PART - I RISK AND RELATED TOPICS

CHAPTER ONE

INTRODUCTION

Risk exists whenever the future is unknown. Because the adverse effects of risk have
plagued mankind since the beginning of time, individuals, groups, and societies have
developed various methods for managing risk. Since no one knows the future exactly,
everyone is a risk manager not by choice, but by sheer necessity.

1.1. Risk Defined

The word risk is used in many different ways. It can refer to general uncertainty, doubt,
an insured object, or chance of loss.

Williams and Heins define risk as the variation in the outcomes that could occur
over a specified period in a given situation. If only one outcome is possible, the variation
and hence the risk is o. If many outcomes are possible, the risk is not 0. The greater the
variation, the greater the risk.

For the purpose of this course we will define risk as the possibility of an adverse
deviation from a desired outcome that is expected or hoped for. If you own a houre, you
hope it will not catch fire. When you make a wager, you hope the outcome will be
favorable. The fact that the outcome in either event may be something other than what
you hope for constitutes a possibility of loss or risk.

Note that the above definition is not subjective. Risk is a state of the external
environment. This possibility of loss must exist, even though the individual exposed to
that possibility may not be aware of it. If the individual believes that there is a possibility
of loss where none is present, there is only imagined risk, and not risk in the sense of the
real world. Finally, there is not requirement that the possibility of loss must be
measurable, only that it must exist.

Risk is uncertainty as to loss. If a cost or a loss is certain to occur, it may be

planned for in advance and treated as a definite, known expense. It is when there is
uncertainty about the occurrence of a cost or loss that risk becomes an important
problem.

When risk is said to exist there must always be at least two possible outcomes. If
we know in advance what the outcome will be, there is no risk. For example, investment
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in a capital asset involves a realization that the asset is subject to physical depreciation
and that its value will decline. Here the outcome is certain so there is no risk.

The degree of risk is inversely related to the ability to predict which outcome will
actually occur. If the risk is 0, the future is perfectly predictable. If the risk in a given
situation can be reduced, the future becomes more predictable and more manageable.

In a two - outcome situation for which the probability of one outcome is 1 and the
probability of the second outcome is 0, the risk is 0 because the actual outcome is known.

1.2. Risk Versus Probability

It is necessary to distinguish carefully between risk and probability. Probability refers to

the long-run chance of occurrence, or relative frequency of some event. Insurers are
particularly interested in the probability or chance of loss, or more accurately, the
probability that a loss will occur to one of a group of insured objects.

Risk as differentiated from probability, is a concept in relative variation. We are

referring here particularly to objective risk, which is the relative variation of actual from
probable or expected loss. Objective risk can be measured meaningfully only in terms of
a group large enough to analyze statistically. If the number of objects is too small, the
range of probable variation is so large that is virtually infinite as far as the insurer is
concerned.

1.3. Risk Versus Uncertainty

Uncertainty is the doubt a person has concerning his or her ability to predict which of the
many possible outcomes will occur. Uncertainty is a person's conscious awareness of the
risk in a given situation. It depends upon the person's estimated risk-what that person
believes to be the state of the world-and the confidence he or she has in this belief. A
person may be extremely uncertain about the future in a situation where in reality the risk
is small; on the other hand, this person may have great confidence in his or her ability to
predict the future when in fact the future is highly uncertain. Unlike probability and risk,
uncertainty cannot be measured by any commonly accepted yardstick

1.4. Risk Distinguished from Peril and Hazard

Many persons commonly employ the terms "risky," "hazardous," and "perilous"
synonymously. For clarity in thinking, however, the meanings of these words should be
carefully distinguished

A peril is a contingency, which may cause a loss. We speak of the peril of "fire" or
"windstorm," for "hail" or "theft". Each of these is the cause of a loss that may occur.
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 A hazard, on the other hand, is that condition which creates or increases the
probability of loss from a peril. For example, one of the perils that can cause loss to an
auto is collision. A condition that makes the occurrence of collisions more likely is an icy
street. The icy street is the hazard and collision is the peril. In winter the probability of
collision is higher owing to the existence of icy streets. In such a situation, the risk of
loss is not necessarily any higher or lower, since we have defined risk as the uncertainty
that underlying probability will work out in practice.

It is possible for something to be both a peril and hazard. For instance sickness is a
peril causing economic loss, but it is also a hazard that increase the chance of loss from
the peril of premature death.

There are three basic types of hazards: physical, moral, and morale.

1. Physical Hazard. A physical hazard is a condition stemming from the physical

characteristics of an object that increases the probability and severity of loss
from given perils. Physical hazards include such phenomena as the existence of
dry forests (hazard for fire), earth faults (hazard for earthquakes), and icebergs
(hazard to ocean shipping). Such hazards may or may not be within human
control. For example, some hazards for fire can be controlled by placing
restrictions on building camp fires in forests during the dry season. Some
hazards, however, cannot be controlled. For example, little can be done to
prevent or to control air masses that produce ocean storms.

2. .Moral Hazard. A moral hazard stems from the mental attitude of the
insured. A moral hazard is a condition that increases the chance that some
person will intentionally (1) cause a loss or (2) increase its severity. Some
unscrupulous persons can make, or believe that they can make, a profit by
bringing about a loss. For example, arson, inspired by the possibility of an
insurance recovery, is a major cause of fires. A dishonest person, in the hope of
collecting money from the insurance company, may intentionally cause a loss.
3. Morale Hazard. The moral hazard includes the mental attitude that
characterizes an accident-prone person. A moral hazard is condition that causes
persons to be less careful than they would otherwise be. Some persons do not
consciously seek be bring about a loss, but the fact that they have insurance
causes them to take more chances than they would if they had no insurance. The
purchase of insurance may create a morale hazard, since the realization that the
insurance company will bear the loss may lead the insured to exercise less care
than if forced to bear the loss alone. Morale hazard results from a careless
attitude on the part of insured persons toward the occurrence of losses.

