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 CHAPTER 3
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INSURANCE

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What is Insurance?
› There is no single definition of insurance.
› American Risk & Insurance Association has defined
insurance as follows:
✓ Insurance is pooling of accidental losses by transfer of
such risks to insurers, who agree to indemnify insured
for such losses, to provide other financial benefits on
their occurrence, or to render services connected with
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the risk.
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Cont’d
› Insurance may be defined in various ways:

› Firstly, from individual point view it may be defined as a

risk transfer mechanism or an economic device whereby
a person, called insured transfers a risk of a possible
financial loss resulting from unforeseeable events
affecting property, life or body to a person called insurer
for consideration.
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Cont’d
› Secondly, from point of view of insurer,

insurance may be defined as a mechanism

through which a risk is distributed among group of

persons who are exposed to same type of risk, i.e.,

persons who bear risk of suffering a financial loss as

a result of events affecting property, life or body.AcFn

Cont’d
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› A formal social device for reducing risk by transferring

risks of several individual entities to an insurer.
› Insurer agrees, for a consideration, to assume, to a
specified extent, losses suffered by the insured.
› Pooling of accidental losses by transfer of such risks to
insurers, who agree to indemnify insured's for such
losses, to provide other financial benefits on their
occurrence, or to render services connected with risk.
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Cont’d

› A social device in which a group of individuals (called

“insured's”) transfer risk to another party (called an

“insurer”) in order to combine loss experience, which

permits statistical prediction of losses and provides for

payment of losses from funds contributed (premiums)

by all members who transferred risk. AcFn

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Insurance Terminology

› Insurance is an arrangement between an individual

(consumer) & an insurer (insurance company) to
protect the individual against risk.
› A policy is a contract between the individual & insurer
specifying terms of insurance arrangements
› A policyholder is a consumer who purchases policy
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Cont’d
› A premium is a fee paid to insurer to be covered
under specified terms
› A deductible is amount paid out of pocket by policy
holder for initial portion of a loss before insurance
coverage begins
› Risk is uncertainty about a situation’s outcome
▪ This can be unpredictable events which lead to loss or
damage
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Cont’d
› Underwriting:
› Process of selecting risks (insurance applicants) &
classifying them according to their degrees of insurability so
that appropriate rates may be assigned.
› Process also includes rejection of those risks that do not
qualify.
› Note: insurance profits may come from both underwriting
and investment.
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Basic Characteristics of Insurance

› Pooling of losses:
› Spreading losses incurred by few over entire group
› Risk reduction based on the Law of Large Numbers
› Payment of fortuitous/Accidental losses:
› Insurance pays for losses that are unforeseen, unexpected, and occur as a
result of chance
› Risk transfer:
› A pure risk is transferred from insured to insurer, who typically is in a
stronger financial position
› Indemnification:
› Insured is restored to his or her approximate financial position prior to
occurrence of the loss
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Law of Large Numbers:

› The larger the number of separate-but-similar risks in a group,

more predictable future losses become.

› Insurance companies must predict losses on a group basis in

order to arrive at fair premiums for individuals within groups.

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Requirements of an Insurable Risk

› Large number of exposure units
➢ 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
› to predict average loss

› Accidental and unintentional loss

➢ Loss should be accidental and outside insured’s control

› to control moral hazard, to assure randomness AcFn
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Cont’d
› Determinable and measurable loss
➢ Loss should be definite as to cause, time, place & amount
› To facilitate loss adjustment; insurer must be able to determine if loss is covered
and if so, how much should be paid.

› No catastrophic loss
➢ Loss should not be catastrophic.
➢ This means that large proportion of exposure units should not incur
losses at the same time.
› To allow pooling technique to work

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Cont’d
› exposures to catastrophic loss can be managed by:
› dispersing coverage over a large geographic area, using reinsurance
› Calculable chance of loss
› to establish an adequate premium
› Economically feasible premium
› so people can afford to buy
› Premium must be substantially less than the face value of the
policy
❑Based on these requirements:
› Most personal, property and liability risks can be insured.
› Market risks, financial risks, production risks and political
risks are difficult to insure
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Insurance vs. Gambling

Gambling
Insurance
› Gambling creates a new
› Insurance is technique for
speculative risk
handling already existing pure › Outcome of game is not
risk known
› Insurance is socially productive: › Gambling is not socially
productive
› both parties have a common
› Winner’s gain comes at
interest in the prevention of a
expense of loser
loss
› Gambler bears risk
› Insured transfers risk while
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Insurance vs. Speculation

Insurance: Speculation:
› It deals with speculative risk.
› Insurers insure pure risks.
› Speculating involves taking
› Paying a premium to
on risk in order to profit from
protect against unfavorable
insight based price
event under conditions of
movements.
uncertainty.

