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CHAPTER THREE
INSURANCE

The meaning of Insurance

Overview
The word insurance is mentioned quite often in everyday conversation. In the
previous two chapters, the term insurance has been mentioned many times. True that
insurance is a buzzword that is used by many people. You surely have some basic
understanding of the word but, as a student of business, the concept embodied in the
usage of the usage of the word insurance needs to be very clear to you. In this section,
we will discuss what is meant by insurance in sufficient detail. We may list some
definitions of insurance to clearly describe the terminology but giving definition is by
no means the only thing we are going to do in this section. Rather in an effort to
present the concept in a very clear manner, we shall make efforts to distinguish
insurance from other concepts such as gambling, speculation, etc.
 Insurance Defined
What is your understanding of the term insurance?

At some point in your life you may have purchased insurance policies or you may know
of some one who has purchased insurance policies. If that is the case, it seems you have
some notion as to what this term really means and thus you understand the fact that
insurance is a system used to handle risk or transfer risk. But that simple understanding
would not suffice and in this section we will do our best to define insurance properly. As
I have promised in the above overview, when defining insurance we won’t be limited by
listing definitions as this will not properly serve our purpose. Besides, it is some how
difficult to give a comprehensive explanation of the term by limiting oneself with one or
two definitions, some definitions. However, though not comprehensive by themselves,
may provide reasonably sufficient explanation of the term.

Consider the following definitions of insurance.

Definition 1: An insurance policy is a contract whereby a person called the insurer

undertakes against payment of one or more premiums to pay to a person called the
beneficiary, a sum of money where a specified risk materializes.
Definition 2: Insurance is a device by means of which the risks of two or more persons
or firms are combined through actual or promised contributions to a fund out of which
claimants are paid.

Definition 3: Insurance is a device for transfer of risks of individual entities to an insurer,

who agrees, for a consideration called the premium, to assume to a specified extent of
losses suffered by the insurer.

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Have you read the definitions properly? What do they indicate?

The above definitions will enable you to give attention to the following points:
 Insurance is a risk transferring mechanism.
 There are usually two parties in the insurance contract. The first party is the entity,
which is transferring the risk; being either a person or an organization. The second
party is the one accepting the risk or in other words the one to whom the risk is
transferred, which in insurance terminology is refereed to as the insurer.

Are there always only two parties?

In some types of insurance three parties might be involved. For instance, in fidelity
guaranty policy, three parties are involved. In an insurance contract both parties have
their own responsibilities. When an insured transfers his/her risk to the insurer, there is a
price to be paid. In insurance terminology, we refer to this as a premium. In fact the
insurer has also responsibility to fulfill. That is if the specified risk materializes within
the specified period of time, the insurer agrees to compensate the insured or the insured’s
beneficiary.

 Though insurance is basically a two party contract, there are times when it might
involve three parties.
But first what do we mean by compensation?
By compensation we are referring to the fact that the insurer restores the insured to
his/her former financial position. In other words the insurer indemnifies the insured. We
will say more about this in subsequent sections.

But how can insurers agree to accept the risk that others are avoiding, especially when
they know there are so many fire incidents, accidents, thefts, injuries and other losses
incidents day?

The answer strongly lies in the very fact that insurers can predict with some certainty
how many incidents there will be. They do not know exactly but, based on their long
experience of dealing with risk, they have a very good idea. More important, they know
that it is not every one who is going to suffer the risk.
An example may illustrate this point. There could be more than hundred thousand people
who own vehicles. Most of these people might have purchased automobile insurance
policies as they are afraid of car accidents. But in reality only very few automobile
accidents might happen. Thus since the insured has a good knowledge of this fact it
agrees to accept the risk the individuals. The thing is so many people worry about the risk
of accidental losses while in reality only a very few people actually suffer risks.

Think for a moment the street where you live by. How many fire incidents can you
remember recently in the houses around that street?

It is really not all that likely that your house will catch fire: that your car will bump into
another car; that you yourself will be injured at work. Nevertheless, if it did happen, it
could be a disaster for you. Insurance company, which we have refereed to as the insurer,

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is able to offer the protection. It does so by grouping together a large number of people
who all feel exposed to the same form of risk. This could be fire, theft, accident or any
other risk that we have mentioned before and will look at later in more detail.
 An insurer becomes willing to accept a risk transferred to it due to its specialized
knowledge as to the probable occurrence of losses.
In any case an insurer gathers together people that are exposed to the same risk knowing
that in any one year very few in the group will actually suffer any loss. By collecting an
amount of money from each person in the group, they can accumulate a fund, an amount
of money out of which the losses suffered by the few who become victims can be paid.
This is one important function of insurance and we shall say more about it in the next
unit.
The point we’ve mentioned in the above paragraph might make you pose a question:
If the insurer has to pay money to the insured what is the point of it all? Will it not be
better to just put the money in the Bank instead of paying it to an insurance company, and
wait for the day the loss might happen?

Not really! Give it a good thought and you will see that the bank option is not really a
better choice.

Think about it! If you own a 500,000 Birr house, a 300,000 Birr car, and say a 3,000,000
Birr worth factory, how much will you put in the Bank?

3,800,000 Birr, right? That is a big amount of money. You may not have that amount of
money and even if you have, it is unwise to tie up such an amount rather than using it for
investment. As you do not really know when the risk will happen, and it is unlikely you
could put away enough money for such an occurrence.
 A term premium refers to the price the insured pays to the insurer for the protection
he/she gets from the latter.
Besides, the money paid to an insurance company, the premium, is a very, very small
amount in relation to the value of a house, car or factory. We will discus about premium
determination in the future but as insurance fund is established out of contributions of
various people, the rate each one is expected to pay is too small as compared to the value
of the subject matter insured. The only reason the insurance company requires such a
relatively low premium is because it has gathered premiums from a large number of
people, most of who will not suffer a loss or at least won’t suffer the risk at one time.

The premiums paid by all the people who seek protection go towards paying for the
losses of the few who actually suffer. This does not mean that if you did not suffer at the
hands of some risk, you have paid your money for nothing. You had the security, you had
the peace of mind all through the year and, if anything had happened, you would have
been financially protected.

So insurance is a mechanism which takes upon itself the risks of others. It does so by
asking for a contribution, a premium, from each person seeking protection and then holds
this money, investing it wisely, until some has to be paid to the few who will actually fall
victim of risk.

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Does that mean all insured pay equal amount of premiums?

It is important to point out here that not all the contributions to this common pool will be
the same. Different pools exist for different kinds of risk such as fire, theft, motor
accidents, and aviation, marine and so on. But within one form of risk, the premiums will
not be the same.

Take the pool, which an insurance company might operate for motor accidents. It would
not be fair for a man with a two-door small Toyota car to pay the same as the owner of a
one million Birr worth 320 Model Mercedes Benz. Nor would it be reasonable for the
family man with a small Volkswagen car to pay the same as an eighteen year old boy
who has just received his driving license with a Mercedes sports car.

The above examples illustrate the fact that different members of the pool present different
hazards to the pool and their contribution to the fund varies accordingly. Thus there must
be some balance between how much a person puts in and how much it is likely the pool
will have to pay that person in the event of a claim.

This is what insurance companies are doing in their offer of insurance policies. Insurance
companies in our country offer various policies and they charge different rates for
different types of subject matters insured. Even when considering the same subject matter
insured, say automobiles, the rate varies for different ones.
 Premiums charged for different types of insurance coverage vary depending on the
degree of risk they bring into the group.

In general, we can say that insurance is one major devise for dealing with problems of
risk. It is a group devise in that people exposed to similar risks create a common fund out
of which the misfortune will be paid. Insurance then gives people some degree of
security. It allows them to get peace of mind and relieve themselves from a great deal of
financial hardship.

Basic characteristics of Insurance

The insurance has the following characteristics which are, generally, observed in case of
life, marine, fire and general insurances.
1. Sharing of Risk:
Insurance is a device to share the financial losses which might befall on an individual or
his family on the happening of a specified event. The event may be death of a bread-
winner to the family in the case of life insurance, marine-perils in marine insurance, fire
in fire insurance and other certain events in general insurance, e.g., theft in burglary
insurance, accident in motor insurance, etc. The loss arising from these events if insured
are shared by all the insured in the form of premium.