1.5. Classes of Risk

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Risks may be classified in several ways according to their cause, their economic effect, or
some other dimension. However, there are certain distinctions that are particularly
important for our purpose stated hereunder.

1.5.1. Financial Versus Non Financial Risks

In its broadest context, the term risk includes all situations in which there is an exposure
to adversity. In some cases this adversity involves financial loss, while in others it does
not. There is some element of risk in every aspect of human endeavor and many of these
risks have no (or only incidental) financial consequences. In this course we are concerned
with those risks which involve a financial loss.

1.5.2. Static Risk Versus Dynamic Risks

A second important distinction is between static and dynamic risks.

Dynamic risks are those resulting from change the economy. They are risks
associated with changes, especially changes, especially changes in human wants and
improvements in machinery and organization. For example, changes in the price level,
consumer tastes, income and output, and technology may cause financial loss to members
of the economy.

Static risks involve those losses, which would occur even if there are no change in
the economy. These are risks connected with losses caused by the irregular action of the
forces of nature or the mistakes and misdeeds of human beings.

Static risks are risks stemming from a level, unchanging society that is in stable
equilibrium. Examples include the uncertainties due to random events such as fire,
windstorm, or death. They would be present in an unchanging economy. If we could hold
consumer taste, output, and income, and the level of technology constant, some
individuals would still suffer financial loss. These losses arise from causes other than the
changes in the economy, such as the perils of nature and the dishonesty of other
individuals.

Dynamic risks normally benefit society over the long-run since they are the result
of adjustments to misallocation of resources. They usually affect a large number of
individuals and are generally considered less predictable, since they occur with no precise
degree of regularity. Static risks, unlike dynamic risks usually result in a loss to society,
affect directly few individuals at most, exhibit more regularity over a specified period of
time and, as a result, are generally predictable.

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1.5.3. Pure Risks Versus Speculative Risks

A distinction has been made between pure risk and speculative risk, which further
clarifies the nature of risk. A pure risk exists when there is a chance of loss but no chance
of gain. For example, the owner of an automobile faces the risk associated with a
potential collision loss. If a collision occurs, the owner will suffer a financial loss. If
there is no collision, the owner's position remains unchanged.

A speculative risk exists when there is a chance of gains as well as a chance f loss.
For instance, expansion of an existing plant involves a chance of loss and chance of gain.
Pure risks are always distasteful, but speculative risks possess some attractive features.
In the above example, i.e., expansion of existing plant, the investment made may be lost
if the product s not accepted by the market at a price sufficient to cover costs but this risk
is born in return for the possibility of profit. Gambling is also a good example of
speculative risk. In a gambling situation risk is deliberately created in the hope of gain.

Pure risks also differ from speculative risks in that they generally are repeatable
under essentially the same condition and thus are more amenable to the law of large
numbers (a basic law of mathematics, which states that as the number of exposure units
increases, the more certain it is that actual loss experience will equal probable loss
experience).

This means that one can more successfully predict the proportion of units that will
be loss if they are exposed to a pure risk than if they are subject to a speculative risk.
One notable exception to this statement is the speculative risks associated with games of
chance, which are highly amenable to this law.

In a situation involving a speculative risk, society may benefit even though the
individual is hurt. For example, the introduction of socially beneficial product may cause
a firm manufacturing the product it replaces to go bankrupt. In a pure-risk situation
society almost always suffers if any individual experiences a loss.

The distinction between pure and speculative risk is an important one, because
normally pure risks are insurable. Insurance is not concerned with the protection of
individuals against those losses arising out of speculative risks. Speculative risk is
voluntarily accepted because of its two dimensional nature, which includes the possibility
of gain and loss.

Both pure and speculative risks commonly exist at the same time. For example,
the ownership of a building exposes the owner to both pure risks (for example, accidental
damage to the property) and speculative risk (for example, rise or fall in property values
caused by general economic conditions).

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Classification of Pure Risks

While it would be impossible to list all the risks confronting an individual or business
organization, we can briefly outline the nature of the various pure risks that we face. For
the most part, these are also static risks. Pure risks that exist for individuals and business
firms can be classified under one of the following:
a) Personal Risks. These consist of the possibility of the loss of income or assets
as a result of loss the ability to earn income. In general earning power is
subject to four basic perils:
1. premature death
2. dependent old age
3. sickness or disability
4. unemployment

b) Property risks. Anyone who owns property faces risks simply because such
possession can be destroyed or stolen. Property risks embrace two distinct
types of loss: direct loss and indirect or consequential loss. Direct loss is the
simplest to understand. If a house is destroyed by fire, the property owner loses
the value of the house. This is a direct loss. However, in addition to losing the
value of the building itself the property owner no longer has a place to live,
and during the time required to rebuild the house, it is likely that the owner
will incur additional expenses living somewhere else. This loss of use of the
destroyed asset is an indirect or consequential loss.

An even better example is the case of a business firm. When a firm's

facilities are destroyed, it loses not only the value of these facilities but also the
income that would have been earned through their use. Property risks, then,
can involve three types of losses.
i) the loss of the property
ii) loss of use of the property or its income and
iii) additional expenses occasioned by the loss of the property.

c) Liability Risk. The basic peril in the liability risk is the unintentional injury of
property of others through negligence or carelessness. However, liability may
also result from intentional injuries or damage. Under our legal system, the
laws provide that one who has injured another or damaged another man's
property through negligence or otherwise, can be held responsible for the harm
cause. Liability risks therefore, involve the possibility of loss of present assets
or future income as a result of damages assessed or legal liability arising out of
either intentional or unintentional torts or invasion of the rights of others.
d) Risk arising from failure of others. When another person agrees to perform a
service for you he/she undertakes an obligation which you hope will be met.
When the person's failure to meet this obligation would result in your financial
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 loss risk exists. Example of risks in this category include failure of a contractor
to complete a construction project as scheduled or failure of to make payments
as expected.

