Risk Management & Insurance

Chapter 3
INSURANCE: An Introduction
 Chapter 1: Agenda
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1.1. Definition of Risk

1.2. Risk Vs Uncertainty, and chance of loss

1.3. Risk, peril and hazard

1.4. Classes of Risk

1.5. Types of pure risk

1.5.1. Personal pure risks
1.5.2. Property pure risks
1.5.3. Liability pure risks
 Chapter 2: Agenda
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2.1. Meaning of risk Management

2.2. Objectives of risk Management

2.3. Process of Risk Management

2.3.1. Identification of potential risks

2.3.2. Measurement potential risks

2.3.3 Selection of due Tools of Risk Management

2.3.4 Administration of the Entire Program

 Chapter 3: Agenda
4

1. Chapter 3:
2. INSURANCE: An Introduction
1. 3.1. Definition & function of insurance.

2. 3.2. Basic Characteristics of Insurance

3. 3.3. Requirement of insurable risk

4. 3.4. Insurance Vs (gambling, Speculation)

5. 3.5. Social and Economic Value of Insurance.

 After studying this chapter you should be able to:
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1. Define insurance from different point of view

Learning Objectives

2. Appreciate the functions of insurance.

3. List and describe basic characteristics of insurance.

4. List and Explain the requirements of insurable risks

5. Recognize insurance, gambling and speculation.

6. Appreciate the Cost and benefits of insurance

 3.1. Definition & functions of Insurance
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3.1.1. Definitions of insurance from the view point of:

1. Individual: An economic device to transfer risk

Definitions

2. Social: A device to reduction or elimination risk

3. Functional: A cooperative device to share risk

4. Contractual: A contract between insured and insurer

 3.1.1. Definitions of insurance from the view point of:
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I. Insurance defined from the individual point of

view.
 Individual : An economic device to transfer risk
Definitions –1

 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.
 Economic Device
 Transfer Risk
 A Small Certain Cost (The Premium)
 A Large Uncertain Financial Loss
 People thought about insurance !!!
 3.1.1. Definitions of insurance from the view point of:
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II. Insurance defined from the society point of view.

 Social: A device to reduction or elimination risk
 From the social point of view, insurance is an economic device
Definitions - 2

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.

 Economic device
 Reduction or elimination risk
 Through the process of combining a sufficient number
(pooling)
 Homogeneous exposures
 To make the losses predictable
 3.1.1. Definitions of insurance from the view point of:
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III. Insurance defined from the Functional point of view.

 Functional: A cooperative device to share risk
 “Insurance is a co-operative device to spread the
Definitions - 3

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”.
 Example: local saying
 Co-operative device
 Poling/ spreading loss
 Similar exposure
 3.1. Definition & basic Characteristics of Insurance
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IV. Insurance defined from THE contractual point of view.

 Contractual : A contract between insured and insurer
 Insurance contract may be defined as a contract by which one
Definitions - 4

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.
 Contract
 Two Parties:
1. Insurer/insurance company
2. Insured
 Mutual Agreement
 Indemnification / compensation
 3.1. Definition & functions of insurance
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3.1.2. FUNCTIONS OF INSURANCE

Primary Functions

Primary functions of insurance

1. Insurance provides certainty of payment against uncertainty of loss
2. Insurance provides financial protection against probable loss.
 Insurance will not control loss

3. Risk sharing amongst the members of insurance.

 Ancient times
 This days based on probability of loss
 Con’t
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Secondary functions of insurance

Secondary functions

1. Insurance prevents (frequency) loss

1. Why ?
2. How ?
3. With whom ?
2. Insurance provides capital for the society.
3. Insurance reduce anxiety ( fear and worry).
4. Insurance enhances efficiency of individuals
5. Insurance enhances economic growth of a country
 3.2. Basic Characteristics Of Insurance
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1. Pooling Of Loss: Sharing, spreading, combination

Basic Characteristics

2. Risk Transfer: From insured to insurer

3. Payment For Accidental Losses: Except life …….with

4. Indemnification: Compensation.
 3.2. Basic Characteristics of Insurance (con’t…..)
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1. Pooling Of Loss:
Basic Characteristics con’t

 Pooling Means: Spreading of losses incurred by the

few over the entire group, so that in the process,
average loss is substituted for actual loss

 The other name of pooling is sharing, spreading,

combination of loss.

 Pooling involves large number of homogeneous

exposure units
A. Large number of exposure units
B. Homogeneous exposure units
 3.2. Basic Characteristics of Insurance (con’t…..)
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A. Pooling involves Large number of exposure units

Basic Characteristics con’t

 Why? Guess what?

