss based
on the law of large numbers. Loss date 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.
2. Accidental and Unintentional
A second requirement is that the loss should be accidental and unintentional.
Ideally, the loss should be out of control of insured and fortuitous. If a person
causes a loss deliberately he should be kicked out from the indemnification.
The requirement of accidental and unintentional is important because of two
reasons.
a. Intentional losses were paid: If intentional losses were paid, moral hazard
would be substantially increased, and premiums would rise as a result. The
substantial increases 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.
b. The loss should be accidental: 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 because the insured knows
when the loss will occur. Thus, prediction of future experience may be highly
inaccurate if a large number of intentional or nonrandom losses occur.
3. Determinable and Measurable
The 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 cause, 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. Such as, an
insurer promises to pay a monthly benefit to disabled person under a
disability income policy. But some dishonest insured pretend to be sick or
injured to collect amount from the insurer. Even if the claim is legitimate
insurance company has to determine whether the insured satisfies the
definition of disability or not, as stated in the policy. Sickness and disability
are subjective so these events affect different person in different ways. For
example, two persons are insured. They are under separate disability income
214 BANKING AND INSURANCE
contract. These two accountants may be injured in an auto accident. Both are
classified as totally disabled person. However, one accountant may be strong
willed and he may be more determined to return to work. If he is
rehabilitated and he returns to work, the disability income benefits will
terminate. But another disabled person may receive the disability income
benefits because of disability to return to work. It is difficult to determine
whether some body is actually disabled. Thus, ideally all losses should be
both determinable and measurable.
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. For example, Krishna has more expensive fur coat and that fur coat has
been insured under the home-owners policy. If a thief steals that fur coat in
that condition insurance company is compelled or it has full, responsibility to
give compensation. But question arises that if that fur coat is lost because of
forgetting to bring from laundry by his wife. In that situation insurance
company has no any kind of responsibility for compensation.
4. No Catastrophic Loss
The fourth requirement is that ideally the loss should be catastrophic. This
means that a 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, then
the pooling technique breaks down and becomes unworkable. Premium
must be increased to prohibitive level, and the insurance technique is no
longer a viable arrangement by which losses 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 problem of a catastrophic
loss.
a. Re-insurance can be used: Re-insurance can be used by which insurance
companies are indemnified by re-insurers for catastrophic losses. Re-insurer
is the shifting of part or all of the insurance originally written by one insurer
to another. The re-insurer is then responsible for the payment of its share of
the loss.
b. Dispersing their coverage over a large geographical: Insurers can avoid
the concentration of risk by dispersing their coverage a large geographical
area. The concentration of loss exposures in a geographical area exposed to
frequent floods, earthquake hurricanes or other natural disasters can result in
 INSURANCE AND RISK 215 216 BANKING AND INSURANCE

periodic catastrophic losses. If the loss exposures are geographically
dispersed, the possibility of catastrophic loss is reduced.
c. New financial instruments are now available for dealing with
catastrophic losses: 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.
5. 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 is difficult. Thus, without governmental assistance, these losses are
difficult for private carriers to insure.
6. Economically Feasible Premium
A final requirement is that the premium should be economically feasible. The
insured must be able to pay premium. In addition, for the insurance to be an
attractive purchase, the premium paid must be substantially less than 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 $1000 life insurance policy on
a man aged 99, but the pure premium would be about $980, and an
additional amount for expenses would exceed the face amount of the
insurance.
Based on these requirements, personal risks, poverty risks and liability risks
all can be privately insured, because the requirements of an insurable risk
generally can be met. By contrast, most of market risks, financial risks,
production risks and political risks are usually uninsurable by private
insurers. These are uninsurable for several reasons.
a. Speculative: Most market risks, financial risk, production risk and political
risk are uninsurable. Since they are speculative and so are difficult to insure
privately.
b. Catastrophic loss: The potential of each to produce a catastrophic loss is
grate; this is particularly true for political risk, such as risk of war.
c. Calculation of premium difficult: Calculation of proper premium for such
risk may be difficult because the chance of loss cannot be accurately
estimated. For example, insurance that protects a retailer against loss because
of a change in consumer tastes, such as a style change, generally is not
available. Accurate loss data are not available and there is no accurate way to
calculate a premium. The premium charged may or may not be adequate to
pay all losses and expenses. Since private insurers are in business to make a
profit, certain risks are uninsurable because of the possibility of substantial
losses.
