CHAPTER – 3

INSURANCE
Definition: Insurance can be defined from: -
 Economic,
 Legal,
 Business,
 Social point of views.
A) In economic sense: for instance,
 Insurance: is a mechanism of providing certainty or
predictability of loss with regard to pure risk.
By reducing uncertainty in the business environment,
 it will create peace of mind that enables businessmen
focus on their primary activities instead of worrying about
the existence of possibility of loss so that societies can
grow more economically.
B) From legal point of view:
 Insurance: is a contract whereby, a consideration
(price) paid to a party adequate to the risk, becomes
security to the other that he shall not suffer loss or
damage by the happening of risks specified in the
contract for which s/he may be exposed to.

 The contracting parties are the insured, who is

responsible to pay the price(premium) for obtaining
the security, and the insurer, who will assume the risk
is transferred to.

۞ This makes insurance a means of transferring risk

for a premium (price) from one party known as the
insured to another called insurer.
C) From business perspective:
 Insurance: is defined as a cooperative device to spread the
loss caused by a particular risk over a number of persons who
are exposed to and who agree to ensure themselves against
that risk.
The function of insurance: -
 Spread the loss over a large number of persons who agreed
to cooperate each other at the time of loss.
 Risk cannot be averted/removed but loss occurring due to a
certain peril can be distributed among the agreed persons.
 They agree to share the loss because the chance of loss, i.e.,
the time and amount, to a person is not known.

nsurance does not decrease the uncertainty for the individual

as to whether the event will occur, nor does it alter the
probability of occurrence, but it does reduce the probability
of financial loss connected with the occurring event.
 Any of the insured may suffer loss to a given
risk; so, the rest of the persons who have agreed
will share the loss.
 The larger the number of such persons, the
easier the process of distribution of loss.
D) From the social point of view
 Insurance is defined as a device to accumulate
funds to meet uncertain losses of capital of the
society, which is carried out through the transfer
of the risk of many individual to one entity/.
 From the view point of the insured, insurance is

a transfer device.
 From the view point of the insurer, insurance is
a retention or combination device.
 Insurance does not prevent losses, nor does it
reduce the cost of losses to the economy as a
whole.
 As a matter of fact, it may very well have the
opposite effect of causing losses and increasing
the cost of losses for the economy as a whole.

 The existence of insurance encourages some

losses for the purpose of defrauding the insurer,
and in addition, people are less careful and may
exert less effort to prevent losses than they might
if the insurance did not exist.
 Basic Characteristics of Insurance
 An insurance plan or arrangement typically has certain
characteristics. They include the following:
A)Pooling of loss:
 Pooling or the sharing of losses is the heart of insurance.
 It is spreading of loss incurred by the few over the entire
group, so that, in the process, average loss is substituted for
actual loss.
 It implies: -
1) the sharing of loss by the entire group and
2) prediction of future losses with same accuracy based on
the law of large numbers.
 By pooling or combining the loss experience of a large
number of exposure units, an insurer may be able to predict
future losses with some accuracy.
 From the view point of insurer, if future losses can be
predicted in high level of accuracy, objective risk will be
reduced.
B) Payment of fortuitous losses: (occurring by chance)
 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.
C) Risk transfer:
 Risk transfer means that a pure risk is transferred from the insured to the
insurer, who typically is in a strong financial position and is willing to
pay the loss than the insured.
 From the view point of the individual,
 pure risks that are typically transferred to insurers include the risk of
premature death, poor health, disability, destruction and theft of property,
and liability lawsuits.
Speculative risks: refer to ‘‘the situation characterized by a possibility of
either a loss or a gain’’.
 It provide favorable or unfavorable consequences.
Pure risks: refer to the situation in which only a loss or no loss would occur.
 There are only two distinct outcomes; loss or no loss.
 Most pure risks are insurable.
D) Indemnification: (Compensation /Reimbursement for
loss, or damage )
 Indemnification means that the insured is restored to
his or her approximate financial position prior to the
occurrence of the loss.