1.5.4. Fundamental Risk Versus Particular Risks

The distinction between fundamental and particular risks is based on the differences in
origin and consequences of the losses. Fundamental risks involve losses that are
impersonal in origin and consequence. They are group risks caused by economic, social,
and political phenomena, although they may also result from physical occurrences. They
affect large segments or even all of the population. Since these are group risks,
impersonal in origin and effect they are, at least for the individual, unpreventable.

Particular risks involve losses that arise out of individual events and that are felt by
individuals rather than by the entire group. They are risks personal in origin and effect
and more readily controlled. Examples of fundamental risks are those associated with
extraordinary natural disturbances such as drought, earthquake and floods. Examples of
particular risks are the risk of death or disability from non-occupational causes, the risk
of property losses by such perils as fire, explosion, theft, and vandalism, and the risk of
legal liability for personal injury or property damage to others.

Since fundamental risks are caused by conditions more or less beyond the control
of the individuals who suffer the losses and since they are not the fault of anyone in
particular, it is held that society rather than the individual has a responsibility to deal with
them. Although some fundamental risks are dealt with through private insurance (for
example, earthquake insurance is available from private insurers in many countries, and
flood insurance is frequently include in all risk contracts covering movable personal
property) it is an inappropriate tool for dealing with most fundamental risks, and some
form of social insurance or other transfer program may be necessary.

Particular risks are considered to be the individual's own responsibility,

inappropriate subjects for action by society as a whole. The individual through the use of
insurance, loss prevention, or some other technique deals them with.

1.5.5. Objective Risks Versus Subjective Risks

Objective risks, or statistical risk, applicable mainly to groups of objects exposed to loss,
refers to the variation that occurs when actual losses differ from expected losses. It may
be measured statistically by some concept in variation, such as the standard deviation.
Subjective risk on the other hand, refers to the mental state of individual who experiences
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doubt or worry as to the outcome of a given event. It is a psychological uncertainty that
stems from the individual's mental attitude or state of mind.

Subjective risk has been measured by means of different psychological tests, but
no widely accepted or uniform tests of proven reliability have been developed. Thus,
although we recognize different degrees of risk-taking willingness in persons, it is
difficult to measure these attitudes scientifically and 5to predict risk-taking behavior,
such as insurance-buying behavior, from tests of risk-taking attitudes.

Subjective risk may affect a decision when the decision-maker is interpreting

objective risk. One risk manager may determine that some given level of risk is "high"
while another may interpret this same level as "low". These different interpretations
depend on the subjective attitudes of the decision-makers toward risk. Thus it is not
enough to know only the degree of objective risk; the risk attitude of the decision maker
who will act on the basis of this knowledge must also be know. A person who knows that
there is only one chance in a million that a loss will occur may still experience worry and
doubt, and thus would by insurance, while another would not. For example, Business A
insures the plant against fire even though the premium may be very high, while Business
B, a neighbor operating under similar conditions, refuses the insurance. In this example
A can be described as apparently perceiving a higher degree of risk in the given situation
and behaving more conservatively than B. A tends to be a risk averted and B, a risk taker.

Why Study Risk?

It has been aptly stated that "man is the only case in a nature where life becomes aware of
itself." However, man makes numerous choices and decisions on uncertain conditions.
He is not aware of all that threatens him and eventually the ultimate reality and certainty
that is, death. Thus, we live in an uncertain world in which decisions must be make and
risks taken.

When a person gets married, goes into business, decides to attend college, buys a
house or does innumerable other things that affect his life in any important way, he is
naturally some what apprehensive over the outcome. He is uncertain as to how this
particular action will turn out, but he always hopes for the best. He usually considers the
various alternatives and make up his mind only after weighing the advantages and
disadvantages of each course of action. We say that this individual is facing the
uncertainties of the future, that is, the different kinds of risks. Usually he is happier for
making decision that he is almost certain is correct. He likes the soft-heard advice, "be
sure you are right, then go ahead." Conversely, he usually dislikes decisions that he has
to make "in the dark," those with more risks attached.

As a illustration, consider the various uncertainties that enter into the purchase of a
home by taking a loan from a bank to repaid within 20 years. The family breadwinner
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must make the decision whether or not to buy a certain home in the environment of
uncertainties such as:

i) Is the level of my income high enough and certain enough to enable me make the
payments for 20 years?
ii) How can I protect the investment for my family's benefit in case I should die
before the loan is repaid?
iii) Will my health permit me to continue to work for 20 years?
iv) Would it be better to rent rather than to buy and use my funds for other purposes?
if so, what risks characterise the alternative uses of my fund?
v) How can I protect my investment in case of fire, flood, wind-storm, or other peril?
vi) It is possible that may investment will lose value because of a job
transfer and consequent forced sale of property?
vii) In order to have exactly the type of house ji want, should I take the risk of building
a home rather than buying.

If the potential home buyer cannot find satisfactory answers to those and other
questions, he may decide that "the risks are too great" and fail to purchase a home.
Indeed, the subject of risk is of great importance to an "economic man"; risk has an
element of distastefulness (economists would call it disutility) that make him want to
eliminate it. The more completely he can avoid risk, the better. Because people usually
try to avoid all the uncertainties they can, the subject of risk and its wise management has
received important consideration by social scientists for many years. They have tried to
identify what type of risks there are and how to avoid or to handle risk in some
satisfactory manner.

CHAPTER - TWO

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 RISK MANAGEMENT

The environment of modern business, particularly the large industrial unit, is becoming
increasingly complex. This increased complexity creates greater need for special
attention to the risks facing the enterprise. Most large corporations and many smaller
ones employ specialized managers to grapple with the problems of increased risk.