APPLICATIONS:
THE RISKS OF FIRE AND UNEMPLOYMENT
You will understand more clearly the requirements of an insurable risk if you
can apply these requirements to a specific risk. For example, consider the risk
of fire to a private dwelling. This risk can be privately insured because the
requirements of an insurable risk are generally fulfilled.
Table 1
Risk of Fire as an Insurable Risk.
Requirements Does the risk of fire satisfy the requirements?
1. Large number of exposure
Yes. Numerous exposure units are present.
units
2. Accidental and unintentional Yes. With the exception of arson, most fire losses are
loss accidental and unintentional.
3. Determinable and Yes. If there is disagreement over the amount paid, a property
measurable loss insurance policy has provisions for resolving disputes.
Yes. Although catastrophic fires have occurred, all exposure
4. No catastrophic loss
units normally do not burn at the same time.
Yes. Chance of fire can be calculated, and the average severely
5. Calculable chance of loss
of a fire loss can be estimated in advance.
6. Economically feasible Yes. Premium rate per $ 100 of fire insurance is relatively
premium low.
Then in this modern age consider the risk of unemployment which is
uninsurable, can risk of unemployment fulfill the requirement of any kind of
insurable risk? In Table 2 we can see clearly risk of insurance which never
fulfill any kind of requirement.
Table 2
Risk of Unemployment as an Insurable Risk.
Requirements Does the risk of unemployment satisfy the requirements?
requirements?
Not completely. Although there are a large number of employees,
1. Large number of exposure units predicting unemployment is difficult because of the different types of
unemployment and labour.
2. Accidental and unintentional No. A large proportion of unemployment is due to individuals who
loss voluntarily quit their jobs.
 INSURANCE AND RISK 217 218 BANKING AND INSURANCE

3. Determinable and measurable

Not completely. The level of unemployment can be determined, but the We can control the adverse selection by using policy provisions. For example,
measurement of loss is difficult. Some unemployment is involuntary;
loss)
however, some unemployment is voluntary.
by making provision of the suicide clause in life insurance and the
No. A serve national recession or depressed local business conditions preexisting conditions clause in health insurance.
4. No catastrophic loss
could result in a catastrophic loss.
The different types of unemployment generally are too irregular to
5. Calculable chance of loss
estimate the chance of loss accurately. INSURANCE AND GAMBLING COMPARED
No. Adverse selection, moral hazard, and the potential for a
6. Economically feasible premium
catastrophic loss could make the premium unattractive. Insurance is always regarded as gambling, but there are three important
differences between them.
First, it is difficult to predict unemployment because there are different types
of unemployment. Like, the workers may be professionally highly skilled,
Figure 4
semi-skilled, unskilled, blue-collar and white-collar etc. In addition, Insurance and Insurance and Gambling Compared
unemployment rates vary significantly by occupation, age, gender, Gambling
Compared.
education, marital status, city, state and by a host of other sectors.
Government programs change frequently. Because of governments economic Create new Gambling is socially Restore
policy unemployment is affected. By this large numbers of workers may be speculative risk unproductive

unemployed at the same time. So, that potential of catastrophic loss is present
and the duration of different unemployed persons may be different. Different
types of unemployment occur irregularly so that it is difficult to calculate
chance of loss accurately. Thus risks of unemployment are not generally
privately insured but it is insured by social insurance programs.
ADVERSE SELECTION AND INSURANCE
When insurance is sold to insured by insurer, insurers have to face the
problem of adverse selection. Adverse selection is the tendency of persons
with a higher-than-average chance of loss to seek insurance at standard rates,
which if not controlled by underwriting, results in higher-than-expected loss
levels. For example, high risk drivers seek auto insurance at standard rates
from them who has serious health problem who seek life insurance at
standard rates. Business firms which are robbed or burglarized repeatedly
seek crime insurance at standard rates and including them in standard rate
proves hazardous. If insured gets at standard rates higher than average loss
of possibility at that situation we say adverse selection has been made by
insurance company. If it is not controlled by using rules and regulations
adverse selection can result in higher than expected loss levels.
