CHAPTER 3

Nature of
Insurance
INS200
RISK AND
INSURANCE
Chapter Contents:
3.0 Nature if insurance
3.1 The concepts of insurance, common
pool and law of large numbers
3.2 The operations and function of
insurance
3.3 The benefits of insurance
3.4 The characteristics of insurable risks
Chapter Outcomes:
Upon completion of this chapter, you should be able to:

Describe the concepts of insurance

State the functions and the applications of insurance

Identify the elements of an insurable risk

Describe the benefits of insurance enjoyed by person

involved
3.1 The concepts of insurance,
common pool and law of large numbers
DEFINITION
• Insurance – an agreement whereby a group of individuals facing
similar risks can share the fortuitous losses of the unlucky few by
the transfer of such risks to the insurer who agrees to compensate
the losses

More explanation..
• An insurance contract (policy) made between a client (pool
participant/ policyholder) and insurance company (insurer)
• Under a policy, the policyholder is obliged to make stipulated
payments (premiums/ monthly payments) to the insurer
• Whereas, the insurer is obliged to make claim payment to the
policyholder or his selected beneficiary upon the occurrence of a
specific loss
 Definition of Insurance
according to Vaughan & Vaughan (2008)

•Viewpoint of individual:

•“ An economic device whereby the individual substitutes a small certain cost

(the premium) for a large uncertain financial loss (the contingency insured
against) that would exist if it were not for the insurance contract. ”

•Viewpoint of society:

•“ An economic device for reducing and eliminating risk through the process
of combining a sufficient number of homogeneous exposures into a group in
order to make the losses predictable for the group as a whole. “
Let us look in details some of the insurance terms

INSURANCE CONTRACT
• Also known as a policy
• It is a written agreement between an insurer
and a client
• The insurance contract contains the following:
• Details of the insurer & client
• Insurance pricing
• Terms & conditions
• Insured perils (a situation whereby client
can be paid claim payment when it happen)
INSURANCE CLIENT
• People who need protection from risks so they
buy insurance
• Also known as insurance buyer
• Also known as insured (a person who is
protected by insurance company)
• Also known as policyholder (a person who own
an insurance policy)
• Also known as pool participant (member who
contribute fund in an insurance deposit
account)
• Has a responsibility to pay an agreed amount
of money (premium) to the insurer
INSURANCE COMPANY

• A company that give protection to an insured

from risks so they sell insurance
• Also known as insurance seller or insurer
• Has a responsibility to pay claim payment to
the insured or his/her beneficiary when an
insured peril happened to him/her
INSURANCE PREMIUM
• Insurance fee
• An agreed amount of money paid by the insured to the
insurer
• Paid in regular basis e.g. yearly or monthly
• Insurer set the premium so that money received will be
enough to pay expected losses

INSURANCE CLAIM PAYMENT

• An agreed amount of money paid by the insurer to an
insured when an insured peril happened to the insured
Self-exercise from past year questions
• Short essay
1. Define insurance. (5 marks)

• Fill in the blanks

Insurance Premium Policy Insurer

1. ____________ is known as an agreement whereby a group of individuals

facing similar risks can share the fortuitous losses of the unlucky few by the
transfer of such risks to the insurer who agrees to compensate the losses.
2. ____________ is an agreed amount of money paid by the insured to the
insurer as insurance fee.
3. ____________ is a written agreement between an insurer and a client.
4. ____________ is also known as a company that give protection to an insured
from risks so they sell insurance.
 CONCEPT OF COMMON POOL

• It involves contributions from many insured pooled together to

pay for losses suffered by few.
• The operation of common pool is based on the successful
application of the law of large number

Contribution from many

policyholder

Will be gathered in a common

pool (similar risk insured)

To pay losses suffered by a

few
PREMIUM FUND LOSS
Premium
Pooled together Pay losses
contributions
fund (common suffered by a
from many
pool) few
insured
Concept of common pool

Insurance deposit account

e.g. fire insurance

operated by insurer

when one / few insured suffer loss

money is given to help the insured cover for

the loss
 LAW OF LARGE NUMBER
• Explain that the greater the number of similar risk, the more
accurate the insurer can be predicting future losses.
• With this Law, it allows the insurer to fix premium/contribution to
the pool on advance.
• The effect allows the person insuring knows he will not have to pay
any more premium at the end of the period of insurance.
MANY PEOPLE FACING ACCURATE IN
SIMILAR RISKS PREDICTING FUTURE
EASIER TO FIX
LOSSES
(HIGH PROBABILITY OF THE PREMIUM
RISK TO HAPPEN AGAIN)

FEW PEOPLE FACING INACCURATE IN

SIMILAR RISKS PREDICTING FUTURE
LOSSES DIFFICULT TO FIX
(LOW PROBABILITY OF THE PREMIUM
RISK TO HAPPEN AGAIN)
Law of large number

AVERAGE OUTCOME PREDICTED

Loss: RM13,300 Loss: RM14,500 Loss: RM13,300 FOR FUTURE LOSSES
(13,300 + 14,500 + 13,300 + 18,100 + 20,000 + 11,000)
6

= RM15,033.33

Loss: RM18,100 Loss: RM20,000 Loss: RM11,000

SUBJECT MATTER
• Subject matter of insurance refers to what is being protected/ insured.
• Subject matter of contract refers to how much is the insurance value.

