CHAPTER THREE

INSURANCE

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 Insurance Defined
Insurance can be defined as a contractual agreement
between two parties: the insurer and the insured.

Under the agreement, the insurer agrees to reimburse

loss (as defined in the insurance contract) in return for
the insured's premium payment

Insurance is a system used to handle risk, or transfer

risk.

Insurance is a device used to spread the loss suffered

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by an individual or firm to the members in the group.
The following Three points must be considered
regarding insurance contracts
1. There are usually two parties in the contract:
the insurer and the insured.
2. The insured transfers his risk to the insurer.
To this effect, he will have to pay premium.
3. If the specified risk materializes (happened
to the insurance), within a specified period,
the insurer will make financial compensation
to the insured or his beneficiary.
The insured is restored to his former position
called Indemnification.
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 Basic characteristics of insurance
An insurance plan or arrangement typically has certain
characteristics.
Pooling of losses
– Spreading losses incurred by the few over the entire
group
– Risk reduction based on the Law of Large Numbers
Payment of accidental losses
– Insurance pays for losses that are unforeseen,
unexpected, and occur as a result of chance
– The loss must be accidental
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Risk transfer
– A pure risk is transferred from the insured to
the insurer, who typically is in a stronger
financial position

Indemnification
– The insured is restored to his or her
approximate financial position prior to the
occurrence of the loss
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 Fundamentals of insurable risks
Not all risks are commercially insurable.
• Insurers normally insure only pure risks.
• However, not all pure risks are insurable.
• A risk could be considered an ideally
insurable risk if it satisfies the six conditions
below.
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/disastrous
5. The chance of loss must be calculable
6. The premium must be economically feasible 6
1. There must be a large number of exposure units
– There must be a sufficiently large number of
homogeneous exposure units to make the losses
reasonably predictable.
– Example: Large number of houses in a city can be
insured through property insurance on houses.
2. The loss must be accidental and unintentional
– The loss must be the result of a contingency
– The loss must not be something that is certain to happen
 Two reasons why the second requirement is necessary:
1- To control moral hazard
If the intentional loss paid by insurer, moral hazard
would be increased substantially and the premiums would
rise consequently ( eg. fake accident, fraudulent claim,
inflating the amount of a claim, Intentionally burning the
unsold merchandise).
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 2- To assure randomness
– The loss should be accidental because the law of
large number is based on the random occurrence
of events whereby the intentional loss is not a
random event. Therefore, the aim of law of large
number is violated due to the prediction of
future experience may be highly inaccurate.
3. The loss must be determinable and measurable
– To facilitate loss adjustment
• Insurer must be able to determine if the loss is
covered and if so, how much should be paid.

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4. No catastrophic loss
– The loss should not be catastrophic
meaning that a large number of exposure
units should not incur losses at the same
time
– Losses occurred from earth quakes,
floods and other natural disasters will
not be insured.
– Exposures to catastrophic loss can be
managed by:
• dispersing coverage over a large geographic
area
• using reinsurance

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5. Calculable chance of loss
– The insurer must be able to calculate both the
average frequency and the average severity
of future losses with some accuracy to
establish an adequate premium
6. Economically feasible premium
- The cost of insurance must not be high in
relation to the possible loss
- so people can afford to buy

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 • Dose the risk of Fire satisfy these
requirements?

• Dose the risk of unemployment satisfy

these requirements?

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 Adverse Selection and Insurance
• When the insurance is sold, insurers must deal with the
problem of Adverse Selection.
• Adverse selection is the tendency of persons with a higher
than-average chance of loss to seek insurance at standard
rates “
Examples
1- High drivers who seek auto insurance at standard rates
2- Persons with serious health problems who seek life or
health insurance at standard rates
3- Business firms that have been repeatedly robbed or
burglarized seek crime insurance at standard rates.
Hence, insurance companies try to control adverse selection by:
• – Careful underwriting (selection and classification of
applicants for insurance)
• - Policy provisions 12
 Insurance vs. Gambling
Insurance Gambling
• Insurance is a technique • Gambling creates a new
for handing an already speculative risk
existing pure risk

• Insurance is socially • Gambling is not socially

productive: productive
– both parties have a – The winner’s gain comes
common interest in the at the expense of the
prevention of a loss loser

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 Insurance vs. Speculation
Insurance Speculation
• Risk is transferred by a • Risk is transferred by a
contract contract
• Insurance involves the • Speculation involves
transfer of insurable risks that are typically
risks uninsurable
• Insurance can reduce • Speculation involves
the objective risk of an only risk transfer, not
insurer through the risk reduction.
Law of Large Numbers

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 Benefits and Costs of Insurance
Benefits of Insurance
Indemnification for Loss
– To provide financial compensation to those insured
who suffered losses due to accidental misfortune
– Contributes to family and business stability
Source of Investment Funds
– Premiums may be invested, promoting economic growth
Reduction of Worry
– Insurance reduces the physical and mental stress that
insured’s face concerning the possibility or financial loss.

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Encourages Saving
– In life insurance, certain policies have dual
advantages: Financial protection in the event of
death, and saving in the event of survival.
Enhances Efficient Utilization of Resources

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 Limitations of Insurance
Insurance deals with only pure risks.
- Not all pure risks are insurable.

- Examples include Flood, earthquake …

Cost of Doing Business

– Insurers consume resources in providing insurance to

society
– 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 17
 Fraudulent Claims
• Losses that are intentionally caused
Examples include the following:
 Auto accidents are faked or staged to collect
benefits.
 Dishonest claimants fake slip-and-fall accidents.
Inflated Claims
 Another cost of insurance relates to the submission
of inflated.
 Although the loss is not intentionally caused by the
insured, the dollar amount of the claim may exceed
the actual financial loss. 18
 End of
the
chapter 19