Several factors have contributed to the increased complexity of modern enterprise and
have greatly enlarged the risks faced by business. Among these factors are inflation, the
growth of international operations, more complex technology, and increasing government
regulation.

2.1. What is Risk Management?

The increased complexity of modern enterprise called for special task to dealing with
risks facing modern enterprises. The specal task to identify, analyze, and combat
potential operating risks is referred to as risk management. In other words, risk
management s a systematic way of protecting business resources and income against
losses so that the organization's aims are reached without interruption, creating stability
and contributing to profit. It is a scientific approach to the problem of dealing with risks
faced by individuals and business. Because of the pervasiveness of risk and its
significant adverse economic effects, man is constantly searching for ways in which he
can manage risk to his advantage.

In brief, risk management s the science that deals with the techniques of
forecasting future losses so as to plan, organize, direct and control efforts made minimize
(eliminate if possible) the adverse effects of those potential losses. It is the reduction and
prevention of the unfavorable effects of risk at minimum cost through its identification,
measurement and control.

In general, the risk manager deals with pure, not speculative, risk. Hence, risk
management is the identification, measurement, and treatment of pure risk exposures.

The Development of Risk Management

At one time business enterprises paid little attention to the problem of handling risk.
Insurance policies were purchased on a haphazard basis, with considerable over lapping
coverage on hand, and wide gaps in coverage of important exposures on the other. Little
control over the cost of losses and insurance premium was exercised. Many risks were
assumed when they should have been insured and vice versa. It was gradually realized
that greater attention to this aspect of business management would yield great dividends.
Instead of having insurance decision handled by a busy executive whose primary
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responsibility lay in another area, management began to assign this responsibility first as
a part-time job to an officer, perhaps the treasurer, and later as a full time position.

As the full scope of responsibility for risk management was realized, an insurance
department was established, with several people employed. At first the department
manager was usually known as the insurance buyer. Later the title was changed to
insurance manager or risk manager.

Many different titles, including insurance buyer, are still used, but the tendency is
to reflect the broader nature of the manager's duties and responsibilities. Assistants to the
insurance manager often include specialists in various branches of insurance, law,
statistics, and personal relations.

Functions of Risk Management

In general, the functions of the risk manager include the following:

1. To recognize exposures to loss, the risk manager must first of all be aware of the
possibility of each type of loss. This is a fundamental duty that must precede all
other functions. Before other functions potential loss exposures must be identified.
2. To estimate the frequency and size of loss; that is, to estimate the probability of
loss from various sources.
3. To decide the best and most economical method of handling the risk
of loss, whether it be by assumption, avoidance, self-insurance, reduction of
hazards, transfer, commercial insurance, or some combination of these methods.
4. To administer the programs of risk management, including the tasks
of constant re-evaluation of the programs, record keeping, and the like.

It is the responsibility of the risk manager to see that the concern's profits are not
lost because of the occurrence of a peril which could have been insured against or
otherwise adequately handled.

2.2. Risk Identification

The first step in business risk management is to identify the various types of potential
losses confronting the firm; the second step is to measure these potential losses with
respect to such matters as their likelihood of occurrence and their probable severity.

Risk identification is the process by which a business systematically and

continuously identifies property, liability, and personnel exposures as soon as or before
they emerge. Unless the risk manager identifies all the potential losses confronting the
firm, he will not have any opportunity to determine the best way to handle the

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undiscovered risks. The business will unconsciously retain these risks, and this may not
be the best or even a good thing to do.

In one way or another, the risk manager must dig into the operations of the concern
and discover the risks to which the organization is exposed. To identify all the potential
losses the risk manager should have a look at insurance policy checklists, risk manager
should have a look at insurance policy checklists, risk analysis questionnaires, flow-
charts, analysis of financial statements, and inspections of the organization's operations.

Insurance policy checklists: Insurance policy checklists are available from insurance
companies and from publishers specializing in insurance related publications. Typically,
such lists include a catalogue of the various policies or types of insurance that a given
business might need. The risk manager simply consults such a list, picking out those
policies applicable to the concern. A principal defect of this approach s that it
concentrates on insurable risks only, ignoring the uninsurable pure risks.

Loss exposure checklists are available from various sources, such as insurers,
agencies, and risk management associations. These checklists are possible sources of
loss to the business firm from destruction of physical and intangible assets. Sources of
loss are organized according to whether the loss is predictable or unpredictable,
controllable or uncontrollable, direct or indirect, or from different types of legal liability.
After each items the user can ask the question, "It this a potential source of loss in our
firm?" Use of such a list reduced]s the likelihood of overlooking important sources of
loss.

Risk Analysis Questionnaire: Risk analysis questionnaires sometimes called "fact

finders" are designed to lead the risk manager to the discovery of risks through series of
detailed and penetrating questions. Most of the time these questionnaires are designed to
identify both insurable and uninsurable risks. It directs the risk manager to secure
specific information concerning the firm's properties and operations.

This questionnaire contains a list of questions designed to remind the risk manager
of possible loss exposures. For example, here are some sample questions:

1. If a building is leased from someone else, does the lease make the firm responsible for
repair or restoration of damage not resulting from its own negligence?
2. Are company-owned vehicles furnished to directors, executives, or employees for
business and personal use? If so, to what extent?
3. Are there any key service facilities or warehouses whose function must continue even
though the structures and equipment may be damaged?
4. Indicate the maximum amount of money, checks, and securities that may be on hand
in any one office during and outside business hours.

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Flow-Charts: A third systematic procedure for identifying the potential losses facing a
particular firm is the flow-chart approach. First, a flow chart or series of flow charts is
constructed, which shows all the operations of the firm, starting with raw materials,
electricity, and other inputs at suppliers' locations and ending with finished products in
the hand of customers. Second, the checklist of potential property, liability, and
personnel losses is applied to each property and operation shown in the flow chart to
determine which losses the firm faces.