2. Co-operative Device:

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The most important feature of every insurance plan is the co-operation of large number of
persons who, in effect, agree to share the financial loss arising due to a particular risk
which is insured. Such a group of persons may be brought together voluntarily or through
publicity or through solicitation of the agents.
An insurer would be unable to compensate all the losses from his own capital. So, by
insuring or underwriting a large number of persons, he is able to pay the amount of loss.
Like all cooperative devices, there is no compulsion here on anybody to purchase the
insurance policy.
3. Value of Risk:
The risk is evaluated before insuring to charge the amount of share of an insured, herein
called, consideration or premium. There are several methods of evaluation of risks. If
there is expectation of more loss, higher premium may be charged. So, the probability of
loss is calculated at the time of insurance.
4. Payment at Contingency:
The payment is made at a certain contingency insured. If the contingency occurs,
payment is made. Since the life insurance contract is a contract of certainty, because the
contingency, the death or the expiry of term, will certainly occur, the payment is certain.
In other insurance contracts, the contingency is the fire or the marine perils etc., may or
may not occur. So, if the contingency occurs, payment is made, otherwise no amount is
given to the policy-holder.
Similarly, in certain types of life policies, payment is not certain due to uncertainty of a
particular contingency within a particular period. For example, in term-insurance then,
payment is made only when death of the assured occurs within the specified term, may be
one or two years. Similarly, in Pure Endowment payment is made only at the survival of
the insured at the expiry of the period.
5. Amount of Payment:
The amount of payment depends upon the value of loss occurred due to the particular
insured risk provided insurance is there up to that amount. In life insurance, the purpose
is not to make good the financial loss suffered. The insurer promises to pay a fixed sum
on the happening of an event.
If the event or the contingency takes place, the payment does fall due if the policy is valid
and in force at the time of the event, like property insurance, the dependents will not be
required to prove the occurring of loss and the amount of loss. It is immaterial in life
insurance what was the amount of loss at the time of contingency. But in the property and
general insurances, the amount of loss as well as the happening of loss, are required to be
proved.
6. Large Number of Insured Persons
To spread the loss immediately, smoothly and cheaply, large number of persons should
be insured. The co-operation of a small number of persons may also be insurance but it
will be limited to smaller area. The cost of insurance to each member may be higher. So,
it may be unmarketable.
Therefore, to make the insurance cheaper, it is essential to insure large number of persons
or property because the lesser would be cost of insurance and so, the lower would be
premium. In past years, tariff associations or mutual fire insurance associations were
found to share the loss at cheaper rate. In order to function successfully, the insurance
should be joined by a large number of persons.

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7. Insurance is not a gambling:

The insurance serves indirectly to increase the productivity of the community by
eliminating worry and increasing initiative. The uncertainty is changed into certainty by
insuring property and life because the insurer promises to pay a definite sum at damage
or death.
From a family and business point of view all lives possess an economic value which may
at any time be snuffed out by death, and it is as reasonable to ensure against the loss of
this value as it is to protect oneself against the loss of property. In the absence of
insurance, the property owners could at best practice only some form of self-insurance,
which may not give him absolute certainty.
Similarly, in absence of life insurance, saving requires time; but death may occur at any
time and the property, and family may remain unprotected. Thus, the family is protected
against losses on death and damage with the help of insurance.
From the company's point of view, the life insurance is essentially non-speculative; in
fact, no other business operates with greater certainties. From the insured point of view,
too, insurance is also the antithesis of gambling. Nothing is more uncertain than life and
life insurance offers the only sure method of changing that uncertainty into certainty.
Failure of insurance amounts gambling because the uncertainty of loss is always looming.
In fact, the insurance is just the opposite of gambling. In gambling, by bidding the person
exposes himself to risk of losing, in the insurance; the insured is always opposed to risk,
and will suffer loss if he is not insured.
By getting insured his life and property, he protects himself against the risk of loss. In
fact, if he does not get his property or life insured he is gambling with his life on
property.
8. Insurance is not Charity:
Charity is given without consideration but insurance is not possible without premium. It
provides security and safety to an individual and to the society although it is a kind of
business because in consideration of premium it guarantees the payment of loss. It is a
profession because it provides adequate sources at the time of disasters only by charging
a nominal premium for the service.
Gambling :Gambling is the act of risking money or something of value on an uncertain
event, usually for the purpose of winning additional money or material goods. It involves
three key elements:
 Consideration: .

 Risk/Chance

 Prize:

Is insurance in a sense similar to gambling?

The answer to this question requires a proper insight as to what these terminologies really
stand for. The essential feature about gambling is that it creates a risk where none existed
before.

What are you doing when you buy a lottery?

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When you buy a lottery ticket or place a bet on a horse, you are putting your money at
risk in a bid to profit out of it. In that aspect you are putting your money at risk which
was not in jeopardy before. You may or you may not win and thus there is a chance of a
loss or a gain. Insurance, however, is a device to transfer risk. When some one purchases
an insurance policy, the objective in mind is not to make profit out of it but to just create
a means of avoiding accidental losses.

 The man who gambles creates a risk, which did not exist previously, whereas the
man who insures minimizes a risk which was already there and which is not in his
power to avoid.

 The gambler, with the hope of a gain, goes out of his way to bring a risk into
being while the man, who insures, for purposes of avoiding a loss, goes out of his
way to hedge against a risk which already exists.

 The man who gambles accepts deliberately the risk of loss in exchange for the
possibility of profit; the man who insures accepts deliberately the certainty of a
small loss in exchange for the freedom from risk of devastating catastrophic loss.
One major difference between gambling and insurance is in that the former creates a new
risk while the latter attempts to minimize an already existing risk.

We can say then that the gambler bears a risk while the insured transfers a risk.
Considering the many risks to which we are exposed daily: fire, motor accident, etc.,
there is certainly no complete escape from the hazards, and the man who gambles by not
insuring against them is gambling against frightful odds.

The man who insures, on the other hand, pays fixed, a certain, and relatively small loss
(the premium), and in doing so, does not gamble which would have been ruinous to him
and his family.
A gambler prefers uncertainty to certainty while the insured prefers vice versa.
Activity
Answer the following questions on the space provided.
1. Give some definitions of insurance.
 Insurance is a financial arrangement where an individual or entity receives financial
protection or reimbursement against losses from an insurance company.
2. Explain in your own words what is meant by insurance.
3. Distinguish insurance from gambling.
Insurance:
 Purpose: Protects against potential losse
 Risk Management: Spreads risk among many people
 Outcome: Compensation for loss, providing financial stability
 Legality: Heavily regulated to protect consumers.
Gambling:
 Purpose: Seeks to generate profit from an uncertain outcome.

 Risk Creation: Creates risk for the purpose of potential gain.

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 Outcome: Win or lose, often with significant financial impact.

 Legality: Regulated, but with different intentions and purposes compared to insurance

4.Why, in your opinion is the insured willing to accept the risk, which the insurer wants
to transfer?

The functions, benefits and limitations of insurance

Introduction
Insurance plays an extremely important role in ensuring the economic wellbeing
of a country, but it does not have a high profile and therefore many people have
little idea of the full role it plays. For many, knowledge of insurance is limited to
their own personal house, motor or life insurance. These forms of domestic
insurance are all-important, but are in relation to small part of the overall activity
within the insurance industry.

In this unit then we will explore the role insurance plays in attempting to address
some of the problems created by risk. Accordingly, we will see that what insurance
service provides to the industry, and individuals have far reaching benefits both for
those who insure and for the country as a whole. For reasons of easy presentation we
will start by looking at the main functions of insurance and then move on to examine
the benefits which can be derived from performing these functions. And finally we
will touch upon the benefits and costs of insurance.

The Functions of Insurance

Overview

The main function of any organization is to meet the objectives laid down for it
by its owner. In industry, the owners will normally be a large number of
shareholders, and objectives are usually measured in terms of monetary return on
their investment. This is also true for many insurance organizations. But functions
of individual organizations are not much of a concern for us here. Rather than
discussing the functions of individual organizations, we will in this section
concentrate on the function of insurance itself.

What is the role of insurance? What function does it perform?

From the discussion we have made above, you have some basic notion of how
insurance works: a person pays a premium at the beginning of a year and can make a
claim if certain events that occur. This is equally true for individuals insuring their
houses and for airlines insuring jumbo jets at the other end. The concept is not
difficult to grasp, or so we might think! But it is important to elaborate as to why
insurance exists or what specific functions it serves.

Risk Transfer

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The primary function of insurance is to act as a risk transfer mechanism. We can see
this by considering two examples, the individual and a business organization. Think
of the car owner who has a car valued at, 100,000 Birr, which probably represents one
of the largest investments he is ever likely to make. A considerable amount of his
savings has been invested in its purchase and even the least risk-conscious person
would recognize that he/she is at risk in such a situation. The car could be stolen,
damaged in an accident or catch fire. Or probably there could be an accident resulting
in a serious injury to passengers or other people.

How will the owner of the car cope with all of these potential risks and their financial
consequences?

The person has no knowledge of whether or not any of them will materialize and, if
they do, what the cost is likely to be He could get to the end of the year completely
free of incident, or his car could he totally destroyed tomorrow! Insurance will not, in
itself, prevent any of the above risks from occurring. What it rather does is to provide
some form of financial security. The owner of the car can transfer the financial
consequences of the risk to the insurer, in return for paying a premium.

