Chapter one

The Nature of risk

Introduction:
The risk is concerned with physical and financial well-being. The people are living with some
threatening like fire, flood, earthquake, accident, terrorist attack, etc. That shows certain risks are
present in our society. We can say, we are living in a risky world. In the present day context,
individuals have a strong desire for financial security and protection against those events that threaten
their financial security. Financial security can be threatened by numerous factors such as;
- If the family head is killed in an accident
- Destruction of property by fire, floods, earth quakes and other natural factors.
- Infected by serious diseases such as Cancer, Heart disease, HIV etc.
Thus, it is apparent that certain factors can threaten the financial security of individuals and their
families.
1.1Definition of Risk:
There is no single definition of risk. But for our understanding we can define risk as follow:
1. Risk is defined as uncertainty concerning the occurrence of a loss.
2. The chance of loss.
3.The dispersion of actual from expected results
4.The probability of any outcome different from the one expected
From the above definitions of risk there are common elements in all definitions i.e.
indeterminacy( the outcome must be in question) and loss( at least one of the possible outcomes is
undesirable
For example, the risk of being killed in an auto accident for a truck driver is present because
uncertainty is present. Likewise, the risk of lung cancer for smokers is present because uncertainty is
present.
Thus, risk is uncertainty regarding loss. This means that the loss may or may not happen. In short, risk
is the same thing as uncertainty.

1.2 RISK vs. UNCERTAINTY:

The dictionary meaning of risk is the possibility of meeting danger or suffering harm or loss”. The
dictionary meaning of uncertainty is “the state of being uncertain”. Here, uncertain means “feeling
doubt about”.
Thus, uncertainty of meeting with a loss or damage is known as risk.
Uncertainty refers to a state of mind characterized by doubt, based on a lack of knowledge about what
will or will not happen in the future. Uncertainty is simply psychological reaction to the absence of
knowledge about the future.

Risk vs. Probability (chance of loss)

Chance of loss is closely related to the concept of risk. “Chance of loss” is the long- run chance of
occurrence or relative frequency of some event where as risk is a concept in relative variation.
Probability has both objective and subjective aspects.
Objective probability: is the long-run relative frequency of an event based on the assumption of an
infinite number of observations and of no change in the underlying conditions.
Subjective probability is the individual’s personal estimate of the chance loss

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Chance of loss is the probability that an event will occur. Objective risk is the relative variation of
actual loss from expected loss. “The chance of loss may be same for two different groups, but
objective risk may be different. For example, Africa Insurance Company (AIC) has 10000 homes
insured in Addis Ababa and 10000 homes insured in Nazareth and that the chance of loss in each city
is 1%. Thus, on an average 100 homes should burn annually in each city. However, if the annual
variation in losses ranges from 70 to 120 in Addis, but only from 90 to 110 in Nazareth, objective risk
is greater in Addis even though the chance of loss in both cities is the same.

1.3Distinction of Risk from Peril & Hazard:

Peril is defined as the cause of loss. If a house burns because of fire, the peril (the cause of
loss) is the fire. Likewise, some common perils that cause damage or loss to the property include fire,
theft, burglary, storm, earthquake, etc.
A hazard is a condition that creates or increases the chance of loss. There are three types of hazards;
i) Physical hazard
ii) Moral hazard
iii) Morale hazard
i) Physical Hazard:
A physical hazard is a physical condition that increases the chance of loss. Examples of
physical hazards are icy roads that increase the chance of an auto accident, defective lock on a door
that increases the chance of theft, etc. If a house with defective wiring burns in a fire, the defective
wiring is the physical hazard.
ii) Moral Hazard:
Moral hazard is dishonesty or character defects in an individual that increase the frequency
or severity of loss. For example, the dishonest persons may fake an accident to collect the insurance or
they intentionally burn unsold merchandise that is insured.
A business firm may be overstocked with inventories and insured. The man may deliberately burn
unsold merchandise that is insured to collect claims from the insurance company. Here, the unsold
merchandise burns in a fire due to the dishonesty of that man. This is known as moral hazard.
iii) Morale Hazard:
Morale hazard is defined as carelessness to a loss because of the existence of insurance.
Examples of morale hazard include leaving a door unlocked that allows a burglar to enter, rash driving
without proper signaling. Careless acts like these increase the chances of loss.

1.4 CLASSES OF RISK

The risks may be classified basically into the following major types. They are as follows;
1) Objective and subjective risks.
2) Pure risks and Speculative risks
3) Static risks and Dynamic risks
4) Fundamental risks and Particular risks
5) Financial and Non financial risk
6) Diversifiable and non- diversifiable risks
7) Risk Related with Business Activities

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 1) Objective and subjective risks
Objective Risk:
Objective risk is defined as the relative variation of actual loss from the expected loss.
loss.
For example, assume that a man has 1000 houses insured over a long period of time, and on
average10 houses burn each year. However, we cannot expect 10 houses to burn each year exactly. In
some years, 8 houses may burn, while other years 12 houses may burn. Thus, there is a variation of 2
houses from the expected number of 10. This relative variation of an actual loss from expected loss is
known as OBJECTIVE RISK.
Subjective Risk:
Subjective risk is defined as uncertainty based on a person’s mental condition or state of
mind.
For example, a person who has drunk more in the bar may attempt to drive home on his own.
Here, he may uncertain whether he will arrive home safely without any accident due to drunken
driving. This mental uncertainty is called SUBJECTIVE RISK.
The impact of subjective risk varies depending on the individual. Two persons in the same
situation may have a different perception of risk, and their behavior may be altered accordingly. If an
individual experiences great mental uncertainty (high subjective risk) concerning the occurrence of a
loss, that person’s behavior may be affected. Thus, high subjective risk often results in conservative
and prudent behavior, while low subjective risk results in less conservative behavior. A motor cyclist
who has met with an accident in a particular road will be more cautious and he will drive slowly while
riding through that road. However, another motor cyclist who has not met with an accident may have a
rash driving on the dame road. Thus, the risk of meeting with an accident is perceived in different
manner by the two motor cyclists. The first motor cyclist has high subjective risk and thus prudent, but
the second motorcyclist has less subjective risk and thus less conservative
The Degree of Risk
Degree of risk is the range of variability around the expected losses, which are calculated using the
chance of loss concept by means of the following formula:

Objective risk= probable variation of actual from expected loss⁄ expected loss

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 Consider the possibility of fire loss to buildings in two towns i.e Adama and Addis Ababa. There are
200,000 houses in each town and, on average , each town has 100 fire losses per year. By looking at
historical data from the towns, statisticians are able to estimate that in Adama town the actual number
of fire losses during the nest year will very likely range from 95to 105. In addis ababa, however, the
range probably will be greater , with at least 80 fire losses expected and possibly as many as 120.The
degree of risk for each town is computed as follows:
Degree of risk for Adama= 105-95⁄100=10 percent
Degree of risk for addis= 120-80⁄100= 40 percent
As shown ,the degree of risk for addis is four times that for Adama, even though the chance of loss are
the same
2) Pure Risk and speculative Risk:
Pure risk is defined as a situation in which there are only the possibilities of loss or no loss.
The only possible outcomes are loss and no loss. Examples of pure risks include premature death,
medical expenses, damages of properties from fire, flood, earthquake, etc.

Types of Pure Risk:

The following are the important types of pure risks;
i) Personal risks
ii) Property risks
iii) Liability risks
iv) Risks arising from the failure of others
i) Personal Risks:
Personal risks are risks that directly affect an individual.
individual. Examples of personal risks are
possibility of the complete loss or reduction of earned income, extra expenses, etc. There are four
major personal risks.
a) Risk of premature death
b) Risk of insufficient income during retirement
c) Risk of poor health
d) Risk of unemployment
(a) Risk of premature death is defined as the possibility of death of a person to die before attaining
the average age of living. If the family head dies, then surviving family members receive an
insufficient amount. They may be financially insecure.
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 (b) Risk of old age is the possibility of insufficient income during the retirement . The majority of
workers in Ethiopia retire before age 65. When they retire, they lose their earned income. Unless they
have sufficient financial assets, or have access to other sources of retirement, they will be exposed to
financial insecurity during retirement.
(c) Risk of poor health is another important personal risk. The risk of poor health includes both the
payment of medical bills and the loss of earned income. For example, an open heart surgery may cost
more than 50,000 Birr, a kidney transplant can cost more than 30,000 Birr. Unless these persons have
adequate health insurance, private savings, and financial assets, or other sources of income to meet
these expenditures, they will be financially insecure.
(d) Risk of unemployment is another major threat to financial security. Unemployment can cause
financial insecurity in three ways;
- First, the worker loses his or her earned income
- Second, because of economic conditions, the worker may be able to work only part time
- Finally, if the duration of the unemployment is extended a long period, past savings may be
exhausted
(ii) Property Risks:
Persons owning property can be damaged because of fire, lightning, windstorms and numerous
other causes.
There are two major types of loss in the damage of property;
a) Direct loss
b) Indirect loss
A direct loss is defined as a financial loss that results from the physical damage, destruction, or
theft of the property. For example, if a house is destroyed by a fire, the physical damage to the house is
is known as direct loss.
An indirect ( consequential ) loss is a financial loss that results indirectly from the occurrence of a
direct physical damage or theft loss. Thus, in addition to the physical damage loss, the property owner
no longer has a place to live , and during the time required to rebuild the house , it is likely the owner
will incur additional expense living somewhere else. This loss of use of the destroyed asset is an
indirect loss
(iii) Liability Risks:
Risks:

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 Liability risks are another type of pure risk that most persons face. One can be made legally
liable, if he or she do something that results in bodily injury or property damage to someone else. The
court of law may order that person to pay substantial damages to the person who is injured.
Motorists are being held legally liable for the negligent operation of their vehicles. Business
firms are also being sued because of defective products that harm or injure customers.
(IV) Risks arising from failure of others. When another person agrees to perform a service for you,
Him or her undertakes an obligation that you hope will be met. When the person’s failure to meet this
obligation would result in your financial loss. Example of risk min this category is the failure of a
contractor to finish the construction according to the agreed schedule.
Speculative Risk:
Speculative risk is defined as a situation in which either profit or loss is possible. For
example, if you purchase 100 shares of a company, you may gain if the price of that share increases
but may lose if the price declines. Thus, here there are possibilities of both profit and loss.
Pure risk Vs Speculative risk:
Speculative risk can be differentiated from the pure risk in three ways;

Pure risk Speculative risk

1. Private insurers generally insure only 1. Speculative risks are not considered
pure risks. insurable.
2. Insurers can predict loss in advance in 2. Insurers cannot predict loss/gain in
pure risks. advance in speculative risks.
3. It is harmful to the society. 3. Society may benefit from a speculative
E.g. Earthquake, fire, flood, etc. risk even though a loss occurs.
E.g. Increase in share price.

3) Static Risks and Dynamic Risks:

Static risks are risks connected with losses caused by the irregular action of nature or by the
mistakes and misdeeds of human beings. These losses arise from causes other than the changes in the
economy, such as the perils of nature and the dishonesty of other individuals. static risks are not a
source of gain to the society. Examples of static risks include earthquake, flood, premature death, etc.
Static risks are same as pure risks and present in an unchanging economy.

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 Dynamic risks are associated with a changing economy. Dynamic risks are always speculative
risks where both profit and loss are possible. Examples are the changes in the price level, tastes of
consumers, income, technological changes, new methods of production, etc. These dynamic risks
normally benefit society over the long run, since they are the result of adjustment to misallocation of
resources
Static Vs Dynamic Risk:
Static Risks Dynamic Risks
1. More static risks are pure risks. 1. Dynamic risks are always speculative
risks.
2. Static risks are present in an unchanging 2. Dynamic risks are associated with a
economy. changing economy.
3. It is harmful to the society. 3. It may be beneficial to the society.
4. It affects people as a whole. 4. It affects more individuals.

Static and dynamic risks are not independent. Greater dynamic risks may increase some types
of static risks. An example involves uncertainty due to weather related losses. This risk is usually
considered to be static. However, recent evidence suggests that environmental pollution caused by
increased industrialization may be affecting global weather patterns and there by increasing the source
of static risk. Here, the increased industrialization is a dynamic risk.
4) Fundamental Risks and Particular Risks:
fundamental risks involve losses that are impersonal in origin and consequence. Fundamental
risk is a risk that affects the entire economy or large number of persons or groups within the economy.
economy.
Examples include high inflation, cyclical unemployment and war.
The risk of a natural disaster is another important fundamental risk. Tornadoes, earthquakes,
floods and forest fires can result in property damage as well as the loss of numerous lives.
Particular risks involve losses that arise out of individual events and are felt by individuals. A
particular risk is a risk that affects only individuals and not the entire community. Examples are car
thefts, house thefts, etc. Here, only individuals experiencing such losses are affected, not the entire
economy.

