Hailey college of banking and finance

Assignement : Fundamentals And Terminology

Of Insurance
Date : October 25 ,2010

Presented by : Emad ul Islam

Roll no : Mi10BBA032
Presented to : Sir Khursheed Ahmed
Q: The term insurance can be defined in both
legal and financial terms .How do these
definitions differ?
Legal definition of insurance:
It is more fully defined to be a contract by which one of the parties, called
the insurer, binds himself to the other, called the insured, to pay him a
sum of money, or otherwise indemnify him in case of the happening of a
fortuitous event, provided for in a general or special manner in the
contract, in consideration of a premium which the latter pays, or binds
himself to pay him. 

Financial definition of insurance:

A contract between a client and a provider whereby the client makes
monthly payments, called premiums, in exchange for the promise that
the provider will pay for certain expenses. For example, if one
purchases health insurance, the provider will pay for (some of) the
client's medical bills, if any. Likewise in life insurance, the provider will
give the client's family a certain amount of money when the client dies.
The insurance company spreads the risk of any one expense by pooling
the premiums from many clients

In the eyes of law insurance is an agreement between two

parties where one party agrees to compensate the other one in
case of loss to property or any thing mentioned in the
agreement, where as in the eyes of finance it is a contract
between two parties where one party pays an amount called
premium annually or monthly against the security of risk ,the
party which provide compensation is called insurer , and the
one getting compensation is called insured

Q: Describe the difference between direct and

indirect losses, Give example of each.
Direct loss:
“Property loss in which the insured peril is the proximate cause (an
unbroken chain of events) of the damage or destruction. Most basic
property insurance policies (such as the standard fire policy) insure
against only direct loss and not indirect loss or consequential loss.

Indirect loss:
“Loss that is not a direct result of a peril. For example, damage to
property of a business firm would be a direct loss, but the loss of
business earnings because of a fire on its premises would be an indirect
loss.

Indirect losses also called CONSEQUENTIAL LOSSES or loss of use

are a secondary result of an peril.

There must be direct loss before there can be an indirect loss.

Examples:
Direct loss:
If a house is damaged by fire caused by electric shock or gas, this loss is
called direct loss

Indirect loss:
Living expenses caused while living when the damaged house was
under construction is indirect loss
Q: What is the difference between a hazard
and a peril? Give examples of each.

Peril:
“A peril is something that can cause a loss. Examples include falling,
crashing your car, fire, wind, hail, lightning, water, volcanic eruptions,
choking, or falling objects. “

Hazard:
“A hazard is any condition or situation that makes it more likely that a
peril will occur.”

Hazards include: 
 Physical hazard: like ice on the sidewalks, smoking, or skydiving;
 Moral hazards:(most of which are avoidable), like dishonesty (such as
burning down the warehouse when your company goes bankrupt to collect insurance
money or buying insurance on someone with yourself as beneficiary and then killing
them); and
 Morale hazard: like a careless attitude since "insurance will pay for it."

Examples:
Peril,
Peril include earthquake, storms, heavy rain , fire, tornadoes, heart
attack and criminal acts.

Insurance companies compensate the loss caused by perils.

Hazard,

Storing 55 gallons of oil in oil drum increase the severity of frequency of

loss, using cheap building material while constructing house, using
cheap quality brake oil while using a car, not wearing seat belt while
driving a car and eating high cholesterol food are the hazards which may
increase the chance of peril to occur.
We can also say that,

 Peril refers to “the causes of loss”

 Peril is caused by hazards.
 Hazard is something which exacerbates the precarious situation.

Q: What is the difference between insurable

losses and depreciation expense?
Insurable losses:
Insurable losses are those losses,
 Those have large number of exposures.
 Those are accidental.
 Those are definite and measureable.
 Those are not catastrophic.
 Those are economically feasible to insure.

 Large number of exposure means that the loss is in

common, e.g. many people are suffering from that loss, in
this way insurance companies can accumulate huge
funds,large number of exposures to loss also help to predict
the loss through law of large numbers.
 In order to have an exposure insurable the losses need to
be accidental from the stand point of insured,if an exposure
is certain to result in loss or damage then insurance
companies are sure to pay the claim.
 To be insurable a loss should have a definite time and place
of occurrence and the amount of loss must be measureable
in pecuniary terms.
 Effective pooling of exposure means that the exposure units
are independent, independence means that a loss suffered
by one insured does not affect other insured or group of
insureds. If exposures are not independent then loss to one
 insured can cause losses to sizable proportions of insured’s
at the same time.
 Insurance companies seek to cover only those exposures
which are economically feasible to insure
Because of this constraint loss exposures involving small
losses and as well as those involving high probability of loss
are generally considered uninsurable losses