 Thus, if your house burns in a fire, the insurance policy

will indemnify you or restore you to your previous
position. If you are sued because of the negligent
operation of an automobile, your liability insurance
policy will pay those sums that you are legally obligated
to pay. Similarly, if you are seriously disabled, a
disability-income insurance policy will restore at least
part of the lost wages.
 Requisites/requirements of Insurable Risks
 not all risks are commercially insurable.
 Insurers normally insure only pure risks. However, not all
pure risks are insurable.
 Certain requirements usually must be fulfilled before a
pure risk can be privately insured.
 The characteristics of risks that make it feasible for private
insurers to offer insurance for them are called the
requisites of insurable risks.
 A risk could be considered an ideally insurable risk if it
satisfies the following preconditions:-
A)There must be a large number of exposure units:
 There must be a sufficient large number of homogeneous
exposure units to make the losses reasonably predictable.
 A large number of exposure units enhance the operation of
an insurance plan by making estimates of future losses
more accurate.
 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 insureds in the
underwriting class.
B)The loss must be accidental and unintentional:
 The loss must be the result of a contingency(possible but
not certain to occur); that is, it must be something that may
or may not happen.
 It must not be something that is certain to happen.
 If the insurance company knows that an event in the future
is inevitable, it also knows that it must collect a premium
equal to the certain loss that it must pay, plus an additional
amount for the expenses of administering the operation.
 The loss should be beyond the control of the insured. This
means that if an individual deliberately causes a loss, he or
she should not be indemnified/compensated for the loss.
 The requirement for an accidental and
unintentional loss is necessary for two reasons:-
1. 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.
2. Second, the loss should be accidental because the
law of large numbers is based on the random
occurrence of events.
 A deliberately caused loss is not a random event
since the insured knows when the loss will occur.
C)The loss must be determinable and measurable:
 The loss produced by the risk must be determinable,
describable and measurable.
 This means the loss should be definite as to cause, time,
place and amount.
 We must be able to tell when a loss has taken place, and
we must be able to set some value on the extent of it.

D)The loss should not be catastrophic:

 This means that a large proportion of exposure units
should not incur losses at the same time.
 The insurance principle is based on a notion/fact of
sharing losses, and inherent in this idea is the assumption
that only a small percentage of the group will suffer loss
at any one time.
 pooling is the essence of insurance.
 Insurers ideally wish to avoid all catastrophic
losses.
 In reality, however, this is impossible, because
catastrophic losses periodically result from :-
floods, hurricanes/tornadoes/destructive
windstorm, 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.
A)The chance of loss must 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.
F)The premium must be economically feasible:
The cost of the insurance must not be high in relation to
the possible loss.
 The insurance must be economically feasible.
 The insured must able to pay the premium.
 The probability of loss must be reasonable, or else the cost
of risk transfer will be excessive. The more probable the
loss, the greater the premium will be.
 In order to have an economically feasible premium, the
probability of loss must be relatively low.
 If the probability of loss is too high, the cost of the policy
will exceed the amount that the insurer must pay under the
contract.
 Functions of insurance
Insurance has two major functions:-

1. Primary Functions
 Providing certainty. Insurance provides certainty of
payment at the uncertainty of loss. assurance is given to
payment of compensation at the time of loss.
 Protection. The main function of insurance is to provide
protection against the probable chances of loss.
 Risk-sharing. When the risk takes place, all the persons
who are exposed to the risk share the loss.
2. Secondary Functions
 Prevention of loss. Primarily concerned with the
financial consequences of losses. Insurers do also have an
interest in reducing the frequency and the severity of loss.
 In short, the function of insurance is not merely
compensating those who suffered loss at the time the risk
materializes.
 However, insurance must make sure that adequate loss
prevention and loss control mechanisms were
implemented by the insured to minimize the probability
and severity of the loss.
Secondary Functions…
 Providing Capital. Insurance companies have, at their
disposal, large amounts of money.
o This arises due to the fact that there is a time gap between
the receipt of a premium and the payment of a claim.
 Insurers promotes a wide range of different forms of
investment by providing protection for those collateral
assets.
 By having spread of investments, the insurance industry
helps national and international businesses in their
borrowing.
 
BENEFITS OF INSURANCE
 The major social and economic benefits of insurance
include:
i. Indemnification for loss:

Indemnification permits individuals, families, and

business firms to be restored to their former
financial position after a loss occurs.

ii. Less worry and fear:

