CHAPTER THREE

INSURANCE

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OVE RVIEWOF INS URANCE

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What is Insurance?
 Insurance stands for the pooling of fortuitous
losses via transfer of such risk to insurer who
agrees to indemnify the insured against such
losses ,to provide other pecuniary benefits or
to render services that are connected with the
risk.
 Insurance is an arrangement by which an

entity substitutes a small certain cost with a

large un certain loss.

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What is insurance?
Insurance may be defined in economic,
legal business, social point of view as
follows:

Legal point of view: insurance is a contract

by which one party, in consideration of the price
paid to him adequate to the risk, becomes
security to the other that he shall not suffer
loss, damage or prejudices by the happening of
the perils specified in the policy.

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In economic sense: insurance is
an important tool that provide certainty or
predictability aiming at reducing uncertainty
in regard to pure risks. It accomplishes this
result by pooling or sharing of risk.

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 Business Point of views: as a
business institution, insurance has been
defined as a plan by which large number of
people associate themselves and transfer
risks of individuals to the shoulders of all
members of the policy.

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 Social View Point: insurance is
defined as a social device for making
payment for the accumulation of fund to
meet uncertain losses of capital which is
carried out through the transfer of risk of
many individuals to one person or a group of
persons. It is a device through which few
unfortunates are paid by many who are
member of the policy.

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Basic characteristics of insurance
1. Pooling of losses: spreading of
losses incurred by few over the entire
group.
2. Payment of fortuitous losses:
fortuitous loss means unforeseen or
unexpected loss.
3. Risk transfer
4. Indemnifications

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FUNCTIONS OF INSURANCE

Primary Functions
 Insurance provides certainty.

 Insurance provides protection.

 Risk-sharing.

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Secondary Functions
 Prevention of loss.
 It provides capital.
 It improves efficiency.
 It helps in economic progress

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INSURANCE, GAMBLING AND SPECULATION

INSURANCE Vs GAMBLING
* Gambling is socially unproductive. In
contrast, insurance is always socially
productive.
* In gambling there is a possibility of gain
where as the man who insures the risk is not
expected to make a gain out of the insurance
transaction.

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* The man who gambles accepts deliberately
the risk of loss in exchange for the possibility
of profit.Where as the man who insures
accepts deliberately the certainty of a small
loss in exchange for the freedom from risk of
devastating catastrophic loss;
* The gambler bears the risk while the insured
transfers the risk

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*Gambling creates risks which did not exist
previously where as insurance protects the
insured against a risk which was already in
being.

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INSURANCE VS SPECULATION
 Through speculation, individuals enter
into a risk deliberately in the
anticipation of profits;
 Speculation is a technique for

handling risks that are typically

uninsurable.
 Insurance can reduce the objective

risk of an insurer by the application of

the law of large numbers
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CHARACTERISTICS OF INSURABLE RISK

 Not all risks are commercially insurable

 From the viewpoint of the insurer, there are

ideally six requisites of insurable risk.

1. Large Number of exposure units.

2. Accidental and Unintentional Loss.

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3. Determinable and measurable

4. No catastrophic Loss

5. Calculable chance of loss

6. Economically Feasible Premiums

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SOCIAL AND ECONOMIC VALUES OF INSURANCE

1. Risk transfer/Indemnification
2. Reduction of Uncertainty
3. Encourages Savings
4. Help Businesses Continue Without
Interruption of Operation
5. Provide Funds for Investment
6. Keeps Families Together

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 7. Provides Basis for Credit
8. Promotes Loss Control Systems
9. It provides Financial Stability to the
Community .
10. Stimulates International Trade and
Commerce
11. It affords peace of mind

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Disadvantages/ Costs of Insurance

Problems associated with insurance includes:

1. moral hazard problems
2. morale hazard problems

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 Cost of Insurance: insurers incur operating
expenses such as loss control costs, expense
involved in acquiring insured including
advertisement costs, state premium taxes,
and general administrative costs.