The most positive benefit of using flow charts is that they force the risk manager to
become familiar with the technical aspects of the organization's operations, thereby
increasing the likelihood of recognizing special exposures.

On-Site Inspections: On-site inspections are must form the risk manager. By observing
firsthand the firm's facilities and the operations conducted thereon the risk manager can
learn much about the exposures faced by the firm. Just as one picture is worth a thousand
words one inspection tour may be worth a thousand checklists. An examination of
organization's various operation sites and discussions with managers and
workers will often uncover risks that might otherwise have gone undetected.

While no single method or procedure of risk identification is free of weaknesses

the strategy of management must be to employ that method or combination of methods
that best fits the situation hand.

2.3. Risk Measurement

After the risk manager has identified the various types of potential losses faced by his
firm, these exposures must be measured. Risk measurement is required by the risk
manager for two purposes: I) to determine the relative importance of potential losses and
ii) To obtain information that will help him to decide upon the most desirable
combination of risk management tools.

Dimensions to be Measured

Information is needed concerning two dimension of each exposure:

i) The loss frequency or the number of losses that will occur and
ii) The severity of losses. The total impact of these losses if they should be retained,
not only their dollar values, should be included in the analysis.

Why we Need Each Dimension

Both loss-frequency and loss-severity data re needed to evaluate the relative importance
of an exposure to potential loss. Contrary to the views of most persons, however, the
importance of an exposure to loss depends mostly upon the potential loss severity, not the
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potential frequency. A potential loss with catastrophic possibilities, although infrequent,
is far more serious than one expected to produce frequent small losses and no large
losses.

On the other hand, loss frequency cannot be ignored. If two exposures are
characterized by the same loss severity, the exposure whose frequency is greater should
be ranked more important. An exposure with a certain potential loss severity may be
ranked above a loss with a slightly higher severity because the frequency of the first loss
is much greater than that of the second. There is no formula for ranking losses in order of
importance, and different persons may develop different rankings. The rational approach,
however, is to place more emphasis on loss severity.

An example may clarify the point. The chance of an automobile collision loss may
be greater than the chance of being sued as a result of the collision, but the potential
severity of the liability loss s so much greater than the damage to the owned automobile
that there should be no hesitation in ranking a liability loss over the property loss.

A particular type of loss may also be subdivided into two or more kinds 9of losses
depending upon whether the loss exceeds a specified dollar amount. For example,
consider the collision loss cited in the preceding paragraph. This loss may be subdivided
into two kinds of losses: I) collision losses of $100 (for some other figure) or less and ii)
losses over $100. Losses in the second category are the more important, although they
are less frequent. Another illustration would be the losses associated with relatively small
medical expenses as contrasted with extremely large bills. Such a breakdown by size of
loss shows clearly the desirability of assigning more weight to loss severity than to loss
frequency.

In determining loss severity the risk manager must be careful to include all the
types of losses that might occur as a result of a given event as well as their ultimate
financial impact upon the firm. Often, while the less important types of losses are
obvious to the risk manager, the more important types are much more difficult to identify.
The potential direct property losses are rather generally appreciated in advance of any
loss, but the potential indirect and net income losses (such as the interruption of business
while the property is being repaired) they may result from the same event are commonly
ignored until the loss occurs.

The ultimate financial impact of the loss is even more likely to ignored in
evaluating the dollar value of any loss. Relatively small losses, if retained, cause only
minor problems because the firm can meet these losses fairly easily out of liquid assets.
Somewhat larger losses may cause liquidity problems which in turn may make it more
difficult or more costly for the firm to borrow funds required for various purposes.
Finally, very large losses may have serious adverse affects upon the firm's financial
planning, and their dollar impact may be much greater than it would be for a firm that
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could more easily absorb these losses. Ultimately the loss could be the ruin of the
business as a going concern.

To illustrate, a fire could destroy a building and its contents valued at $300,000; the
ensuing shutdown of the firm for six months might cause another $360,000 loss. This
$660,000 loss of the difference between the going-concern value of the business, say
$2,400,000, and the value for which the remaining assets could be sold, say $1,500,000,
causing a $900,000 loss.

Finally, in estimating loss severity, it is important to recognize the timing of any

losses as well as their total dollar amount. For example, a loss of $5,000 a year for 20
years is not as se3fere as immediate loss for $100,000 because of:
i) the time value of money, which can be recognized by discounting future dollar
losses at some assumed interest rate, and
ii) the ability of the firm to spread the cash outlay over a longer period.

Loss-frequency and loss-severity data do more than identify the important losses.
They are also extremely useful in determining the best way or ways to handle an
exposure to loss. For example, the average loss frequency times the average loss severity
equals the total dollar losses expected in an average year. These average losses can be
compared with the premium the firm would have to pay an insurer for complete or partial
protection.

2.4. Risk Measurement and Probability Distribution

The Law of Large Numbers.

The law of large numbers, a basic law of mathematics, states that as the number of
exposure units increases, the more certain it is that actual loss experience will equal
probable loss experience. Hence, the risk diminishes as the number of exposure units
increases.

The law of large numbers constitutions a fundamental theoretical basis for risk
management function. As large bodies of appropriate statistics on losses are gathered and
analyzed, the risk manager may predict loss experience with considerable accuracy.
Therefore, in the case of empirical probabilities, the requirement of large number has dual
application.

i) To estimate the underlying probability accurately, the undertaking must have a

sufficiently large sample. The larger the sample, the more accurate will be the
estimate of the probability.

15
ii) Once the estimate of the probability has been made, it must be applied to a
sufficiently large number of exposure units to permit the underlying to work itself
out.

In this sense, to the risk manager, the law of large numbers means that the larger
the number of cases examined in the sampling process, the better the chance of making a
good estimate of the probability, the larger the number of exposure units to which the
estimate is applied, the better the chance that actual experience will approximate a good
estimate of the probability.

