CHAPTER THREE: OVERVIEW OF INSURANCE

3.1. Definition of Insurance

 There is no single definition of insurance. Insurance can be defined from the viewpoint of
several disciplines, including law, economics, history, risk theory, and sociology.

 For example, from an economic viewpoint, insurance is a system for reducing financial risk
by transferring it from a policy owner to an insurer.

 From social aspect of insurance involves the collective bearing of losses through
contributions by all members of a group to pay for losses suffered by some group members.
 From a legal standpoint, an insurance contract (policy) transfers a risk, for a premium
(consideration), from one party (the policy owner) to another party (the insurer).

 According to 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.

 Insurance is designed to protect the financial well-being of an individual, company or other

entity in the case of unexpected loss. Insurance is a promise of compensation for specific
potential future losses in exchange for a periodic payment.
 3.2. Basic Characteristics of Insurance

1. Pooling of loss
 Insurance is based on a mechanism called risk pooling, or a group
sharing of losses.
 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.
 Insurance collects and pools the premiums of thousands of
people, spreading the risk of losses across the entire pool.
 By carefully calculating the probability of losses that will be
sustained by the members of the pool, insurance companies can
equitably (fairly) spread the cost of the losses to all the members.
 The risk of loss is transferred from one to many and shared by all
insured’s in the pool.
 Cont…

2. 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
.
3. Risk Transfer
 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.
 From the view point of individual, pure risk that are typically transferred to
insurer include, the risk of premature death, poor health, disability, destruction
and theft of property and personal liability lawsuits.

4. Indemnification: It means that the insured is restored to his or her approximate

financial position prior to the occurrence of the loss. For example, if the home of
insured burns in fire, homeowner policy will indemnify or restore the insured to
previous positions.
 3.3. Fundamentals/ Requirements/ of insurable risk

From the view point of insurer, there are ideally six requirements of insurable risks. These are:
1.There must be a large number of exposure units.
 Ideally, there should be a large group of roughly similar, but not necessarily identical,
exposure units that are subject to the same peril or group of perils.
2. The loss must be accidental and unintentional.
A second requirement is that the loss should be accidental and unintentional; w/c means, the
loss should be fortuitous and outside the insured's control.
3. The loss must be determinable and measurable.
The third requirement is that the loss should be both determinable and measureable. This
means Loss should be definite as to cause, time, place, and amount.
4. The loss should not be catastrophic.
The fourth requirement is that ideally the loss should not be catastrophic. This means that a
large proportion of exposure units should not incur losses at the same time.
5. The chance of loss must be calculable.
The insurer must be able to calculate both the average frequency and the average severity of
future losses with some accuracy. This requirement is necessary so that a proper premium can
be charged that is sufficient to pay all claims and expenses
6. The premium must be economically feasible.
The premiums paid by the insured must be substantially less than the face value, or amount,
of the policy.
 3.4. Insurance and Gambling Compared

 Some people claim that insurance is a gamble. However, Insurance is actually the
opposite of gambling. The following are the differences between insurance and
gambling.
A. Gambling creates a new speculative risk, while insurance is used for managing an
already existing pure risk. No new risk is created by the insurance transaction.

B. Gambling is a win-lose situation because one person wins while the other loses.
But Insurance is a win-win situation because both the insurer and the insured have a
common interest in the prevention of loss. Both parties win if the loss does not occur.

C. In the case of gambling, the loss is created intentionally while in the case of
insurance the loss is accidental.

D. Gambling transactions never restore the losers to their former financial position.
In contrast, if loss occurs, insurance contracts restore the position of the insured
financially in whole or in part.
 3.5. Insurance and Speculation Compared

 Both are similar in that risk is transferred. However, there are

some important differences exist between them.

 Insurance transfer risks that are insurable since the

requirements of an insurable risk generally can be met. While
speculation is a technique for handling risks that are typically
uninsurable.

 Insurance can reduce the risk of an insurer by application of

the law of large numbers, but speculation only involves
transfer of risks and not reduction of risk.
 3.6. Benefits and Cost of Insurance to the society

3.6.1 Benefits of Insurance to society

1. Indemnification of losses: The primary objective of insurance is
to provide financial compensation to those insured who suffered
accidental losses.
 The essence of insurance is the principle of indemnity, means that
the person who suffers a financial loss is restored to his/her
approximate financial position prior to the occurrence of the loss.
2. Less worry and fear(Peace of mind):
 Insurance promise the insured to indemnify
 The insured is certain regarding the payment of loss.
 Insured is less worry and fear regarding to risk of accident.
 Business and individual may promote economic efficiency.
 3. Source of Investment Funds

 Insurance enables savings of individuals to accumulate with the insurance

companies by way of premium received. These funds are invested in securities
issued by big companies as well as Government. E.g. Individuals who insure their
lives to cover the risks of old age and death are induced to save a part of their
current income, which is by itself of great importance.
4. Loss control
 The system of rating, which rewards risk prevention measures with lower
premiums, encourages loss prevention. E.g Workplaces implement health and
safety measures, drivers drive more carefully; homeowners install burglar alarms
etc. Society would suffer greater losses if it were not for these measures.
5. Reduce cost of capital: leads to increase investment this leads to increases
production again this leads to decrease price of product finally this leads to
increasing living standard of society
6. Enhancement of credit
- Aid to small business: due to the existence of insurance small business firm
can compete with large business firm.
E.g. if big business firm unfortunately exposed to risk in the market, they may cover
some amount of money lost, while small business is not
 3.6.2 Cost of Insurance to the society

1. Cost of doing business(operating expense)

 loss adjustment cost

 loss control cost

 administrative expense

 contingency loss
2. Loss that are intentionally caused. (fraudulent claims)
*Moral hazard
3. Inflated claims
 Attorney for plaintiffs may seek high liability judgements.

 Physicians may charge above average fees

 Disabled persons may malinger to collect disability income benefits for a longer duration.