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Functions and organizations of
insurance
 Some of the common functions performed in
almost all insurance companies include:
A. Production function (Selling insurance
policy)
B. Underwriting(Selection of risk)
C. Rate making(Insurance pricing)
D. Managing claims(Loss settlements)
E. Finance and investments
F. Miscellaneous services like legal aid and
more

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BASIC PRINCIPLES OF INSURANCE

 A)The principle of Insurable Interest : refers

to the existence of financial relationship to
the subject matter insured. The insured must
have some legally recognized relationship
with the subject matter insured.

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 Generally in the case of life
insurance insurable interest must
exist at the inception of the
policy. In the case of property
insurance insurable interest must
exist at the time of loss.

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B) The principle of Indemnity:
 The principle of indemnity states that the

insured, in the event of loss, receives

financial compensation equal to the amount
of the loss or the face value of the policy. The
insured is only restored to his or her previous
financial position. Meaning , the insured
should not profit from the loss.

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 The principle of indemnity is not applicable to
personal (life)insurances.
 C) The principle of Subrogation

. It is the right of one person (the insurer) to

stand in the place of another (the insured) to
avail himself on the latter's rights and
remedies.

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D) Utmost good-faith

This means that a higher degree of honesty is

imposed on both parties to an insurance
contract than is imposed on parties to other
contracts.
The three legal doctrines of this principle are:
1. Representation: is the statement made by
an applicant for insurance. An insurance
contract is voidable at the insurer's option if
the representation is material and false.

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 2. Concealment: refers to non –disclosure.
Silence when obliged to speak.
3. Warranty : breach of warranty leads to
cancelation of contract.
E) The principle of Contribution
calls for an "equitable distribution" of any loss
among multiple insurers.

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REQUIREMENTS OF AN INSURANCE CONTRACT

 An insurance to be legally enforceable

contract, must meet four basic requirements:
1. Offer and Acceptance : in most cases, the
applicant for insurance makes the offer and
the company accepts or rejects the offer. A
binder is a temporary contract for insurance
and can be either written or oral.

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 2. Consideration: Consideration refers to the
value that each party gives to the other.
3. Competent Parties: this means the parties
must have legal capacity to enter into a
binding contract.
4. Legal Purpose. A final requirement is that
the contract must be for a legal purpose.

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DISTINCT LEGAL CHARACTERISTICS OF INSURANCE CONTRACTS

1. Aleatory Contract: is one in which the

values exchanged are not equal.
2. Unilateral Contract: means that only one
party makes a legally enforceable promise. In
this case, only the insurer .
3. Conditional Contract: this means the
insurer's obligation to pay a claim depends
on whether or not the insured or the
beneficiary has complied with all policy
conditions.

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4. Personal Contract: this means the
contract is between the insured and the
insurer.
5. Contract of Adhesion. 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.

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6. Contracts of Uberrimae Fidei
 is utmost good faith that can be restated as

the highest standard honesty.

7. Contract of Indemnity

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 CHAPTER FOUR
MAJOR CLASSIFICATIONS OF INSURANCE

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Insurance can broadly be classified in to two
fundamental classes:
A. Life insurance

B. Non Life Insurance

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The difference between life insurance and general
insurance (non-life insurance)

 Risk
 Indemnity
 Insurable interest
 Procedural arrangements
 Premium and sum assured Computations
 Insurance elements

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Life Insurance Policies
 Ordinary Life insurance

 Health insurance

 Disability income insurance

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Life insurance
 It is a valued policy that pays a stated sum to
a named beneficiary at the event of death or
to the insured him/herself up on survival.
 It is an all risk contract covering all perils

leading to the premature death of a person.

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Basic characteristics of life
insurance
 It is not a contract of indemnity.
 It is a valued policy
 The insurer considers age, gender,

occupation etc prior to setting premium.

 The insured and policy owner may be

different.
 The probability of claim increases with the

passage of time.

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Underwriting in life insurance
 Underwriting refers to the process of
selecting and classifying applicants for
insurance. Applicants who meet the
underwriting standards are insured at a
standard rate.
 Under writing is used to avoid adverse

selection.