Meaning and Types of Probability

For our purposes, probability may be defined as the chance or likelihood that an event
will occur. Probability measurements are stated as fractions between 0 and 1. The
smallest value that a probability statement can have is 0 (including the event is
impossible) and the largest value it can have is 1 (including the event is certain to occur).
0
Thus, in general: 0<p (A)<1, where the symbol P is used to designate the
probability of an event and P(A) denotes the probability that event A will occur in a
single observation or experiment.

Probability Categories

Probabilities may be classified in several ways.

1. An a priori (before the fact) probability- is one that can be determined in advance
without experimentation. Assigning a figure of 0.5 to the chance of getting a head
in a single flip of a coin is an a priori probability. In rolling a single die (one-half
of a pair of dice) there are six possible outcomes because there are six sides. Each
outcome is equally likely to occur. Therefore the priori probability of throwing any
given number is 1/6.

2. A relative frequency (or empirical) probability is one that is determined after the
fact from observation and experimentation. No prior assumption of equal
likelihood is involved. For example, before including coverage for certain types of
dental problems in health insurance policies for employed adults, an insurance
company wished to determine the probability of occurrence of such problems, so
that the insurance rate can be set accordingly. Therefore, the statistician collects
data for 10,000 adults in the appropriate age categories and finds that 100 people
have experienced the particular dental problem during the past year. The
probability of occurrence is thus P(A) = 100 = 0.01 or 1%
10,000

16
 When we do not know the underlying probability of an event and cannot
deduce it from the nature of the even, we can estimate it on the basis of past
experience. Suppose that we are told the probability that 21-year-old male will die
before reaching age 22 is 0.00183. What does this mean? It means that someone
has examined mortality statistics and discovered that, in the past, 183 men out of
every 100,000 alive at age 21 have died before reaching age 22. It also means that,
barring changes in the cases of these deaths we can expect approximately the same
proportion of 21-year-old to die in the future.

1. Subjective probability occurs in situations whether a priori or empirical values

can't be determined, and so probabilities are assigned on the basis of someone's
personal judgement or intuition. For example, a plant manager may believe that
there is a 0.6 probability that the union will call a strike next week. This probability
is the manager's subjective estimate of the likelihood of a strike, and it is not an a
priori or empirical value. The accuracy of the strike estimate, of course, depends on
the manager's experience and skill.

Since individuals may differ in their degree of confidence in the outcome of

some future event even when offered the same evidence, their opinions expressed
as probabilities, will differ. Statements of opinion regarding the likelihood that an
event will occur when expressed as probabilities are called subjective probabilities.
Mutually Exclusive and Nonexclusive Events

Two or more events are mutually exclusive, or disjoint, if they cannot occur together.
That is the occurrence of one event automatically precludes the occurrence of the other
event (or event). For instance, suppose we consider the two possible events "ace" and
"king" in respect to a card being drawn form a deck of playing cards. These two events
are mutually exclusive, because any given card cannot be both an ace and a king.

Tow or more events are nonexclusive, or joint when it is possible for them to occur
together. Note that this definition does not indicate that such events must necessarily
always occur together. For instance, suppose we consider the two possible events "ace"
and "spade." These events are not mutually exclusive, because a given card can be both
an ace and a spade; however, it does not follow that every ace is a spade or every spade is
an ace.

Consider the following example. In a study of consumer behavior, an analyst

classifies the people who enter a stereo shop according to set ("male or "female") and
according to age ("under 30" or "30 and above"). The two events or classifications,
"male" and "female" are mutually exclusive, since any given person would be classified
in one category or the other. Similarly, the events "under 30" and "30 and above" are also
mutually exclusive. However, the events "male" and under 30" are not mutually
exclusive, because a randomly chosen person could have both characteristics.
17
Addition Rules of Probability

Addition rule for mutually exclusive events

Two events are said to be mutually exclusive if the occurrence of one event prevents the
occurrence of the other event. For example, when you flip a coin a single time, if you get
a head it is obviously impossible to get a tail, and vice versa. Therefore, these two
possible outcomes of a single trial are mutually exclusive

When two events are mutually exclusive, the probability that one or the other of
the two events will occur is the sum of their separate probabilities. The rule of addition
for mutually exclusive events is
P (A or B ) = P ( AUB) = P (A) + P (B)

When drawing a card from a deck of playing cards, the events "ace" (A) and "king"
(K) are mutually exclusive. The probability of drawing either an ace or a king in a single
draw is

P(A or K ) = P (A) + P (K)

= 4 + 4
52 52
= 8 or 2
52 13

If you roll a single die, the probability of getting either a 1 aor a w is computed as
follows.
P (1 or 2 ) = P (1) + P (2)
= 1 + 1 .
= 6 6
= 2 or 1 .
6 3

Now let's suppose that jane is shopping for new tires. The probability is 0.25, o.30, 0.20,
0.15 or o.10 that she will buy Michelin Goodyear, General, Firestone, or Continental
tires. What is the probability that she will buy either General or Continental tires?

P(general or Continental) = P(general) + P(Continental)

=0.20 + 0.10
= 0.30

18
Addition Rule When Events are not Mutual Exclusive

If two events are not mutually exclusive, it is possible for both events to occur. For
events that are not mutually exclusive, the probability of the joint occurrence of the two
events is subtracted from the sum. We can represent the probability of joint occurrence
by P(A and B). in the language of set theory this is called the intersection of A and B and
the probabiliy is designated by P(A n B). thus, the rule of addition for events that are not
mutually exclusive is

P(A or B) = P(A) + P(B) - P(A and B)

For example when drawing a card from a deck of playing cards, the events "ace"
and "spade" are not mutually exclusive. The probability of drawing an ace (A) or spade
(S) (or both) in a single draw is

P(A or S) = P(A) + (S) _ P(A and S)

4 + 13 - 1
52 52 52
16 or 4
52 13

If the probabilities are 0.37, 0.30, and 0.20 that a Gardner will buy a lawn mover,
edger, or lawn mover and edger on April 1, then the probability that the gradner will buy
a mover or ldger on that day is:

P(mover or edger) = P(mover) + p(edger) - P(mover and edger)

= 0.37+0.30- 0.20
= 0.47

Independent Events, Dependent events and Conditional Probability

Two events are independent when the occurrence or no occurrence of one event has no
effect on the probability of occurrence of other event. Two events are dependent when
the occurrence r nonoccurrence of one event does affect the probability of occurrence of
the other event.