The same is true for businesses. The managing director of a given company knows
that his fir is exposed to a whole range of risks, which we have discussed in detail in
the first module. He does not know if any of them will materialize and, if they do,
what the cost is likely to be. However, if he has a loss of some kind, he will have to
recover the cost from his customers by increasing the price of the product he
manufactures, or the service he provides.

What cost will he pass on?

He has no idea whether he will have a loss or not, or the cost of any loss which might
occur. The function that insurance performs in this situation is to be a risk transfer
mechanism. The managing director can exchange his uncertainty for certainty in
return for a definite loss. The risks themselves are not removed, but the financial
consequences of some are now become apparent with greater certainty and their costs
can budgeted accordingly.

A whole range of benefits flow from this primary function of risk transfer and these
are discussed in much detail in the second section of this unit. But before moving on
to examine each one in detail, there are two other functions, which we should look at:
the common pool and equitable premiums. There are some disagreements among risk
and insurance writers and practitioners as to whether these two are functions by
themselves or are benefits that are derived from the first function. In this instance we
will consider them as functions in their own right.
 A primary function of insurance from which the whole range of benefit flows is
the fact that it serves as a risk transfer mechanism.

Creation of a common pool

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To elaborate the second function of insurance, let me point out what used to be the
case when a common pool was not created. In the early days of marine insurance, the
various merchants who were having goods carried on a ship would agree to make
contributions to those who may have suffered a loss during the voyage, after the loss
had taken place. This certainly removed the risk of a total loss from any one
merchant, as each one knew that his loss would be shared. What it did not do was to
give the merchant any idea of what his loss would be; he only knew this after a
voyage. If there had been no losses then he would have anything to pay, but he had
agreed to share in any losses which had taken place and the exact amount of these
could have only been determined after the event had taken place.

Do you think this was a satisfactory state of affairs?

Not really! This was not an entirely satisfactory state of affairs. It would have been
far better to know what your share of the loss was going to be, before it took place.
This seems a strange thing to say. And it could trigger a question to your mind; how
can one calculate the amount of a loss before it takes place? This is where the
common pool comes in. The difficulty for any one person is that they can only guess
what the future holds in terms of losses. The owner of a 50,000 Birr house does not
know if he will have a loss during any one-year and if he does what it will cost, he
could put aside a few hundred Birr in a special bank account to prepare for a loss, but
that loss could be several thousand Birr, the complete destruction of the house or
nothing at all. However, it would be different if he could get together with other
people in the same situation. In other words, the case would be different if a common
pool is created.

What difference would the creation of a common pool make? Creating a common
pool in the context of insurance involves collecting premiums from many insured
individuals into a collective fund. Here are some key differences it can make

In order to clarify this point and the function of a common pool, let us concentrate on
the risk of the person’s house being totally destroyed and say that there is one in a
thousand chances that this will happen during the year. We could’ve obtained this
figure from past experience of similar houses, or from consulting publicly available
statistics. To an individual homeowner, this knowledge that one in every thousand
houses will be destroyed has no great value: but if we consider a large number of
houses, it does begin to mean something. For example, if there were one thousand
similar houses, then we could say that one of them will probably be destroyed during
the year. (This is the one in a thousand chance of a house being totally destroyed). On
the average, therefore, the expected total loss would amount to 50,000 Birr. Knowing
this, the owners of the one thousand houses could all contribute at least 50 Birr into a
common pool, and there would then be enough to pay for the one loss. (I hope you do
remember our discussion of expected value concept in the previous chapter).

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To be realistic, we would have to say that there is no guarantee that there would only
be one loss. This is what was expected, based on our calculations, but there could of
course be more than one loss or even no loss. However, the principle remains the
same; the losses of the few are met by the contributions of the many, and the
mechanism which allowed this to happen is what we referred to as a common pool.
 Another function of insurance is the creation of a common pool, which enables
individuals or organizations to make contributions for financing of a loss
occurring to a member.

Why would an insurance company be willing to take such risks?

An insurance company sets itself up to operate such a pool. It takes contributions, in

the form of insurance premiums from many people and pays the losses of some few.
The contributions have to be enough to meet the total losses in any one-year and
cover the other costs of operating the pool including the profit of the insurer. Even
after taking all these costs into account, insurance is still a very attractive proposition
in very many cases. This is why then insurance companies are willing to take the risks
transferred to them.

In operating the common pool, the insurer benefits from the law of large numbers.
This says that the actual number of events occurring will tend towards the expected
number where there are a large number of similar situations. This can be seen in a
simple illustration with a coin: a flip of a coin could result in a head or a tail. Flipping
a coin twenty times could result in any combination of heads and tails; we could get
twelve heads and eight tails, nine heads and eleven tails or any other split. On the
simple mathematics of the situation, we would expect to get the same number of
heads and tails, because the chance of getting either one is 50% However, flipping the
coin twenty times may not give us the result we expected. Had we tossed the coin ten
thousand times we would almost certainly get something very, very close to five
thousand heads and five thousand tails? The law of large numbers would have
operated to give a result, which was in keeping with the underlying probability.
 The law of large numbers is the basic reason that makes possible the creation of
the common pool, which by itself makes insurance a group scheme.

Going back to the house insurance example, we can see the same law at work. The
insurer can fairly confidently predict what the final total cost is likely to be in any one
year, simply because a large number of similar events are insured and the final
number of events will tend to be very close to the expected number. There are one
thousand houses and the insurer expects only one of them to be totally destroyed. The
cost of this will be 50,000 Birr and a contribution will have to suffice he made to the
insurer. The actual outcome in one year may vary from what is expected, but a small
provision in the amount collected from each person insuring will take care of this.

The result is that the insurer can fix a premium and the person insuring knows,
subject to the type of cover purchased, that he will not have to pay any more at the
end of this year.

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Equitable premiums

What do we mean by equitable premiums? Equitable premiums refer to insurance

premiums that are fair and just, considering the risk level of each insured individual.

It is clear that there can be several of these pools one for each main type of risk. The
people who have houses to insure would not contribute to the same pool as those
insuring cars. Operating in this way allows an insurer to identify, which types of
insurance are profitable and which are not. In realty there may be some transferring of
funds across the pools, but this stage it is simpler for us to imagine individual pools
for different types of risk.

Even when risks of a similar type are brought together in a common pool, they do not
all represent the same degree of risk to the pool itself. That is, the probability of a loss
having to be met by the pool is not equal over all those in the pool. For example an
old building made up of wood represents a different risk from one of standard brick
construction. Besides, an eighteen year old driver, with a fast sports car, is quite a
different risk from a forty year old married man, driving a family saloon. And an
employee using woodworking machinery is probably at greater risk of personal injury
than someone who spends his/her working days in an office.

In each of these examples, the insurer is faced with risks of differing magnitude or
hazards. The probability of an event occurring was quite different for each of the
pairs in the examples that we quoted. This will have to be reflected in the
contributions which each will make to the pool. It would not be equitable to expect
the driver of the family car to that who chooses to make an equitable contribution to
that pool.

In chapter 2 we have introduced frequency and severity as being very important

characteristics of risk data. Clearly the ideas of hazard and value are closely linked to
frequency and severity. Each risk has the probability with which it occurs, its
frequency or hazard. It also has the eventual cost should it occur, the severity or value
as we have termed it in this Unit.

How an equitable contribution is arrived at will be discussed later, but it can be seen
that the assessment of risk is extremely important. The insurer has to ensure that a fair
premium is charged, which reflects the hazard and the value which the person or
company brings to the pool. This is a complex enough process by itself, but in
addition, the premium must also be competitive. There is not just one insurer in the
market place and hence competition enters into the calculation. For instance if
Ethiopian Insurance Corporation charges a premium that greatly exceeds that quoted
by other insurers, then it will probably lose the business. Charging too little also have
its dangers: the contributions to the pool would be less than required and a loss would
be made. This loss would have to be recouped at some stage, possibly making the
premiums uncompetitive at that time.

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 Insurance works under equitable premiums in that every one is made to contribute
according to the risk he/she brings in.
Think back over the section that we have just finished discussing! What are the main
functions of insurance and how are they related?

We have looked at three main functions of insurance; viz.,

Risk transfer;
Creation of the common pool; and
Equitable premiums.
These three functions are all inter-dependent: the creation of the common pool and
the calculation of equitable premiums all assist in providing a sound risk transfer
mechanism.