However, adverse selection can not be completely eliminated or avoided but
by careful underwriting, it can be controlled. Underwriting means the
process of selecting and classifying applicants for insurance. Applicants who
meet underwriting standards are insured at standard rates. Applicants who
don't meet underwriting standards are denied (rejected) or extra premiums
are paid. Insurance companies insure of the applicants who have chance of
loss higher than average, but these applicants must pay higher premiums.
The adverse selection of insurance arise when applicants who has chance of
loss higher than average are successful to achieve at standard rates.
a. Create new speculative risk: First difference is that gambling creates a
new speculative risk while insurance is a technique for handling an already
existing pure risk. If you bet Rs 3000 on a horse race you will start to create a
new speculative risk but if you insure Rs 3000 on fire insurance you will
transfer present risk of fire into insurance based upon contract and no new
risk is created by the transaction.
b. Gambling is socially unproductive: And 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 insured both have a common interest in the prevention
of loss. Both parties win if the loss does not occur.
c. Restore: Moreover, consistent gambling transactions generally never
restore the losers to their former financial position. In contrast, insurance
contracts restore the insureds financially in whole or in part if a loss occurs.
INSURANCE AND HEDGING COMPARED
We discussed the concept of hedging in chapter eight. Risk can be transferred
into speculators with the help of purchased future contracts. However, an
insurance is not taken as hedging. But both techniques are similar because
risks are transferred by contract in both and there is no new creation of risks.
Although both techniques have similar and important elements there are
some important differences between them.
 INSURANCE AND RISK 219 220 BANKING AND INSURANCE

1. Private Insurance
Figure 5 a. Life and Health Insurance: Life insurance companies take responsibility to
Insurance and Insurance and Hedging Compared
Hedging provide financial security after the death of insured and they try to avoid
Compared. possible future risks. Thus, insurance companies provide benefits for funeral
expenses, medical bills, estate taxes, other expenses as a result of death.
An insurance transaction involves Insurance can reduce the object risk
the transfer of insurable risks of an insurer by application of the Death benefits can be arranged to provide periodic income payments to the
law of large number deceased's dependents. These insurance companies sell both individual and
group retirement plan that help to provide fixed benefits after retirement. In
a. An insurance transaction involves the transfer of insurable risks: An addition, life insurance companies also sell individual and group health
insurance transaction involves the transfer of insurable risks because the insurance policy which covers medical expenses from sickness or injury.
requirements of an insurable risk generally can be met. However, hedging is Finally, both types of insurance companies also sell disability income
the technique for handling risks that are typically uninsurable, such as coverage. By selling disability income coverage individuals during period of
protection against a decline in the price of agricultural products and raw disability can achieve income benefits.
materials.
b. Property and Liability Insurance
b. Insurance can reduce the object risk of an insurer by application of the
law of large number: As the large numbers of exposure units increase, the (i) Fire insurance: Fire insurance is the contract of indemnity. An insured
insurer’s prediction of future losses improves, because the relative variation gives fixed premium to insurance companies, instead of premium given by
of actual loss from expected loss will decline. Thus, many insurance insured within the time of insurance. Insurance companies take
responsibility of providing compensation if insured's property is damaged.
transactions reduce objective risks. In contrast, hedging typically involves
Fire insurance covers the loss or damage to real estate and personal property
only risk transfer, not risk reduction. The risk of adverse price fluctuation is
because of fire lighting or removal from the premises. Other perils covered
transferred to speculators who believe they can make a profit because of
are windstorm, hail, and vandalism. Indirect losses also can be covered,
superior knowledge of market condition. The risk is transferred, not reduced
including the loss of profits and rents and the extra expenses incurred as a
and prediction of loss generally is not based on the law of large numbers.
result of a loss from the interruption of business.
(ii) Marine insurance: Marine insurance is also contract of indemnification.
TYPES OF INSURANCE In marine insurance an insured gives fixed premium to insurance companies
There are different types of insurance however insurance has been classified and insurance companies take responsibility to indemnify instead of
into two groups for study. Insurance may be private or governmental. premium.
Private insurance can be divided into life and health insurance and property Marine insurance is often called transportation insurance because it covers
and liability insurance. Government insurance can be divided into social goods in transit against most pure risks which are connected with
insurance and all other government insurance. So private and public transportation. Marine insurance is divided into ocean marine insurance and
insurance can be classified as follows: inland marine insurance.
• Ocean Marine Insurance: This insurance provides protection for all types
Figure 6
of ocean-going vessels and their cargoes. In United States it is used on the
Types of insurance.