The outcomes associated with tossing a fair coin twice in succession are
considered to independent events, because the outcome of the first toss has no effect on
the respective probabilities of a head or tail occurring on the second toss. The drawing of
two cards without replacement from a deck of playing cards are dependent events,
because the probabilities associated with the second draw are dependent on the outcome
of the first draw. Specifically, if an "ace" occurred on the first draw, then the probability

19
of an "ace" occurring on the second draw is the ratio of the number of aces still
remaining in the deck to the total number of cards remaining in the deck, or 3 .
15

When two events are dependent, the concept of conditional probability is

employed to designate the probability of occurrence of the related event. The expression
P (B/A) indicates the probability of event B occurring given that event A has occurred.
Note that "B/A" is not a fraction.

Multiplication Rule for Independent Events.

The rules of multiplication are concerned with determining the probability of the joint
occurrence of A and B. This is the intersection of A and B; the probability is designated
by P(A n B).

Assume that you have one red die and one green die and you wish to know the
probability throwing a 2 with this pair of dice. This means, of course, throwing a 1 on
the red die and a 1 on the green die. The probability of throwing a 1 on the red die is 1/6
and will be 1/6 regardless of the result obtained by tossing the green die. Since the
probabilities of getting a 1 on the green die or a 1 on the red die are not affected by the
result on the other die these events are said to be independent.

If two events are independent, the probability that they will both occur is the
product of their separate probabilities. This may be stated as:

P(A and B) = P(A n B) = PA) X P(B)

For the problem of throwing a 2 with the dice, the probability is:
P(1 0n red and 1 on green) = P(1 on red) X P(1 on green)
= 1/6 X1/6
= 1/36
If a fair coin is tossed twice the probability that both outcomes will be "heads" is 1/2 x
1/2 =1/4

Another illustration of independent events is sampling with replacement. Let's

consider a bowl containing 10 poker chips, 6 red and 4 white. A chip us drawn its color
is noted, and it is replaced in bowl; then a second chip is drawn. The probability that the
second chip will be red or the probability that it will be white isn't affected by the result
of the first draw. Therefore, the probability that a sample of two with replacement will
result in two red chips is:

P(two red) = P(red on first drew) x P(red on second draw)

= 0.6 x 0.6
20
 =0.36
Multiplication Rule for Dependent Events

If we have a dependent (or conditional) event situation the probability of occurrence of

one event depends on whether or not the other happens. In this case the probability that
both f the dependent events will occur is:

P(A and B) = P(A) x P(B/A)

The term (B/A) is dependent or conditional probability and s read "the probability of B
given A".

Let's again consider out previous example of the bowl containing six red and four
wihte poker chips. A chips is drawn, and then a second chip is drawn and the first chp is
not replaced. (we are thus sampling without replacement.) the probability that the
second chip is red or the probability that it is white depends on the result of the first draw.
The probability that a sample of two drawn in this fashion results in two red chips is:
P(two red) x P(red on first draw) x P(red on second draw/red on first draw)
=6 x 5
10 9

30 or 1
90 3

Suppose that set of `10 spare parts is known to contain eight good parts (G) and
two defective parts (D). Given that two parts are selected are both goos is:

P(G1 and G2 ) = P(G1) P(G2/G1)

=8 x 7
10 9

= 56 or 28
90 45

Total birr Losses Per Year

The probability distribution of total birr losses per year shows each of the total birr losses
that the business may experience in the coming year and the probability that each of these
losses might occur. For example, assume that a business has a fleet of eight cars each of
which is valued at 10,000 birr and is subject to both partial and total physical damage
losses. A hypothetical probability distribution that might apply in this

Situation is shown in the following table

21
 Birr losses
Per year Probability

Table - 1 0 0.400
500 0.300
1,000 0.200
5,000 0.080
10,000 0.010
20,000 0.006
40,000 0.003
80,000 0.001

Each of the birr losses per year could be produced by many combinations of the
number of accidents per year and the average birr losses per accident. For example, the
500 birr loss could result from one accident involving a 500 birr loss or two accidents
involving an average loss of 250 birr each, or in many other ways. The 10,000 birr loss
could result from one car being totally destroyed, or two cars suffering an average loss of
5,000 each, or some other combination of accidents and average loss.

Useful Measurements

From probability distributions of total birr losses per year (refer to Table - 1) one can
obtain useful information concerning:
i) The probability that his business will incur some loss.
ii) The probability that "severe" losses will occur, and
iii) The risk or variation in the possible results. These measurements will be
illustrated using the probability distribution in Table - 1.

Give this distribution, the probability that the business will suffer no birr loss is 0.40.
because the business must suffer either no loss or some loss, the sum of the probabilities
of no loss and of some loss must equal 1.0. Consequently, the probability of some loss is
equal to 1 - 0. 40, or 0.60. An alternative way to determine the probability of some loss is
to sum the probabilities for each of the possible birr losses; i.e. 0.300 + 0.200 + 0.080 +
0.010 + 0.006 + 0.003 + 0.001, or 0.60.