Activity
Answer the following questions on the space provided.
1. Discuss the association between creation of a common pool and equitable
premiums
2. What is the primary function of insurance?
3. “The three functions of insurance are interrelated.” Discus. Insurance has three main
functions: risk transfer, risk pooling, and risk allocation. These functions are
interconnected and work together to create a comprehensive risk management system

The Benefits of Insurance

Overview

As has been discussed in the foregoing section, the main function of insurance is to
spread the losses suffered by an insured member over the whole of the insuring
community. It does this by serving as a risk transfer mechanism and thus paying out
compensations to those who suffer losses from the pool created by the equitable
contributions of all insured individuals. Each individual will contribute to the fund an
amount, which is commensurate with the risk he introduces. If the above is properly
fulfilled, therefore, both the individual insured and the insurer stand to benefit. While the
insured feels secured in the knowledge that insurance is there in case of a loss, the insurer
on the other hand benefits from investment income and any profits made.

The existence of a sound insurance market is an essential component of any successful

economy and the proof of this can be seen in many parts of the world. The fact that
insurance is much less talked about than other financial institutions (such as banks,
merchant banks and building societies) is no reflection of its real importance. Many
writers on economic history and the history of insurance comment on the link between a
sound insurance market and industrial development. The benefits, which prompted many
writers to make such observations, are still obtainable and we will look at some of these
benefits in the next part. As there is no special significance attached to the order in which
they are mentioned we will simply go on discussing them one by one. And finally we will
touch upon some of the costs of insurance.

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In this section of this unit, we will be more specific and try to assess those specific
benefits of insurance enjoyed by individuals, business firms, and the society at large.
Thus make sure you have achieved the following objectives when you go through this
section.

What do you think are the main benefits of insurance?

Below are some of the main benefits that insurance provides.

Financial Security
Insurance provides financial security to an individual whether he is engaged in service or
business or a profession. An individual is exposed to risk or accidental death or
disablement or illness. Personal accident and sickness insurance affords financial
protection.

In addition to death or illness an individual’s property might be exposed to the risk of

fire, business or a profession. An individual is exposed to risk or accidental death or
disablement or illness. Personal accident and sickness insurance affords financial
protection.

In addition to death or illness an individual’s property might be exposed to the risk of

fire, burglary, etc. His house may be burgled and the savings of a lifetime may be lost. A
fire may ruin the resources of a trader or shopkeeper. The relevant policies provide the
necessary financial protections. Similar protections are available under numerous other
types of insurance the details of which will be discussed in the forthcoming module.

In brief, since insurance protects an individual against accidental or fortuitous events and
its financial consequences, he/she would be freed from anxiety on this score and thereby
gets encouraged to make savings and generally lead a better life.

 By purchasing different insurance policies, people can enjoy financial security

insurance provides.
Note that this very concept of financial security can be expressed in term of reduction of
reserve requirement. Perhaps we can say that the greatest social value---indeed, the
central economic function--- of insurance is to obtain the advantages that flow from the
reduction of risks. One of the chief economic burdens of risk is the necessity for
accumulating funds to meet possible losses, and one of the great advantages of the
insurance mechanism is that it greatly reduces the total of such reserves necessary for a
given economy. Because the insurer can predict losses in advance, it needs to keep
readily available only enough funds to meet those losses and to cover expenses. If each
insured had to set aside such funds, there would be need for a far greater amount. For
example, a 100,000 Birr building can be insured against fire and other physical perils for
about less than 500 Birr a year. If insurance were not available, the insured would
probably feel a need to set aside funds at a much higher rate than 500 Birr a year. This
example shows the very important role insurance plays in reducing the need to put aside
large amounts of reserve money.

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Peace of Mind
Peace of mind is the other benefit insurance provides. The knowledge that insurance
exists to meet the financial consequences of certain risks provides a form of peace of
mind. This is important for private individuals when they insure their car, house,
possessions and so on, but it is also of vital importance in industry and commerce.

Why should a person put money into a business venture when there are so many risks
which could result in the loss of the money?

We’ve pointed out earlier that risk is an inherent element of business and we also have
underlined the fact that there is a possibility of managing it. This is what encourages
people to engage in business regardless of the existence of risk. In other words, buying
insurance allows the entrepreneur to transfer at least some of the risks of being in
business to an insurer, in the manner we have described earlier and makes him engage in
business.

Insurance also acts as a stimulus for the activity of businesses, which are already in
existence. This is done through the release of funds for investment in the productive side
of the business, which would otherwise require to be held in easily accessible reserves to
cover any future loss. Medium sized and larger firms could certainly create reserves for
emergencies such as fires, thefts or serious injuries.

However, this money would have to be accessible reasonably quickly and hence the rate
of interest which the company could obtain would be much less than the normal rate.
Quite apart from this is the fact that the money would not be available for investment in
the business itself.

Because of the effects of the common pool, the business is able to purchase insurance at a
premium, which is less than the fund that the company itself would have to retain, even
assuming it could retain anything in the first place. The premium can be looked upon as a
certain loss to the business, but the firm is now free to continue its business and invest in
the knowledge that certain risks are now provided for. With this peace of mind it can
develop its business activities.

This peace of mind, or security, has become an important aspect of business activity in
many sectors. Some forms of insurance are compulsory by law and others are required to
be in force under the terms of contracts. In the case of compulsory insurance, such as
injury to employees at work, it is society that has decided it wants the security or peace of
mind which insurance brings. In the case of insurance being required to satisfy, for
example, certain construction contracts, it is another business that wants to have the
security of knowing that the people they are doing business with are protected by
insurance.

Insurance provides peace of mind.

Assistance to Businesses

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Modern industry involves heavy investment of capital in the form of buildings, costly
machinery, plant and equipment. This capital is exposed to loss or damage by fire, theft,
accident and many other perils, insurance provides the necessary cover. Without the help
of insurance, industrialists and businessmen would have to freeze a part of their capital to
pay for the losses caused by various contingencies, i.e. to create an insurance fund.
Instead, by paying a small fixed contribution by way of a premium, they are able to
obtain financial security. Insurance, thus, not only protects the capital in industry but also
releases the capital for further expansion and development of business and industry.

In shipping business, too, heavy capital values are involved and with the help of marine
hull insurance, ship owners are enabled to embark upon a program of steady expansion of
their fleet which would otherwise be rendered almost impossible because of the worry
and anxiety caused by the fear of catastrophic loss.

By eliminating the adverse consequences of risk, insurance encourages business

enterprises. The very existence of risk, that is, uncertainty concerning the future is a
severe handicap in economic activities. Insurance removes the fear, worry and anxiety
associated with this future uncertainty and thus encourages free investment of capital in
business enterprises and promotes efficient use of existing resources. Thus insurance
encourages commercial and industrial development and thereby contributes to a vigorous
economy and increase national productivity.

Financial Stability to Commerce Industry and the Community

How do you think insurance is advantageous in providing financial stability?

In addition to the benefits discussed above, the provision of financial stability is another
benefit of insurance. An example may illustrate this point. Suppose a firm suffered
significant loss due to fire accident. The serious fire accident will not only cause material
damage to buildings, plant and machinery but will also result in an interruption of
production with its attendant consequential losses. Stoppage of production will result in
loss of profits, unemployment and loss of trade to the business community. This example
illustrates the fact that accidental losses that affect businesses would not only produce
economic waste but would also affect the entire community.

You may wonder how insurance would be beneficial in this regard. It has a lot of things
to do with it. For instance, loss of profits insurance in fire and engineering classes of
business is designed to protect against the various consequential losses. Whereas fire
insurance pays for material damage, loss of profits insurance provides indemnity with
respect to net profits, wages, taxes and other standing charges and increased cost of
working during the period of interruption of business.

Thus, loss of profits insurance and other forms of insurance lend stability to industry, and
avoid economic dislocation. This, needless to say, would directly benefit the community.
We can therefore say insurance helps the economic equilibrium of a nation.
 In addition to providing peace of mind and assistance to businesses, insurance
provides financial stability to businesses and the community at large.

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Insurance Serving as a Basis of Credit

It may surprise you but most business organizations these days strongly depend on
insurance for their operation. It is a common practice for banks and financial institutions
to lend money to industrial and commercial undertakings only on the basis of the
collateral security of insurance. No bank or financial institution would advance loans on
property unless it is insured against loss or damage by insurable perils.

You may well notice that here in our country, too, construction companies are required to
submit financial guarantee from insurance companies whenever they compete for tender.
Besides, the majority of road transport vehicles, for example, are bought with finance
provided by hire purchase companies with the support of banks. Insurance provides the
ultimate financial protection both to the hire purchase companies and the banks through
the issue of hire purchase and financial guarantees against default by the operators.

The role of insurance in relation to banking is particularly significant in internal and

international trade, which is financed by banks on the security provided by marine
insurance. Overseas trade is conducted through a system of credit. The importer of goods
opens a letter of credit in a bank authorizing the exporter to draw on the importer a bill of
exchange against the value of the shipment of goods. Thereupon, the bank will be
prepared to discount the bill, i.e., pay the exporter immediately, provided the goods
involved in the transaction are covered by a marine policy which is lodged with the bank
as collateral security.

