CHAPTER THREE

INSURANCE
 INSURANCE DEFINED
1. A system used to transfer risk of individuals for payment of premium. 
 The insured considers insurance as a transfer device.

 It is retention and combination device for the insurer.

 It is an arrangement that establishes a common fund out of which

financial compensation is made to those who faces accidental losses.
 It is a pooling of risks of many people who are exposed to the same
risk.
 It is a device used to spread the loss suffered by an individual or firm
to the members in the group.
 INSURANCE DEFINED
 It is a method to provide security to the insured person against the
probable loss.
"Why the insurer accept risks that other people try to avoid?’’
1. Pooling of similar risks (predict with a reasonable accuracy).
2. Financial capacity to assume/ take risk
3. Can enforce certain loss reduction and prevention measures
4. For losses that are beyond their capacity, insurers arrange a
reinsurance mechanism.
5. The knowledge and the skill to apply various risk reduction and
risk control measures.
 SOCIAL AND ECONOMIC VALUES
 RISK TRANSFER/INDEMNIFICATION
 Provide financial compensation to those insured who
suffered accidental losses.
 Indemnification is made out of the fund established by the
members contribution or premium payment.
 The loss is spread to all members on equitable basis and
the financial burden of the unfortunate is reduced.
 
 REDUCTION OF UNCERTAINTY
 Reduces the physical and mental stress and provides peace
of mind. It is a psychological benefit that may not be
quantified but still of great importance.
 Reduces worries and anxieties which can make every one to
work more productive and perform his duties properly without
anxiety.
 This has direct implication on the society (the society will be
secured from unexpected loss and interruption of services
from those who will face unexpected loss).
 Help Businesses Continue Without
Interruption of Operation
 The insured firm will not be knocked out of business by
fire or liability or other insurable risks.
 The insurer indemnifies the losses and restores the firm to
its former position.
 Insurance helps small businesses since they cannot bear all
the risks by themselves. By transferring their risk, they can
safely perform their operation and compete with larger
firms.
PROVIDE FUNDS FOR INVESTMENT
 Premiums collected by insurance companies are
not left stagnant. They are used to provide a big
source long-term investment capital for the
national economy.
 The loan is made available to investors through
banks and it serve as a stimulant for the national
economy to be healthier.
 KEEPS FAMILIES TOGETHER
 Family can continue to live together after disastrous
adversaries.
Example: if a husband with life insurance dies, his family can
receive the compensation from the insurer and can earn their
live as it was before at least to some extent.
  It relieves pressure on social welfare system, thereby

reserving government resources for essential social security

activities.
 PROVIDES A BASIS FOR CREDIT
 Insurance policies are used as a guarantee for personal
and business bank loans.
 This days banks lend money on the basis of the collateral
security of insurance.
 PROMOTES LOSS CONTROL
SYSTEMS
  Insurance companies have tried and are continuing to
introduce several kinds of loss reduction and prevention
schemes.
Example: health education and boilers, installation of fire
extinguishers, burglar alarms…..
 The introduction of loss control programs can reduce losses

to businesses and individuals and complement good risk

management thereby benefiting society as a whole.
 It provides Financial Stability to the Community
 It creates certainty in the environment thereby stimulating
competition among business enterprises in a certain region.
 Fair competition is a greater advantage to the society since it
reduces price, encourage efficient utilization of scarce resources
and produce quality products.
 Avoids or at least minimizes production stoppage that
produces an economic wastage, and results in loss of profit to
the insured, unemployment and loss of trade and services to the
business community.  
 Stimulates International Trade and Commerce
 Goods traded at the international market are highly
vulnerable to risk of loss due to large number of perils.
As a result it is difficult to think of international trade with
out insurance.
 Insurance coverage may be a condition for engaging in
international trade and commerce. Insurance serves as a
"lubricant of trade", without it trade and commerce may
stifle.
 DISADVANTAGES OF INSURANCE
MORAL HAZARD
 It encourages fraud to collect dishonest claims. When
individuals are insured against a particular risk, they may
intentionally increase the chance of loss, or exaggerate the
claim.
MORALE HAZARD
 Increases carelessness in life. Insured take more risks than
they would if they had no insurance coverage which may
result in excessive losses in the community.
 COSTS OF INSURANCE
 INSURERS’ OPERATING EXPENSES
 Loss control costs
 Loss adjustment expenses,
 Expense involved in acquiring insured, (advertisement
cost), state premium taxes, and
 General administrative costs.
 Additionally, the insured is expected to cover a
reasonable amount for profit and contingencies.
 LIMITATIONS OF INSURANCE
 It is a device used to deal with pure risks only. Even not
all pure risks are insurable.
 Doesn’t provide protection against a wide range of risks. It
has a limited application.
 CHARACTERISTICS OF INSURABLE RISKS
 A large number of independent units should be exposed to
the same risk. Therefore, there must be a sufficiently large
number of risks of a similar class being insured so as to predict
accurately the average loss experience.
 It must be possible to calculate/measure the chance of loss in
monetary terms.
 The loss should be accidental from the view point of the
insured as distinguished from the expected loss. Example:
Depreciation
 CHARACTERISTICS OF INSURABLE RISKS
 The possible loss must not be catastrophic. The risks
covered by insurance should affect only a relatively small
portion of the total insured population at a given time. Other
wise, a single occurrence of the risk would bankrupt the
insurance companies.
Example: fundamental risks such as war and earthquake.
 There must be an insurable interest. Financial

relationship in the subject matter of insurance can avail the

insurance protection.
 CHARACTERISTICS OF INSURABLE RISKS
 The potential loss must be large. The peril must be
capable of causing a loss so large that the insured cannot
bear it himself without economic distress.
 The cost of insurance should not be prohibitive. The cost
of insuring (premium) must be economically feasible and
within the reach of nearly everyone; otherwise it will be
confined to a very small section of the society. The premium
should be reasonable.
 CHARACTERISTICS OF INSURABLE RISKS
 The risk must be consistent with public policy. The
insurance contract should not be against the public policies,
for example, insurance effected by terrorists for fines imposed
for the offences.
 The insured must be subject to real risk whatever may be
the subject matter of insurance for which the insured seeks
protection, the subject matter must be adversely affected on
the happening of the event, i.e., the subject matter must be
potentially exposed to the risk.
 INSURABLE RISK
 Pure risks: property (direct and indirect property losses; personal and
legal liability losses).
 Non-catastrophic losses
 Risk with low probability of occurrence
 UN INSURABLE RISKS
 Speculative risks such as market risks,

 Fundamental risks (war, earthquake, political and economic losses).

 Wear and tear of goods, e.g. Depreciation.

 Risk that are against public policy.

END OF THE CHAPTER