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Factors to be considered in
underwriting
 Age
 Gender
 Physical condition
 Personal and Family medical histories.
 Occupation
 Financial position(Personal income)
 Habits
 Avocation(Leisure time activities)

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Important terms in life insurance
 Death Benefit (Sum assured)- Amount
beneficiaries receive.
 Cash Value -Amount of savings

accumulation.
 Face Value

It is the death benefit (for term, Whole life,

etc)
It is the death benefit minus cash value

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Types of Life Insurance

A. Whole life insurance

B. Endowment Insurance

C. Term Insurance

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Term Insurance

Basic features:
 It provides protection for a temporary
period.
 Most of term policies are renewable.
 Most term policies are convertible.
 It has no cash value/savings element.
 They are relatively cheap.
 Can be of single premium or level
premium

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Types of Term Insurance

1. Level Term Insurance

2. Decreasing Term Insurance
3. Increasing Term Insurance
4. Renewable Term Insurance
5. Convertible Term Insurance
6. Non-Convertible Term Insurance
7. Re-entry Term Insurance

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Whole Life Insurance
General characteristics
It provides Life time protection
It has mutual advantages of saving and
protection.
It has additional merits of cash surrender
value, non forfeiture, dividend,investment
etc

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Types of Whole Life Insurance

The three types of WLI are:

A. Ordinary Life Insurance

B. Limited pay Life Insurance

C. Single Payment Life Insurance

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Endowment Insurance Policy
General characteristics
It provides temporary protection.
It has mutual advantages of saving and
protection.
It has surrender option, loan provision,
dividend, settlement etc
High premium

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Supplementary Insurance Contracts (Riders)

 Supplementary accidents insurance

 Disability and Waiver of premium benefits

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 Chapter 5
Life Insurance Premium
Calculations
In general, premium must be sufficient to:
Cover expected claims
Create an estimate for outstanding claims
Provide a reserve

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 Meet all expenses
Provide for profit
Variables to be considered in insurance
pricing:
 Inflation
 Interest rates
 Exchange rates
 Competition

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Assumption
 The basic assumption is that premiums are
collected at the beginning of the year and
benefits are to be settled at the end of the
year.

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 PREMIUM TERMS

Net premium
 Considers only the mortality rate and rate of

interest.
 Ignores operating costs charged by the

insurer.
 Provides the insurer only with the amount of

money required to pay death claims.

 Could be single or level premium.

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 Net Single Premium
 Is the net premium to be paid as a single sum

at the beginning of the contract

 The present value of the future death benefits
 It is sum that, together with compound

interest, will be sufficient to pay all death

claims

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 Net Level Premium
 A premium charge that doesn't change from

year to year throughout the term of the policy

Loading
 The amount that must be added to the pure

premium for expenses, profit, and a margin

for contingencies.

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 GROSS PREMIUM
 GP = PP + LP (GP)

Where: GP = gross premium

PP = pure premium
LP = loading percentage

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Computing Net Single Premium

◦ The information required to calculate net single

premium are:
 Age and gender of the insured;
 Mortality rate;
 Interest rate; and
 Amount of insurance policy

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Net Single Premium
Example 1
An insurer issued a one year term insurance for
100,000 men aged 30 for a death benefit of
Birr 10,000 each. Assume that the interest
rate is 10% and each insured brings the same
level of risk. The Mortality table is provided
below:

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Age Mortality rate (for each 1000 life)

30 1.73

31 1.78

32 1.83

33 1.89

34 1.95

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 Required
 : Assume that the insurer issued a one year
term insurance policy, Calculate the Net
Single Premium to be paid by the insured's?