The banks advance money on the physical security of the goods. But if the goods are lost
or damaged, this security will be extinguished. Hence, the collateral security in the form
of a marine insurance policy therefore, forms an integral part of overseas trade, and is
regarded as an important integral part of commerce.
 Insurance serves as a basis of credit.

Reduction of Losses
Have you ever thought that insurance would play any role in reduction of losses?

People might erroneously think that insurance has nothing to do with loss prevention.
This might seem proper since insurance companies get profit by retaining risks
transferred from others rather than preventing or reducing them. True that insurance is
primarily concerned with the financial consequences of losses, but it would be fair to say
that insurers have more than a passing interest in loss control. The argument that
maintains insurers have no real interest in the complete control of a loss, as this would
inevitably lead to an end to their business is a rather shortsighted view. Insurers do have
an interest in reducing the frequency and severity of losses, not only to enhance their own
profitability but also to contribute to a general reduction in the economic waste that
follows from losses. We looked at the cost of risk in chapter 1 and it would be fair to say
that insurers have played a major role in loss controls over the years. In the case of fire
insurance, we can trace the involvement of insurers in loss control right back to the start
of the concept of fire insurance. We will say a little more on this later in this chapter, but

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at this point it is sufficient to state that insurance companies have provided the only form
of fire fighting for many years and this is certainly evidence of an active interest in loss
controls. In modern times, the insurance industry pools its resources and funds on- going
research work into the prevention and control of many forms of a loss. A number of
individual insurance companies have developed considerable expertise in the technology
of different forms of loss control and are regarded as being at the forefront of research in
this field.

In a practical way, buyers of insurance will normally come into contact with the loss
control services offered by an insurer when they meet the surveyor. The insurer or indeed
the insurance broker may employ the surveyor, and part of his job is to give advice on
loss controls. Many insurers employ specialist surveyors in fire, security, liability and
other types of risk; others will employ people with broader, but less detailed knowledge.

The surveyor will assess the extent of the risk to which the insurance company is
exposed. In doing so he will also offer advice, which could take the form of a pre-loss
control (reducing the chance that something will happen) or a post-loss control (after an
event has occurred).

The best time for a surveyor to be consulted is at the planning stage of a project. He can
then incorporate features that may minimize risks and control losses. A good example of
this is the installation of automatic fire-sprinkler systems. It is obviously far simpler and
cheaper to include a sprinkler system in the design of a building, rather than to alter a
building once it has been constructed to just install sprinklers. Most builders are alert on
the value of fire prevention and control, but the same principle applies to safety and
security.

In fact we can go on arguing that the very basis of rating methods adopted by insurers is
designed to avoid or reduce losses. For example, in fire insurance, extra rates are charged
for undesirable features in the risk, e.g. inferior construction, and discounts are provided
for improvements in risk such as installation of fire sprinkles system as is pointed out in
the above paragraph.

Can you give other examples of insurance policies that have an implied objective of loss
reduction?

Motor insurance policies can be cited as possible examples here as they have a loss
reduction object in view, viz., reduction of losses. Insurers offer special discount for
those cars that are well-maintained and this would encourage the insured to involve in
various loss reduction efforts. In marine insurance, too, lower rates are charged if better
methods of packaging are adopted by shippers so that the loss potential is reduced.

We can go on listing! Briefly, however, we can say that many insurance policies
incorporate various conditions and warranties in their policies with the object of
encouraging the insuring public to take precautions against losses or damages.

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Insurers arrange surveys and inspections of risks, before acceptance, by qualified

engineers and others with experience in the field. This is done mainly in fire and
engineering insurance and to an extent in accident insurance. The scope of fire surveys
would include inspection of trade processes, storage of hazardous goods, lightning,
heating and power construction of walls and roof, fireproof doors and protective
partitions, fire extinguishing appliances, hydrant systems, water pressures and other
similar features.

The object of these surveys is not only to assess the risk for rating purposes but also to
suggest and recommend to the insured various improvements in the risk, which will
attract lower rates of the premium, and, what is more important, reduce the loss potential.
In accident insurance, burglary surveyors make recommendation with regard to security
measures such as better parking system, appointment of watchmen, etc. Engineering
surveyors play a most useful part in accident prevention as valuable technical advice is
provided with respect to plant and machinery.

In the course of their underwriting operations, insurers have acquired specialized

knowledge and experience in different classes of risks. Successful underwriting depends
upon careful and scientific assessment of risks. Insurers, therefore, find it necessary to
obtain expert knowledge of the processes involved in the manufacture, the physical and
chemical properties of materials, the methods of fire extinction, the methods of packing
cargoes, trade routes, port condition and new methods of ship propulsion. In fact, insurers
keep abreast of technical developments in industry and commerce and with the
accumulated knowledge and experience gained in and for underwriting risks; they render
a vital service to the community in minimizing economic waste. It would be
uneconomical for insurers to have large teams of experts in various disciplines, scattered
all around the country. Independent firms of adjusters provide loss-adjusting services on
a fee basis to insurers. These adjusters contribute greatly to the minimization of losses by
knowing how best to get a business back on its feet after a loss, where to obtain
temporary plant, which specialist repairers to approach, where to dispose of salvage at the
best price, and so on. Another point worth mentioning here is the fact that insurers are
closely associated with several agencies and institutions engaged in fire loss prevention,
industrial safety and road safety.

Though the practice is not yet highly developed in our country, insurers in some other
countries have established the Loss Prevention Association. That association has
objectives of creating an awareness of the need for loss prevention and implementing loss
prevention measures in the various sectors of the economy, thereby increasing
productivity and saving national wealth.
 Insurance companies play a great role in the reduction of losses.

The Loss Prevention Association has a department that works in close collaboration with
the fire brigades in the event of fire losses. Whereas the main function o the fire brigade
is to extinguish the fire, the function of this department, which is referred to as Salvage
Corps, is to save the property from further damage by water, smoke and heat and to take
care of the salvage.

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Before we go to the next point, let me just give you some illustrations of loss prevention
and control in the field of property and liability insurance.
These include:
- Investigation of fraudulent insurance claims,
- Research into the causes of susceptibility to loss on highways,
- Recovery of stolen vehicles and other auto theft prevention work,
- Development of fire safety standards and public educational programs,
- Provision of leadership in the field of general safety,
- Provision of fire protection and engineering counsel for oil producers, and
- Investigation and testing of building materials to see that fire prevention standards
are being met.

Investment of Funds
Do you think that insurance companies make investments?

Insurance companies have, at their disposal, large amounts of money. This arises due to
the fact that there is a time gap between the receipt of a premium and the payment of a
claim. A premium could be paid in January and a claim may not occur until December, if
at all it occurs. This means the insurance companies have this money and can invest it. In
fact, an insurer will have the accumulated premiums of all insurers over a long period of
time. In 1988, the Association of Brithish Insurers (ABI) reported that the total value of
invested assets was £258,728 million. Here in our country, too, Ethiopian Insurance
Company’s investment has a big amount of money.

Well it has a vast sum of money, but what is the benefit that it conveys?

We have listed investment as one of the benefits of insurance and the benefit lies in the
use to which the money is put. Insurers invest in a wide range of different forms of
investment. By having a spread of investments, the insurance industry helps national and
international governments in their borrowing. It also helps industry and commerce, by
making various forms of loan and by taking up shares that are offered on the open
market. Insurers make up part f what are termed the institutional investors; the others
include banks, building societies and pension funds.

Investment is also made in property. If you have ever seen one of the yearly bulletins of
Ethiopian Insurance Company, you may note that the company has made considerable
real estate investment.

The following table shows the actual investments of EIC at 2000.

Investments of EIC as reported on 2000/2001

a) These are as follows:-

Non-life Life Branch in Total in Birr 2000 Total in

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Branch in Birr Birr Birr

Shares in non
Nationalized
Companies 262,500 - 262,500 262,500
African
Reinsurance
Corporation 4,924,383 - 4,924,383 4,924,383
Mortgage loans - 17,706 17,706 17,706
Loans to policy
Holders - 4,541,304 4,541,304 4,187,405
Loan to Kotebe
Housing project - 5,494,470 5,494,470 6,941,176
Shares in the
African export
Import bank 2,438,000 - 2,438,000 2,438,000
Export import
Bank
Shares in united
Investors Share
Company 850,000 - 850,000 850,000
Shares in the
Ethiopian sugar
Industry support
Center 6,000 - 6,000 6,000
Loan to
Construction and
Business Bank 75,506,970 - 75,506,970 81,291,340
Treasury bills 23,843,856 2,943,870 26,787,726 28,729,913
107,831,709 12,997,350 120,829,059 129,648,423
As you can see from the above table, investments in shares are stated at acquisition cost
less provision for losses of Birr 616,936 (2000 Birr 616,936). Investments under life
Branch are net of provision of Birr 197,380 (2000 Birr 197,380).

