Chapter 1: Introduction to Insurance

Maryam Sholevar Jimma University

Insurance Practice and Procedure

by Maryam Sholevar

Presenting at

Department of Banking and Finance


Chapter One

Introduction

Insurance is a social device for spreading the chance of financial loss among

a large number of people. Insurance protects against pure risk.

Risk is the possibility of losing economic security.

Risk can be of two kinds: speculative or pure And only pure risks are insurable.


Pure Risk

Pure risk involves only two possible outcomes:

loss or no loss, with no possibility of gain or profit


The Law of Large Numbers:

The average of the results obtained from a large number of trials should

be close to the expected value.

Underwriting:

The process of selecting certain types of risks that have historically

produced a profit.

Peril:

A potential cause of loss. Accident, fire, and theft are common perils.

Hazard:

Anything that increases the seriousness of a loss or increases

the likelihood that a loss will occur.


Adverse Selection:

Is the tendency of person with a higher than average chance

of loss to seek insurance at the average state, which if not

Controlled by underwriting, result in higher than expected

Loss levels.

Insurance is not same as gambling. Gambling is creat a new

speculative risk and socially is unproductive but insurance

Deals with pure risk and socially is productive.

Insurance is not same as hedging. Insurance involves the

Transfer of pure risk and reduce objective risk but hedging

Involves just the transfer of speculative risk not risk

Reduduction.


Types of Insurance:

Private insurance, consist of health insurance, property and

liabilty insurance.

Government Insurance, cnosist of social insurance and other

Government insurance programs.


How does insurance work?You pay a fee called a premium, and in exchange,

the insurance company agrees to pay you a certain

amount of money


HISTORY OF INSURANCE

Chinese merchants to reduce their risks,

split the shipment into smaller portions and

placed them on several boats.

They knew that if one did sink,

the majority of the cargo

would reach its destination safely.

Origins in China


Basic Characteristics Of Insurance

Pooling of losses

Payment of fortuitous losses

Risk transfer

Indemnification


Pooling of losses

Spreading of losses incurred by the few over the entire group.

• Key mechanism is “law of large number”.

• Future losses are predicted based on law of large number.

Note• Pooling of loss is the spreading of losses incurred by the few over the

entire group so that in the process average loss is substituted for actual loss.

• The primary purpose of pooling is to reduce the variation in possible

Outcomes , which reduces risk.


Payment of fortuitous losses

A fortuitous loss is one that is unforeseen and

unexpected and occurs as a result of chance.

Insurance policies do not cover intentional losses


Risk Transfer

Risk transfer means that a pure risk is transferred from

the insured to the insurer,who typically is in a stronger

Financial position to pay the loss than the insured.


Indemnification

Means that the insured is restored to his or her approximate

financial position prior to the occurrence of the loss.


Insurable Risk

Insurer normally insure only pure risk.

Not all pure risks are insurable

1. There must be a large number of exposure units.

2. The loss must be accidental and unintentional.

3. The loss must be determinable and measurable.

4. The loss should not be catastrophic.

5. The chance of loss must be calculable.

6. The premium must be economically feasible.


Insurable Risk

1. There must be a large number of exposure units.

an insurance organization prefers to have a large

number of similar units when insuring

a possible loss exposure.

The concepts of mass and similarity are thus

considered before an insurer accepts a loss exposure.


Insurable Risk

2. The loss must be accidental and unintentional.

Loss should be fortuitous and outside the insured’control.

Two purposes of this requirement are :

1. If intentional losses were paid, moral hazard

would be substantially increased.

2. Law of large number requires random occurrence

of events.


Insurable Risk

3. The loss must be determinable and measurable.

Purpose of this requirement is to enable an insurer

to determine if the loss is covered under the policy,

and if it is covered, how much should be paid.


Insurable Risk

4. The loss should not be catastrophic.

This is to ensure that a large proportion of

exposure units should not incur losses at the

same time.


Insurable Risk

5. The chance of loss must be calculable.

Both average frequency and the average severity

of future losses with some accuracy.

Purpose of this requirement is to assess

the appropriate premium.


Insurable Risk

6. The premium must be economically feasible.

For the insurance to be attractive purchase,

the premiums paid must be substantially less

than the face value


unique characteristics of insurance contracts

• Insurance contracts are contracts of adhesion, which is a

take it or leave it contract.

• Insurance contracts are unilateral in that there is only one promise

made and it’s made by the insurer to pay in the event of a loss.

• Insurance contracts are conditional. Two types of conditions:

1) conditions precedent; and 2) conditions subsequent.

A condition precedent is a condition that must be fulfilled to activate

the contract.

Conditions subsequent

are acts or duties that must be adhered to in order to receive the benefits of

the policy.


unique characteristics of insurance contracts

• The insured must have an insurable interest.

• It is a contract based on the principal of indemnity

(insured cannot make a profit from a claim on insurance).

• Insurance contracts are aleatory in nature, which means The performance

of one or both parties is contingent on the occurrence of an event that may

never materialize.

• Utmost Good Faith – Both parties to the insurance contract almost totally

rely on the honesty of the other party. The insurer relies on the honesty

of the insured in providing underwriting information; the insured relies on

the honesty of the insurer that they will pay when a covered loss occurs.


COST AND BENEFITS OF INSURANCE

BENEFITS

*Indemnification for losses

*Reduction of worry and fear

*Source of investment fund

*Loss prevention

*Enhancement of credit

COST

*Cost of doing business

*Fraudulent claims

*Infalted Claims


Function Of Insurance

(i) Primary Functions

* Insurance provides certainty

*Insurance provides protection

*Risk-Sharing

(ii) Secondary Functions

*Prevention of loss

*It Provides Capital

*It Improves Efficiency

*It helps Economic Progress

Inurance

Chapter 1: Introduction to Insurance

Education

Transcript of Chapter 1: Introduction to Insurance