Example: Fire insurance policy on a house

Subject matter Subject matter

of Insurance of Contract
 Important Concepts (summary)
Concept Explanation
Concept of • Contribution from many policyholders will be gathered in a
common pool common pool (similar risk insured) and the contribution will be
used to pay losses suffered by a few. The operation of the
common pool is based on the successful application of the law
of large number.
Law of large • Explains that the greater the number of similar risk, the more
numbers accurate the insurer can be in predicting future losses.
• It allows the insurer to fix premium to the pool in advance.
• Insurance company knows that although single events are
random and largely unpredictable, the average outcome of many
similar events can be predicted.
• When insurance company sells many policies, they face
relatively little risk because they can be sure total premiums paid
will equal total money paid out.
Subject matter • The life, property, rights or any potential legal liability insured
of insurance under a policy.
Subject matter • The insured’s financial interest in the subject matter of
of contract insurance.
Self-exercise from past year questions
• Short essay
1. Write short notes on the following:
i. Common pool (5 marks)
ii. Law of large numbers (5 marks)
2. Differentiate between subject matter of contract and subject matter of
insurance. (6 marks)

• Fill in the blanks

Common pool Law of large Subject matter of Subject matter of

numbers insurance contract
1. ____________ refers to the contribution from many policyholders will be gathered
in a common pool (similar risk insured) and the contribution will be used to pay
losses suffered by a few
2. ____________ explains that the greater the number of similar risk, the more
accurate the insurer can be in predicting future losses.
3. ____________ refers to life, property, rights or any potential legal liability insured
under a policy.
4. ____________ refers to insured’s financial interest in the subject matter of
insurance
3.2 (i) Operation of Insurance

How does insurance work?

Collect premium
Premium are Used by the
from a group of
then pooled insurer to pay
people in similar
together losses
circumstances
 PREMIUM

POLICY

POLICYHOLDERS INSURER

CLAIM PAYMENT
3.2 (ii) The functions of insurance
A. PRIMARY FUNCTIONS
1) Risk transfer
2) Creation of common pool
3) Equitable premium
B. SECONDARY FUNCTIONS
1) Releasing funds otherwise tied of in reserves
2) Stimulate business enterprise
3) Stimulate business in other ways
4) Remove fear and worry
5) Reduction of losses
6) Savings
7) Social benefits
C. INDIRECT FUNCTIONS
1) Investment of funds in public or private sector
2) Invisible exports
3) Sources of employment
A. PRIMARY FUNCTIONS
1) RISK TRANSFER
• Through insurance, insured can transfer the financial
consequences of risk to the insurer in the return for paying
premium
• To substitute a known cost for an unknown event involving an
unknown cost.

2) CREATION OF COMMON POOL

• Insurance uses a common pool concept when it involves
contributions from many insured pooled together to pay losses

3) EQUITABLE PREMIUM
• Premium is determined based on the application of law of
large number
• The insurer has to assess risk that need to be insured e.g. low
risk exposure, low premium.
B. SECONDARY FUNCTIONS
1) RELEASING FUNDS OTHERWISE TIED UP IN
RESERVES
• Business enterprises and others are able to avoid freezing
capital to provide financial protection against losses
• Fund released would be available for investment

2) STIMULATE BUSINESS ENTERPRISE

• Helps to maintain the present large scale industrial and
commercial organizations with the transference of their risks
to insurer

3) STIMULATE BUSINESS IN OTHER WAYS

• Facilitate overseas trade
• Facilitate financing or property by banks
…continue
4) REMOVE FEAR AND WORRY
• Helps to remove fear and worry for losses, thus establish
confidence and improve personal efficiency

5) REDUCTION OF LOSSES
• Help to reduce losses both in frequency and severity to their
actions and recommendation in rating, survey, inspection and
salvage activities

6) SAVINGS
• Encourage saving i.e. life insurance is often used as a means
of savings

7) SOCIAL BENEFITS
• Through: compensation paid by insurers to insured which
reduced the cost of social service
• E.g. Workers of factory destroyed by fire might face
unemployed if factory been uninsured
C. INDIRECT FUNCTIONS
1) INVESTMENT OF FUNDS IN PUBLIC OR PRIVATE
SECTOR
• To earn interest/ income

2) INVISIBLE EXPORTS
• Contribute to a country’s balance of payments
• E.g. whilst Britain is a net exporter of insurance,
Malaysia is net importer of insurance

3) SOURCES OF EMPLOYMENT
• Generated numerous employment opportunities
 • Create peace of mind
1. Remove fear & worry • Helps to eradicate fear & worry for losses
• Hence improve confidence & personal efficiency

• Compensation paid by insurer to policyholders that

2. Social Benefit reduced the cost of social service
• Example: Workers of a factory destroyed by fire maybe
dismissed if the factory was not being insured.