 For Prediction of future losses with some accuracy
 How?
 Through the law of large numbers
 It (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.

 Example : Tossing a coin

 Look at the expected and observed probability and the resulting

deference in prediction given different tosses
 3.2. Basic Characteristics of Insurance (con’t…..)
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B. Pooling involves Homogeneous exposure units

Basic Characteristics con’t

What do we mean by Homogeneous exposure ?

 Examples :
 Personal auto
 Commercial auto
 Health
 Life insurance

Why we need units to be Homogeneous exposure ?

 For a fair and equitable premium and indemnification

 3.2. Basic Characteristics of Insurance (con’t…..)
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2. Payment of fortuitous losses

Basic Characteristics con’t

 The second characteristic of private insurance is the 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.

 The law of large numbers is based on the assumption that

losses are accidental and occur randomly.
 3.2. Basic Characteristics of Insurance (con’t…..)
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3. Risk Transfer
Basic Characteristics con’t

 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.

Example:
 From the view point of the individual, pure risks that are
typically transferred to insurers include the risk of
 Personal: Premature death, poor health, disability,
 Property: Destruction and theft of property, and
 Liability: lawsuits: product liability risk
 3.2. Basic Characteristics of Insurance (con’t…..)
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4. Indemnification
Basic Characteristics con’t

Indemnification means that the insured is resorted to his or her

approximate financial position prior to the occurrence of the loss.
 ?
Example:
 Thus, if your house burns in a fire, the homeowner’s policy will
indemnify you or restore you to your previous position.
 Example:
 Personal: Premature death, poor health, disability,
 Property: Destruction and theft of property, and
 Liability: If you are sued because of the negligent operation of an
automobile, your automobile liability insurance policy will pay those
sums that you are legally obligated to pay.
 3.3. Requirements of insurable risk
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 Risk management deals with pure risk exposure and consequently

insurance normally insure/deals only with pure risk exposures.
Elements/requirements

 Yet, 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.
1. There must be a large no of homogeneous exposure units

2. The loss must be accidental and unintentional

3. The loss must be determinable and measurable.

4. The loss should not the catastrophic

5. The chance of loss must be calculable

6. The premium must be economically feasible

 # 1. There must be a large no of homogeneous exposure units
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Large number:
Elements/requirements

 For easy prediction of future loss with some accuracy.

 Homogeneous exposure:
 For fair and equitable collection of premium.
 # 2. The Loss Must Be Accidental
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Elements/requirements

The loss must be :

 Accidental
 Unintentional
 Unforeseen

Except:
 Life insurance intentional self suicide after 2 years of
protection.
 # 3. The Loss Must Not Be Catastrophic
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Elements/requirements

 Meaning of Catastrophic risk:

 A risk that may cause a loss on a the majority or the entire
member of the insurance.

 Other way of covering catastrophic loss

 Re-insurance
 Distributing loss to large geographic area
 # 4. The Loss should be determinable and measurable.
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Elements/requirements

This means the loss must be definite as to :

 Cause
 Place
 Time
 Amount

Example:
Death Vs Disability
1. Cause ? ?
2. Place ? ?
3. Time ? ?
4. Amount ? ?
 # 5. The Loss Must be easily calculable
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Elements/requirements

Calculable In terms of
 Frequency and
 Severity

So that
 pure premium
 operating expanse
 profit margin and finally
 gross (total) premium will be determined

Example
 # 6. The premium should be economically feasible
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Elements/requirements

Premium should be economically:

 Feasible
 Affordable
 Attractive
 And lesser than the amount that is surmised to be paid
 3.4. Insurance Vs Gambling and Speculation
3.4.1. Insurance Vs Gambling

Insurance Gambling

Deals an already existing risks.  Create new speculative risk

 Socially productive
 Socially unproductive

 Both parties have a common interest

to reduce the risk.  Parties have antagonistic
interest

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 3.4.2. Insurance Vs speculation

Insurance Speculation
 Similarity  Similarity
 No new risk creation
 Risk transfer
 Subject for probability

 Difference
 Transfer pure risk
 Reduce objective risk with the
help of the LLN
 Difference
 Transfer speculative risk
 It is a mere transfer of
risk
3.5. Cost and Benefits of Insurance

Benefits Costs

 Indemnification  Cost of doing insurance

 Loss prevention
 Inflated/ exaggerated
 Reduction of fear and worry
claims
 Provision of capital

 Enhancement of credit
 Fraudulent claims
End!