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5. Financial and non- financial Risk
Financial risk is the one where the outcome can be measured in monetary terms. Example: loss of car
through accident or collision
Non- Financial risk refers to risky situation where outcomes cannot be measured in terms of money.
Example: one’s feeling following death of a close relative.
6. Diversifiable and non-diversifiable risks
A risk is non-diversifiable if pooling agreements are ineffective to reduce risks for the participants in
the pool. They are uninsurable. Example: Economic depression of 1929-1933
A Risk is diversifiable if it is possible to reduce risks through pooling or risk sharing agreements. They
are insurable. Example: automobile owners , persons injured by car accident
7. Risk Related with Business Activities
1. Business Risks- are inherent in the economic environment and related with the physical operation of
the firm. Example: variation in the level of sales , cost
2.Financial Risk- Related with debt financing . Example: unable to pay interest rate and the principal
on maturity, stock prices, bankruptcy, insolvency, etc
3. Interest rate risk- related with change in interest rate
4. Purchasing power risk- due to inflationary situations
5. Market risk- due to stock price variability caused by investors reaction to real or psychological
expectations and working of the economy. It is systematic and no diversifiable risk on investors
Risk related with International Business Activities:
 exposure:-due to gain and loss of foreign currency
 Translation exposure:-through consolidation of financial statements
 Economic exposures:- exchange rate risk which affect future cash flows

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 Chapter II
Risk management

Introduction
In the previous chapter we have tried to see the meaning of risk and the several types of pure risks that
affect individuals and businesses. Now in this chapter you will enjoy reading how to manage risk
exposures. After sources of risks are identified and measured, a decision can be made as to how the
risk should be handled. The process used to systematically manage pure risk exposures is known as
risk management. This chapter is organized in to three sections. The first section will devote to define
the meaning of risk management. The second section will deal with the distinction between risk
management and insurance management. the third section will have a read about the objectives of risk
management In the forth section we will see the process or risk management.
2.1Definition of Risk Management
Before going to the details of risk management it is appropriate to define it first. The term Risk
Management is defined as follows
1. systematic process for the identification and evaluation of pure loss exposures faced by an
organization or individual and for the selection and implementation of the most appropriate
techniques for treating such exposures”.
2. A general management function that seeks to assess and address the causes and effects of
uncertainty and risk on an organization
3. Risk management is the identification, analysis and economic control of those risks which can
threaten the assets and earnings capacity of an enterprises.

As a general rule, the risk manager is concerned with only management of pure risks, not speculative
risks.

2.2Objectives of Risk Management

As mentioned in the chart below, the objectives of risk management can be broadly classified into two:
1) Pre-loss Objectives
2) Post-loss Objectives

OBJECTIVES

PRELOSS OBJECTIVES POSTLOSS OBJECTIVES

TO PREPARE FOR THE SURVIVAL OF THE FIRM

POTENTIAL LOSSES IN THE
MOST ECONOMICAL WAY
TO CONTINUE OPERATING

REDUCTION OF ANXIETY
STABILITY OF EARNINGS

TO MEET ANY
EXTERNALLY IMPOSED 9
OBLIGATION
 CONTINUED GROWTH

SOCIAL RESPONSIBILITY

I. Pre-loss Objectives
An organization has many risk management objectives prior to the occurrence of a loss. The most
important of such objectives are listed & explained as follows;

1. The first objective is that the firm should prepare for potential losses in the most economical
possible way. This involves as analysis of safety program expenses, insurance premiums and
the costs associated with the different techniques of handling losses.
2. The second objective is the reduction of anxiety. In a firm, certain loss exposures can cause
greater worry and fear for the risk manager. For example, a threat of a lawsuit from a defective
product can cause greater anxiety than a possible small loss from a minor fire. However, the
risk manager wants to minimize the anxiety and fear associated with such loss exposures.
3. The third pre-loss objective is to meet any externally imposed obligations. This means that the
firm must meet certain obligations imposed on it by the outsiders. For example, government
regulations may require a firm to install safety devices to protect workers from harm. Thus, the
risk manager is expected to see that these externally imposed obligations are met properly.

II. Post-loss Objectives

Post-loss objectives are those which operate after the occurrence of a loss. They are as follows;
A. The first post-loss objective is survival of the firm. It means that after a loss occurs, the firms
can at least resume partial operation within some reasonable time period.
B. The second post-loss objective is to continue operating. For some firms, the ability to operate
after a severe loss is an extremely important objective. Especially, for public utility firms such
as banks, dairies, etc, they must continue to provide service. Otherwise, they may lose their
customers to competitors.
C. Stability of earnings is the third post-loss objective. The firm wants to maintain its earnings per
share after a loss occurs. This objective is closely related to the objective of continued
operations. Because, earnings per share can be maintained only if the firm continues to operate.
D. Another important post-loss objective is continued growth of the firm. A firm may grow by
developing new products and markets. Here, the risk manager must consider the impact that a
loss will have on the firm’s ability to grow.
E. The fifth and the final post-loss objective is the social responsibility to minimize the impact
that a loss has on other persons and on society. A severe loss can adversely affect the
employees, customers, suppliers, creditors and the community in general. Thus, the risk
manager’s role is to minimize the impact of loss on other persons.
Thus, these are the pre-loss and post-loss objectives of risk management. A prudent risk manager must
keep these objectives in mind while handling and managing the risk.

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2.3 STEPES OF RISK MANAGEMENT

Whether the concern is with a business or an individual situation, the same general steps can be used to
analyze systematically and deal with risk. This is known as RISK MANAGEMENT PROCESS.
The Risk Management Process has four steps to be implemented by the risk manager. They are
shown in the following chart;

STEPS IN RISK MANAGEMENT PROCESS

RISK IDENTIFICATION
(Identify Potential Losses)

RISK MEASUREMENT
(To Evaluate Potential Losses)

SELECTION OF APPROPRIATE RISK MANAGEMENT TOOLS

(For Handling Losses)
(Avoidance, Loss Prevention, Loss control, Retention, Non-
Insurance Transfer and Insurance)

RISK ADMINISTRATION
(Implement & Administer the Program)

2.3.1 Identifying the potential losses (Risk Identification)

The first and foremost step in the risk management process is to identify all pure (risk) loss exposures.
“A problem identified is half solved” goes to the first phase of risk management process. Risk
identification is the process by which an organization is able to learn the areas in which it is exposed to
risk. It is the process by which a business systematically and continuously identifies property, liability
and personnel exposures as soon as or before they emerge. Risk identification is a continues process
and involves investigation of new risks. Basically risk identification concerned for two issues. These
are identification of exposure and sources of risk ( risk identification techniques) .
1. Identification of exposures
Here, it is the responsibility of the risk manager to identify several types of potential losses.
These potential losses include the following;
1. Property loss exposures
- Building, plants, other structures
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 - Furniture, equipment, supplies
- Electronic data processing (EDP) equipment; computer software
- Inventory
- Accounts receivable, valuable papers and records
- Company planes, boats, mobile equipment
2. Liability loss exposures
- Defective products
- Environmental pollution (land, water, air, noise)
- Sexual harassment of employees, discrimination against employees, wrongful termination
- Premises and general liability loss exposures
- Liability arising from company vehicles
- Misuse of the Internet and e-mail transmissions, transmission of pornographic material
- Directors' and officers' liability suits
3. Business income loss exposures
- Loss of income from a covered loss
- Continuing expenses after a loss
- Extra expenses
- Contingent business income losses
4. Human resources loss exposures
- Death or disability of key employees
- Retirement or unemployment
- Job-related injuries or disease experienced by workers
5. Crime loss exposures
- Holdups, robberies, burglaries
- Employee theft and dishonesty
- Fraud and embezzlement
- Internet and computer crime exposures
6. employee benefit loss exposures
- Failure to comply with government regulations
- Violation of fiduciary responsibilities
- Group life and health and retirement plan exposures
- Failure to pay promised benefits
7. Foreign loss exposures
- Acts of terrorism
- Plants, business property, inventory
- Foreign currency risks
- Kidnapping of key personnel
- Political risks

2. Risk identification techniques

A risk manager has several sources of information that can be used to identify major and minor loss
exposures. They are as follows;

(a) Physical inspection of company plant & machineries can identify major loss exposures.
(b) Organizational chart
(c) Check list (Extensive risk analysis questionnaire)- can be used to discover hidden loss exposures
that are common to many firms.

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(d) Flow charts that show production and delivery processes can reveal production bottlenecks where
a loss can have severe financial consequences to the firm.
(e) Financial Statements can be used to identify the major assets that must be protected.
(f) Interaction with other departments
(g) Interaction with outside suppliers and professional organizations
(h) Historical Loss Data. Departmental and historical claims data can be invaluable in identifying
major loss exposures.
(i) Contract analysis
Risk managers must also be aware of new loss exposures that may be emerging. More recently misuse
of the internet and e-mail transmissions by employees have exposed employers to potential legal
liability because of transmission of pornographic material and theft of confidential information.

2.3.2Evaluating Potential Losses (Risk Measurement)

The second step in the risk management process is to evaluate and measure the impact of losses on the
firm. This involves an estimation of the potential frequency and severity of loss.
Loss frequency refers to the probable number of losses that may occur during some given
period of time. Loss severity refers to the probable size of the losses that may occur.
Once the risk manager estimates the frequency and severity of loss for each type of loss exposure, the
various loss exposures can be ranked according to their relative importance. For example, a loss
exposure with the potential for bankrupting the firm is much more important than an exposure with a
small loss potential.
Although the risk manager must consider both loss frequency and loss severity, severity is more
important. Therefore, the risk manager must also consider all losses that can result from a single event.
Both the maximum possible loss and maximum probable loss must be estimated. The maximum
possible loss is the worst loss that could possibly happen to the firm during its lifetime. The maximum
probable loss is the worst loss that is likely to happen. For example, if a plant is totally destroyed in a
flood, the risk manager may estimate that replacement cost, demolition costs and other costs will total
Birr10 million. Thus, the maximum possible loss is 10 million Birr. The risk manager also estimates
that another flood causing more than 8 million Birr of damage to the plant. Thus, for this risk manager,
the maximum probable loss is 8 million Birr. We have the following risk measurement techniques
A. Qualitative risk measurement like almost nil. Slightly, moderate, definite, etc
B. Quantitative risk measurement- probability distribution
Probability Distribution
A probability distribution shows , for each possible outcome , the probability of its occurrence.

2.3.3 Tools of Risk Management:

The third step is to identify the available tools of risk management. The major tools of risk
management are categorized as follows
1. Risk control techniques- attempts to reduce the frequency and severity of accidental losses to the
firm and includes:
a. Avoidance
b. loss prevention
c. Loss Control
d. separation /diversification
e. combination
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2. Risk financing techniques- provide for the funding of accidental losses after they occur and includes:
a. retention
b. self- insurance
c. non- insurance transfers
d. insurance
Risk control techniques
A. Avoidance
Avoidance means that a certain loss exposure is never acquired, or an existing loss exposure is
abandoned. For example, a firm can avoid earthquake loss by not building a plant in an earthquake
prone area. An existing loss exposure may also be abandoned. For example, a pharmaceutical firm that
produces a drug with dangerous side effects may stop manufacturing that drug.

Advantages of Avoidance
1. The chance of loss is reduced to zero, if the loss exposure is not acquired.
2. If an existing loss exposure is abandoned, the possibility of loss is either eliminated or reduced.

Disadvantages of Avoidance
1. It may not be possible to avoid all losses. For example, a company cannot avoid the pre-mature
death of a key executive.
2. It may not be practical or feasible to avoid the loss exposure. In the above said example, the
pharmaceutical company can avoid losses arising from the production of a particular drug.
However, without any drug production, the firm will not be in business.
B. Loss Prevention
Loss Prevention aims at reducing the probability of loss so that the frequency of losses is reduced. For
example:
a) Automobile accidents can be reduced if motorists take a safe driving course and drive
defensively.
b) A boiler explosion can be prevented by periodic inspection by a safety engineer.
c) Occupational accidents can be reduced by the elimination of unsafe working conditions and
by strong enforcement of safety rules.
d) Fires can be prevented by forbidding workers to smoke in an area where highly flammable
materials are being used.
C. Loss Control
It is another method of handling loss in a risk management program. Loss control activities are
designed to reduce both the frequency and severity of losses. Loss control deals with an exposure that
the firm does not wish to abandon. The purpose of loss control activities is to change the characteristics
of the exposure so that it is more acceptable to the firm. Thus, the firm wishes to keep the exposure but
wants to reduce the frequency and severity of losses.
The following are the examples that illustrate how loss control measures reduce the frequency and
severity of losses.

Measures that reduce loss frequency
 Quality control checks
 Driver examination
 Strict enforcement of safety rules
 Improvement in product design
Measures that reduce loss severity
 Installation of an automatic sprinkler
 Installation of Burglar alarm system
 Early treatment of injuries
 Rehabilitation of injured workers

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 D. Separation/ diversification
Putting things in different location
E. Combination
Combination or pooling makes loss experience more predictable by increasing the number of
exposure units.

Risk financing techniques

A. Retention/assumption/
Retention means that the firm retains part or all of the losses that result from a given loss exposure. It
can be effectively used when three conditions exist.
Conditions for using retention
No other method of treatment is available. Insurers may be unwilling to write certain type of
coverage. Non-insurance transfers may not be available. In addition, although loss control can reduce
the frequency of loss, all losses cannot be eliminated. In these cases, retention is a residual method. If
the loss exposure cannot be insured or transferred, then it must be retained.

The worst possible loss is not serious. For example, physical damage losses to automobiles in a
large firm’s fleet will not bankrupt the firm.
Losses are highly predictable. Retention can be effectively used for workers compensation
claims, physical damage losses to automobiles, etc. Based on past experience, the risk manager can
estimate a probable range of frequency and severity of actual losses.

Determining Retention Levels

If retention is used, the risk manager must determine the firm’s retention level, which is the Birr
amount of losses that the firm will retain. A financially strong firm can have a higher retention level
than one whose financial position is weak.
Though there are many methods of determining retention level, the following two methods are very
important.
First, a Corporation can determine the maximum retention at 5% of the company’s annual earnings.
Second approach is to determine the maximum retention as between 1% and 5% of the firm’s net
working capital.

