CHAPTER

THREE
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 OUTLINES
 Insurance Defined
 Basic characteristics of insurance
 Fundamentals of insurable risk
 Insurance and gambling compared
 Insurance and Speculation compared.
 Benefits and costs of insurance
 Benefits of insurance to the society
 Cost of insurance to society
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 Insurance Defi ned
Insurance is a contractual agreement two parties: the
between
insurer and the insured.
Under the agreement, the insurer agrees to reimburse loss (as
defined in the insurance contract) in return for the insured's
premium payment.
Insurance is a system used to handle risk (transfer) risk.
Insurance is a device used to spread the loss suffered by an
individual or firm to the members in the group.
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The following three points must be considered
regarding insurance contracts
1. There are usually two parties in the contract: the insurer
and the insured.
2. The insured transfers his risk to the insurer. To this effect,
he will have to pay premium.
3. If the specified risk materializes (happened to the
insurance), within a specified period, the insurer will
make fi nancial compensation to the insured or his
beneficiary.
The insured is restored to his former position called
Indemnifi cation.
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 Basic Characteristics of Insurance
An insurance plan or arrangement typically has
certain characteristics.
Pooling of losses
–Spreading losses incurred by the few overthe
entire group
–Risk reduction based on the Law of Large Numbers
Payment of fortuitous losses
–Insurance pays for losses that are
unforeseen,
unexpected, and occur as a result of chance
–The loss must be accidental 5
Risk transfer
– Only pure risk is transferred from the insured to the insurer,
who typically is in a stronger financial position

Indemnifi cation
– The insured is restored to his or her approximate
financial position prior to the occurrence of the loss

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 Fundamentals of insurable risks
🖝Not all risks are commercially insurable.
Insurers normally insure only pure risks.
However, not all pure risks are
insurable.
A risk could be considered an ideally insurable risk if
it satisfies the six conditions below.
1) There must be large number of exposure units
2) The loss must be accidental and unintentional
3) The loss must be determinable and measurable
4) The loss should not be catastrophic
5) The chance of loss must be calculable 7
1) There must be a large number of exposure units
– There must be a sufficiently large number of homogeneous exposure
units to make the losses reasonably predictable.
– Example: Large number of houses in a city can be insured
through property insurance on houses.
2) The loss must be accidental and unintentional
2) The loss must be the result of a contingency
3) The loss must not be something that is certain to happen
🖝Two reasons why the second requirement is necessary:
-1- To control moral hazard
• If theintentional loss paid by insurer, moral hazard be increased
would
substantially and the premiums would rise consequently (fake accident, fraudulent
claim, inflating the amount of a claim, Intentionally burning the unsold
merchandise). 8
-2- To assure randomness
–The loss should be accidental because the law of
large number is based on the random
occurrence of events whereby the intentional
loss is not a random event.
3) The loss must be determinable & measurable
–To facilitate loss adjustment
• Insurer must be able to determine if the loss is
covered and if so, how much should be paid.

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4) No catastrophic loss
– Losses occurred from earth quakes, floods and other natural disasters will
not be insured.
– The loss should not be catastrophic meaning that a large
number of exposure units should not incur losses at the same time
– To allow the pooling technique to work
– Exposures to catastrophic loss can be managed by:
• dispersing coverage over a large geographic area
• using reinsurance
5) 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
– To establish an adequate premium
6) Economically feasible premium
– The cost of insurance must not be high in relation to the possible loss.
– So people can afford to buy
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 QUESTIONS
? Dose the risk of Fire satisfy these
requirements?

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 Does the risk of fi re satisfy the requirements?
1. Large number of exposure units
2. Accidental and unintentional loss
3. Determinable and measurable loss
4. No catastrophic loss
5. Calculable chance of loss
6. Economically feasible premium
Yes. Numerous exposure units are present.
Yes. most fi re losses are accidental
Yes. It can be measurable
Yes.
Yes. Chance of fi re can be calculated, and the
average severity of a fi re loss can be
estimated in advance.
Yes. Premium rate of fi re insurance is
relatively low.
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 Adverse Selection and Insurance
• When the insurance is sold, insurers must deal with the problem of
Adverse Selection.
• Adverse selection is the tendency of persons with a higher
than- average chance of loss to seek insurance at standard rates “
Examples
1. High drivers who seek auto insurance at standard rates
2. Persons with serious health problems who seek life or
health insurance at standard rates
3. Business firms that have been repeatedly robbed or
burglarized seek crime insurance at standard rates.
Hence, insurance companies try to control adverse selection by:
– Careful underwriting (selection and classification of
applicants for insurance)
– Policy provisions
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 Insurance vs. Gambling
Insurance Gambling
• Insurance a • Gambling creates a
technique
is for handing new speculative risk
already existing pure
risk. • Gambling is not socially
• Insurance is socially productive
productive: –The winner’s gain comes
–both parties have a at the expense of the
common interest in the loser
prevention of a loss 14
 Insurance vs. Speculation
Insurance Speculation
• Risk transferred by • Risk is transferred by
contract
is a a contract
• Insurance involves the • Speculation involves
transfer of insurable risks risks that are typically
• Insurance can reduce the uninsurable
• Speculation involves
objective risk of an insurer risk transfer, not only
through the Law of Large reduction. risk
Numbers

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 Benefits and Costs of Insurance
Benefits of Insurance
Indemnifi cation for Loss
– Toprovide financial compensation to those insured who
suffered losses due to accidental misfortune
– Contributes to family and business stability
Source of Investment Funds
– Premiums may be invested, promoting economic growth
Reduction of Worry
– Insurance reduces the physical and mental stress
that insured’s face concerning the possibility or financial
loss.
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Encourages Saving
–In life insurance, certain policies have dual
advantages: Financial protection in the event of
death, and saving in the event of survival.
Enhances Efficient Utilization of Resources

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 Limitations of Insurance
Insurance deals with only pure risks.
- Not all pure risks are insurable.
- Examples include Flood, earthquake …
Cost of Doing Business
– Insurers consume resources in providing insurance to
society
– 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. 18
 Fraudulent Claims
Examples include the following:
Auto accidents are faked or staged to collect benefits.
Dishonest claimants fake slip-and-fall accidents.
Infl ated Claims
Another cost of insurance relates to the submission of
inflated or “padded” claims.
Although the loss is not intentionally caused by the insured,
the dollar amount of the claim may exceed the actual
financial loss.

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 END OF
CHAPTER
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