Types of Insurance Great Lakes and navigable waterways. It is used to insure vehicles and
cargo. There may be agreement to cover the legal liability of the owners
and shippers.
Private Insurance Government Insurance
• Inland Marine Insurance: This insurance covers the goods being shipped
on land. Exports, imports, domestic shipments and the mean of
a. Life and health insurance a. Social insurance
transportation are included in land marine insurance. For example
b. Property and liability insurance b. Other govt. insurance programs
bridges, tunnels, and pipelines. In addition inland marine insurance
covers also personal property like, fine art, jewelry and furs.
 INSURANCE AND RISK 221
(iii) Casualty insurance: This insurance too is contract of indemnification. In
casualty insurance insured provides fixed premium to insurer. Instead of
premium or payments insurance company takes full responsibility to provide
indemnification of fixed payment during the period of insurance to insured
whose property has been damaged or lost except by fire, marine etc. Casualty
insurance is a broad field of insurance which covers whatever is not covered
by fire, marine and life insurance. It has been divided into following groups.
• Auto insurance. This insurance is contract between insurer and insured.
It covers legal liability arising out of ownership or operation of an auto. It
provides physical damage insurance on auto, medical bill payment
insurance and provides protection for uninsured motorists. Insurance
company promises to provide possible risk of indemnification to insured
or to ownership or to motorist.
• General liability insurance: This insurance covers legal liability arising
out of property damage or bodily injury to others. Legal liability may be
arisen out of ownership of business property sales or distribution of
products or professional services.
• Burglary and theft insurance: Burglary is defined somewhat narrowly to
mean the unlawful taking of property from within premises closed for
business, entry to which has been obtained by force. There must be visible
marks of the forcible entry. Thus, if a customer hides in a store until after
closing hours or enters by an unlocked door, steals some goods, and
leaves without having to force a door or a window, the definition of
burglary is not met under a burglary policy.
Theft is a broad term that includes all crimes of stealing, robbery, or
burglary. Theft is a catch-all term and is usually not distinguished from
larceny. Thus any stealing crime not meeting the definition of burglary or
robbery is theft. Confidence game or other forms of swindles are theft, not
robberies or burglaries.
• Workers compensation insurance: This insurance helps these workers
who fall in sickness or met in accident during the time of job. The
insurance pays medical bills, disability income benefits and, death
benefits to dependents of an employee whose death is job related.
• Glass insurance: This insurance promise to indemnify to the insured
whose glass gets damaged due to any reason.
• Nuclear insurance: This insurance provides the protection against losses
resulting from nuclear accidents.
• Crop hail insurance: This insurance provides protection against losses at
crops resulting from hailstorms and other perils.
• Other miscellaneous insurance:
Title insurance: Financial losses due to the legal defect are covered by
title insurance.
222 BANKING AND INSURANCE
Credit insurance: This insurance provides protection against loss
occurred when an account receivable is not collected.
(iv) Multiple-line insurance: Multiple-line insurance agrees to provide
indemnification to insured whose property has been damaged. So, it
combines both property and casualty coverages into one contract. For
example, a home owner's policy also covers fire insurance and liability
insurance.
(v) Fidelity and surety bonds: Fidelity bonds provide protection against loss
caused by the dishonest or fraudulent acts of employees, such as
embezzlement and theft of money. Surety bonds provide for monetary
compensation in cause of failure by bonded persons to perform certain acts,
such as the failure of a contractor to construct a building on time.
2. Government Insurance
At the present time numerous government insurance programs have been
established and are operating different programs. Government insurance can
be classified into social insurance and other government social insurance
program. Which are discussed below.
a. Social insurance. This insurance was firstly started in Britain, and then
slowly it was developed in other countries. In modern time social insurance
has great contribution in the field of insurance. The main aim of social
insurance is to serve the society. Social insurance programs are regarded as
Government insurance but there is difference between social insurance and
government insurance because social insurance has own typical features.
Social insurance is utilized for workers who work in factories. These workers
have to face different types of problems on their working. Social insurance
programs provides protection against risk resulting from financial losses.
Social programs are financed by both sides insurer and insured compulsorily.