Methods for paying losses

If retention is used, the risk manager must have some method for paying losses. Normally, a firm can
pay losses by one of the following three methods:

(a) The firm can pay losses out of its current net income, with the losses treated as expenses for
that year. However, a large number of losses could exceed current net income. Then, other
assets may have to be liquidated to pay losses.
(b) Another method is to borrow the necessary funds from a bank. A line of credit is established
and used to pay losses as they occur.

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 (c) Another method for paying losses is an unfunded or funded reserve. An unfounded reserve is a
book keeping account that is charged with the actual or expected losses from a given risk
exposure. A funded reserve is the setting aside of liquid funds to pay losses.
Advantages of Retention
The advantages are as follows;
(a) The firm can save money in the long run if its actual losses are less than the loss allowance in
the insurer’s premium.
(b) The services provided by the insurer may be provided by the firm at a lower cost. Some
expenses may be reduced, including loss-adjustment expenses, general administrative expenses,
commissions and brokerage, etc.
(c) Since the risk exposure is retained, there may be greater care for loss prevention.
(d) Cash flow may be increased since the firm can use the funds that normally would be held by
the insurer.
Disadvantages of Retention
The following are the disadvantages:
(a) The losses retained by the firm may be greater than the loss allowance in the insurance
premium that is saved by not purchasing the insurance.
(b) Actually, expenses may be higher as the firm may have to hire outside experts such as safety
engineers. Thus, insurers may be able to provide loss control services less expensively.
(c) Income taxes may also be higher. The premiums paid to an insurer are income-tax deductible.
However, if retention is used, only the amounts actually paid out for losses are deductible.
Contributions to a funded reserve are not income-tax deductible.
B. Self-insurance
Self- insurance is a special form of planned retention by which part or all of a given loss exposure
is retained by the firm.

C. Non-Insurance Transfers
Non-insurance Transfers is another method of handling losses. Non-insurance transfers are methods
other than insurance by which a pure risk and its potential financial consequences are transferred
to another party. Examples of non-insurance transfers include contracts, leases and hold-harmless
agreements.
For example, a company’s contract with a construction firm to build a new plant can specify that the
construction firm is responsible for any damage to the plant which it is being built.

A firm’s computer lease can specify that maintenance, repairs and any physical damage loss to the
computer are the responsibility of the computer firm. Otherwise, a firm may insert a hold-harmless
clause in a contract, by which one party assumes legal liability on behalf of another party. Thus, a
publishing firm may insert a hold-harmless clause in a contract, by which the author and not the
publisher is held legally liable if anybody sued the publisher.

Advantages of Non-Insurance Transfers:

(a) The risk manager can transfer some potential losses that are not commercially insurable.
(b) Non-Insurance transfers often cost less than insurance.
(c) The potential loss may be shifted to someone who is in a better position to exercise loss
control.

16
Disadvantages of Non-Insurance Transfers:
(a) The transfer of potential loss would become impossible, if the contract language is ambiguous.
(b) If the party to whom the potential loss is transferred is unable to pay the loss, the firm is still
responsible for the claim.
(c) Non-Insurance Transfers may not always reduce insurance costs since an insurer may not give
credit for the transfers.
D. Insurance
Insurance is also used in a risk management program. Insurance is appropriate for loss
exposures that have a low probability of loss but the severity of loss is high. If the risk manager uses
insurance to treat certain loss exposures, five key areas must be emphasized. They are as follows;
(i) Selection of insurance coverage
(ii) Selection of an insurer
(iii) Negotiation of terms
(iv) Dissemination of information concerning insurance coverage
(v) Periodic review of the insurance program
(i) Selection of insurance coverage’s
The risk manager must select the insurance coverage’s needed. Since there may not be enough
money in the risk management budget to insure all possible losses, the need for insurance can be
divided into three categories;

Essential Insurance includes those coverage’s required by law or by contract, such as workers
compensation insurance. It also includes those coverage’s that will protect the firm against a loss that
threatens the firm’s survival.
Desirable Insurance is protection against losses that may cause the firm financial difficulty,
but not bankruptcy.
Available insurance is coverage for slight losses that would merely inconvenience the firm.

(ii) Selection of an Insurer

The next step is that the risk manager must select an insurer or several insurers. Here, several
important factors are to be considered by the risk manager. These include the following:
 Financial strength of the insurer
 Risk management services provided by the insurer
 The cost and terms of protection

The insurers' financial strength is determined by the size of policy owner’s surplus,
underwriting & investment results, adequacy of reserves for outstanding liabilities, etc. The risk
manager can identify the financial strength of the insurer by referring the rating given to that insurance
company. For example in America, A.M.Best Company is one of the famous rating companies that
publish the rating of insurers based on their relative financial strength. Besides the financial strength,
the risk manager must also consider the risk management services by the insurer and the cost and terms
of protection.

(iii) Negotiation of terms:

After the insurer is selected, the terms of the insurance contract must be negotiated. If printed
policies, endorsements and forms all used, the risk manager and insurer must agree on the documents
that will form the basis of the contract. If a specially tailored manuscript policy is written for the firm,
17
the language and meaning of the contractual provisions must be clear to both parties. If the firm is
large, the premiums are negotiable between the firm and insurer.
(iv.) Dissemination of information concerning insurance coverage:
Information concerning insurance coverage must be given to others in the firm. The firm’s employees
must be informed about the insurance coverage, the records that must be kept, the risk management
services that the insurer will provide, etc.

(v) Periodic review of the insurance program:

The entire process of obtaining insurance must be evaluated periodically. This involves an
analysis of agent and broker relationships, coverages needed, cost of insurance, quality of loss-control
services provided, whether claims are paid promptly, etc.
Advantages of Insurance
(a) The firm will be indemnified after a loss occurs. Thus, the firm can continue to operate.
(b) Uncertainty is reduced. Thus, worry and fear are reduced for the managers and employees,
which should improve their productivity.
(c) Insurers can provide valuable risk management services, such as loss-control services, claims
adjusting, etc.
(d) Insurance premiums are income-tax deductible as a business expense.
Disadvantages of Insurance
(a) The payment of premiums is a major cost. Under the retention technique, the premiums could
be invested in the business until needed to pay claims, but if insurance is used, premiums must
be paid in advance.
(b) Considerable time and effort must be spent in negotiating the insurance coverages.
(c) The risk manager may take less care to loss-control program since he has insured. But, such a
lax attitude toward loss control could increase the number of non-insured losses as well.

SELECTING AN APPROPRIATE TOOL

Risk Management Matrix

Type of Loss Frequency Loss Severity Appropriate Risk Management

Loss Technique
1 Low Low Retention
2 High Low Loss Control & Retention
3 Low High Insurance
4 High High Avoidance

In determining the appropriate method or methods of handling losses, the above matrix can be used. It
classifies the various loss exposures according to frequency and severity.

o The first loss exposure is characterized by both low frequency and low severity of loss.
One example of this type of exposure would be the potential theft of an Office
Secretary’s Note pad. This type of exposure can be best handled by retention, since the
loss occurs infrequently and when it occurs it does not cause financial harm.
o The second type of exposure is more serious. Losses occur frequently, but severity is
relatively low. Examples of this type of exposure include physical damage losses to
18
 automobiles, shoplifting and food spoilage. Loss control should be used here to reduce
the frequency of losses. In addition, since losses occur regularly and are predictable, the
retention technique can also be used.
o The third type of exposure can be met by insurance. Insurance is best suited for low
frequency, high severity losses. High severity means that a catastrophic potential is
present, while a low probability of loss indicates that the purchase of insurance is
economically feasible. Examples include fires, explosion and other natural disasters.
Here, the risk manager could also use a combination of retention and insurance to deal
with these exposures.
o The fourth and most serious type of exposure is characterized by both high frequency
and high severity. This type of risk exposure is best handled by avoidance. For
example, if a person has drunken and if he attempts to drive home in that drunken stage,
the chance of meeting with an accident is more. This loss exposure can be avoided by
not driving at the drunken stage or by having a driver to drive his car.

2.3.5 RISK ADMINISTRATION

The next and the final step in the risk management process is implementation and administration of the
risk management program. It involves three important components;
(i) Risk management policy statement
(ii) Co-operation with other departments
(iii) Periodic review and evaluation
(i) Risk management policy statement:
A risk management policy statement is necessary in order to have an effective risk management
program. This statement outlines the risk management objectives of the firm, as well as company
policy with respect to the treatment of loss exposures. It also educates top level executives in regard to
the risk management process and gives the risk manager greater authority in the firm.
In addition, a risk management manual may be developed and used in the program. The manual
describes the risk management program of the firm and can be a very useful tool for training new
employees who will be participating in the program.
(ii) Co-operation with other departments:
The risk manager has to work in co-operation with other functional departments in the firm. It will
facilitate to identify pure loss exposures and methods of treating these exposures.
The Accounting Department can adopt Internal Accounting Controls to reduce employees' fraud and
theft of cash. The Finance Department can provide information showing how losses can disrupt profits
and cash flow. The Marketing Department can prevent liability suits by ensuring accurate packaging.
Besides, safe distribution procedures can prevent accidents.The Production Department has to ensure
quality control and effective safety programs in the plant can reduce injuries and accidents.
The Personnel Department may be responsible for employee benefit program, pension program and
safety program.

(iii) Periodic review and evaluation:

The risk management program must be periodically reviewed and evaluated to see whether the
objectives are being attained or not. Especially, risk management costs, safety programs and loss
preventive programs must be carefully monitored. Loss records must also be examined to detect any
changes in frequency and severity. Finally, the risk manager must determine whether the firm’s overall

19
risk management policies are being carried out, and whether the risk manager is receiving the total co-
operation of the other departments in carrying out the risk management functions.

2.4 TYPE OF RISKS BASED ON THE SEVEN MAJOR CATEGORIES

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 Chapter III
INSURANCE

3.1DEFINITION OF INSURANCE
The definition of insurance can be made from the following points of view:
 Functional Definition
 Contractual Definition
 From an individual point of view
 From the social point of view

Functional Definition
“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, from the definition we can derive following features of insurance;
(a) Insurance is a co-operative device to spread the risk.
(b) Insurance is the system to spread the risk over a number of persons who are insured against
the risk.
(c) Insurance is based on the principle to share the loss of each member of the society on the basis
of probability of loss to their risk.
(d) Insurance is a method to provide security against losses to the insured.
Contractual Definition
Insurance contract may be defined as a contract by which one party (the insurer/insurance
company) 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 the Commission on Insurance Terminology of the American Risk and Insurance
Association, “Insurance is the pooling of fortuitous losses by transfer of such risks to insurers, who
agree to indemnify insured for such losses, to provide other pecuniary benefits on their occurrence,
or to render services connected with the risk”.
From an individual point of view

Insurance is an economic device whereby the 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.

From the social point of view

Insurance is an economic device for reducing and eliminating risk through the process of
combining a sufficient number of homogeneous exposures into a group to make the losses predictable
for the group as a whole
Although this definition may not be acceptable to all insurance scholars, it is useful for analyzing the
common elements of a true insurance plan.

3.2 FUNCTIONS OF INSURANCE

The functions of insurance can be studied into two parts;
1. Primary functions
2. Secondary functions

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Primary Functions
i. Insurance provides certainty
Insurance provides certainty of payment at the uncertainty of losses. The uncertainty of loss can
be reduced by better planning and administration. But, the insurance relieves the person from such
difficult task. There are different types of uncertainty in a risk. The risk will occur or not, when will
occur? How much loss will be there? In other words, there are uncertainty of happening of time and
amount of loss. Insurance removes all these uncertainty and the assured is given certainty of payment
of losses.
ii. Insurance provides protection
The main function of the insurance is to provide protection against the probable chances of
loss. The time and amount of loss are uncertain and at the happening of risk, the person will suffer loss
in the absence of insurance. The insurance guarantees the payment of loss and thus protects the insured
from sufferings. The insurance cannot check (or) control the happening of risk but can provide for
losses at the happening of the risk.

iii. Risk Sharing

The risk is uncertain and therefore, the loss arising from the risk is also uncertain. When risk takes
place, the loss is shared by all the persons who are exposed to the risk. The risk sharing in ancient
times was done only at the time of damage or death. But, today, on the basis of Probability of risk, the
share is obtained from each and every insured in the shape of premium without which protection is not
guaranteed by the insurer.
Secondary Functions
i. Prevention of loss
The insurance joins hands with those institutions which are engaged in preventing the losses of the
society because the reduction in loss causes lesser payment to the assured and so more saving is
possible which will assist in reducing the premium. Lesser premium invites more business and more
business cause lesser share to the insured.
Here, the insurance assist financially to health organizations, fire brigade, educational institutions and
other organizations which are engaged in preventing the losses of the masses from death and damage.
ii. It provides capital
The insurance provides capital to the society. The accumulated funds are invested in productive
channels. The dearth of capital of the society is minimized to a greater extent with the help of
investment of insurance. The industry, the business and the individual are benefited by the investment
and loans of the insurers.
iii. It improves efficiency
The insurance eliminates worries and miseries of losses at death and destruction of property. The
carefree person can devote his body and soul together for better achievement. It improves not only his
efficiency, but the efficiencies of the masses are also advanced.
iv. It helps economic progress
The insurance by protecting the society from huge losses of damage, destruction and death,
provides an initiative to work hard for the betterment of the masses. The next factor of economic
progress, the capital, is also immensely provided by the masses.