Depreciation expense:
“That portion of a tangible capital asset which is deemed to have been
consumed or expired, and has thus become an expense.”
OR
“Depreciation Expense is the expense we claim from Accumulated
Depreciation and though it is an expense it does not affect our Cash. We
do not actually "pay" this expense. Depreciation is the decline in
usefulness of a Fixed Asset. “

Q: How does moral hazard differ from morale

hazard? Give examples of each.
Moral hazard:
“If an insured advertently causes loss or damage to his property- which
is insured –in order to collect his insurance proceeds, this is insurance
fraud and the loss results from the moral hazard.”

OR

“Moral hazards are those that result from insured are dishonesty.”

Examples:
1. If someone burns down a building to collect the insurance, the fire
causes the damage but the moral hazard is responsible for this
loss.
 2. If a thief steals Rs, 5000 but the insured claim that 2000 has stolen
, in order to get 1500 more ,this is insurance fraud caused by
moral hazard.

Morale hazard:
“It refers to an attitude of carelessness or indifference to loss created by
the purchase of an insurance contract.”

Insurance can be regarded as a morale hazard because it increases the

possibility of a loss that results from the insured worrying less about
losses. Therefore, they take fewer precautions and may engage in riskier
activities—because they have insurance

Examples:
1. The attitude “why should I care I am insured is the example of
morale hazard.
2. If a person remains unnecessarily in hospital to collect insurance
benefits rather than returning to work is an example of morale
hazard.
3. If a person does not lock the locker – in which gold is placed – just
because that gold is insured. Is also an example of morale hazard.

Q: Explain the term “proximate cause”.

Proximate cause:
“Active direct and efficient cause
of loss in insurance that sets in motion an
unbroken chain of events which bring about damage, destruction,
or injury without the intervention of a new and independent force. Also
called direct cause.”
 OR

“ An event  which, in a natural and continuous sequence, unbroken by

any efficient intervening cause, produces an injury, and without which
the injury would not have occurred.”

OR

 “In this segment of business insurance, this is the first event in a series
that results in a claim. It is not always the one that is nearest in time to
the event.”

Explanation with example:

if lightning cause a fire in a house ,which in turn causes fire truck to
be sent to the fire, and if in responding to the call the truck collides with a
car, one might assert that the proximate cause of the collision between
the fire truck and the car was the lightening that struck 5 miles from the
collision. The question of proximity or nearness to the loss becomes
hazy if stretched thin enough .if the fire truck siren give a heart attack to
a neighbor ,is the lightening the cause of this attack? If while giving
treatment to the patient, the neighbor is given a wrong medicine
negligently and suffers injury is the lightning still the proximate cause?

Sometimes it takes a court trial to determine whether the breaking point

occurs and what the proximate cause of the loss is.

Q: Explain the difference between speculative

and pure risk.
Pure risk:
In pure risk there are two positions, “loss” or “no loss” no loss point is
also called break even point.

OR
A category of risk in which loss is the only possible outcome; there is no
beneficial result. Pure risk is related to events that are beyond the risk-
taker's control and, therefore, a person cannot consciously take on pure
risk. 

Explanation of pure risk by example:

if a car driver is driving his car there are two possibilities , he may struck
his car with another vehicle or injure a person and second possibility is
he came back home without any loss , there was no situation of benefit
or gain so this situation is called pure risk.

Speculative risk:
“In this situation of risk there are three positions one is loss , second is
no loss or breakeven and the third one is gain”

OR
“A category of risk that, when undertaken, results in an uncertain degree
of gain or loss. All speculative risks are made as conscious choices and
are not just a result of uncontrollable circumstances.” 

 speculative risk refers to those exposures to price change that

may result in gain or loss

Explanation of speculative risk by example:

If a person buy share of a company at Rs. 10 ,each and after an year
there may be three positions , the share may reach at value of Rs.20 or
remain Rs.10 or may decline at Rs.5.this type of situation of risk is called
speculative risk
Q: what is cash flow underwriting?
Cash flow underwriting:
“Pricing of the insurance product below the necessary premium rate to
reflect the costs of expected losses. The thesis of this pricing strategy is
to obtain large sums of money to invest and earning a greater return on
the investment than the costs associated with the under pricing of the
insurance product.”