The treasury bills include the statutory deposit that must be kept with the National Bank
of Ethiopia in line with the Licensing and Supervision of Insurance Business
Proclamation No. 86/1994. According to this proclamation such deposit should amount to
15% of the paid up capital and can be kept either in cash or government securities.
However, as per the same proclamation, the deposit or any part thereof shall not be
withdrawn except with the written permission of the National Bank of Ethiopia; nor shall
such deposit be used as a pledge or security against any loan of overdraft.
In any case you can clearly see from the above table that the Ethiopian Insurance
Company has made a big investment.

A through scrutiny of insurance investment shows that the value of life insurance
investment far exceeds that of property insurance. (We will discuss about the basic
classification of insurance in the next Module.) Given what we have said earlier about the

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gap in time between the receipt of premium and the payment of claims, this will now
seem obvious. One other aspect, which is worth noting, is that the pattern of investment is
not the same for the two types of insurance funds. Once again, this has much to do with
the nature of the risks being run. In life assurance, funds. Once again, this has much to do
with the nature of the risks being run. In life assurance, there is expected to he some time
between the receipt of premium and the eventual payment of the claim; as a result, the
funds can be invested in longer-term ventures. In property insurance, the money cannot
be locked away for so long and therefore has to be spread over long, medium and short-
term investments.

The use of this money writhing the economy as a whole is where the benefit lies; both the
government and industry have access to a large pool of working money. This money is
the result of thousands of different people and organizations paying premiums and, in one
sense, the existence of an insurance market really brings about a form of enforced saving.

Consider a person who insures his house for illustrative purposes. Such a person, say,
may not have sufficient free money to be able to purchase shares, buy property or lend
money. However, when the premium from that person is added to the premiums from
several thousands of other people, then a reasonable amount of investment money is
made available.

In brief, insurers are custodians of the fund consisting of premiums received from the
public and they can use this money for investment purposes. A part of the fund insurers
are able to create is utilized for current expenses and current liabilities and the balance is
set aside as reserve which can be invested in government securities, municipal loans,
mortgages and equities. This way, insurers provide investment capital to the government
and the industry.

Are you able to see now how insurance investment benefits the public?

Insurance investment benefits the public in two major ways. One is what we have been
discussing so far. That is insurance investment contributes to the wealth of the nation by
providing the finances necessary for economic development. In addition to this they
reduce the cost of insurance since the income from investments is assumed in the process
of fixing the rates of premiums.

 In addition to reducing the cost of insurance, insurance investment makes

significant contribution to the wealth of nation by providing finances necessary
for economic development.

Social Benefits
What do you think are the societal benefits of insurance?

The fact that the owner of a business has the funds available to recover from a loss
provides the stimulus to business activity which we noted earlier. It also means that jobs
may not be lost and goods or services can still be sold. The social benefits of this are that

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people keep their jobs, their sources of income are maintained and they can continue to
contribute to the national economy. Imagine what would happen if Midrock Ethiopia
ceases operation. You can easily see the effect of this on the community. Unemployment
would increase in the country, there will be less money to spend, and the economy at
large may get depressed.

To a lesser extent, a major loss resulting in the closure of a small business can have the
same impact on the community. Unemployment would increase in the country, there will
be less money to spend, and the economy at large may get depressed.

To a lesser extent, a major loss resulting in the closure of a small business can have the
same impact on a community. It may not be as noticeable as that of Midrock but when
losses are aggregated throughout the country the effect is considerable. Do not get me
wrong! I am not implying that insurance alone keeps people in jobs. What we are
underlining is the fact that insurance plays a significant role in ensuring that there are no
unnecessary economic hardships.

Another benefit that insurance offers to the society is lowering the price of capital.
Because the supply of investable funds is greater than it would be without insurance,
capital is available at a lower cost than would otherwise be possible. This result brings
about a higher standard of living because increased investment itself will raise production
and cause lower prices than would otherwise be the case. Also, because insurance is an
efficient device to reduce risk, investors may be willing to enter fields they would
otherwise reject as too risky. Thus, society benefits by increased services and new
products that are, the hallmarks of increased living standards.

But remember as significant its social benefits are, insurance has some social costs, too.
Needless to say, no institution can operate without certain costs. The three main costs for
an insurance institution that we may raise here include costs that are associated with
operating the insurance business, losses that are caused intentionally, and losses that are
exaggerated.

The first social cost of insurance relates to the use of economic resources, mainly labor,
to operate the business. According to old statistics, the average annual overhead of
property insurers account for about 25 percent of their earned premiums but ranges
widely, depending on the type of insurance. In life insurance an average of 17 percent of
the premium Birr is absorbed in expenses. But this does not mean insurance companies
are not profitable. With all these costs, insurance is still a very profitable venture.

A second social cost of insurance is attributed to the fact that if it were not for insurance,
certain losses would not occur. By this we are referring to losses that are caused
intentionally by people in order to collect on their policies. Although there are no reliable
estimates as to the extent of such losses, it is likely that they are only a small fraction of
total payments. Insurers are well aware of this danger, however, and take numerous steps
to keep it to a minimum.

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The last social cost of insurance we mention here refers to the tendencies of some insured
to exaggerate the extent of damage that results from purely unintentional losses. Several
studies illustrate this point. For example, one survey noted that health expenses for
families that have health insurance tended to be higher than the reported expenses for
uninsured families this is probably true because part of the extent of the loss is within the
control of the insured. In other words, once the accident or sickness has occurred, an
individual may decide to undergo for a more expensive medical treatment, or the
physician may prescribe it if it is known that the insurer will bear most or all of the cost.

 Social costs of insurance include operational costs of insurance, losses that are
intentionally created and those that are exaggerated.

Foreign Exchange Earnings

We have already said that insurance allows people and organizations to spread risks
among themselves. In the same way, we can also say that countries spread risks. A great
deal of insurance is transacted between different countries. For example a significant
volume of trade transaction is transacted between Djibouti and Ethiopia, a notable
insurance transaction takes place.

Do you know that Ethiopian Insurance Corporation has a branch in Djibouti?

Yes, it has a branch in Djibouti and due to premium inflows; our country gets foreign
exchange from insurance. The volume of premium inflows may not be as such significant
in our case but in more developed countries the contribution of insurance in earning
foreign exchange is considerable. A large volume of premium flows into countries and
this is referred to as invisible earnings.

But what do we mean buy invisible earnings?

Every country has to import goods, which it needs for its people and by the same token
engages in export of goods that other people want to buy. Where these goods are
tangible, a visible trade exists; for example, when goods are shipped to a foreign country
and are paid for by that country, these are visible exports. In the case of insurance,
banking, tourism, etc. the goods are invisible and the earning is thus referred to as an
invisible earning.

In any case, insurance ranks with export trade, shipping and banking services as an earner
of foreign exchange to the country. When risks located in another nation are insured
either directly or by means of reinsurance, the premium received will make contributions
to the county’s balance of payments.

To make the position clear, we can assume that one country is exporting a commodity
namely security, to an overseas buyer. Although this commodity is invisible, it is an
export in the same way as any material goods. The profits received from overseas
insurance may therefore be considered as invisible exports. It is obvious that such a
transaction, if profitable, will increase he foreign currency reserves of a nation.

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 Insurance plays no simple role in earning foreign currency to a country.

Limitations on the Scope of Insurance

Overview

In the preceding discussions we have painted a picture that shows one of the
valuable services to individuals and industry. Moreover we have seen that the
provision of this service results in a number of direct benefits to those who
purchase protection and also leads to a number of other, more general, benefits to
the nation as a whole.

As it is the case most of the time, these interesting functions and benefits insurance
provides are not without some limitations. Surely there are limits on the availability
of this risk transfer mechanism. And these limitations of insurance are more or less
related to the nature of insurable risks. In this section we will turn our attention to
discuss the main limitations of insurance. We do so by discussing the main
characteristics of insurable risks. You may remember our earlier discussion on the
main principles of insurance. The limitations of insurance are basically derived from
these principles.

Why are there some risks, which are insurable, and some, which are not?

An example may clarify this point. Suppose a person wants to insure his neighbor’s
house so that he can burn it down to collect premium later. If such things are allowed,
insurance is doing nothing but allowing people to benefit from their own criminal
actions. Even in cases where no criminal intent is present, it does not seem proper for
a person to benefit from a fire at a neighbor’s house as they have no financial interest
in the property which was destroyed.

Which types of events are then insurable? Do you think it is possible to exhaustively
list all events that can be insured and that cannot be insured?