3.3 BASIC CHARACTERISTICS OF INSURANCE

Insurance has several distinct characteristics. They are:
a. Pooling of losses
22
 b. Payment of fortuitous losses
c. Risk transfer
d. Indemnification

Pooling of losses
The other names for pooling are sharing, spreading or combination. "Pooling is the spreading of
losses incurred by the few over the entire group, so that in the process, average loss is substituted for
actual loss". In addition, pooling involves the grouping of a large number of homogeneous exposure
units so that the law of large numbers can operate to provide a substantially accurate prediction of
future losses.
Homogeneous exposure unit means there is a large number of similar (e.g., houses), but not
necessarily identical exposure units that are exposed to the same perils. Thus pooling implies:
The sharing of losses by the entire group and
The prediction of future losses with some accuracy based on the law of large numbers.

a) sharing of loss
The concept of loss sharing can be explained with an example. Assume that there are 10000
houses in Jimma. All the 10000 households agree that if any one of the house is damaged or destroyed
by a fire, the other households will indemnify, or cover, the actual costs of the household who has
suffered a loss. Also assume that each home is valued at 1,00,000 birr, and , on average, one house
burns every year. In the absence of insurance, the maximum loss to each household is 1,00,000 birr, if
the house burns. However, by pooling the loss, it can be spread over the entire group, and if one
household has a total loss, the maximum amount that each household would have to pay only 10 birr
(1,00,000 / 1,000). Thus, the pooling technique results in the substitution of an average loss of 10 birr
for the actual loss of 1,00,000 birr.

b) Prediction of future losses

By pooling the loss experience of a large number of units, an insurer may be able to predict
future losses with some accuracy. From the viewpoint of the insurer if future losses can be predict,
objective risk is reduced. Thus, another characteristic of insurance is risk reduction based on the law of
large numbers.

The law of large numbers states that 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.
For example, if you flip a balanced coin into the air, the chance of getting a head is 0.5. If you flip the
coin only 10 times, you may get a head 8 times. Although, the observed probability is 0.8, the true
probability still 0.5. If the coin were flipped 1 million times, however, the actual number of heads
would be approximately 5,00,000. Thus, as the number of random tosses increases, the actual results
approach the expected results.

Payment of fortuitous losses

A fortuitous loss is one that is unforeseen and unexpected and occurs as a result of chance. In
other words, the loss must be accidental. For example, a person may slip on an icy sidewalk and break
his or her leg. The loss would be fortuitous.

Risk Transfer

23
Risk transfer means that "a pure risk is transferred from the insured to the insurer, who typically is
in a stronger financial position to pay the loss than the insured." Examples: Premature death, Poor
health, Disability, Destruction, Theft of property, etc. With the exception of self insurance, a true
insurance plan always involves risk transfer.

Indemnification
Indemnification means that the insured is restored to his or her approximate financial position prior to
the occurrence of the loss. Examples of insurance which cover the loss are, Home owners policy,
Automobile liability insurance policy, Disability income policy, etc.

3.4 ELEMENTS OR REQUIREMENTS OF AN INSURABLE 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 view point
of the insurer, there are ideally six requirements of an insurable risk.
i. There must be a large number of homogeneous exposure units
ii. The loss must be accidental and unintentional
iii. The loss must be determinable and measurable.
iv. The loss should not the catastrophic
v. The chance of loss must be calculable
vi. The premium must be economically feasible
Large number of Homogeneous Exposure units
The purpose of the first requirement is to enable the insurers to predict losses based on the law of large
numbers. If a sufficiently large number of homogeneous exposure units are present within a class, the
insurer can accurately predict both the average frequency and the average severity of loss.
The items in an insurance pool, or the exposure units, need to be similar so that a fair premium can be
calculated. The fire damage done to brick homes will ordinarily be less than that of suffered by
wooden homes. It would be unfair to combine them is the same insurance pool and charge each insured
the same premium rate based on the combined losses of the pool. If such as attempt were made, the
rate developed would cause the owners of brick home (less susceptible to loss) to pay too high a
premium and the owners of wooden structures (more susceptible to loss) to pay too low a premium.
Accidental and unintentional loss
This means that if an individual deliberately causes a loss, it should not be paid. If the intentional loss
were paid the effect would be as follows.

Insufficient number of homogeneous

exposure units to predict future losses

Fewer persons purchasing the

insurance

Substantial increase in premium

Substantial increase of moral Hazard

Payment for of intentional losses 24

The loss should be accidental because the law of large numbers is based on the random occurrence of
events. A curious example of the application of the principle of accidental losses occurs with life
insurance, for which suicide with in a year or two of a policy being purchased is considered non
accidental. Insurers do not pay such losses. If a suicide occurs several years in after a policy is in force,
however the loss is considered accidental, or the result of mental illness - a cause as accidental as any
other illness.
Determinable and Measurable loss
Loss must be definite, measurable and of sufficient severity to cause economic hardship. This means
the loss must be definite 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. It is difficult
to determine and measure the losses in some cases. E.g. Disability income policy; There are chances of
dishonest claims, taking an illness or injury and collecting the insurance payment.
It is also important that the losses insured against be measurable. The company must determine
whether the insured satisfies the definition of disability as stated in the policy, because sickness and
disability are highly subjective. The basic purpose of this requirement is that the insurers must be able
to determine if the loss is covered under the policy, and if it is covered, how much the company will
pay.

No Catastrophic Loss
This means that ideally a large proportion of exposure units should not incur losses at the same time.
The pooling technique breaks down if most or all of the exposure units in a certain class
simultaneously incur a loss. Examples of catastrophic losses include, flood, hurricanes, earth quakes,
wild fire, tsunami etc. Insurers ideally wish to avoid all catastrophic losses, but still employ two
approaches to handle the this problem.

1. Reinsurance: i.e., Insurance companies are indemnified by re-insurers for catastrophic losses.
It is shifting of part or all of the insurance originally written by one insurer to
another.
2. Dispersing coverage over a large geographical area:
This is a technique to reduce the burden of catastrophic losses by dispersing the
coverage area to different geographic locations.
Calculable Chance of Loss
The insurer must be able to calculate both the average frequency and the average severity of future
losses with some accuracy. This is necessary so that a proper premium can be charged that is sufficient
to pay all claims and expenses and yield a profit during the policy period. Certain catastrophic losses,
however, are difficult to insure because of the chance of loss can not be accurately estimated.
Economically Feasible Premium
The insured must be able to afford to pay the premium. Premium should be substantially less than the
face value, or amount, of the policy.

APPLICATIONS OF REQUIREMENTS OF INSURANCE

Let us consider the risk of fire to a private dwelling this risk can be privately insured since the
requirements of an insurable risk are generally fulfilled.
The risk of Fire as an insurable Risk
Requirements Does risk of fire qualify as insurable?

25
 1. Large number of Yes. A large number of homogeneous exposure units are
homogeneous present.
exposure units
2. Accidental and Yes. With the exception of arson, most fire losses are accidental
unintentional loss 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.
4. No catastrophic loss Yes. Although catastrophic fires have occurred, all exposure
units normally do not burn at the same time.
5. Calculable chance of Yes. Chance of fire can be calculated, and the average severity
loss of a fire loss can be estimated in advance.
6. Economically Yes. Premium rate per Birr 100 of fire insurance is relatively
feasible premium low.

The risk of unemployment, which generally is not privately insurable

Requirements Does risk of fire qualify as insurable?
1. Large number of Not completely. Exposure units are heterogeneous in nature
homogeneous (professional, skilled, semi skilled, and unskilled workers).
exposure units
2. Accidental and No. A large proportion of unemployment is due to individuals
unintentional loss who voluntarily quit their jobs.
3. Determinable and Not completely. The level of unemployment can be determined,
measurable loss but the measurement of loss is difficult. Some unemployment is
involuntary; however, some unemployment is voluntary.
4. No catastrophic loss No. A severe national recession or depressed local business
conditions could result in a catastrophic loss.
5. Calculable chance of No. The different types of unemployment generally are too
loss irregular to estimate the chance of loss accurately.
6. Economically No. Adverse selection, moral hazard, and the potential for a
feasible premium catastrophic loss could made the premium unattractive.

From the above illustration the risk of unemployment does not completely meet the requirements,
because of the following reasons.
 Labor is heterogeneous (professionals, highly skilled, semi skilled, unskilled, blue collar &
while collar workers).
 Unemployment rates vary significantly by occupation, age, sex, education, martial status city,
state, etc.
 Duration of the unemployment varies widely among different group.
 The presence of potential catastrophic loss due to large number of unemployed persons.
 Different types of unemployment on an irregular basis

3.4 INSURANCE, GAMBLING& SPECULATION

Insurance and Gambling

Insurance is often confused with gambling. There are two important differences between them.
26
 Insurance Gambling

 A technique for handling an already  Creates new speculative risk

existing pure risk. that did not exist before
 Socially productive, since neither the  Socially unproductive, since
insurer nor the insured is placed in a the winners gain comes at the
position where gain of the winner expense of the loser.
comes at the expense of the loses

The insurer and the insured have a common interest in the prevention or non occurrence of loss and the
insurer in indemnifies the losses incurred by the insured. Where as gambling transaction never restores
the losses to his or her earlier financial position. A gambler presumably enjoys the risk of gambling
and therefore would be unlikely to pay the premium needed for transferring the risk being enjoyed.

Insurance and Speculation

Both are similar in that risk is transferred by a contract and no new risk is created. The main difference
between insurance and speculation lies in the type of that each is designed to handle, and in the
resulting differences in contractual arrangements. The main similarity lies in the central purpose
behind each transaction. However there are some important differences exist between them.

Insurance Speculation

 Insurance transaction normally  A technique for handling risks

involves the transfer of risks that those are typically insurable.
are insurable, since the
requirements of an insurable risks
generally can be met

 Insurance can reduce the objective  Speculation only involves transfer

risk of an insurer by application of of risks & not reduction of risk.
the law of large numbers The losses can not be predicted
based on the law of large
numbers.

Speculation is a transaction under which one party, for a consideration, agrees to assume certain risk.
The risk of adverse price fluctuation is transferred to speculators who believe they can make a profit
because of superior knowledge of market conditions. The risk is transferred, not reduced and
prediction of loss generally is not based on the law of large numbers. A speculator is a transferee of
risk, and the transferor is usually a business person wishing to pass on a price risk to some one who is

27
more willing and able to bear it. Such a business person then is using the transfer method of handling
the risk.

3.6 BENEFITS OF INSURANCE TO THE SOCIETY

The existence of insurance results in great benefits to society. The major social economic benefits of
insurance include the following.
Indemnification of losses
Less worry & fear
Source of investment fund
Loss prevention
Enhancement of credit

Indemnification for loss

The indemnification function contributes greatly to family and business stability and therefore is one of
the most important social & economic benefit is of insurance. The following table lists the benefits to
individuals and families and also to business firms through the indemnification function of insurance.

To individuals and families To business firms

 Permits individuals & families to be
restored to their former financial position of
lei a loss occurs.
 The families maintain their economic
security.
 They are less likely to apply for public
assistance or welfare.
 They are less likely to seek financial
assistance from relatives & friends.
 Permits the firm to remain in business even
after the loss occurs.
 Employees of the firm would be able to
keep their jobs
 Suppliers continue to receive orders
 Customers can still receive the goods &
services

Less Worry and Fear

Such families who may be exposed to risks the possible worry & fears are reduced.

 Persons insured their life in the event of their  Less worry about financial security of their
premature death. dependents.

 Persons insured for long term disability
 Property owners who are insured
 Do not worry about the replacement of their
earnings, if a serious illness or accident
occurs.
 Enjoy greater peace of mind since they know
they are covered if a loss occurs.

Worry and fear are also reduced after a loss occurs since the insured know that they have insurance
that will pay for the loss.
Source of Investment funds
Insurance provide funds for capital investment and accumulation. Premiums are collected in advance
of the losses and funds not needed to meet the immediate losses can be loaned to business firms. These
investments…..
 increases society's stock of capital goods
28
  promote economic growth
 promote full employment
 reduce cost of borrowings of business firm
Loss prevention
Insurance companies are actively involved in numerous loss prevention programs and also employ a
wide variety of loss prevention personnel. (E.g. Safety Engineers, Specialists in fire prevention,
Occupational Safety and Health, etc.) Some of the loss prevention activities are:
 High way safety & reduction of automobile death.
 Fire prevention
 Reduction of work related disabilities
 Prevention of automobile thefts
 Prevention and detection of arson losses
 Prevention of defective products that could injure the users
 Prevention of boiler explosions
 Educational programs on loss prevention

The loss prevention activities reduce both direct and indirect, or consequential losses. Society benefits
since both types of losses are reduced.
Enhancement of Credit
Insurance makes a borrower a better credit risk, because its gives greater assurance that the loan will be
repaid.
E.g.
a) Property insurance is obtained while lending for purchase of houses. Property insurance
protects the lender's financial interest if the property is damaged or destroyed.
b) Temporary loan may obtained by insuring inventories of business firms.
c) Insurance on automobile is required to get a loan for purchasing any new automobile
Thus insurance can enhance a person's credit worthiness.

COST OF INSURANCE TO SOCIETY

No institution can operate without certain costs. These are listed below so that one can obtain an
impartial view of the insurance institution as a social device. The major social costs of insurance
include the following:
 Cost of doing business
 Fraudulent claims
 Inflated claims

Cost of doing the business

The main social cost of insurance lies in the use of scarce of economic resources land, labor capital
and organization to operate the business. In financial terms, an expense loading must be added to the
pure premium to cover the expenses incurred by insurance companies. 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. The cost is
justified from the insured's view point as follows:
 Uncertainty concerning the payment of a covered loss is reduced because of insurance.
 The cost of doing business is not necessarily wasteful, because insurers engage in a wide
variety of loss prevention activities.
 The insurance industry provides jobs to millions of workers.
29
However, because economic resources are used up in providing insurance, a real economic cost is
incurred.