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Benefits and Costs of Insurance

› Insurance as a mechanism of transfer of risk has great
economic and social benefits to individual insured, his family &
country in general.
› The following are some of the major benefits:
Benefits of Insurance to society:
› Indemnification for Loss:
› restores to their former financial position after a loss occurs
› Contributes to family and business stability
› Reduction of Worry and Fear:
› Insured's are less worried about losses AcFn
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› Source of Investment Funds

› Premiums may be invested, promoting economic growth
› Loss Prevention
› Insurers support loss-prevention activities that reduce direct and
indirect losses
› Enhancement of Credit
› Insured individuals are better credit risks than individuals without
insurance

Costs of Insurance to society:

› Cost of Doing Business
› Insurers consume resources in providing insurance to society
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› An expense loading is amount needed to pay all expenses,

including commissions, general administrative expenses, state

premium taxes, acquisition expenses, and an allowance for

contingencies and profit

› Cost of Fraudulent and Inflated Claims

› Payment of fraudulent or inflated claims results in higher

premiums to all insured's, thus reducing disposable income and

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consumption of other goods and services

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Functions and Organization of Insurers

› Production (Selling)
› Underwriting (Selection of Risks)
› Rate Making
› Managing Claims
› Investment
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❖ Production

➢ Securing a sufficient number of applicants for insurance to

enable the company to operate.
❖ Underwriting

➢ Underwriting is the process of selecting risks offered to the

insurer.
➢ Unless the company selects form among its applicants, the
inevitable result will be adverse to the company

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Cont’d
› Hence, the main responsibility of the underwriter is to guard
against adverse selection.
➢ Process of Underwriting
› The underwriter must obtain as much information about the
subject of the insurance as possible within the limitations
imposed by time and the cost obtaining additional data.

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Cont’d

› Four sources from which the underwriter obtains information:-

➢ The Application

➢ Information from Agent or Broker

➢ Investigations

➢ Physical Examinations or Inspections

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Cont’d

❖Rate Making
› An insurance rate is the price per unit of insurance.

› The process of predicting future losses and future expenses,

and allocating these costs among various classes of insured's is

called rate making.

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Cont’d
› Make up of the Premiums
› A rate is the price charged for each unit of protection or
exposure and should be distinguished from a “Premium”,
which is determined by multiplying the rate by the number of
units of protection purchased.
› The unit of protection to which a rate applies differs for the
various lines of insurance.
› In life insurance, for example, rates are computed for each
1,000 birr in protection; in fire insurance the rate applies to
each 100 birr coverage AcFn
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Cont’d
› The insurance rate is the amount charged per unit of exposure.
› The premium is the product of the insurance rate and the number of
units of exposure.
› Thus, in life insurance, if the rate is 25 birr per 1,000 birr of face
amount of insurance, the premium for a 10,000 birr policy is 250
birr.
› The premium is designed to cover two major costs:
➢ The expected loss
➢ The cost of doing business AcFn
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Cont’d
› The pure premium is determined by dividing the total expected
loss by the number of exposures.
› In automobile insurance, for example, if an insurer expects to
pay 100,000 birr of collision loss claims in a given territory,
and there are 1,000 autos in the sued group, the pure premium
for collision will be 100 birr per car, computer as follows:
Expected Loss Br.100,000 =Br.100
› Pure Premium = Exposure Units 1,000

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Cont’d
› The sum of the pure premium and loading is termed as the
gross premium.
› The loading is made up of such items as agents’ commissions,
general company expenses, taxes and fees, and allowances for
profit.

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Cont’d
› Usually the loading is expressed as a percentage of the
expected gross premium.
› In property – liability insurance, a typical loading might be
33.3%. The general formula for the gross premium, the
amount charged the consumer, is
Pure Premium
› Gross Premium = 1 – Loading Percentage
› In above example, where the pure premium was birr 100 per
car, the gross premium would be calculated as
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› Gross Premium = 100 Birr / 1-0.3333 = 150 Birr.
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Cont’d
› Two basic approaches to rate making, class and individual
rating are discusses below.
› Manual or Class Rating
➢ Apply uniformly to each exposure unit falling within some
predetermined class or group.
➢ Everyone falling within a given class is charged the same rate.
› Individual Rating
➢ Each insured is charged a unique premium based largely upon
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the judgment of the person setting the rate.
Cont…
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❖ Managing Claims / Loss Adjustment

➢ The basic purpose of insurance is to provide indemnity to the

members of the group who suffer losses.

➢ This is accomplished on the loss settlement process.

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Cont’d
❖ Investment Function
➢ Payment of premiums gives rise to funds held for
policyholders by the insurer, funds that must be invested in
some manner.
➢ Not all the money collected by the insurer is to be invested.
➢ A certain proportion of it should be kept aside to meet future
claims.

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Organization of Insurers
› Two basic forms of organization of insurers 

1.Single line or product organization

2. All-line organization.
› Single line insurance organizations are those who deal only
with the type business, say life insurance only.
› All-line organization refers to that type of arrangement by
which an insurer may write literally all lines of insurance under
one administrative frame work of a single organization,
example, the Ethiopian Insurance Corporation. (EIC) AcFn
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Thank You!!!

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