We could try to compile a list of the types of events that would be acceptable for
insurance purposes. But there are at least two problems with this approach. For one
thing the list would be almost endless if we attempt to exhaustively list all events.
There are all kinds of incidents that can occur and would be perfectly acceptable for
insurance protection. Thus it would be almost impossible to list them all.

For another thing, even if we may be able to do so, the list would never be up to date.
Risk is dynamic, in the sense that it is always changing, so that any list of events
which are suitable for the form of risk transfer we have described would also have to
change continually.

This does not mean though that there is no need of attempting to distinguish both. It is
still necessary to have some idea of what can and cannot be insured and, with the
above problems in mind, a different approach is called for. Rather than listing the

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events themselves, we have noted the characteristics or nature of insurable risks. This
list will not be infinite, as would any list of insurable events, but will still be flexible
enough to cope with a change.

There is one caveat which should be made at this point: It is not possible or indeed
wise, to be dogmatic about these classifications of insurable risk. The world of
business is not a static environment. It changes to adjust to circumstances as it is
perceived, and what may be an uninsurable risk today could very well be insurable
tomorrow. In any case let us discuss now the main characteristics of insurable risk
one by one. Keep in mind that by so doing we are discussing one major limitation of
insurance, the fact that insurance is not applicable for all events.

The point we are making in many ways is that insurance has some limitations, as all
risks cannot be insured. Even if the importance of insurance to combat risk is
undeniable, there are certain legal, commercial and moral considerations which make
it impossible to ensure every conceivable kind of risk. To be more specific, the
following conditions must be fulfilled for insurance to be operative.

A) There must be large number of similar objects.

One of the most important requirements from the stand point of the insurer is that the
probable loss must be subject to advance estimation. What we mean by this is that the
number of insured objects must be sufficiently large and that the objects themselves
must be similar enough to allow the law of large numbers to operate.

Do you remember the concept of the law of large numbers we’ve discussed?

We have emphasized there the fact that the expected value of a given event becomes
equal with the actual happening when there are large numbers of exposed units. It has
often been said that insurance is subject to the law of large numbers. This means if
there are no sufficient number of insured, insurance mechanisms may not work
properly.

An example may illustrate this point. Taddese wants to buy life insurance policy for
his girl friend. But as you all know insurers do not offer insurance coverage for a girl
friend-boy friend relationships. This is because there are no large number of people
who want to make use of this kind of coverage. Had there been sufficient number of
insured, the policy might have been offered in the insurance market.

 Another limitation of insurance is that there must be a large number of similar

risks for insurance to be available.

Why do you think is insurance unavailable for small number of risks?

This is so because if an insurance fund was made up from the contributions of
relatively small number of members, the common pool created will not be sufficient
to cover accidental losses a member may suffer.

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The point is if only a few objects are insured; the insurer is subject to the same
unused certainties as the insured. As is the case with Taddese’s example the field of
life insurance is one in which this requirement works particularly well. Life insurers
have gathered reliable statistics over many years and have developed tables of
mortality that have proved to be very accurate as estimates of probable loss.
Furthermore, as life insurance is well accepted by the public, especially in the
developed world, it is relatively easy for the insurer to obtain a large number of
exposure units. Hence the law of large numbers works so well that for all than
practical purposes the life insurer is able to eliminate its risk. This might not be the
case in other types of insurance policies the likes of nuclear energy liability or
insurance to space travel, where adequate numbers of exposures may be lacking.

Note that in addition to having a sufficiently large numbers of insured objects, the
nature of the objects must be enough alike so that reliable statistics of probability of
loss can be formulated. It would be improper, for example, to group commercial
buildings with private residences for purposes of fire insurance, as the hazards facing
these classes of building are entirely different. Furthermore, the physical and social
environment of all objects in the group should be roughly similar so that no unusual
factors are present that would cause losses to one part of the group and not to the
other part. For instance, even if both of them are buildings, the one located in a
hurricane zone must not be grouped with the one located a thousand miles from the
coast.

B) There must be insurable interest.

What we mean by this is that the person seeking insurance must have legal entitlement to
insure the article or event exposed to risk.

It is a must that an insured should have clear financial interest in the subject matter
insured.

C) The loss must be fortuitous.

Another requirement is that the loss must be entirely fortuitous. In other words it must
be an unexpected or unintentional loss from the ‘insured’s point of view, the ‘insured’
being any person, company or organization insured by an insurance company. This
principle follows from the fact that it is not possible to insure against an event, which
will definitely occur, since it involves no uncertainty of loss and therefore no transfer
of risk would be taking place.

This principle then rules out inevitable events such as damage caused by wear and
tear and depreciation. Any damage or loss inflicted on purpose by the insured would
also be ruled out. Provided that they were entirely fortuitous as far as the insured was
concerned.

 When we say that the loss must be fortuitous we are referring to the fact that the
loss must not be definitely expected or deliberately intended.

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Using the terminology of frequency and severity, we could say that the frequency and
severity of any risk must be beyond the control of the insured. The one example that may
seem to fall outside this rule, and yet is insurable, is the risk of death itself. We all know
that it is possible to purchase life assurance, even though death is probably one of the few
certainties there are! However, the timing of death is what is fortuitous and it is with this
that life assurance is primarily concerned.

Thus insurance is limited to those loses that are surrounded by some uncertainty.
Otherwise, there would be no risk. If the risk or uncertainty has already been eliminated,
insurance serves no purpose, as the min function of insurance is to reduce risk.

What is your opinion as far as AIDS patients are concerned?

Should there be life insurance or not?

As an AIDS patient is suffering from an incurable disease that will cause death within a
given time, there is little uncertainty or risk concerning the payment of loss. Thus,
insurance is not feasible for this type of cases. Theoretically, the insurer could issue a
policy, but the premium would have to be large enough to cover both the expected loss
and the insurer’s cost of doing business. The cost of such a policy would probably be too
high for the insured prospective. Another point we may raise here in connection with this
principle is that because of the requirement that the loss be accidental, insurers normally
exclude all policies for any loss caused intentionally by the insured. If the insured knew
that the insurer would pay for intentional losses, a moral hazard would be introduced,
causing both losses and premiums to rise. And clearly, if premiums become exceedingly
high, few would purchase insurance, and the insurer would no longer have a sufficiently
large number of exposure units to be able to obtain a reliable estimate of future losses.
Thus the first requirement of an insurable risk would not be met.

Such a scenario is similar to the phenomenon of adverse selection, which is the tendency
of insured’s who know that they have a greater than average chance of loss to seek to
purchase more than an average amount of insurance. When an insured possesses
knowledge about likely losses that are unavailable to insurers, the insured is said to have
asymmetric information. The existence of asymmetric information is one cause of
adverse selection. In general, insurers try to control adverse selection by investigating
potential insured’s and then providing coverage only to those who meet specified
standards. This process of selecting insured’s from among the many applicants is called
underwriting and will briefly be introduced in the last module.

 Asymmetric information is a terminology that refers to cases when the insured has
better information than the insurer.
To illustrate the unfortunate effects that adverse selection would cause if insurers did not
practice underwriting, consider the example of crime insurance. Businesses operating in
high-crime areas are the ones most likely to want to buy crime insurance, even t a
premium that is too high to be attractive to firms in safer locations. If an insurer does not
engage in some degree of underwriting, it may find itself selling primarily to very high-
risk firms. Subsequent loss payments will be more than expected, and premiums will

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have to be increased. As premiums increase, fewer businesses will be interested in the

insurance, and the only ones who ultimately find the protection economically attractive
will be those with a very high chance of loss. This is a very risky scenario as it may
ultimately lead to the total failure of the insurance industry.

D) Insurance is limited only to financial values.

Insurance can only provide monetary compensation. In other words, the scope of
insurance is limited to the intrinsic value of the article concerned or to the precise
financial consequences of an insured event. Sentimental value and esteem cannot be
replaced in the event of a loss. For example, insurance companies might have tried to
compensate America financially for the losses it suffered due to the September 11
incident but they cannot in any way change the fact that America’s “virginity” is no
longer there. In other words, they cannot change the fact that Americans are feeling more
insecure than ever about the threat of terrorism.

This example clearly shows the fact that the essence of insurance, as we have seen
earlier, is to act as a risk transfer mechanism and thus provides financial compensation
for a loss. Insurance does not remove the risk. What it does is to try to provide financial
protection against the consequences. If this is the case then, the risk which is to be
insured must result in a loss which is capable of being measured in financial terms.

In the case of property loss or damage, this is easy to see. The monetary value of a
property lost can be established and, subject to the terms of the insurance policy,
compensation can be provided. The exact value of the loss will not be known at the
outset, but only after the event has occurred. All material damage to or theft of property
would fall into this category.

