Overview of Insurance in Risk Mangement




Insurance  is  an  important  method  of  transferring  pure  loss  exposures  to  an  entity  better positioned  to  handle  these  risks.  But  what  is  insurance  and  how  does  insurance  work?  This chapter  analyse  the  insurance  mechanism.  You  will  learn  the  important  characteristics  of insurance and what conditions must be present for arisk to be privately insurable. Although  insurance  provides  many  benefits  to society, there are some costs associated with the use of insurance. These costs and benefits are discussed in this chapter.

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, actuarial science, 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.  The  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  business  point of  view,  insurance  is  a  financial arrangement that redistributes the costs of unexpected losses. Insurance involves the transfer of potential losses to an insurance pool, the pool combines all the potential losses and then transfers the cost of the predicted losses back to those exposed. Thus, insurance involves the transfer of loss exposures to an insurance pool, and redistribution of losses among the members of the pool.

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).  It  is a contractual arrangement in which the insurer agrees to pay a predetermined sum to a beneficiary in the event of the insured’s death. By virtue of a legally binding contract, the possibility of an unknown  large  financial  loss  is  exchanged  for  a  comparatively  small  certain  payment.  This contract is not a  guarantee  against a loss occurring, but a method of  ensuring that payment is made for a loss that does occur.

According  to  the  commission  on  insurance  terminology  of  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,  to  provide  other  pecuniary  benefits  on  their occurrence, or to render services connected with the risk. A promise of compensation for specific potential future losses in exchange for a periodic  payment. Insurance is designed to protect the financial  well-being  of  an  individual,  company  or  other  entity  in  the  case  of  unexpected  loss. Agreeing  to  the  terms  of  an  insurance  policy  creates  a  contract  between  the  insured  and  the insurer. In exchange for payments from the insured  (called premiums), the insurer agrees to pay the policy holder a sum of money upon the occurrence of a specific event.


Suppose Ethiopian  Insurance Corporation has sold 500,000 fire insurance policies, through its various branches i.e., policies that cover losses related to residential buildings so that the insurer will have to pay compensation to the insured or the beneficiary of the policy in case where such property is devastated by fire or lightening. The money collected from the sale of these policies form  the  pool  out  of  which  compensation  shall  be  paid  to  those  persons  who  have  suffered financial loss because of damage to the insured house. Let us say that in the given financial year 10,000 policyholders have sustained financial losses /or lost their properties because of various perils  which  are  covered  by  the  policy.  So,  the  insurer  according  to  the  obligation  it  has undertaken pays compensation to these policy holders out of the pool mentioned above, i.e., the price collected by the insurer from the sale of the policies (premium). In other words this means that all 500,000 policy holders who have paid the premium have contributed to the compensation paid  to  those  who  have  sustained  losses.  This  also  means  that,  the  insurer  has  distributed  the losses sustained by the 10,000 policyholders among  the remaining 490,000 policyholders whose properties were not damaged or destroyed in the given year.


3.2 Basic Characteristics of Insurance

Insurance  has  a  number  of  distinct  characteristics. These  characteristics  include:  pooling  of losses, payment of fortuitous losses, risk transfer, and indemnification of losses.

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. In addition, pooling involves the grouping of large number of exposure units so that the law of large number can operate to provide a  substantially  accurate prediction of future losses. Ideally, there should be a large number of similar, but not necessarily identical, exposure units that are subject to the same perils. People exposed to a risk agree to share losses on an equitable basis. They transfer the economic risk of loss to an insurance company. 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. Each person pays a premium that is measured to be fair to them and to all based on the risk they impose on the company and the pool (each class of policies should pay its own costs). If all insured’s contribute a fair amount to the loss of fund held by the insurance company, there will be sufficient dollars in the fund to pay the loss benefits of those insured’s that exposed for loss in the coming year.

Individually, we do not  know when  we  will exposed for  accident or loss, but statistically, the insurer can predict with great accuracy the number  of individuals that will incurred a loss in a large  group  of  individuals.  The  insurance  company  has  taken  uncertainty  on  any  individual’s part,  and  turned  it  into  a  certainty  on  their  part. Thus  pooling  implies:  Sharing  of  loss  by  the entire  group  and  prediction  of  future  losses  with  some  accuracy  based  on  the  law  of  large number.