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Net Single Premium
Example 2
 Consider the following information
 3 Years term policy
 Policy amount = 5,000 to be paid at the end

of the year.
 Number of policyholders at age 30 =

958,000.
 Interest rate = 10%

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 Mortality rate, male, 1990.
Age Numberof Number of Probability
Yea

living dying of dying

r

1 30 958,000 1657 0.00173

2 31 956,343 1702 0.00178
3 32 954,641 1747 0.00183

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Mortality rate, male, 1990.
Ag Number Number Probabilit
Year

e of living of dying yof dying

1 30 958,000 1657 0.00173

2 31 956,343 1702 0.00178
3 32 954,641 1747 0.00183

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Expected death claims
Age Number of Policy Expected
Year

Dying Amount Annual death

claims
1 30 1657 5,000 8,285,000
2 31 1702 5,000 8,510,000
3 32 1747 5,000 8,735,000
Total expected death claims Br.25, 530,000

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1 2 3 4 = (2*3) 5 6 = (4/5)
Year Expected PV PV of No. of Annual
Annual Death Factor at Annual Insured net
Claims 10% Claims Premium
1 8,285,000 0.9091 7,531,893.5 958,000 7.862
2 8,510,000 0.8264 7,032,664 958,000 7.341
3 8,735,000 0.7513 6,562,605.5 958,000 6.850
25,530,000 21,127,16 22.053
3

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 Net single premium = 21127163/958,000
= 22.053

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Amortization table

Year Beg. Interest at Beginning Death Ending

Balance 10 % balance + Interest claims balance

1 21,127,163 2,112,716.3 23,239,879.3 8,285,00 14,954,879.3

0

2 14,954,879.3 1,495,487.93 16,450,367.23 8,510,00 7,940,367.23

0

3 7,940,367.23 794,036.72 8,734,403.95 8,735,00 (596.05) *

0

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 ◦Net Level Premium
 In this case the policyholders will pay annual
premiums of equal size.
 Consider the following three major points:

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NLP
 Not all the policyholders will pay the
annual level premiums (Since some of
them are expected to die before the end of
the term).
 The insurer will collect a limited amount of
money to invest at the very beginning of
the policy.
 The total annual level premiums paid by a
policyholder under the level scheme will be
greater than the single net premium.


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Here, cause it is difficult to compute we
assume that the insured pays a level premium
of 1 birr every year.

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Year Age No. of PV of Br.1payable PV of Birr.1
Insured at beginning of premium
year
1 30 958,000 1 958,000
2 31 956,343 0.9091 869,411
3 32 954,641 0.8264 788,915
Total 2,616,326

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 Premium Payment per insured
= 2,616,326/958,000
= 2.731

Desired annual premium = Net Single Premium

PV of Br. 1 Premium
Payment
= 22.05/2.73
= 8.075

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Endowment premium computation
 Endowment policy has saving and protection
advantages.
 Ordinary Endowment = Term insurance

policy+ Pure endowment.

 Pure endowment(PE): pays the sum only if the

insured survives the endowment period.

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Example
◦ A person at age 25 purchased a 5-year ordinary
endowment policy for Br. 1,500. Interest rate is 15%
annually.
◦ A portion of the Mortality Table presented below is
to be used for the calculation of the pure premium.

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Age Number Living Number Dying
25 966301 1710
26 964591 1669
27 962922 1647
28 961275 1634

29 959641 1641
30 958000

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◦ Net Single Premium (NSP)
Probability values for death and survival, present
value factors, expected death claims and maturity
claims are calculated presented below.

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Ag Prob.of Prob.of PV Expecte
e Deathin surviving the factor @ d Death
each policy policy period 15% Claim
period
25 1710/966301 0.8696 2565000
26 1669/966301 0.7561 2503500
27 1647/966301 0.6575 2470500
28 1634/966301 0.5718 2451000
29 1641/966301 0.4972 2461500
30 958000 958000/966301 0.4972 1437000000
= 0.99141

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 The Net Single Premium for an ordinary endowment
policy is composed of two parts:
 NSP for the term life component; and
 NSP for the pure endowment part.