Worry and fear are reduced for a family and
property owner both before and after a loss.
Because the insured know that they have insurance
that will pay for the loss.
BENEFITS OF INSURANCE………..(Cont’d)
iii. Source of investment fund:
 The insurance industry is an important source of fund for
capital investment and accumulation.
 Insurers also invests in social investments, such as
housing and economic development for the benefit of the
general public.
iv. Encourage confidence to undertake new venture:
 Venture: an undertaking activities involving a chance of
risk, or danger especially : a speculative business
enterprise.
 Many business would not be started, and much research
and development would not be embarked upon or
started, unless the people concerned had confidence in
the protection against losses from risks provided by
insurance.
v. Loss prevention:
 Society benefits with the involvement of insurance
companies directly and indirectly in the loss prevention
activities.
 Such as; reduction of automobile deaths, fire prevention,
and reduction of wok related disabilities and etc..
vi. Reduces cost of capital
 Cost of capital is a company's calculation of the
minimum return that would be necessary in order to
justify undertaking a capital budgeting project, such as
building a new factory.
 The term cost of capital is used by analysts and
investors, but it is always an evaluation of whether a
projected decision can be justified by its cost.
 Investors may also use the term to refer to an
evaluation of an investment's potential return in
relation to its cost and its risks.
vii. Enhancement of credit
 Those insured assets are easily
acceptable collateral for credit.
The Role & Importance of insurance
The role and importance of insurance can be discussed in three phases:
individuals, business, & society
1) Uses to an individual (The insured person)
 Insurance provides security and safety.
 Insurance reduces the physical and mental stress that insured faces.
 Insurance affords peace of mind for the insured.
 Insurance protects the loss of mortgaged property.
2)Uses to Business
 Reduction of uncertainty of payment due to the occurred losses.
 Increasing business efficiency.
 Capital source for investment (if the capital source is not only internal)
 Improve Credit Standing/Insured assets are easily accepted as security.
The Role & Importance of insurance
3)Uses to society
 Wealth protection:
 With the advancement of the society, the wealth or the property of the society
attracts more hazards resulting in the creation of new types of insurance
invention to protect them against the possible losses.
 Through prevention of losses, insurance protects the society against
degradation of resources and ensure stabilization and expansion of business
and industry.
The Role & Importance of insurance……cont’d
 Economic growth
 Insurance provides strong hand & mind and protection against loss of property.
 In addition to these, insurance companies accumulate large sum of money
available for investment purpose that will enhance the economic development
of nations.
 Capital Formation/mobilize saving of the people and invest.
 Generating Employment Opportunities :
 
Generally
 The fact that the owner of a business has the opportunity to
recover from a loss provides the stimulus to business activity
that we noted earlier.
 It also means that jobs may not be lost and goods or services
can still be sold.
 The social benefit of this is that people keep their jobs, their
sources of income are maintained and they can continue to
contribute to the national economy.
We all know the effects on a community when:-
 a large employer moves or ceases operation;
 the area runs the risk of being depressed(suffering the
damaging effects of a lack of demand or employment),
 people have less money to spend and the consequences of
this can be far reaching.
TERMS IN INSURANCE.
i. Insurance policy : A written or printed
document, formally setting-out
particulars/details of the contract which has
been made between the insured and insurer.

ii. Insured : The first party, which is transferring

the risk; being either person or organization.
iv. Insurer : The second party, which is the one accepting the risk
or the one to whom the risk is transferred.
v. Premium : is a price to be paid by the insured to the insurer.
vi. Proceed: the amount of cash that insurers pay to insured at a
time of loss.
vii. Pooling : Sharing of total loss to the group within the same
exposure unit.
viii. Pool : The premium insurers collects to create a ‘fund’ to protect
the group of insurers themselves.
 Pool- A group of insurers or reinsurers through which particular
types of risks (often of unexpected in its nature) are underwritten
, with premiums, losses, and expenses shared in agreed ratios.
viii. Underwriting: the process insurers use to determine the risks
of insuring your property. It involves the insurance company
determining whether your firm poses an acceptable risk and, if it
does, calculating a fair premium price for your coverage.
 3.5. Insurance and Gambling Compared
Insurance is often erroneously confused with gambling.
There are three important differences between them.
 First, gambling creates a new speculative risk, while
insurance is a technique for handling an already
existing pure risk. Thus, if you bet $500 on a horse
race, a new speculative risk is created, but if you pay
$500 to an insurer for a homeowner’s insurance policy
that includes coverage for a fire, the risk of fire is
already present. No new risk is created by the
transaction.
Second, gambling is socially unproductive since the winner`s
gain comes at the expense of the loser. In contrast, insurance
is always socially productive, since neither the insurer nor the
insured is placed in a position where the gain of the winner
comes at the expense of the loser.

The insurer and the insured both have a common interest in the
prevention of a loss. Both parties win if the loss does not
occur.

Third, gambling transactions never restore the losers to their

former financial position. In contrast, insurance contracts
restore the insured financially in whole or in part if a loss
occurs.
 Both the insured and the gambler may collect more money
than they payout, the outcome being determined by some
chance event.

 However, through the purchase of insurance, the insured

transfers an existing pure risk.

A gambler creates a speculative risk.

 Gambler bear risk, while insured transfer risk.

 Gambler prefers uncertainty to certainty, while the insured

prefers certainty to uncertainty.
Insurance Vs gambling

Generally:-
Gambling
 Creates new speculative risk.
 Socially unproductive because the winners gain comes at
the expense of the loser.
 Never restore the losers to their former financial position.
 Gambler bear risk.
 Gambler prefers uncertainty to certainty.
Insurance
 Handling an already existing pure risk.
 Socially productive.
 Restore the position of insured financially in whole or in
part if a loss occurs.
 Insured transfer risk.
 Insured prefers certainty to uncertainty.