CHAPTER THREE

INSURANCE: FUNCTION AND ECONOMIC ROLE OF

INSURANCE
Nature and Function of Insurance
• Insurance is the process of polling unexpected losses.
• The process by which individual, groups or organizations transfer
risks to insurer, who is capable of paying losses to the insured.
Insurer:
 Insurance company, collection of customers
 Pays compensation for insured
Insured:
 Customer of insurance company.
 Are those who transfer unexpected losses to insurers
 Pay premium to insurance company
Premium: amount of money paid by insured to insurer (insurance
company) so that they can get insurance compensation. 1
3.1 Definition of Insurance:
There is no single definition of insurance,
Insurance can be defined from the viewpoint of several
disciplines, including law, economics, history, actuarial
science, risk theory, and sociology.
 The commission of Insurance Terminology of the
American Risk and Insurance Association has defined
insurance as follows.

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“Insurance is the pooling of accidental losses by transfer
of such risks to insurers, who agree to indemnify insured's
for such losses, to provide other financial benefits on their
occurrence, or to render services connected with the risk”.
3.2 Basic characteristics of insurance:
A. Pooling of Losses

B. Payment of Accidental/Fortuitous Losses

C. Risk Transfer
D. Indemnification
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A. Pooling of Losses
Pooling or the sharing of losses is the heart of insurance

 It is the spreading of losses incurred by the few over the

entire group.
 Pooling involves the grouping of a large number of exposure
units prediction of future losses (LLN).
So that, pooling implies:
(1) The sharing of losses by the entire group, and

(2) Prediction of future losses with some accuracy based on the

law of large numbers(LLN). 4
Example: Assume that 1000 farmer in Central Oromiya agree that if any
farmer’s home is damaged or destroyed by a fire, the other members of the
group will indemnify, or cover, the actual costs of the unlucky farmer who
has a loss.
Assume also that each home is worth Birr100,000 and one average, one
home burns each year. In the absence of insurance, the maximum loss to
each farmer is $100,000 if the home should burn.
However, by pooling the loss, it can be spread over the entire group, and if
one farmer has a total loss, the maximum amount that each farmer must
pay is only birr 100 (birr100,000/1000).
In effect, the pooling technique results in the substitution of an average loss
of birr100 for the actual loss of birr100,000.
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 From the viewpoint of the insurer, if future losses can be
predicted, objective risk is reduced.
B. Payment of Accidental Losses:
An accidental loss is one that the unforeseen and
unexpected and occurs as a result of chance.
 In other words, the loss must be accidental.
The LLN is based on the assumption that losses are
accidental and occur randomly.
Insurance policies do not cover intentional losses.
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C. Risk Transfer:

 Risk transfer means that a pure risk is transferred from the insured to

the insurer.

 It includes risk of premature death, poor health, disability,

destruction and theft of property, and liability lawsuits.

D. Indemnification:

 Indemnification means that the insured is restored to his or her

approximate financial position prior to the occurrence of the loss.

Example: If your home burns in a fire, a homeowner’s policy will

indemnify you or restore you to your previous position 7

D. Indemnification…. continued
Methods of Providing Indemnity
There are four basic methods of providing an indemnity:-
1. Cash: Many claims are settled by means of a cash
payment to insured.
2. Repair: An adequate repair constitutes an indemnity
3. Replacement: It is sometimes advantageous for the
insurer to replace an article rather than to pay cash.
4. Reinstatement. They is a term usually found in fire
insurance and concerns the restoration or rebuilding
of premises to their former condition.

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3.3 Fundamental of Insurable Risk
Insurers normally insure only pure risks exposures. However, not all pure
risks are insurable.
 From the viewpoint of the insurer, there are ideally six requirements of an
insurable risk.
Requirements:
a) Large Number of homogeneous Exposure Units
b) Accidental and Unintentional Loss
c) Determinable and Measurable Loss
d) No Catastrophic Loss
e) Calculable Chance of Loss
f) Economically Feasible Premium 9
a) Large Number of homogeneous Exposure Units
 The first requirement of an insurable risk is a large number of similar
exposure units.
 But not necessarily identical, exposure units that are subject to the
same peril or group of perils.