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NS = 1500 1500 1500 1500 1500 1500
P x x x x x x
0.001 0.0017 0.0017 0.001 0.0016 0.9914
77 27 04 77 98 1
x x x x x x
0.869 0.7561 0.6575 0.571 0.4972 0.4972
6 8

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= 2.31 1.96 1.68 1.45 1.27 7
3
9.
3
6

= 8.67 7 7
3 4
9. 8.
3 0
6 3

P. Total
E Premium
P
re
m
Total Life Premium iu
m

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◦ Net level Premium (NLP)

Prob. of PV Factor PV of Expected

Collecting birr 1 Collection
Level Premium
1 1 1.0000
0.9982 0.8696 0.8681
0.9965 0.7561 0.7535
0.9948 0.6575 0.6541
0.9931 0.5718 0.5679
3.8435

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• The NLP for the term life part of the policy is
therefore Br. 2.2545 (8.665/3.843).
◦ The NLP for the pure endowment part of the policy
is therefore Br. 192.369 (739.36/3.8435)
• The NLP premium for the ordinary endowment
policy is:
= NPL term Life+ NPL pure endowment
= 2.255 + 192.369
=194.624


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Example 2
 An insurer issued an ordinary endowment
policy for 100,000 males with a face amount
of birr 1000 for 5 years. The policy is issued
at the age of 30 at 10% interest rate. The
mortality table is given below.
Age Mortality rate(for each 1000
life)
30 1.73
31 1.78
32 1.83
33 1.89
34 1.95
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Required
A. Calculate the NSP of the policy.
B. Calculate the NLP of the policy.

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Claim settlement in life insurance
Steps
 1st Notification of claims
 2nd Investigation of claims
 3rd Acceptance or rejection of claims

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EXERCISE
 According to the 1980 cso mortality
table ,out of an initial population size of
1,000,000 the number of people living at age
40 is 937723.Data on the number of people
dying at the respective age are given as
follow:

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 Age No. dying
40 2832
41 3076
42 3127
43 3594
Assume all people at age 40 purchased a
three year term life insurance for birr 3000
at an interest rate of 10%

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REQUIRED
A. Calculate the Net Single Premium (NSP).
B. Calculate the Net Level Premium (NLP).
Assume further that each insureds at age 40
acquired a 3 year endowment life insurance
instead of term life insurance, compute:
C. The Net Single Premium.
D. The Net Level Premium.

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Health Insurance
 Is the type of insurance that provides
indemnification for expenditures and loss of
income resulting from loss of health.
There are two types of insurance in the
generic term of health insurance.
 Disability income insurance

 Medical expense insurance.

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 Disability income insurance is a form of
health insurance that provides periodic
payments when the insured is unable to work
as a result of illness or injury.
 Medical expenses insurance includes payment
of the cost of medical care that results from
sickness and injury.

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 Medical expense insurance is divided into four
major classes:
 Hospitalization expense contract
 Surgical expense contract
 Regular medical expense contract
 Major medical expense contract

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Non Life Insurance
 Refers to any other insurance which does not
cover the risk of life loss.
It includes:
 Motor Insurance
 Burglary and House breaking insurance
 Fire and lightening insurance
 Marine Insurance
 Aviation insurance
 Pecuniary insurance (including Fidelity

Guarantee Insurance ) etc

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 Co-insurance
A co-insurance clause in a property insurance
requires the insurer to insure the property for
a certain stated % age of its insurable value.
Amount of recovery = Amount of insurance carried X Actual
loss Amount of insurance required

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Eg. Insurable value = 10,000br
Amount of insurance carried(coverage)
= 6000br
Co-insurance clause 80% of the insurable
value.
Actual loss = 4000br
Required: Compute the amount recoverable
from the insurance company.

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Eg 2. An asset has an insurable value of
15,000br and each insurance policy contains
an 80% co-insurance clause .
Determine the amount recoverable from the
insurance co. in case below.
Policy Insurance Loss incurred (Br)
coverage(Br)
1 9000 6000

2 12000 9000

3 12000 14000

4 14000 10000

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END OF CONCEPTS OF
INSURANCE

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