Fraudulent claims
These are the claims made against the losses that one caused intentionally by people in order to collect
on their policies. There always exists moral hazard in all forms of insurance. Arson losses are on the
increase. Fraud and vandalisms are the most common motives for arson. Fraudulent claims are made
against thefts of valuable property, such as diamond ring or fur coat, and ask for reimbursement. These
claims results in higher premiums to all insured. These social costs fall directly on society.

Inflated claims
It is a situation where, the tendency of the insured to exaggerate the extent of damages that result from
purely unintentional loss occurrences. Examples of inflated claims include the following.
a) Attorney for plaintiffs may seek high liability judgments - Liability insurance
b) Physicians may charge above average fees - health insurance
c) Disabled persons may malinger to collect disability income benefits for a longer duration.
These inflated claims must be recognized as an important social cost of insurance. Premiums must be
increased to cover the losses, and disposable income that could be used for the consumption of other
goods or services is thereby reduced.
The social costs of insurance can be viewed as the sacrifice that society must make to obtain the social
benefits of insurance.
3.7. ORGANIZATION OF INSURERS
The organizational framework in which insurance functions are carried out varies considerably
according to the size and scope of operations of the particular company. There are several ways in
which organizational patterns may be classified: by function, by territory, by product line, and through
groups or fleets of companies. Multiple line and all line organization, discussed below, refers to the
corporate structures employed to offer the insurance product.

Functional organization
Insurers frequently set up departments corresponding roughly to the various specialized activities
performed, such as underwriting, production, rate making, accounting, and financial. Each department
has a supervisor or vice-president who is responsible for this function wherever it is performed
throughout the organization. Functional organization is rarely used in a pure form, but is combined
with other patterns.

Territorial Organization
If a Company is operating over a large area, it may divide its operations according to geographical
divisions. Certain operations, such as investment and finance, legal, actuarial, and general accounting,
are often carried out by a central office. Other operations, such as underwriting, claims, rate making,
and production are decentralized in each of the branches. Decentralization is a general practice when
the size of distant markets increases to the point that it is more efficient to make certain decisions at a
local level than to refer everything to a central office. An example of such a decision might be the
underwriting of certain risks where frequent contact with the insured is necessary. Dealing from afar
might be unwieldy, inefficient, and ultimately cause a loss of business.

Product Organization
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In some insurance operations, particularly among multiple-line insurers, the problems arising from
differing classes of insurance are so technical and specialized that it is inefficient to have all types of
business handled by the same staff. In these cases, the business may be organized according to product
divisions.
It is common in a life insurance company to find separate divisions handling group life insurance,
group disability insurance, industrial life insurance, and group pensions. Within each group, major
functions such as underwriting, accounting, claims, production, and policyholder service may be
performed, with other functions carried on by the home office.
In property and liability insurance, particularly in multiple line companies, separate divisions are
commonly created for the major types of insurance, such as fire, inland marine, bonding, liability,
automobile, and workers' compensation.
Group Organization
Much insurance in the world is written under the sponsorship of groups, or fleets, of insurers. A fleet is
a group of companies operating under central holding company management. Groups were originally
formed to enable insurers to offer a complete line of coverage because state laws restricted the types of
insurance to be written by a single insurer. This restriction no longer exists because of multiple line
laws, but groups still continue to be important. Group organization permits insurers to offer specialized
services to clients, but at the same time consolidate functions that can best be coordinated from one
central office (e.g. actuarial, financial management, and accounting).

Multiple line organization

Companies commonly described as multiple line are firms that underwrite many types of property and
liability insurance within the administrative framework of a single organization. Only rarely may such
companies handle life insurance directly, but usually must do so through a separate company. The
multiple line type of organization permits the simplification of insurance contracts. Most insurance
authorities suggest that requiring a separate policy for every type of coverage is in efficient and
unnecessary. Why not combine, say, fire, windstorm, automobile, residence liability, residence
burglary, and a personal property floater in to one "package policy" designed for the home owner, who
would then have just one company, one policy, and one agent for most insurance needs? The agent
would have a much larger commission from personal lines and would be able to service each customer
more satisfactorily. Further more, the customer would be likely to buy more coverage in a package
than individually, thus enabling the insurer to obtain a wider spread of risks. The success of the
homeowner's contract demonstrates the soundness of this reasoning.
Multiple line legislation has opened up new fields to insurers. The new types of contracts that multiple
line laws have permitted have become known as multi-peril policies. These are policies under which
several different types of perils, formerly written under separate contracts, are now combined into one.
They include both home owners' policies and commercial multiple peril contracts.

All line Organization

All line organization refers to an arrangement by which an insurer may write all lines of insurance
under one administrative charter.

@ #@ # $ % & * # $ % & *@ # $ %@ # $ % & * & * $ % & *

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 CHAPTER – IV
FUNDAMENTALS OF INSURANCE CONTRACT
4.1 LEGAL PRINCIPLES UNDERLYING INSURANCE CONTRACTS
4.1.1. PRINCIPLE OF INDEMNITY

The principle of indemnity is one of the most important legal principles in insurance. The principle of
indemnity states that the insurer agrees to pay no more than the actual amount of the loss; stated
differently, the insured should not profit from a loss. Most property and liability insurance contracts are
contracts of indemnity. If a covered loss occurs, the insurer should not pay more than the actual
amount of the loss.
The principle of indemnity has two fundamental purposes. The first purpose is to prevent the insured
from profiting from a loss. For example, if Kristin's home is insured for $100,000, and a partial loss of
$20,000 occurs, the principle of indemnity would be violated if $100,000 were paid to her. She would
be profiting from insurance.

The second purpose is to reduce moral hazard. If dishonest insureds could profit from a loss, they
might deliberately cause losses with the intention of collecting the insurance. If the loss payment does
not exceed the actual amount of the loss, the temptation to be dishonest is reduced.

Actual Cash Value

The concept of actual cash value underlies the principle of indemnity. In property insurance, the basic
method for indemnifying the insured is based on the actual cash value of the damaged property at the
time of loss. The courts have used three major methods to determine actual cash value:
 Replacement cost less depreciation
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  Fair market value
 Broad evidence rule

Replacement Cost Less Depreciation Under this rule, actual cash value is defined as replacement
cost less depreciation. It takes into consideration both inflation and depreciation of property values
over time. Replacement cost is the current cost of restoring the damaged property with new materials
of like kind and quality. Depreciation is a deduction for physical wear and tear, age, and economic
obsolescence.

For example, Shannon has a favorite couch that burns in a fire. Assume she bought the couch five
years ago, the couch is 50 percent depreciated, and a similar couch today would cost $1000. Under the
actual cash value rule, Shannon will collect $500 for the loss because the replacement cost is $1000,
and depreciation is $500, or 50 percent. If she were paid the full replacement value of $1000, the
principle of indemnity would be violated. She would be receiving the value of a new couch instead of
one that was five years old. In short, the $500 payment represents indemnification for the loss of a
five-year-old couch. This calculation can be summarized as follows:
Replacement cost = $1000
Depreciation = (couch is 50 percent depreciated)
Actual cash value = Replacement cost - Depreciation
$ 500 = $ 1000 - $ 500

Fair Market Value - Some courts have ruled that fair market value should be used to determine actual
cash value of a loss, Fair market value is the price a willing buyer would pay a willing seller in a free
market.

The fair market value of a building may be below its actual cash value based on replacement cost less
depreciation. This difference is due to several reasons, including a poor location, deteriorating
neighborhood, or economic obsolescence of the building.
In one case, a building valued at $170,000 based on the actual cash value rule had a market value of
only $65,000 when a loss occurred. The court ruled that the actual cash value of the property should be
based on the fair market value of $65,000 rather than on $170,000.

Broad Evidence Rule - Many states now use the broad evidence rule to determine the actual cash
value of a loss. The broad evidence rule means that the determination of actual cash value should
include all relevant factors an expert would use to determine the value of the property. Relevant factors
include replacement cost less depreciation, fair market value, present value of expected income from
the property, comparison sales of similar property, opinions of appraisers, and numerous other factors.

4.1.2. PRINCIPLE OF INSURABLE INTEREST

The principle of insurable interest is another important legal principle. The principle of insurable
interest states that the insured must be in a position to lose financially if a loss occurs. For example,
Abebe has an insurable interest in his car because he may lose financially if the car is damaged or

33
stolen. He has an insurable interest in his personal property, such as a television set or computer,
because you may lose financially if the property is damaged or destroyed.
Purposes of an insurable interest

To be legally enforceable, all insurance contracts must be supported by an insurable interest. Insurance
contracts must be supported by an insurable interest for the following reasons.
 To prevent gambling
 To reduce moral hazard
 To measure the amount of the insured's loss in property insurance

Firs, an insurable interest is necessary to prevent gambling. If an insurable interest were not required,
the contract would be a gambling contract and would be against the public interest. For example, one
could insure the property of another and hope for a loss to occur. One person could similarly insure the
life of another person and hope for an early death. These contracts clearly would be gambling contracts
and would be against the public interest.
Second, an insurable interest reduces moral hazard. If an insurable interest were not required, a
dishonest person could purchase a property insurance contract on someone else's property and then
deliberately cause a loss to receive the proceeds. But if the insured stands to lose financially, nothing is
gained by causing the loss. Thus, moral hazard is reduced.
Finally, in property insurance, an insurable interest measures the amount of the insured's loss. Most
property contracts are contracts of indemnity, and one measure of recovery is the insurable interest of
the insured. If the loss payment cannot exceed the amount of one's insurable interest, the principle of
indemnity is supported.

4.1.3 PRINCIPLE OF SUBROGATION

The principle of subrogation strongly supports the principle of indemnity. Subrogation means
substitution of the insurer in place of the insured for the purpose of claiming indemnity from a third
person for a loss covered by insurance. The insurer is entitled to recover from a negligent third party
and loss payments made to the insured. For example, a negligent motorist fails to stop at a red light and
smashes into Ato Tereie's car, causing damage in the amount of 5000 Br. If he has collision insurance
on his car, his company will pay the physical damage loss to the car and then attempt to collect from
the negligent motorist who caused the accident, the insured gives to the insurer legal rights to collect
damages from the negligent third party.

Purposes of Subrogation
Subrogation has three basic purposes. First, subrogation prevents the insured from collecting twice for
the same loss. In the absence of subrogation, the insured could collect from the insurer and from the
person who caused the loss. The principle of indemnity would be violated because the insured would
be profiting from a loss.

Second, subrogation is used to hold the guilty person responsible for the loss. By exercising its
subrogation rights, the insurer can collect from the negligent person who caused the loss.

34
Finally, subrogation helps to hold down insurance rates. Subrogation recoveries can be reflected in the
rate making process, which tends to hold rates below here they would be in the absence of subrogation.

4.1.4 . PRINCIPLE OF UTMOST GOOD FAITH

An insurance contract is based on the principle of utmost good faith that is, a higher degree of honesty
is imposed on both parties to an insurance contract than is imposed on parties to other contracts.

Thus, the principle of utmost good faith imposed a high degree of honesty on the applicant for
insurance. The principle of utmost good faith is supported by three important legal doctrines:
representations, concealment, and warranty.

Representations
Representations are statements made by the applicant for insurance. For example, if you apply for life
insurance, you may be asked questions concerning you age, weight, height, occupation, state of health,
family history, and other relevant questions. Your answers to these questions are called
representations.

The legal significance of a representation is that the insurance contract is avoidable at the insurer's
option if the representation is (1) material, (2) false, and (3) relied on by the insurer. Material means
that if the insurer knew the true facts, the policy would not have been issued, or it would have been
issued on different terms false means that the statement is not true or is misleading. Reliance means
that the insurer relies on the misrepresentation in issuing the policy at a specified premium.

For example, Jamana applies for life insurance and states in the application that he has not visited a
doctor within the last five years. However, six months earlier, he had surgery for lung cancer. In this
case, he has made a statement that is false, material, and relied on by the insurer. therefore, the policy
is voidable at the insurer's option. If Jamana dies shortly after the policy is issued, say three months,
the company could contest the death claim on the basis of a material misrepresentation.

Concealment
The doctrine of concealment also supports the principle of utmost good faith. A concealment is
intentional failure of the applicant for insurance to reveal a material fact to the insurer. Concealment is
teh same thing as nondisclosure; that is, the applicant for insurance deliberately withholds material
information from the insurer. The legal effect of a material concealment is the same as a
misrepresentation the contract is voidable at the insurer's option.

For example, Joseph DeBellis applied for a life insurance policy on his life. Five months after the
policy was issued, he was murdered. The death certificate named the deceased as Joseph DeLuca, his
true name. The insurer denied payment on the grounds that Joseph had concealed a material fact by not
revealing his true identity and that he had an extensive criminal record.

Warranty
The doctrine of warranty also reflects the principle of utmost good faith. A warranty is a statement of
fact or a promise made by the insured, which is part of the insurance contract and must be true if the
insurer is to be liable under the contract. For example, in exchange for a reduced premium, the owner
of a liquor store may warrant that an approved burglary and robbery alarm system will be operational
at all time. The clause describing the warranty becomes part of the contract.

35
 4.2VALID ELEMENTS OR REQUIREMENT OF AN INSURANCE CONTRACT
An insurance policy is based in the law of contracts. To be legally enforceable, an insurance contract
must meet four basic requirements: offer and acceptance, consideration, competent parties, and legal
purpose.