Generally revenues of Government is not financed in social insurance
program. The contributions are usually earmarked for special trust funds the
benefits in turn are paid from these funds. In addition the right to receive
benefits is ordinarily derived from or linked to the recipient's post
contributions. The benefits and contributions generally vary among the
beneficiaries according to their prior earning but the most part of benefits are
earmarked for low income group. Moreover, most social insurance programs
are compulsory and employers are encouraged to finance legally and they
participate in programs. There are different types of social insurance
programs which are explained below.
(i) Old-age, survivors, and disability insurance: This insurance is known as
social security. It is a program of income maintenance that provides
retirement, survivor and disability benefits to eligible individual and
families.
 INSURANCE AND RISK
(ii) Medicare insurance: This insurance is part of the total social security
program which covers the medical expense of most people aged 65 and older
and certain disabled people younger than age 65.
(iii) Unemployment insurance: This insurance provides weekly cash benefits
to those capable workers who are experiencing short-term involuntary
unemployment. Unemployment insurance is provided up to 26 weeks
regularly in United States. Extended benefits are also provided to those
workers who exhaust their regular benefits.
(iv) Workers compensation insurance: Any worker may be sick or may meet
on accident while working. There may be financial loss to workers because of
sickness or accident. Workers compensation insurance finances against loses
resulting from the sickness or accident. The owners of factories fulfill their
legal responsibility by insuring workers compensation insurance. Thus
workers compensation insurance is a social insurance program which
provides medical care, cost benefits and rehabilitation service to workers fall
in sickness or accident.
(v) Compulsory temporary disability insurance: This insurance provides
protection against losses caused by temporary disability.
(vi) Railroad retirement act: This act provides retirement benefits survivor
benefits and disability income benefits to railway workers who meet certain
eligibility requirements.
(vii) Railroad unemployment insurance act: This insurance act provides
unemployment and sickness benefits to rail workers.
b. Other Government Insurance Programs: There insurance programs are
present into both federal and state level according to construction of
government. However, these programs do not have the special features as
social insurance programs. In federal employment retirement system, the
civil service retirement system, various life insurance programs for veterans,
pension termination insurance, insurance on checking and saving accounts in
commercial banks and federal flood insurance, federal crop insurance and
numerous other programs are included.
BENEFITS OF INSURANCE TO SOCIETY
The major social and economic or financial benefits of insurance cover the
following:
Figure 7
Benefits of Benefits of Insurance to Society
Insurance to
Society.
Indemnification Less worry Source of Loss
for loss and fear investment funds prevention
223 224 BANKING AND INSURANCE
1. Indemnification for Loss
An indemnification permits individuals and families to be restored to their
former financial position after a loss occurs. As a result, they are able to
maintain their financial security. Insured don't have to depend upon relatives
or friends for financial support if there is loss in a part or whole.
Indemnification helps to continue in business and employees to keep their
jobs for business firms. According to orders of suppliers they continue to
receive order and it is easy to receive goods and service for customers what
they want or what they desire. Community also gets benefit from
indemnification because tax base is not eroded. In short, indemnification for
loss has great contribution for stability and development of family or
profession therefore indemnification for loss is one of the most important
social and economic or financial benefits of insurance.
2. Less Worry and Fear
Second benefit of insurance is less worry and fear. Insurance helps to reduce
worry and fear of individual or community. Property may be damaged but
before damage of property insurance provides financial security to insured.
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. Insureds don't have to worry about the loss of
earning if a serious illness or accident occurs. Persons insured for long-term
don't have mental tension because they know they are covered if a loss
occurs in their life. Because of insurance even after a loss occurs worry and
fear are reduced.
3. Source of Investment Funds
Source of funds is needed for any kind of industries. To establish the
industries money is important without money we can't imagine function of
industries. Thus for establishment of industries source of investment funds is
important. Premiums are collected before the loss. Funds can be loaned to
business firms where funds are not needed to pay immediate losses. These
funds may be invested in shopping centre, hospital, factories, housing
development and new machinery or equipment. Which help to increase
society's stock of capital, goods and helps to promote economic growth and
area of full employment can be created. Insurance can also invested in social
areas, for example; housing, nursing home, and economic development
projects. The total supply of loanable funds is increased due to advance
payment of insurance premiums, which helps business firms to get loan at
lower rate which is impossible in the absence of insurance.
Finally, payment is provided to insurer as premiums which helps to establish
Enhancement
of credit
a large and special trust fund. It helps the nation to develop in any field by
 INSURANCE AND RISK 225
utilizing source of investment fund. Thus, insurance has great contribution
for collecting funds.