Examples: The simplest illustration of risk pooling involves  providing life insurance for one year, with all members of the group the same age and possessing similar prospects for longevity. The members of this group agree that a specified sum, such as $100,000, will be paid to the beneficiaries of those members who die during the  year, the cost of  the payments being shared equally by the members of the group. In its simplest form, this arrangement might involve an assessment upon each member in the appropriate amount as each death occurs. In a group of 1,000 persons, each death would produce an assessment of $100 per member. Among a group of 10,000 males aged 35,  21  of  them  could  be  expected  to  die  within a  year,  according  to  the  1980  Commissioners Standard  Ordinary  Mortality  Table  (more  on  this  later).  If  expenses  of  operation  are  ignored, cumulative assessments of Birr210 per person would provide the funds for payment of $ 100,000 to  the  beneficiary  of  each  of  the  21  deceased  persons.  Larger  death  payments  would  produce proportionately larger assessments based on the rate of $2.10 per $ 1000 of benefit.

Payment of fortuitous losses

The second characteristic of 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. For example, a person may slip on an icy side walk and break his or her leg. The loss would be fortuitous.

Risk Transfer

Risk  transfer  is  another  essential  future  of  insurance.  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


The last characteristic of insurance is  indemnification. It means that the insured is restored to his or her approximate financial position prior to the  occurrence of the loss. Thus, if the home of insured  burns  in  fire,  homeowner  policy  will  indemnify  or  restore  the  insured  to  previous positions. If you are sued because of the negligent of an automobile, your auto liability insurance policy will pay those sums that you are legally obliged to pay. Similarly, if you become seriously disabled, a disability income insurance policy will restore at least part of the lost wages.


3.3 Fundamentals of Insurable Risk

Insurer  normally  insures  only  pure  risk.   However  not  all  pure  risks  are  insurable.  Certain requirements usually must be fulfilled before pure  risk can be privately insured. From the view point of insurer, there is ideally six requirements of an insurable risks. These are:

  1. There must be a 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.
  6. The premium must be economically feasible.

Large number of exposure units: The first requirement of an insurable risk is 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.  For example, a large  number of  surrounding dwellings in a city can be grouped together for purposes of providing property insurance on the dwellings. The purpose of this first requirement isto enable the insurer to predict loss based on the law of large numbers. Loss data can be compiled over time, and losses for the group as a whole can be predicted with some accuracy. The loss costs can then be spread over all insured’s in the underwriting class. For  a  plan  of  insurance  to  function,  the  pricing  method  needs  to  measure  the  risk  of  loss  and determine the amount to be contributed to the pool by each participant. The theory of probability provides such a scientific measurement. 

Insurance  relies  on  the  law  of  large  numbers  to  minimize  the  speculative  element  and  reduce volatile fluctuations in year-to-year losses. The greater the number of exposures (lives insured) to a peril (cause of loss/death), the less the observed loss experience (actual results) will deviate from  expected  loss  experience  (probabilities).  Uncertainty  diminishes  and  predictability increases as the number of exposure units increases. It would be a gamble to insure one life, but insuring 500,000 similar persons will result in death rates that will very little from the expected.

Accidental and Unintentional loss: A second  requirement  is  that  the  loss  should  be  accidental  and  unintentional;  ideally,  the loss should be fortuitous and outside the insured's control. Thus, if an individual deliberately causes a loss, he or she should not be indemnified for the loss. The requirement of an accidental and unintentional loss is necessary for two reasons. First, if intentional  losses  were  paid,  moral  hazard  would  be substantially  increased,  and  premiums would  rise  as  a  result.  The substantial increase in premiums could  result  in  relatively  fewer persons purchasing the insurance, and the insurer might not have a sufficient number of exposure units to predict future losses. The second reason is the loss should be accidental since the law of large number is based on the random occurrence of events. A deliberately caused loss is not random event because the insured known when the loss occur. Thus, prediction of future experience may be highly in accurate if a large number of intentional or random loss occur.

Determinable and Measurable Loss: 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. Life insurance in most cases meets this requirement easily. The cause and time of death can be readily determined in most cases, and if the person is insured, the face amount of life insurance policy is the amount paid. Some losses, however, are difficult to determine and measure. For example, under a disability income policy, the insurer promises to pay a monthly benefit to the disabled promises to pay a monthly  benefit to the disabled person if the definition  of  disability  stated in the  policy  is satisfied. Some dishonest claimants may deliberately fake sickness or injury to collect from the insurer. Even if the claim is legitimate, the insurer must still  determine whether  the insured satisfies the definition of disability stated in the policy.  Sickness and disability are highly subjective and the same event can affect two persons quite differently.

For example, two accountants who are insured under separate disability-income contracts may be injured in an auto accident, and both may be classified as totally disabled. One  accountant, however, may be stronger  willed and more determined to return to work.  If  that  accountant undergoes  rehabilitation  and  returns to work, the disability-income  benefits  will terminate. Meanwhile, the other accountant would still continue to receive disability-income benefits according to the terms of the policy. In short, it is difficult to determine when a person is actuallydisabled. However, all losses ideally should be both determinable and measurable. The basic purpose of this requirement is to enable insurer to determine if the loss is covered under  the  policy,  and  if  it  is covered,  how  much should be paid. 