Offer and Acceptance

The first requirement of a binding insurance contract is that there must be an offer and an acceptance
of its terms. In most cases, the applicant for insurance makes the offer, and the company accepts or
rejects the offer. An agent merely solicits or invites the prospective insured to make an offer. The
requirement of offer and acceptance can be examined in greater detail by making a careful distinction
between property and liability insurance, and life insurance.
In property and liability insurance, the offer and acceptance can be oral or written. In the absence of
specific legislation to the contrary, oral insurance contracts are valid. As a practical matter, most
property and liability insurance contracts are in written form. The applicant for insurance fills out the
application and pays the first premium (or promises to pay the first premium). This step constitutes the
offer. The agent then accepts the offer on behalf of the insurance company. In property and liability
insurance, agents typically have the power to bind their companies through use of a binder. A binder is
a temporary contract for insurance and can be either written or oral. Thus, the insurance contract can be
effective immediately, because the agent accepts the offer on behalf of the company. This procedure is
usually followed in personal lines of property and liability insurance, including homeowners policies
and auto insurance. However, in some cases, the agent is not authorized to bind the company, and the
application must be sent to the company for approval. The company may then accept the offer and
issue the policy or reject the application.

In life insurance, the procedures followed are different. A life insurance agent does not have the power
to bind the insurer. Therefore, the application for life insurance is always in writing, and the applicant
must be approved by the insurer before the life insurance is in force. The usual procedure is for the
applicant to fill out the application and pay the first premium.

Consideration
The second requirement of a valid insurance contract is consideration the value that each party gives to
the other. The insured's consideration is payment of the first premium (or a promise to pay the first
premium) plus an agreement to abide by the conditions specified in the policy. The insurer's
consideration is the promise to do certain things as specified in the contract. This promise can include
paying for a loss from an insured peril, providing certain services, such as loss prevention and safety
services, or defending the insured in a liability lawsuit.

Competent Parties
The third requirement of a valid insurance contract is that each party must be legally competent. This
means the parties must have legal capacity to enter into a binding contract. Most adults are legally
competent to enter into insurance contracts, but there are some exceptions. Insane persons, intoxicated
persons, and corporations that act outside the scope of their authority cannot enter into enforceable
insurance contracts. Minors normally are not legally competent to enter into binding insurance
contracts; but most states have enacted laws that permit minors to enter into a valid life insurance
contract.

36
The insurer must also be legally competent. Insurers generally must be licensed to sell insurance in the
state, and the insurance sold must be within the scope of its charter or certificate of incorporation.

Legal Purpose
A final requirement is that the contract must be for a legal purpose. An insurance contract that
encourages or promotes something illegal or immoral is contrary to the public interest and cannot be
enforced. For example, a street pusher of heroin and other illegal drugs cannot purchase a property
insurance policy that would cover seizure of the drugs by the police. This type of contract obviously is
not enforceable because it would promote illegal activities that are contrary to the public interest.
4.3 UNIQUE CHARACTERISTICSOFINSURANCECONTRACTS
Insurance contracts have distinct legal characteristics that make them different from other legal
contracts. Several distinctive legal characteristics have already been discussed. As we noted earlier,
most property and liability insurance contracts are contracts of indemnity; all insurance contracts must
be supported by an insurable interest; and insurance contracts are based on utmost good faith. Other
distinct legal characteristics are as follows:
 Aleatory contract
 Unilateral contract
 Conditional contract
 Personal contract
 Contract of adhesion
Aleatory Contract
An insurance contract is aleatory rather than commutative. An aleatory contract is a contract where the
values exchanged may not be equal but depend on an uncertain event. Depending on chance, one party
may receive a value out of proportion to the value that is given. For example, assume that Lorri pays a
premium of $500 for $100,000 of home owners insurance on her home. If the home were totally
destroyed by fire shortly thereafter, she would collect an amount that greatly exceeds the premium
paid. On the other hand, a homeowner may faith fully pay premiums for many years and never have a
loss.

In contrast, other commercial contracts are commutative. A commutative contract is one in which the
values exchanged by both parties are theoretically equal. For example, the purchaser of real estate
normally pays a price that is viewed to be equal to the value of the property.

Unilateral Contract
An insurance contract is a unilateral contract. A unilateral contract means that only one party makes a
legally enforceable promise. In this case, only the insurer makes a legally enforceable promise to pay a
claim or provide other services to the insured. After the first premium is paid, and the insurance is in
force, the insured cannot be legally forced to pay the premiums or to comply with the policy
provisions. Although the insured must continue to pay the premiums to receive payment for a loss, he
or she cannot be legally forced to do so. However, if the premiums are paid, the insurer must accept
them and must continue to provide the protection promised under the contract.

In contrast, most commercial contracts are bilateral in nature. Each party makes a legally enforceable
promise to the other party. If one party fails to perform, the other party can insist on performance or
can sue for damages because of the breach of contract.

37
Conditional contract
An insurance contract is a conditional contract. That is, the insurer's obligation to pay a claim depends
on whether the insured or the beneficiary has complied with all policy conditions. Conditions are
provisions inserted in the policy that qualify or place limitations on the insurer's promise to perform.
The conditions section imposes certain duties on the insured if he or she wishes to collect for a loss.
Although the insured is not compelled to abide by the policy conditions, he or she must do so to collect
for an insured loss. The insurer is not obligated to pay a claim if the policy conditions are not met. For
example, under a homeowners policy, the insured must give immediate notice of a loss. If the insured
delays for an unreasonable period in reporting the loss, the insurer can refuse to pay the claim on the
grounds that a policy condition has been violated.

Personal Contract
In property insurance, insurance is a personal contract, which means the contract is between the
insured and the insurer. Strictly speaking, a property insurance contract does not insure property, but
insures the owner of property against loss. The owner of the insured property is indemnified if the
property is damaged or destroyed. Because the contract is personal, the applicant for insurance must be
acceptable to the insurer and must meet certain underwriting standards regarding character, morals, and
credit.
A property insurance contract normally cannot be assigned to another party without the insurer's
consent. If property is sold to another person, the new owner may not be acceptable to the insurer. In
contrast, a life insurance policy can be freely assigned to anyone without the insurer's consent because
the assignment does not usually alter the risk or increase the probability of death.

Contract of Adhesion
A contract of adhesion means the insured must accept the entire contract, with all of its terms and
conditions. The insurer drafts and prints the policy, and the insured generally must accept the entire
document and cannot insist that certain provisions be added or deleted or the contract rewritten to suit
the insured. Although the contract can be altered by the addition of endorsements or other forms, the
endorsements and forms are drafted by the insurer. To redress the imbalance that exists in such a
situation, the courts have ruled that any ambiguities or uncertainties in the contract are construed
against the insurer. If the policy is ambiguous, the insured gets the benefit of the doubt.

CHAPTER- V
INSURANCE CONTRACTS

"Insurance contracts are complex legal documents that reflect both general rules of law and insurance
law". When buying an insurance contract, the buyer is expected to be paid for a covered loss. Whether
he or she can collect and the amount paid is governed by insurance law. Insurance contracts are also
termed as "technical documents designed for a specific purpose. These contracts create a binding
agreement between two parties, allowing one party to transfer an exposure to loss to another party".

BASIC PARTS OF AN INSURANCE CONTRACT

38
Despite their complexities, insurance contracts generally can be divided in to five parts, according to
C. Arthur Williams’s et.al. (Principles of Risk Management and Insurance, 2nd Edition vol.2) They are:
Declarations
Insurance Agreement
Exclusions
Conditions
Miscellaneous Provisions
Where as Mark S. Dorfman (Introduction to Risk Management & Insurance, 4 th Edition, 1991) says
that all commercial and personal property insurance policies have several of the following common
elements:
i. Declarations
ii. Insurance agreement
iii. Deductibles
iv. Definitions
v. Exclusions
vi. Conditions
vii. Endorsements or Riders

These basic parts of an insurance contract are shown graphically as the building blocks below:

 Establishes "named insured"

Declarations
 Provides Rating information

 Creates binding agreement between insures & insured

Insuring  Sub agreements provide specific coverage
Agreements

39
  Cause insured to bear first Birr amount of covered losses.
Deductibles  Control insurance costs and morale hazard.

 Establish meaning of important words found in the policy, there by

Definitions reducing room for ambiguity

 Limits insurance coverage by specifically identifying perils, people, and

Exclusions property or time period not covered.

 Specify the rights and duties of the insurers and insured under the
contract.
Conditions

 Amends contract to create more coverage.

Endorsements &
Riders
Although all insurance contracts do not necessarily contain all the above parts in the order given, such
a classification provides a simple and convenient framework for analyzing most insurance contracts.
Declarations
Declarations are statements that provide information about the property or life to be insured.
This information is used for underwriting and rating purposes and for identification of property or life
to be insured.

40
Contents of the Property Insurance
o Identification of the insurer
o Name of the insured
o Location of the properly
o Period of protection
o Amount of insurance
o Amount of the premium
o Size of the deductible (if any)
o Any other relevant information
Contents of the Life insurance
o Identification of the insurer
o Name of the insured
o The age of issue
o The premium
o The issue date of contract
Insuring Agreement
The insuring agreement summarizes the major promises of the insurer. These promises and the
conditions under which losses are to be paid are described in the insuring agreement. There are two
basic forms of an insuring agreement:
a. Named-Perils Coverage and
b. All risk coverage
Named-Perils Policy:Those perils specifically listed in the policy are covered. For example, in the
homeowner's policy, the property damage from fire or lighting is covered, since
these perils are listed and flood damage is not covered, since flood is not a listed
peril.
"All-Risk" Policy: All-risks policy is also called as open perils policy. It covers all losses except
those losses specifically excluded.
e.g. > loss resulting from war
> mechanical breakdown
> breakage of fragile articles
Insurers now-a-days have deleted the word "all-risks" policy forms. Instead American Insurance
Services Office uses the term called "risks of direct loss to property". They have also drafted a
"special causes-of-loss from that is used in commercial property insurance. Both these terminology is
interpreted to mean that all losses are covered except those losses excluded.
Life Insurance is a typical example of an "all risks" policy. Most life insurance contracts cover all
causes of death whether by accident or by disease. The major exceptions are death caused by suicide
during the first two years and, in some contracts, death caused by war.

Deductibles
A deductible is a provision by which a specified amount is deducted from the total loss
payment that otherwise would be payable. Deductibles typically are found in property, health, and
automobile insurance contract. It is not applied in life insurance because the insured's death is a total
loss. Also, a deductible generally is not used in personal liability insurance because the insurers must
provide a legal defense, even for a small claim. Property, health & automobile insurance policies
commonly provide for the insured to pay the first birr of an insured loss.

Purpose of Deductibles
 To eliminate small claims
 To reduce premiums
 To reduce moral and morale hazard

A deductible eliminates small claims that are expensive to handle and process. It makes no
economic sense for the insurer to incur Birr 200 of expenses to settle a Birr 50 claim. Hence, small
losses can be better budgeted out of personal or business income.
Deductibles are also used to reduce premiums. Since small losses are eliminated, more of the
premium birr can be used for the larger claims. The savings from reduced expenses and loss claims are
reflected in lower premium rates. The concept of using insurance premium to pay for large losses
rather than for small losses is often called the "large loss principle." The objective is to cover large
losses that can financial ruin and individual and exclude small losses that can be budgeted out of the
person's income.

Deductibles are used to reduce both moral and moral hazard, since the insured may not profit if a loss
occurs. It encourages persons not to be dishonest and deliberately cause a loss in order to profit from

ADAMA UNIVERSITY 57
insurance and also encourage them to be more careful with respect to the protection of their property
and prevention of loss.

Types of Deductibles:
Insurance contracts contain a wide variety of deductibles. There some common deductibles
frequently found in property insurance contracts and health insurance contracts separately.

Deductibles for Deductibles for

Property Insurance Health Insurance
 Straight Deductibles  Calendar Year Deductibles
 Aggregate Deductibles  Corridor Deductibles
 Franchise Deductibles  Elimination (waiting) Period.

Straight deductible: With a straight deductible the insured must pay a certain number of birr of loss
before the insurer is required to make a payment. Such a deductible typically applies to each loss.
Straight deductible is mostly typically found in automobile collision insurance. For instance, assume
that Merit has her 2001 Toyota car insured for a collision loss, subject to a 250 birr deductible. If she
makes a claim for a collision loss of 5000 birr, she would receive only 4750 birr.

Aggregate deductible: In some property insurance contracts, an aggregate deductible may be used; by
which all covered losses during the year are added together until they reach a certain level. If total
covered losses are below the aggregate deductible, the insurer pays nothing. Once the deductible is
satisfied, all losses thereafter are paid in full. For example, assume that a property insurance contract
contains a 1000 birr aggregate deductible for the calendar year. If a loss of 500 birr occurs in
January, the insurer pays nothing. If a 2000 birr loss occurs in February, the insurer would pay 1500.
At this point, the aggregate deductible of 1000 has now been satisfied for the year. If a 5000 loss
occurs in March, it is paid in full. Any other covered losses occurring during the year would also be
paid in full.

Franchise deductible: A franchise deductible is expressed either as a percentage or birr amount, under
which there is no liability on the part of the insurer unless the loss exceeds the amount stated. But once
the loss exceeds this amount, however, the insurer must pay the entire claim. Sometimes this franchise
deductible is termed "disappearing deductible", because the deductible has no effect once the loss
reaches the specified amount. In ocean marine insurance it is common to use a franchise agreement
expressed as a percentage, since shippers expect minor losses from bad weather, rolling ships, and the
frequent handling of cargo and major losses caused by fire, sinking, stranding, and collision. For
example, assume that an exporter from Ethiopia is shipping goods to India that are valued at 100,000
birr, and a 5% franchise deductible is present in the contract. Any loss of 5000 birr or less is paid by
the insured. However, if the actual loss exceeds 5000 birr, the entire amount is paid in full by the
insurer. In effect, this type of deductible acts as a disappearing deductible, since small losses are not
paid, but a large loss exceeding the deductible amount is paid in full.