4. Loss Prevention
Insurance companies are involved actively in many programs to prevent loss.
These companies recruit different kinds of specialist for loss prevention. For
example, safety engineers, specialist in fire prevention etc. These specialists
give knowledge of loss prevention to the society by which future possible
risk can be reduced directly or indirectly. Society also gets benefit directly or
indirectly. Property or liability insurers have operated the programs of loss
prevention which included the following:
• Highway safely and reduction of automobile deaths
• Fire prevention
• Reduction of work related disabilities
• Prevention of auto thefts
• Prevention and detection of arson losses
• Prevention of defective products that could injure the user
• Prevention of boiler explosion
• Educational programs on loss prevention
The loss prevention activities reduce consequential losses directly or
indirectly. It helps society to improve in economic field.
5. Enhancement of Credit
A final benefit of insurance is enhancement of credit. It improves better credit
risk of a person. It guarantees to pay the value of the borrowers' collateral or
it assures that the loan will be repaid. For example, when a house is
purchased the lending institution requires property insurance on the house
before providing loan. If the property is destroyed insurance company
protects the lenders financial interest. Similarly, it is necessary to insure
inventories before the loan is made for seasonal business. And if a new car is
purchased and financed by a bank there must be physical damage insurance
of a car before the loan is made. Thus insurance can enhance a person's
credit.
COST OF INSURANCE TO SOCIETY
Although the insurance industry provides enormous social and economic
benefits to society, it is necessary to recognize the social cost of insurance.
Costs of insurance to society are as following:
226 BANKING AND INSURANCE
Figure 8
Cost of Insurance
to Society. Costs of Insurance to Society
Cost of doing business Fraudulent Inflated claims
1. Cost of Doing Business
Insurance industries consume means and economic resource like land,
labour, capital and business enterprises in providing insurance to society. In
financial terms expense loading must be added to the pure premium in their
daily operation. An expense loading is the amount needed to pay all
expenses state premium taxes, acquisition expenses and an allowance for
contingencies and profit of 10%for insured is used charge in United States by
the companies related to property and liability. As a result, total cost in
society will be increased. For example, assume that there is a small village
whose property is uninsured and village has an average of Rs. 100 million of
free losses each year. Later if villagers insure property the costs to this village
will be increased. Assume that the expense loading is 35% of losses; total cost
is increased to Rs. 135 million in that small village. The additional costs can
be justified for several reasons.
a. Payment of covered loss is reduced: From the viewpoint of insured
uncertainty concerning the payment of covered loss is reduced because of
insurance.
b. Provides jobs to millions of workers: Insurance industries provide jobs to
millions of workers.
c. Insurers engage in a wide variety of loss prevention actives: The cost of
doing business is not wasted because insurers involve to prevent many kinds
of losses.
In society economic resources are used up in providing insurance so real
economic cost is incurred.
2. Fraudulent Claims
Cost of insurance comes from the submission of fraudulent claims. Following
sentences include example of fraudulent claims.
• Auto accidents are faked or staged to collect benefits
• Dishonest claimants use slip and fall as 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 of life insurance policies on death.
 INSURANCE AND RISK 227
All insured's premium has to be increased because of above fraudulent
claims. Insured also can cause a loss deliberately to take benefit because
insurance is present. These social costs affect directly on society.
3. Inflated Claims
The final cost of insurance refers to inflated claims or “padded” claims.
Although the loss is not intentionally caused by the insured, the amount of
the claim may exceed the actual financial loss. Examples of inflated claims
are included as.
• Attorneys for plaintiffs sue for high liability a judgment that exceeds the
true economic loss of victim.
• Insured inflate the amount of damage in auto mobile accident claims.
• Disabled person may pretend to be sick for disability income benefits for
a longer duration.
Inflated claims should be regarded as important social cost of insurance.
Premiums must be increased in providing additional losses. As a result
disposable income and the consumption of other goods and service are
reduced.
Summary
1. There is no single definition of insurance. However, a typical insurance
plan contains four elements.
a. Pooling of loss
b. Payment of fortuitous losses
c. Risk transfer
d. Indemnification
2. Pooling means that the losses of the few are spread over the group, and
average loss is substituted for actual loss. Fortuitous losses are
unforeseen and unexpected and occur as a result of chance. Risk transfer
involves the transfer of a pure risk to an insurer. Indemnification means
that the victim of a loss is restored in whole or in part by payment,
repair, or replacement by the insurer.