3. Reducing losses • Helps to reduce losses both in frequency & severity

• Investing funds in public or private sector to earn

4. Investment interest/ income

5. Sources of • Generating numerous employment opportunities

• E.g. Insurance agents, insurance executives
employment

• Encourage saving by offering insurance + saving

6. Savings product
3.4 Insurable risk
DEFINITION

• Risks for which it is relatively easy to get insurance and that

meet certain criteria

• These include being definable, accidental in nature, and

part of a group of similar risks large enough to make losses
predictable

• The insurance company also must be able to come up with

a reasonable price for the insurance

• A risk that meets ideal requirements for efficient insurance

CHARACTERISTIC OF INSURABLE RISK
• Not all risks are capable of being insured
• Risks that are insurable must fulfill certain
characteristics
Large
Financial Pure risks
number of
value only
similar risks

No
Fortuitous Insurable
catastrophic
loss interest
loss

Legal and
Reasonable
not against
premium
public policy
… continue
1. FINANCIAL VALUE
• Insurance is concerned with situations where
monetary compensation is given following a loss
• Should involve a loss that is able to be measure
financially
• Examples:

RISK FINANCIAL MEASURES

Damage to property Cost of repairs
Injury to others Courts awards
Premature death Predetermined level of
compensation
A risk that can be insured should have financial value.
This is whereby the loss can be measured in terms of RM.

RISK: HAUNTED HOUSE RISK: HOUSE ON FIRE

LOSS: RM??? LOSS: RM100,000

INCAPABLE FINANCIAL VALUE CAPABLE FINANCIAL VALUE

This risk CANNOT be

This risk CAN be insured
insured
2. LARGE NUMBER OF SIMILAR RISK
• There must be large number of similar risks before any one of the risks is
capable of being insured
• Reasons
To enable the insurer to predict loss based on the Law of large numbers
If there are few exposures, the principle of “losses of a few to be borne by
many” will not apply

MANY PEOPLE FACING ACCURATE IN

SIMILAR RISKS PREDICTING FUTURE
EASIER TO FIX
LOSSES
(HIGH PROBABILITY OF THE PREMIUM
RISK TO HAPPEN AGAIN)

FEW PEOPLE FACING INACCURATE IN

SIMILAR RISKS PREDICTING FUTURE
LOSSES DIFFICULT TO FIX
(LOW PROBABILITY OF THE PREMIUM
RISK TO HAPPEN AGAIN)
3. PURE RISK ONLY
• Insurance is concerned with pure risks only because most pure risks are more
easily predictable
• On the other hand, speculative risks are less predictable and therefore generally
uninsurable
• Reasons for lack of predictability of speculative risks
Lack of statistical experience
Lack of randomness of occurrence

ACTIVITY: GAMBLING ACTIVITY: DRIVING A CAR

INCUR LOSS NO LOSS GAIN PROFIT INCUR LOSS NO LOSS

SPECULATIVE RISK PURE RISK

4. NO CATASTROPHIC LOSS
• The loss should not be catastrophic (too huge) (E.g. losses arising from earthquakes
or wars)
• A catastrophic loss arise when a large number of exposures incur losses at the same
time
• When this happen, it is obvious that the principle of “losses of a few to be borne by
contributions by many” will not apply

CATASTROPHIC LOSS NON-CATASTROPHIC LOSS

5. FORTUITOUS LOSS
• A fortuitous loss is one that is accidental an unintentional
• The reasons for this requirement are:
If an unintentional loss were paid, the number of claims will increase leading to
an increase in premium
The proper functioning of the Law of Large Numbers depends on, among other
things, on random occurrence of events

FORTUITOUS LOSS NON-FORTUITOUS LOSS

(ACCIDENTAL) (ON PURPOSE)
6. INSURABLE INTEREST
• The policyholder must have right & legally recognized financial interest on the
subject matter of insurance

HAVE DOES NOT HAVE

LEGALLY RECOGNIZED LEGALLY RECOGNIZED
FINANCIAL INTEREST FINANCIAL INTEREST
7. LEGAL AND NOT AGAINST PUBLIC POLICY
• The object of insurance must be legal and not against public policy
• E.g. a ship engaged in smuggling is not an insurable risk because the risk is of an
illegal nature
• Fines and penalties imposed by a law is not insurable because it is against public
policy to provide insurance for such risks
• Example: a person who loves driving over the speed limit cannot take out insurance
on the risk of being summoned by the police for speeding

LEGAL & ILLEGAL &

NOT AGAINST PUBLIC POLICY AGAINST PUBLIC POLICY
8. REASONABLE PREMIUM

• Premium must be reasonable in relation to potential

loss
• A risk that has a very high probability of loss or near
certainty would involve a premium that may be
unreasonable from the perspective insured’s point
of view
• On the other hand, the insurance premium required
to cover a risk worth a few cents may be quite
unreasonable in relation to the potential loss in view
of the insurer’s claim handling expenses
END OF CHAPTER