Catastrophic Loss: 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. As we stated earlier, pooling is the essence of insurance. If most or all of  the exposure units  in a certain class simultaneously incur a loss, then the pooling technique breaks down and become unworkable. Premiums must be increased to prohibitive levels, and the insurance  technique is no longer a viable arrangement by which losses of the few are spread over the entire group. Insurers ideally wish to avoid all catastrophic losses. In reality, however, this is  impossible, because catastrophic losses periodically result from floods, hurricanes, tornadoes,  earthquakes, forest fires, and other natural disasters. Catastrophic losses can also result from acts of terrorism.

Several  approaches  are  available  for  meeting  the  problem  of  a  catastrophic  loss.  First, reinsurance  can  be  used  by  which  insurance  companies  are  indemnified  by  reinsurers  for catastrophic  losses. Reinsurance  is  an  arrangement  by  which  the  primary  insurer  that  initially writes the insurance transfers to another insurer (called the reinsurer) part or all of the potential losses associated with such insurance. The reinsurer is then responsible for the payment of its share of the loss. Second,  insurers  can  avoid  the  concentration  of  risk  by  dispersing  their  coverage  over a large geographical area. The concentration of loss exposure in geographical area exposed to frequent floods, earthquakes, hurricanes or other natural disasters can result in periodic catastrophic loses. If the loss exposures are geographically dispersed,the possibility of catastrophic loss is reduced.

Calculable Chance of Loss: A fifth requirement is that the chance of loss should 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 and yield a profit during the policy period. Certain losses, however, are difficult to insure because the chance of loss cannot be accurately estimated, and the potential for a catastrophic loss is present. For  example, floods, wars, and cyclical unemployment occur on an irregular basis,  and prediction of the average frequency and severity of losses is difficult. Thus, without government assistance, these losses are difficult for private carriers to insure.

Economically Feasible Premium: A final requirement is that the premium should be economically feasible. The insured must be able to pay the premium. In addition, for the insurance to be an attractive purchase, the premiums paid must be substantially less than the face value, or amount, of the policy. To have an economically feasible premium, the chance of loss must be relatively low. One view is that if the chance of loss exceeds 40 percent, the cost of the policy will exceed the amount that the  insurer  must  pay  under  the  contract.  For  example,  an  insurer  could  issue  a  Birr 1000  life insurance  policy  on  a  man  age  99,  but  the  pure  premium  would  be  about  Birr  980,  and  an additional amount for expenses would have to be added. The total premium would exceed the face amount of the insurance."

Calculation of a proper premium may be difficult because the chance of loss cannot be accurately estimated. For  example, insurance  that  protects a retailer against loss because of  a change in consumer tastes, such as a style change,  generally is not available. Accurate loss data are not  available,  and there is no  accurate  way to  calculate a premium. The premium charged mayor may not be adequate to pay all losses and expenses. Since private insurers are in business to  make  a  profit,  certain  risks  are  difficult  to  insure  because  of  the  possibility  of  substantial losses.


3.4 Insurance and Gambling Compared

Insurance is many times compared to gambling because in both, the payment of money is linked to the happening of an uncertain event. Some people claim that insurance is a gamble. Insurance is actually the opposite of gambling. Although insurance is often confused with gambling, there are differences between insurance and gambling. These are:

  • 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.
  •  Gambling  is  a  win-lose  proposition  because  one  person  wins  while  the  other  loses. 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.
  • In the case of gambling, the loss is created intentionally while in the case of insurance the loss is accidental.
  •  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 by a contract and no new  risk is created. The main difference between insurance and speculation lies in the type of that each is designed to handle, and  in  the  resulting  differences  in  contractual  arrangements.  The  main  similarity  lies  in  the central  purpose  behind  each  transaction.  However,  there  are  some  important  differences  exist between  them.  Insurance  transaction  normally  involves  the  transfer  of  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 objective  risk of an insurer by application of the law of large numbers,but speculation only involves transfer of risks and not reduction of risk. The losses cannot be predicted based on the law of large numbers.


3.6 Benefits and Cost of Insurance to the Society

Benefits of Insurance to Society

As explained in the previous section, insurance serves as a very useful means of spreading the

effects of personal as well as business risks by way of loss or damage among many. Thus, the

insured  have  a  sense  of  security.   Individuals  who  pay  premium  periodically  out  of  current income can look forward to an assurance of receiving a fixed amount on retirement or his family being secured in the event of his death. Businessmen also pay premium for insurance of risk of loss without constant worry about the possibility of loss or damage.