For example, a large number of frame dwellings in a city can be grouped

together for property insurance on the dwellings.

b) Accidental and Unintentional Loss

 Ideally, the loss should be accidental and outside the insured’s control.
 If an individual deliberately causes a loss, he or she should not be
indemnified for the loss.
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c) Determinable and Measurable Loss
 3rd requirement loss should be both determinable and
measurable.
 Loss should be definite as to cause, time, place and amount.
 Life insurance in most cases meets this requirement easily.
 The cause and time of death can be readily determined in most
cases, and if the person is insured
 Some losses, are difficult to determine and measure.
For example, under a disability-income policy, the insurer promises
to pay monthly benefit to the disable person if the definition of
disability stated in the policy is satisfied 11
d) Loss should not catastrophic loss
The fourth requirement is that ideally the loss should not be
catastrophic.
 This means that large proportion of exposure units should not
incur losses at the same time
 Insurers ideally which to avoid all catastrophic loses.
 Several approaches are available for meeting the problems of
catastrophic loss:
1st Reinsurance: the shifting of part or all of the insurance originally
written by one insurer to another.
2nd Avoid the concentration of risk: by dispersing their coverage
over a large geographical area
 If the loss exposures are geographically disperses, the possibility
of a catastrophic loss is reduced.
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d) Loss should not catastrophic loss cont’
New financial instruments available for dealing with catastrophic
losses.
Example: Catastrophe bonds
e) Calculable chance of loss
 The insurer must be able to calculate both the average frequency
and the average severity of future losses with some accuracy.
 For Certain losses It is difficult to insure b/c the chance of loss
cannot be accurately estimated, and the potential for a catastrophic
loss is present.
For example: floods, wars and cyclical Unemployment occur on an
irregular basis
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f) Economically Feasible Premium
 The insured must be able to pay the premium.
 The premiums paid must be substantially less than the face value,
or amount, of the policy.
 To have an economically feasible premium, the chance of loss must
be relatively low.
 If the chance of loss exceeds 40%, the cost of the policy will
exceed the amount that the insurer must pay under the contract.
For example, an insurer could issue a $1,000 life insurance policy on
a man age 99, but the pure premium would be about $980, and an
additional amount for expenses would have to be added.
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3.4 Insurance and gambling compared
 There are two important differences between them.
 First, gambling creates a new speculative risk, while insurance is a
technique for handling an already existing pure risk.
 This, the you bet $300 on a horse race, a new speculative risk is
created, but if you pay $300 to an insurer for fire insurance, the risk
of fire is already present and is transferred to the insurer by a
contract.
 No new risk is created by the transaction.
 The second difference is that gambling is socially unproductive, the
winner’s gain comes at the expense of the loser 15
3.4 Insurance and gambling compared cont’
 In contrast, insurance is always socially productive, b/c neither the
insurer nor the insured is placed in a position where the gain of the
winner comes at the expense of the loser.
 The insurer and the insured both have a common interest in the
prevention of a loss.
 Both parties win if the loss does not incur.
 gambling transactions generally never restore the loser to the
former financial position
 However, insurable contract restore the insured financially in
whole or in part if a loss occurs. 16
3.5 Insurance and speculation
 Both are similar in that risk is transferred by a contract and no new
risk is created.
 Similarity- the central purpose behind each transaction

Insurance
 Transaction normally involves the transfer of risks that are
insurable,
 Insurance can reduce the objective risk of an insurer by application
of the law of large number.
Speculation
A technique for handling risk those are typically not insurable
Speculation only involves transfer of risks not reduction of risk.
 The losses cannot be predicted based on the law of large number.17
 3.6 Benefits and cost of insurance
3.6.1 Benefits of insurance to the society
a) Indemnification:
b) Less Worry and Fear
c) Source of Investment Funds: loan to business or other means
d) Loss Prevention: through applying different loss prevention
program
e) Enhancement of Credit: through collateral

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 3.6 Benefits and cost of insurance…continued
3.6.2 Costs of insurance to the society

a) Cost of Doing Business: Insurers consume scarce economic

resources – land, labor, capital and business enterprise - in
providing insurance to society
b) Fraudulent Claims: are faked or staged to collect benefits

c) Inflated Claims: the submission of inflated or “padded” claims.

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 End of the Chapter
Thank you for your attention!

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