Calendar-year deductible: A calendar-year deductible is a type of aggregate deductible that is

commonly found in basic medical expense and major medical insurance contracts. Eligible medical
expenses are accumulated during the calendar year, and once they exceed the deductible amount,
the insurer must then pay the benefits promised under the contract. Once the deductible is satisfied
during the calendar year, no additional deductibles are imposed on the insured.

ADAMA UNIVERSITY 58
 Corridor deductible: Employers with basic medical expense plans often wish to supplement the
basic benefits with major medical benefits. A corridor deductible is a deductible that is frequently used
to integrate a basic medical expense plan with a supplemental major medical expense plan. The
corridor deductible must be satisfied before the major medical plan pays any benefits. The corridor
deductible applies only to eligible medical expenses that are not covered by the basic medical expense
plan. For example, assume that Gidey has 5000 birr of covered medical expenses, of which 4000 birr
are paid by the basic medical expense plan. If the supplemental major medical plan has a 100 birr
corridor deductible, the supplemental plan will cover the remaining 900 birr of expenses, subject to
any limitations or percentage participation clause (coinsurance) that apply.

Elimination (waiting) period: A deductible can also be expressed as an elimination period. An

elimination period is a stated period of time at the beginning of a loss during which no insurance
benefits are paid. An elimination period is appropriate for a single loss that occurs over some time
period, such as the loss of work earnings. Elimination periods are commonly used in disability income
contracts. For example, disability income contracts that replace part of a disabled worker's earnings
typically have elimination periods of seven to ninety days, or even longer. Some contracts pay
disability income benefits from the first day of an accident, but they may require an elimination period
in the event of sickness.

Definition
Insurers often provide definitions of words they consider important or subject to misinterpretation.
Insurance contracts typically contain a definition of the insured under the policy. The contract must
indicate the person or persons for whom the protection is provided. Several possibilities exist
concerning the persons who are insured under the policy.

1. The policy may insure only one person.

For example, in many life and health insurance contracts, only one person is specifically
named as insured under the policy.
2. The policy may contain a formal definition of the Named Insured. The named insured is the
person or persons named in the declarations section of the policy as opposed to someone who
may have an interest in the policy but is not named as an insured.
For example, the named insured under the personal auto policy includes the person named in
the declarations and his or her spouse if a resident of the same household.
3. The policy may also cover Additional Insured's even though they are not specifically named in
the policy.
For example, in addition to the named insured, a homeowner's policy also covers the
following:
 resident relatives of the named insured or
 spouse,
 a son or daughter under age 21 who is in the care of an insured,
 a child in a foster home.
 relatives who are attending college and are away from home.
The personal auto policy covers the following:
 named insured and spouse,
 resident relatives,
 any other person using the automobile with the permission of the named insured.
A group medical expense policy can also cover the following:
 worker's dependents
ADAMA UNIVERSITY 59
Here are some definitions from the Homeowner's Policy.
In this policy, "you" and "your" refer to the "named insured" shown in the
Declarations and the spouse if a resident of the same household. "We", "us"
and "our" refer to the Company providing this insurance.
In addition, certain words and phrases are defined as follows:
Bodily injury > means bodily harm, sickness or disease, including required care, loss
of services and death that result.
Business > includes trade, profession or occupation.
Insured > means you and residents of your household who are:
a) your relatives; or
b) other persons under the age of 21 and in the care of any person
named above.
Insured Location > means:
a) the residence premises;
b) the part of other premises, other structures and grounds used by
you as a residence and:
 which is shown in the Declarations; or
 which is acquired by you during the policy period for your use as
a residence;
Occurrence > means an accident, including exposure to conditions, which results,
during the policy period, in:
a) bodily injury; or
b) damage to property.
Property Damage > means physical injury to, destruction of, or loss of use of tangible
property.

The definitions may appear as a glossary found at the beginning of the policy, or elsewhere in
the body of the text. In both Homeowner's and Personal Auto Policy, boldface type is used to alert the
reader that a particular term has been defined by the insurer.

Exclusions
Exclusions in an insurance contract are listing of the perils, losses, and property that are excluded from
coverage. When the policy states it will not pay for the following losses, and a list of excluded losses
is given, it means the insured has no right to collect payment under the circumstances listed. As such
there are three major types of exclusions.
 Excluded perils
 Excluded losses
 Excluded property
Excluded perils
The contract may exclude certain perils, or causes of loss. Several examples can illustrate this
type of exclusion. Under the typical homeowner's policy, the perils of flood, earth movement, and
nuclear radiation are specifically excluded. In the physical damage section of a personal auto policy,
collision is specifically excluded if the automobile is used as a public taxicab. Finally, in life
insurance and disability income policies, the peril of war if often excluded.

Excluded losses

ADAMA UNIVERSITY 60
 Certain types of losses may also be excluded. For example, in a homeowner's policy,
earthquake losses are not covered without a special endorsement. In the personal liability section of a
homeowner's policy, a liability lawsuit arising out of the negligent operation of an automobile is
excluded. Nor are professional liability losses covered; a specific professional liability policy is
needed to cover this exposure. Finally, under a health insurance policy that covers only accidents,
losses due to sickness and disease are not covered.

Excluded property
The contract may also exclude or place limitations on the coverage of certain property. For
example, in a homeowner's policy, certain types of personal property are excluded, such as
automobiles, airplanes, animals, birds, and fish. In a liability insurance policy, property of others in
the care, control, and custody of the insured is usually excluded.

Reasons for exclusions

Exclusions are necessary for the following reasons.
 Uninsurable perils
 Presence of extraordinary hazards
 Coverage provided by other contracts
 Moral hazard
 Coverage not needed by typical insureds

Exclusions are necessary because the peril may be considered uninsurable by commercial
insurers. There may be an incalculable catastrophic loss; a loss (such as an intentional, self-inflicted
injury) may be within the direct control of the insured; or a loss may be due to a predictable decline in
value (property, such as depreciation, wear and tear), are not insurable.

Exclusions are also used because extraordinary hazards are present. For example, the premium
for liability insurance under a personal auto policy is based on the assumption that the automobile is
normally used for personal and recreational use and not as a public taxicab. The chance of an accident,
and a resulting liability lawsuit, is much higher if the automobile is used as a public taxicab. Therefore,
to provide coverage for a public taxicab at the same premium rate for a family automobile could result
in inadequate premiums for the insurer and unfair rate discrimination against other insureds who are
not using their vehicles as taxicabs. To avoid this problem, public taxicabs are in a separate rating
category, and losses due to the operation of the vehicle as a public taxicab are specifically excluded
under the personal auto policy.

Exclusions are also necessary because coverage is provided by other contracts. Exclusions are
used to avoid the duplication of coverage and to confine the coverage to the policy best designed to
provide it. For example, an automobile is excluded under a homeowner's policy because it is covered
under the personal auto policy and other automobile insurance contracts. If both policies covered the
loss, there would be unnecessary duplication.

Certain property is excluded because of moral hazard or difficulty in determining and

measuring the amount of loss. For example, the standard fire policy excludes money, and the
homeowner contracts limit the coverage of money to $200 in America. If unlimited amounts of money
were covered, fraudulent claims could increase. Also, loss adjustment problems in determining the
exact amount of the loss could increase. Thus, because of moral hazard, exclusions are used.

ADAMA UNIVERSITY 61
 Finally, exclusions are used because the protection is not needed by the typical insured. Since
a particular peril may not be common to a large group of persons, the insured's should not be required
to pay for coverage that they will not need or use. For example, to cover aircraft as personal property
under the homeowner's policy would be grossly unfair to the majority of insureds who do not own
airplanes but who would be required to pay substantially higher premiums.

Conditions
Conditions are provisions inserted in the policy that qualify or place limitations on the insurer's
promise to perform. They explain many of the important relationships, rights, and duties between the
insurer and insured. They also provide a framework for the insurance policy. If the policy conditions
are not met, the insurer can refuse to pay the claim.

The 165 lines of the 1943 New York Standard Fire Insurance Policy (SFP) contain most of the
conditions frequently found in current policy forms. The SFP served as the main building block of all
property insurance forms. Today it has been widely replaced by forms written in more modern,
simplified English.

Common conditions in a contract include the following that are to be fulfilled by the insured on
the occurrence of the losses.
1. Requirement to protect property after a loss. For example, undamaged property must be
protected. If a fire on the roof exposes furniture to damage from the weather, the furniture
should be removed to a warehouse. If property is not protected and suffers damage because of
the lack of care, the insurer need not pay for the subsequent damage. Requiring protection of
undamaged property reduces the morale hazard.
2. File a proof of loss with the company. Prompt notice of loss must be given immediately.
Police must be notified. Inventories must be completed. Insurer should be informed as early as
possible. The purpose of immediate notice provision is to allow the insurer to investigate the
claim promptly. If the insurer can investigate promptly, as is the insurer's right under the policy,
the insured has fulfilled the requirement of the contract.
3. Actively cooperate with the company in determining the amount of loss. Insurers have a right
to a complete inventory, signed and sworn to by the insured. Any substantial concealment or
misrepresentation at this stage allows the insurer to void the contract.
4. Cooperate with the company in the event of a liability lawsuit in fixing the house (in case the
house is on fire).

Endorsements and Riders

Insurance contracts also contain endorsements and riders. The terms "endorsements and riders"
are often used interchangeably and meaning the same thing. An endorsement is a written provision
that adds to, deletes, or modifies the provisions in the original contract. The term "rider" is mostly
used in life and health insurance policies to describe a document that amends or changes the original
policy.

For example, when added to the standard fire policy, the extended coverage endorsement
extends the fire insurance policy to certain additional specified perils. In life and health insurance,
numerous riders can be brought in, such as:
 Add an increase or decrease benefits
 Waive a condition of coverage present in the original policy or amend the basic policy.
For example, after a six-month waiting period, all future premiums may be waived for the
confirmed disability.
ADAMA UNIVERSITY 62
 Approximately 100 different endorsements can be added to homeowner's policy. These include
the following:
 Theft Coverage Extension (broadens the definition of the peril).
 Scheduled Personal Property Endorsement (adds coverage for valuable furs, jewelry and
similar items).
 Business Pursuits (modifies standard policy exclusion and provides liability coverage for a few
business pursuits, including sales and instructional occupations, etc.)
 Watercraft (remove the standard policy exclusion restricting liability coverage for watercraft).
 Home Day Care Coverage Endorsement (extends coverage for home day care business
conducted on the premises).

COINSURANCE

Many property policies contain a clause requiring the insured to purchase some minimum
amount of insurance if the insured wants full coverage on all losses. It the insured purchases less than
the minimum amount, there will be only partial recovery for losses. The minimum amount of insurance
the company required usually is stated as a percentage of the replacement cost of the insured property.
In health insurance and credit insurance the coinsurance clause is simply a straight deductible,
expressed as a percentage.

Nature of Coinsurance
A coinsurance clause inserted in a property for a stated percentage of its actual cash value at the
time loss. If the insured fails to meet the coinsurance requirement at the time of loss, he or she must
share in the loss a coinsurer. For example:

In health insurance  The insured bear 20% of every loss. This controls the fraudulent claims.

In fire insurance  The insured bear a portion of every loss only when underinsured.

Underinsurance is looked upon as undesirable for two reasons:

a) Insurance companies are supposed to restore their policyholders to their original positions.
b) It costs relatively more to insure the business of individuals who are underinsured than it does
to handle the business of individuals who purchase insurance equal to the full value of the
object.
This follows because most losses are partial, and the probability of partial losses is higher than
the probability of total losses. The typical coinsurance clause prorates any partial losses between the
insurer and the insured in the proportion that the actual insurance carried bears to the amount required
under the clause. Usually 80% or 90% of the sound value is the amount required. Sound value means
the actual cash value of the property; that is, the replacement cost less an allowance for
depreciation. Thus, if there is a building with a 10,000 birr sound value written with a 90%
coinsurance clause, 9,000 birr of insurance is required. The insured who carries at least this amount
collects in full for any partial loss. But the insured, who carried half of this amount, or 4,500 birr,
collects only half of any partial loss. The insured who carries 6,000 birr collects two-thirds of any
partial loss.

To determine whether in insured has met the coinsurance requirement on the dwelling, insurers
use the following formula:
Insurance carried
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 x Amount of Loss = Amount Payable by the insurer
Insurance required
If the loss equals or exceeds the amount required under the clause (if the loss is nearly total), there is
no penalty invoked by the coinsurance clause. Thus, if in the above case the loss were 9,000 birr at a
time when the insured is carrying only 6,000 birr of insurance, substitution in the above formula yields
the following;
6,000
x 9,000 = 6,000 birr
9,000
The recovery is 6,000 birr, the amount of insurance carried, and there is no penalty other than
the fact that the insured did not carry sufficient insurance to cover the entire loss.

Purpose of Coinsurance
1. To achieve equity in rating
2. To make underinsurance unattractive to the insured
3. To make the insured to pay a penalty based on the amount of underinsured.