Insurance  plays  a  significant  role  particularly  in  view  of  the  large-scale  production  and

distribution  of  goods  in  national  and  international market.   It  is  an  aid  to  both  trading  and industrial  enterprises,  which  involve  huge  investments  in  properties  and  plants  as  well  as inventories  of  raw  materials,  components  and  finished  goods.  The  members  of  business community feel secured by means of insurance as they get assurance that by contributing a token amount they will be compensated against a loss thatmay take place in future.

Society is not free from risks and uncertainty.  Insurance is a social device providing  financial compensation  to  those  who  suffer  from  misfortune.  Such  payment  being  made  from accumulated contribution of all parties participating in the scheme. Insurance provides stability, in the society by necessary arrangement of securityagainst loss form unexpected risks. Society becomes more peaceful and safe by insurance, which  provides different welfares and financial security against losses from risks. The major benefits of insurance to society are given below.

Peace of mind: Another  benefit  of  insurance  to  society  is  that  it  decreases  the  worry  and  fear  of  members  of society regarding the risk of accident and premature death. The insured replaces the uncertainty of loss with the certainty of a known premium. If family heads have adequate amounts of life insurance,  they  are  less  likely  to  worry  about  the  financial security of their dependents in  the event of premature death. Similarly, businessmen who are insured enjoy greater peace of mind because  they  know  are  covered  if  a  loss  occurs. Thus,  insurance  substitutes  certainty  for uncertainty,  through  the  pooling  of  groups  of  people  who  share  the  risks  to  which  they  are exposed. Uncertain risks of individuals are combined, making the possible loss more certain, and providing  a  financial solution to the problems created by the loss. Small, certain  periodic contributions (premiums) by the individuals in the  group provide a fund from which those who suffer a loss are compensated.The certainty of losing the premium replaces the uncertainty of a larger loss.

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. Thus, if your home burns in fire, a homeowners policy will indemnify you or restore your to previous position.

Loss control: The system of rating, which rewards risk preventionmeasures with lower premiums, encourages loss  prevention.   Workplaces  implement  health  and  safety  measures,  drivers  drive  more carefully; homeowners install burglar alarms and smoke detectors. Society would suffer greater losses if it were not for these measures.

Source of Investment Funds: From  the  national  economic  point  of  view,  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.  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. Insurance is also a source of employment for the people.  The  people  get  employed  directly  in  its  offices  spread  over  the  country  and  it  also provides opportunities to the people to earn their livelihood by working as agent of the insurance companies.

Fewer Burdens to Society: Because insured’s are restored either in part or inwhole after a loss occurs, they are less likely toapply  for  public  assistance  welfare  benefits,  or  to seek  financial  assistance  from  relatives  and friends. So other members of the society need not help the unlucky member even after suffering from loss. If the individuals have not insured the  risk, the relatives and friends should support him financially, when he becomes unlucky victim from the risks.

Cost of Insurance to society

No institution can operate without certain costs. These are listed below so that one can obtain an impartial view of the insurance institution as a social device. The major social costs of insurance include the following: Cost of doing business, Fraudulent claims and Inflated claims

Cost of doing Business: The main social cost of insurance lies in the use of scarce of economic resources land, labor, capital, and organization to operate the business.  In financial terms, an expense loading must be added to the pure premium to cover the expenses incurred by insurance companies. 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. The cost is justified from the insured's view point as follows:

  • Uncertainty  concerning  the  payment  of  a  covered  loss  is  reduced  because  of insurance.
  • The cost of doing business is not necessarily wasteful, because insurers engage in a wide variety of loss prevention activities.
  • The insurance industry provides jobs to millions ofworkers.

However, because economic resources are used up in providing insurance, a real economic cost is incurred.

Fraudulent claims: These are the claims made against the losses that one caused intentionally by people in order to collect on their policies. There always exists moral hazard in all forms of insurance. Arson losses are on the increase. Fraud and vandalisms are the most common motives for arson. Fraudulent claims are made against thefts of valuable property, such as diamond ring or fur coat, and ask for reimbursement. These claims results in higher premiums to all insured. These social costs fall directly on society.

Inflated claims: It is a situation where, the tendency of the insured to exaggerate the extent of damages that result from purely unintentional loss occurrences. Examples of inflated claims include the following.

  • Attorney for plaintiffs may seek high liability judgments - Liability insurance
  • Physicians may charge above average fees - health insurance
  •  Disabled persons may malinger to collect disabilityincome benefits for a longer duration.

These  inflated  claims  must  be  recognized  as  an  important  social  cost  of  insurance.  Premiums must  be  increased  to  cover  the  losses,  and  disposable  income  that  could  be  used  for  the consumption of other goods or services is thereby reduced. The social costs of insurance can be viewed as the sacrifice that society must make to obtain the social benefits of insurance.



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