OR

“A pricing tool used by insurance companies. Cash flow underwriting

occurs when a given insurance product is priced below the rate of
premium required to take into account the cost of expected losses that
will be incurred. The purpose of this strategy is to generate substantial
investment capital from the increased business that will come from the
lower pricing.”

Brief explanation:

The investment capital that is presumably generated by the sales from

the lower-priced product can be used to invest in vehicles that will pay
higher rates of return. If a smaller amount were invested, then a less
advantageous investment may have to be used instead. Ultimately, the
higher investment returns make up for the difference in pricing for the
insurer.
Q: Define “law of large numbers” and what is
the implication of this law in insurance
system?
Law of large number:
“The theory of probability on which the business of insurance is based.
Simply put, this mathematical premise says that the larger the group of
units insured, such as sport-utility vehicles, the more accurate the
predictions of loss will be”

Explanation:
An insurance system can operate successfully only when it can predict
losses accurately. Predicting losses reduce risk. Insurance pools reduce
risk by applying this law, which states that the greater the number of
observations of an event based on chance, the more likely the actual
result will approximate the expected result.

Example: (implication)
Suppose an insurance pool expected 1 percent of its members to
experience a loss, based on historical records of losses. The law of large
numbers states that the greater the number of exposures in the pool ,
the more is the 1 percent loss figure to be realized. By applying the law
the insurance company can predict accurately the dollar amount of
losses it will experience in a given period.
Q: what are the two definitions of risk
discussed in this chapter? Are they really
differ from one another?

Two definitions of risk discussed in this

chapter are :

1. “risk is to be defined as a variation in possible outcomes of an

event based on chance”

2. “Risk is stated as an uncertainity concerning a possible loss.”

 The first definition of risk as variability in possible out comes

focuses attention on the degree of risk in given situations. The
degree of risk is a measure of the accuracy with which the
outcome of an event based on chance can be predicted .

 The second definition of risk as uncertainty concerning loss is

useful because it helps to explain why people purchase insurance .
if Mr.X does not buy insurance, he may be uncertain about
whether he will have to pay for fire losses to his home . He is
uncertain because he does not know in advance if his house will
burn or if a fire occurred, how severe it would be . once he has
purchased fire insurance ,it becomes certain he should have to
pay for no fire losses to his home.
Q: how does insurance redistribute the cost of
losses?
Redistribution of cost of losses:
Insurance involves the transfer of potential losses to an insurance
pool. the pool combines all the potential losses to an insurance pool
. The pool combines all the potential losses and hen transfers the
cost of predicted losses back to those exposed. Thus, insurance
involves the transfer of loss exposures to an insurance pool and the
redistribution of losses among the members of pool .certainty of
financial payment from a pool with adequate resources and
accurate predictability of losses are the hall marks of the insurance
transaction.

Q: list the four building blocks of insurance

premium, why investment earnings are
included in calculations?

1) Cost of paying for losses.

2) Cost of operating and maintaining insurance pool

3) Reserve for unexpected losses

4) Investment earnings
 Investment earnings are included in calculations
because it reduces the premium charged to insured.
Q: In what ways does operating insurance
system benefit the society?
The benefits to the society of insurance systems:
1) Stability in families:
2) Aids the planning process in business
3) Facilitates credit transactions
4) Investment in national economy

Stability in families:
Insurance prevents the families from experiencing the great
hardships caused by unexpected losses of property or the
premature death of the family income provider.

Aids the planning process in business:

Insurance aids the planning process because the planner
knows a property loss will not mean financial ruin and the future
of business cannot be destroyed

Facilitates the credit transactions:

Insurance facilitates credit transactions because creditors are
more willing to lend money if the debtor’s death does not make
collection of the loan difficult.
Investment in national economy:
Insurance companies do not leave the accumulated money
with no use instead they invest it in many businesses and other
financial corporations and in stock exchange bringing prosperity
to economic condition of the country.

Q: why is that the chance of loss, and not the

loss itself, that creates the need for
insurance?

Answer:
Insurance companies make agreement of providing
compensation before the loss took place not after the loss.

People purchase insurance because of risk and risk is the

chance of uncertainty which is before expected loss.
From above two points it is obvious that the loss by itself is not
the reason of purchasing policy but it is the chance of loss in
other words risk which is actually the need for insurance.
Q: what are the major costs of operating
insurance systems?
Answer:
The major costs may include:

 Administrative expenses
 Acquisition expenses
 Managerial expenses
 Accounting expenses
 Unexpected loss expenses
 Investigation expenses
 Court expenses