3. The law of larger numbers states that the greater the number of
exposures, the more likely the actual results will approach the expected
results. The law of large numbers permits an insurer to estimate future
losses with some accuracy.
4. There are several ideal requirements of an insurable risk.
a. There must be a large number of exposure units.
b. The loss must be accidental and unintentional.
228 BANKING AND INSURANCE
c. The loss must be determinable and measurable
d. The loss should not be catastrophic.
e. The chance of loss must be calculable.
f. The premium must be economically feasible.
5. Personal risks, property risk and liability risks can be privately insured,
because the requirements of an insurable risk generally can be met.
However, market risks, financial risks, production risks, and political
risks generally are uninsurable, because these requirements are difficult
to meet.
6. Adverse selection is the tendency of persons with a higher-than-average
change of loss to seek insurance at average rates, which, if not controlled
by underwriting, results in higher-than-expected loss levels.
7. Insurance is not the same as gambling. Gambling creates a new
speculative risk, whereas insurance deals with an existing pure risk.
Also, gambling is socially unproductive, because the winner's gain comes
at the expense of the loser, Insurance is always socially productive
because both the insured and insurer benefits if the loss does not occur.
8. Insurance is not the same as hedging. Insurance involves the transfer of
a pure risk, whereas hedging involves the transfer of a speculative risk.
Also, insurance may reduce objective risk because of the law of large
numbers. Hedging typically involves only risk transfer and not risk
reduction.
9. Insurance can be classified into private and government insurance.
Private insurance consists of life and health insurance and property and
liability insurance. Government insurance consists of social insurance
and other government insurance programs.
10. The major benefits of insurance to society are as follows:
a. Indemnification for loss
b. Less worry and fear
c. Source of investment funds
d. Loss prevention
e. Enhancement of credit
11. Insurance entails certain social costs to society, which include the
following:
a. Cost of doing business
b. Fraudulent claims
c. Inflated claims
 INSURANCE AND RISK 229 230 BANKING AND INSURANCE

b. One critic of private insurance states that “Private insurance cannot be

justified economically because the industry uses scarce economic
Theoretical Questions resources that could be used to provide additional goods and services to
society.” Do you agree or disagree with this statement? Explain your
1. Explain the major characteristics of typical insurance plan. answer.
2. Why is the pooling technique essential to insurance? 4. The potential for adverse selection is present in all forms of insurance.
3. Identify the four classes of insurance based on the marketing approach Underwriting is one technique that is used to control adverse selection.
and explain the distinguishing short characteristics of each. [TU 2064] i. Explain the meaning of ‘adverse selection.”
4. Explain the law of large numbers and show how the law of large ii. Why are insurers concerned about adverse selection?
numbers can be used by an insurer to estimate future losses.
iii. Explain how underwriting can be used to control adverse selection.
5. Explain the major requirements of an insurable risk. [TU 2064]
6. Why are most market risks, financial risks, production risks, and
political risks considered to be uninsurable by private insurers?
7. Write notes on insurance and gambling compared [TU 2064]
8. Write short notes on comparison of insurance and hedging. [TU 2065]
9. Identify the major fields of private and government insurance.
10. How is insurance beneficial to society?
11. Explain the social costs of insurance to society.
12. One author states, "The law of large numbers forms the basis of
insurance." Do you agree or disagree with this statement" Explain your
answer.
13. One critic of private insurance states that "private insurance cannot be
justified economically because the industry uses scarce economic
resources that could be used to provide additional goods and service to
society." Do you agree or disagree with this statement? Explain your
answer.

Application Questions
1. Although no risk completely meets all of the ideal requirements of an
insurable risk, some risks come much closure to meeting them than
others.
a. Identify the ideal requirements of an insurable risk.
b. Compare and contrast automobile collisions and war in terms of
how well they meet the requirements of an insurable risk.
2. One author states that “The law of large number forms the basis of
insurance,” Do you agree or disagree with this statement? Explain your
answer.
3. a. Private insurers provide numerous benefits to society. Explain how
private insurance produces each of the following benefits.
i. Identification
ii. Enhancement of credit
iii. Capital accumulation and investment.