 Insurance cannot replace sentimental value and esteem, as it is only limited to

financial value.
In the next chapters you will see that there are many other forms of insurance protection
available and each of them is concerned with risks which can result in losses capable of
financial measurement. For example, consider the case of injury to people at work.
Employers can effect a policy of insurance that protects them against the risk that an
employee might be injured at work and succeed in a claim against them for
compensation. This is quite different from the case of a property loss or damage. The
actual financial value cannot be arrived at in the same objective manner. In some case,
the court will decide the level of compensation due to an injured person; in others, the
respective lawyers will agree on the amounts. In either case, it is the legal liability to pay
compensation, which is the financial value at risk.

Is this principle applicable in the case of life insurance, too?

Note the fact that life insurance is to some extent a modification of this general rule, in
that life cannot be measured precisely in financial terms. In life insurance, the level of

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financial compensation is agreed at the beginning of a contract. It is impossible to place

values on the life of a wife, husband or child, but the financial sum assured can be
determined at the commencement of the insurance.

E) A determinable and a measurable loss:

Another requirement is that the loss must be definite in time and place. You may wonder
why this needs to be stated, as it seems so obvious. It may seem unnecessary to you to
add this requirement because most losses are easily recognized and can also be measured
with reasonable accuracy. It is a real problem to insurers, however, to even recognize
certain losses, let alone to measure them.

An example may illustrate this point. Suppose an insurer agrees to pay the insured a
monthly income, should the insured become so totally disabled to the extent that he/she is
unable to perform well his or her occupation. The question arises, however, as to who
will determine whether or not he insured meets this condition.

Will it be enough to just take the insured’s word that he/she is disabled?
This surely opens a room to a moral hazard as the insured might act out of good faith and
claim compensation without being disabled. To worsen the matter, say, the insured is
disabled but there is no way to prove as to whether or not the damage is intentional. Thus
sometimes, even if it is clear that a loss has occurred, it may not be easy to decide
whether or not it is intentional and moreover whether it is significant enough to deserve
compensation.

F) A loss not subject to a catastrophic Hazard:

Do you remember the distinction we’ve made between fundamental and particular and
dynamic and static risks in the first chapter?

While discussing the various classifications of insurance, we have pointed out the fact
that dynamic and fundamental are not insurable. Thus for insurance to be available,
conditions should not be such that all or most of the objects in the insured group might
suffer a loss at the same time and possibly from the same peril. Large fires, floods,
earthquakes, and hurricanes that have disrupted major geographical areas in the past can
illustrate such simultaneous disaster to insured objects.

This requisite concerning the absence of a catastrophic hazard also effectively eliminates
many speculative risks from the possibility of being insured. For example, consider the
uncertainty that a retailer faces in connection with the price at which inventories can be
sold. Suppose it wishes to insure that the price of its product will not fall more than 10
percent during the year. Such a risk is subject to a catastrophic loss because simultaneous
loss from this source is possible to all products. Further, the losses are not subject to
advance calculation because, in an ever changing competitive market, past experience is
an inadequate guide to the future. Hence, the insurer would have no realistic basis for
computing a premium. Furthermore, in times of rising prices, few would be interested in
the coverage, and at times of falling prices, no insurer could afford to take on the risk.

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The insurer could get n “spread of risks” over which to average out good years with bad
years.

 An insurance coverage is not extended to include risks of catastrophic nature.

G) Probability of Loss Must Not Be Too High.

The final requisite of an insurable risk is that the probability of loss must be reasonable,
or else the cost of risk transfer will be excessive. This requisite is of concern primarily for
the potential insured, rather than the insurer. Due to the element of risk, insured’s are
often willing to pay more to avoid a loss than the true expected value of that loss. In fact,
if it were not for this phenomenon, insurance could not exist, for insurers must always
charge more for their service than the expected value of a loss. But the more probable the
loss is, the most expensive servicing it would be
 Another requirement of insurance is that the probability of occurrence of a loss to
the subject matter insured should not be too high.

H) The loss must be large enough

Although an insurer theoretically might be willing to provide insurance regardless of the
potential size of a particular loss, a requisite from the standpoint of the insured is that the
maximum possible loss must be relatively large.

What do we mean by this principle?

The large-loss principle states that businesses and individuals should insure potentially
serious losses before relatively minor losses. To do otherwise is uneconomical because
small losses tend to occur frequently and are very costly to recover through insurance. If
one can pay for a loss from savings or current income, it is probably too small a loss to
give insurance high priority as a way of risk treatment.

As an example, suppose there is a 2 percent probability that a collision will completely

destroy a 20,000 Birr car owned by Martha and Family P.L.C. The Company may realize
that the expected value of such a loss is 0.02 x 20,000 Birr, which is 400 Birr. Yet
collision insurance might cost 750 Birr because the insurer must charge enough to pay for
all expected losses plus the cost of doing business.

What do you think should the managers of Martha and Family P.L.C. decide? Should the
Company buy the insurance?

It depends on the relative value of the asset to the Company. If the automobile represents
a large portion of Martha P.L.C’s total assets, insurance may be purchased. But if the car
is one of a large fleet and represents only a small fraction of total assets, the purchase of
insurance is unlikely.

I) Public policy:
We have already seen that the insured must have a financial interest in the loss and that
the loss must be fortuitous. This ruled out the possibility of insuring the property of other

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people, or inflicting damage or loss on purpose in order to benefit from an insurance

policy. However, there are still risks which we might all agree should not be insurable.

It is a common Principe in law that contracts must not be contrary to what society would
consider to be the right and moral thing to do. Contracts to kill a person are unacceptable,
as are contracts to inflict damage on the property of people, or steal from them.

In terms of risk and contracts of insurance, the same principle applies.

Do you think there should be an insurance coverage for thieves due to damages caused on
them while stealing?

It would be contrary to the public policy to insure thieves while they are engaged in
socially undesirable acts. This might seem a little bit far fetched but it helps us see the
point that insurance policies should go in harmony with public policies.

Can you give some other examples to illustrate the concept of public policy?
Providing insurance coverage for a risk of traffic fine could be a good example. Imagine
what would happen if insurance companies provide protection against traffic fine. This in
other words means drivers are being encouraged to violate traffic laws as they deem
necessary. This would increase the probability of accident and ends being harmful to the
society than it is originally intended.

 Insurance policies need to go in harmony with public policies.

Activity
Give written responses to each of the following questions
 Why are some risks insurable while others are not insurable?
 Some risks are insurable because they meet certain criteria that make them
manageable and predictable for insurance companies. Risks that are too uncertain or
catastrophic in nature may not be insurable because they could lead to unsustainable
losses for the insurer. For example, risks related to illegal activities or speculative
ventures are typically not insurable because they are either unpredictable or morally
hazardous.

 Mention any five conditions that must be fulfilled for insurance to be

insurable? ·
 Calculable Loss: The potential loss must be quantifiable in monetary terms. This allows
insurers to estimate the cost of potential claims and set appropriate premiums.

 · Definite and Measurable: The event leading to the claim must be clearly defined and
measurable. This means that the occurrence, time, place, and extent of the loss are
ascertainable.

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 · Accidental and Unintentional: The event should be accidental and not intentional on the
part of the insured. Insurance is meant to cover unforeseen events, not deliberate actions.

 · Large Number of Similar Exposure Units: There must be a large number of similar risks
to predict the likelihood of loss. This helps insurers apply the law of large numbers and set
premiums based on statistical data.

 · Affordable Premium: The premium should be economically viable for the insured. If the
cost of the premium is too high compared to the potential benefit, it becomes impractical for
individuals to purchase the insurance

 Main Functions of Insurance:

 Risk Transfer: Shifting the financial burden of risk from the individual to the insurer.

 Risk Pooling: Collecting premiums from many insured individuals into a common pool to
spread the risk.

 Financial Protection: Providing financial compensation to cover losses from unforeseen

events.

 Loss Prevention: Encouraging risk management and loss prevention measures

among policyholders.

 Social Stability: Contributing to economic stability by reducing the impact of losses

on individuals and businesses.

 Limitations of Insurance Related to the Nature of Insurable Risks:

The limitations of insurance are often tied to the nature of insurable risks. Some key limitations
include:
 Moral Hazard: The risk that the insured may engage in riskier behavior knowing they are
covered.

 Adverse Selection: The tendency for higher-risk individuals to seek insurance more actively
than lower-risk individuals, potentially leading to higher losses.

 Exclusions: Certain risks are excluded from coverage because they are too unpredictable or
catastrophic, such as acts of war or natural disasters

 Underwriting: The process of evaluating and selecting risks can be complex and may lead
to coverage denials for high-risk individuals.

 Affordability: High premiums for certain high-risk individuals or businesses can make
insurance unaffordable.

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