The fundamental purpose of coinsurance is to achieve equity in rating. It happens to be the case
that property insurance rates are expressed as an amount per 100 birr of value. Most property insurance
losses are partial and not total losses. But if every one insures only for the partial loss rather than for
the total loss, the premium rate for each 100 birr of insurance must be higher. This would be
inequitable to the insured who wishes to insure his or her property to its full value. If every one insures
to full value, the pure premium rate for fire insurance will be reduced for each 100 birr of insurance. If
the property owner purchases insurance equal to only 50% of the value of the covered property when
the insurer requires 80% coverage, that insured will receive only partial recovery for a loss.
@#&%$@#&%$@#&%$@#&%$

ADAMA UNIVERSITY 64
 CHAPTER SIX

LIFE INSURANCE

Life Insurers pay death benefits to designated beneficiaries when the insured dies. The death
benefits are designed to pay for funeral expenses, uninsured medical bills, estate taxes, and other
expenses as a result of death.

Premature Death: - can be defined as the death of a family head with outstanding unfulfilled financial
obligations, such as dependents to support, children to educate, and a mortgage to pay off.

Costs of Premature Death

1. The family's share of the deceased bread winner's earnings is lost forever.
2. additional expenses are incurred because of funeral expenses, uninsured medical bills, estate
settlement costs,
3. because of insufficient income, some families will experience a reduction in their standard of
living
4. certain non economic costs are incurred, such as emotional grief, loss of a parental role model,
and counseling and guidance for the children.

Types of Life Insurance

Life insurance policies can be classified as either term insurance or cash value life insurance. Term
insurance provides temporary protection, while cash value life insurance has a savings component and
builds cash values.

Term Insurance
First, the period of protection is temporary, such as 1, 5, 10, or 20 years. Unless the policy is renewed,
the protection expires at the end of the period.
Most term insurance policies are renewable, which means that the policy can be renewed for
additional periods without evidence of insurability.
Most term insurance policies are also convertible, which means the term policy can be
exchanged for a cash value policy without evidence of insurability.
Finally, term insurance policies have no cash value or savings element. Although some long
term policies develop a small reserve, it is used up by the contract expiration date.

Whole Life Insurance

In contrast to term insurance, which provides short term protection, Whole life insurance is a cash
value policy that provides lifetime protection. The following two types of whole life insurance:
- Ordinary life insurance
- Limited payment life insurance

ADAMA UNIVERSITY 65
Ordinary Life Insurance Ordinary Life insurance (also called straight life and continuous premium
whole life) provides lifetime protection to age 100, and the death claim is a certainty. If the insured is
still alive at age 100, the face amount of insurance is paid to the policy owner at that time.
In addition, premiums do not increase from year to year but remain level throughout the
premium paying period.
Ordinary life insurance also has an investment or saving element called a cash surrender value.
The cash values are due to the overpayment of insurance premiums during the early years. For
example, in many ordinary life policies, a $100,000 policy issued at age 20 would have at least
$50,000 of cash value at age 65.
Finally, ordinary life insurance contains cash surrender or non forfeiture options (if
participating), and settlement options that can be used to meet a wide variety of financial needs and
objectives.
Limited payment life insurance: A limited payment policy is another type of traditional whole life
insurance. The insurance is permanent, and the insured has lifetime protection. The premiums are
level, but they are paid only for a certain period. For example, Shannon, age 35, may purchase a 20
year limited payment policy in the amount of $25,000. After 20 years, the policy is completely paid up,
and no additional premiums are required even though the coverage remains in force.

Endowment Insurance
Endowment insurance is another traditional form of life insurance. An endowment policy pays the face
amount of insurance if the insured dies within a specified period, if the insured survives to the end of
the endowment period, the face amount is paid to the policy owner at that time. For example, if At
Gashow, age 35, purchased a 20 year endowment policy and died any time within the 20 year period,
the face amount would be paid to her beneficiary. If he survives to the end of the period, the face
amount is paid to him.

Modified Life Insurance

A modified life policy is a whole life policy in which premiums are lower for the first three to five
years and higher thereafter. The initial premium is slightly higher than for term insurance, but
considerably lower than for an ordinary life policy issued at the same age.

Juvenile Insurance
Juvenile insurance:- refers to life insurance purchased by a parent or adult on the lives of children
younger than a certain age, such as age 14 or 15. Insurers generally require the child to be at least one
month old before he or she can be insured. Some insurers, however, will insure a child as young as one
day old.

Industrial Life Insurance

Industrial life insurance - (some called debit insurance) is a class of life insurance that is issued in
small amounts, and the premiums are payable weekly or monthly. In the past, teh premiums were
collected at the insured's home by an agent of the company. More than nine out of ten such policies
were cash value policies.
In recent years, industrial life insurance has also been called home service life insurance,
reflecting the fact that individual policies are serviced by agents who call at the policy owner's home to
collect the premiums.

Group Life Insurance

Group life insurance is a type of insurance tha provides life insurance on a group of people in a single
master contract.
ADAMA UNIVERSITY 66
Rate Making in Life Insurance
Our discussion of rate making so far has applied largely to property and liability insurance. This
section briefly examines the fundamentals of life insurance rate making.

Net Single Premium

Life insurance policies can be purchased with a single premium, or with annual, semiannual, quarterly,
or monthly premiums. Although most policies are not purchased with a single premium, the net single
premium forms the foundation for the calculation of all life insurance premiums.
The net single premium (NSP) can be defined as the present value of the future death benefit. It
is that amount, which together with compound interest, will be sufficient to pay all death claims. In
calculating the NSP, only mortality and investment income are considered. Insurance company
expenses or the loading element are considered later, when the gross premium is calculated.
The NSP is based on three basic assumptions: (1) premiums are paid at the beginning of the
policy year, (2) death claims are paid at the end of the policy year, and (3) the death rate is uniform
throughout the year.

Term Insurance: The NSP for term insurance can be calculated easily. The period of protection is
only for a specified period or to a stated age. The face amount is paid if the insured dies within the
specified period, but nothing is paid if the insured dies after the period of protection expires.

The NSP for yearly renewable term insurance is considered first. Assume that a $1000 yearly
renewable term insurance policy is issued to a male age 45. The cost of each year's insurance is
determined by multiplying the probability of death by the amount of insurance multiplied by the
present value of $1 for the time period the funds are held. By referring to the 1980 CSO mortality chart
we see that out of 10 million males alive at age zero, 9,210,289 are still alive at the beginning of age
45. Of this number, 41,907 persons will die during the year. Therefore, the probability that a person
age 45 will die during the year is 41,907/9,210,289. This fraction is then multiplied by $1000 to
determine the amount of money the insurer must have on hand from each policy owner at the end of
the year to pay death claims.

The present value of $1 at 5 percent interest is 0.9524. Thus, if the probability of death at age 45 is
multiplied by $1000, and the sum is discounted for one year's interest, the resulting net single premium
is $4.33. This calculation is summarized as follows

If 44.33 is collected in advance from each of the 9,210,289 persons who are alive at age 45, this
amount together with compound interest will be sufficient to pay all death claims.
If the policy is renewed for another year, the NSP at age 46 would be calculated as follows:

ADAMA UNIVERSITY 67
The NSP for a yearly renewable term insurance policy issued at age 46 is $4.69. Premiums for
subsequent years are calculated in the same manner.
Now consider the NSP for a five year term insurance policy in the amount of $1000 issued to a
person age 45. In this case, the company must pay the death claim if the insured dies any time within
the five year period.
The cost of insurance for the first year is determined exactly as before, when we calculated the
net single premium for yearly renewable term insurance. Thus, we have the following equation:

The next step is to determine the cost of insurance fore the second year. Referring back to
Exhibit we see that at age 46,45,108 people will die during the year. Thus, for the 9,210,289 persons
who are alive at age 45, the probability of dying during age 46 is 45,108/9,210,289. Note that the
denominator does not change but remains the same for each probability fraction.
Thus, for the second year, we have the following calculation:

For each of the remaining three years, we follow the same procedure. If the insurer collects $22.74 in a
single premium from each of the 9,210,289 persons who are alive at age 45, that sum together with
compound interest will be sufficient to pay all death claims during the five year period.

Exhibit
Figuring the NSP for a Five Year Term Insurance Policy

Probability of Amount of Present Value of $1 Cost of Insurance

Age Death Insurance of 5%

45 X $1000 X 0.9524 = $ 4.33 (year 1)

46 X $1000 X 0.9070 = 4.44 (year 2)

47 X $1000 X 0.8638 = 4.55 (year 3)

48 X $1000 X 0.8227 = 4.65 (year 4)

X X = ( year 5)

ADAMA UNIVERSITY 68
49 $1000 0.7835 NSP =

Ordinary Life Insurance:- In calculating the NSP for an ordinary life policy, teh same method
described earlier for the five year term policy is used except that the calculations are carried out to the
end of the mortality table (age 99). Thus, in our illustration, the NSP for a $1000 ordinary life
insurance policy issued at age 45 would be $270.84

Net Annual Level Premium

Most life insurance policies are not purchased with a single premium because of the large amount of
cash required. Consumers generally find it more convenient to pay for their insurance in installment
payments. If premiums are paid annually, the net single premium must be converted into a net annual
level premium, the net annual level premium (NALP) is determined by dividing the net single
premium by the present value of a life annuity due (PVLAD) of $1 for the premium paying period.
thus, we obtain the following:

Term insurance - Consider the net annual level premium for a five year term insurance policy in the
amount of $1000 issued at age 45. Recall that the net single premium for a five year term insurance
policy at age 45 is $22.74. This sum must be divided by the present value of a five year temporary life
annuity due of $1. For the first year, a $1 payment is due immediately. For the second year, the
probability that a person age 45 will still be alive at age 46 to make the second payment of $1 must be
determined. Referring back to Exhibit 9,210,289 persons are alive at age 45. Of this number, 9,168,382
are still alive at age 46. Thus, the probability of survival is 9,168,382/9,210,289. This fraction is
multiplied by $1, and the resulting sum is then discounted for one year's interest. Thus, the present
value of the second payment is $0.948. Similar calculations are performed for the remaining three
years. The various calculations are summarized as follows:

Age 45 $1 due immediately = $1.000

9,168,382
Age 46 x $1 x 0.9524  0.948
9,210,289

9,123,274
Age 47 x $1 x 0.9070  0.898
9,210,289

9,074,738
Age 48 x $1 x 0.8638  0.851
9,210,289

9,022,649
Age 49 x $1 x 0.8227  0.806
9,210,289

ADAMA UNIVERSITY 69
 PVLAD of $1 = $4.503

The present value of a five year temporary life annuity due of $1 at age 45 is $4.50. If the net single
premium of $22.74 is divided by $4.50, the net annual level premium is $5.05.

Ordinary Life Insurance:- The net annual level premium for a $1000 ordinary life insurance policy
issued at age 45 is calculated in a similar manner. The same procedure is used except that the
calculations are extended to the end of the mortality table. Thus, the present value of a whole life
annuity due of $1 for ages 45 through 99 must be calculated. If the calculations are performed, the
present value of a whole life annuity due of $1 at age 45 is $15.312. The net single premium ($270.84)
is then divided by the present value of a whole life annuity due of $1 at age 45 ($15.312), and the net
annual level premium is $17.69.

Gross Premium - The gross premium is determined by adding a loading allowance to the net annual
level premium. The loading must cover all operating expenses, provide a margin for contingencies,
and, in the case of stock life insurers, provide for a contribution to profits. If the policy is a
participating policy, the loading must also reflect a margin for dividends.

Three major types of expenses are reflected in the loading allowance: (1) production expenses, (2)
distribution expenses, and (3) maintenance expenses. Production expenses are the expenses incurred
before the agent delivers the policy, such as policy printing costs, underwriting expenses, and the cost
of the medical examination. Distribution expenses are largely selling expenses, such as the first year
commission, advertising, and agency allowances. Maintenance expenses are the expenses incurred
after the policy is issued, such as renewal commissions, costs of collecting renewal premiums, and
state premium taxes.

Exhibit
Commissioners 1980 Standard Ordinary Mortality Table, Male Lives

Age at Number Living Number Dying Ate at Number Living at Number Dying
Beginning of Beginning of During Beginning Beginning of during
of Year Designated year Designated of Year Designated year Designated
Year year
0 10,000,000 41,800 25 9,663,007 17,104
1 9,958,200 10,655 26 9,645,903 16,687
2 9,947,545 9,848 27 9,629,216 16,466
3 9,937,697 9,739 28 9,612,750 16,342
4 9,927,958 9,432 29 9,596,408 16,410
5 9,918,526 8,927 30 9,579,998 16,573
6 9,909,599 8,522 31 9,563,425 17,023
7 9,901,077 7,921 32 9,546,402 17,470
8 9,893,156 7,519 33 9,528,932 18,200
9 9,885,637 7,315 34 9,510,732 19,021

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 10 9,878,322 7,211 35 9,491,711 20,028
11 9,871,111 7,601 36 9,471,683 21,217
12 9,863,510 8,384 37 9,450,466 22,681
13 9,855,126 9,757 38 9,427,785 24,324
14 9,845,369 11,322 39 9,403,461 26,236
15 9,834,047 13,079 40 9,377,225 28,319
16 9,820,968 14,830 41 9,348,906 30,758
17 9,806,138 16,376 42 9,318,148 33,173
18 9,789,762 17,426 43 9,284,975 35,933
19 9,772,336 18,177 44 9,249,042 38,753
20 9,754,159 18,533 45 0,210,289 41,907
21 9,735,626 18,595 46 9,168,382 45,108
22 9,717,031 18,365 47 9,123,274 48,536
23 9,698,666 18,040 48 9,074,738 52,089
24 9,680,626 17,619 49 9,022,649 56,031

ADAMA UNIVERSITY 71