The potential severity of the total birr loss can be measured by stating the
probability that the total losses will exceed various values. For example, the risk manager
may be interested in the probability that the birrr losses will equal or exceed 10,000 birr.
He can calculate these probabilities for each of the values in which he is interested and
for all higher values. For example, the probability that the birr losses will exceed 10,000
birr is equal to 0.006 + 0.003 + 0.001, or 0.01. The given table shows the probability that
the birr losses will equal or exceed each of the values in the table.
22
Two possible uses of this table would be to determine:
i) The probability that the birr loss would exceed the insurance premium that might
be required to purchase complete financial protection against this risk and,
ii) The probability that the birr losses, if retained, could cause serious financial
problems.

Another extremely useful measure that reflects both loss frequency and loss
severity is the expected total birr loss or the average annual birr loss in the long run.
Because the probabilities in the table given represent the proportion of times each birr
loss is expected to occur in the long run, the expected loss can be obtained by summing
the products formed by multiplying each possible outcome by the probability of its
occurrence; i.e. $0(0.400) + $500 (0.300) + $1000(0.200) + $5000 (0.080) +
$10,000(0.010) + $20,000 (0.006) + $40,000 (0.003) + $80,000 (0.001) or $1,170. This
measure is useful because it indicates to the business the average annual loss it will
sustain if it retains the risk.

If an insurer uses the same probability distribution, he will have to collect this
much is annual premium just to pay its losses. The actual premium, however, must be
higher to cover in addition the insurer's expenses and provide some allowamce for profit
and contingencies. The risk manager must decide whether he is willing to pay this
additional amount in order, among other things, to rid himself of the uncertainty.

Two probability distributions may have the same expected loss but may differ
greatly with respect to risk or the variation in the possible results. For example, an
expected value of $1,170 may be produced by the distribution in Table - 1 or by a $1,170
loss every year. Considerable risk is present in the first instance, but there is no risk when
one knows what will happen each year. The greater the variation in the possible results,
the greater the risk. If the risk is small, the annual losses are fairly predictable, and the
business may be well advised to treat these losses as an operating expense. If the risk is
large and some of the unpredictable losses could be serious, it may be wise to shift
potential losses to someone else.

Up to this point, no yardstick has been suggested for measuring risk, but its
relationship to the variation in the probability distribution has been noted. Statisticians
measure this variation in several ways. One of the most popular yardsticks for measuring
the dispersion around the expected value is the standard deviation. Standard deviation is a
number which measures how close a group of individual measurements are to their
average value.

When there is much doubt about what will happen because there are many
outcomes with some reasonable chance of occurrence, the standard deviation will be
large; when there is little doubt about what will happen because one of a few possible
23
outcomes is almost certain to occur, the standard deviation will be small. Another very
simple measure of dispersion is the range. Range is the variation from the smallest
number to the largest number. For example, if a certain business faces a number of losses
in fire consecutive years such as (7, 11, 10, 9, 13) the number of losses varied from 7 to
13. Similarly, if in other five years the losses were (16, 4, 10, 12, 8) the number of losses
varied from 4 to 16.

These observations suggest that the standard deviation and the range of probability
distribution could serve as a measure of the risk associated with that distribution.
However, statisticians have also suggested that for many purposes the coefficient of
variation is a better measure of dispersion.

The coefficient of variation is calculated by dividing the standard deviation by the

expected value. In other words, the stndard deviation is expressed as a precentage of the
average value in the long run. Because a standard deviation of $20 is much more
significant if the expected loss is $10, way, than if it is $2,000, the coefficient of variation
has more appeal as a measure of economic risk than the standard deviation. Many writers,
however, prefer to relate the standard deviation to the maximum amount exposed, their
reasoning being that a standard deviation of #20 is much more important if the maximum
amount that can be lost is $100, say, instead of $10,000. The best procedure is to relate
the standard deviation to both of these bases and to others that may be of interest in a
particular problem.

These measures of riks, unlike the probability of loss, have no simple

interpretation; they are bounded by 0 and infinity, not by 0 and 1. However, by comparing
any of these measures for two or more distributions, one can determine the relative
degrees of risk inherent in those distributions.

Number of Accidents Per Year

Researchers have been much more successful in their studies of the probability
distribution of the number of accidents per year, although much remains to be done in
this area. If each accident produces the same birr loss, the distribution of the number of
accidents per year can be transformed into a distribution of the total birr losses per year
by multiplying each possible number of accidents by the uniform loss per accident;
example, 1(1,000birr,) 2 (1,000 birr,) 3 (1,000 birr,) etc. If the birr loss per accident varies
within a small range, the distribution of the total birr losses per year can be approximated
by multiplying each possible number of accidents by the average birr losses per accident.
If the birr losses per accident vary widely, one needs the probability distribution of the
birr losses per accident and the number of accidents per year to develop information
concerning the losses per accident is lacking, the risk manager will improve his
understanding of the risk situation if he knows the probability distribution of the number
of accidents per year.
24
The Poisson Distribution

One theoretical probability distributing that has proved particularly useful in estimating
the probability that a business will suffer a specified number of occurrences during the
next year is the Poisson distribution. This probability distribution is useful in insurance
situations. For example, auto accidents, fires, and other losses tend to fall in a manner
approximately according to the Poisson distribution.
According to this distribution, the probability that there will be accidents is
m r e -m
P =
r!

where: P = The probability that an event, n, occurs

r = the number of events for which the probability
estimate is need.
r! = r factorial. If r is 5. For example, r! is 5x4x3x2x1 = 120
m = mean = expected loss frequency
e = a constant, base of the natural logarithms equal to
2.71828.

The mean (m) of a Poisson distribution is also its variance. Consequently, it standard
deviation ____ is equal to the Vm.

To obtain a better understanding of how the Poisson is used to calculate

probabilities, consider the following example:

Mr. Marshal has 10 trucks to insure and on the average a total of 1 loss occurs each year
(p = 0.1). What is the probability of more than 2 accidents in a year? Or stated another
way, what is the probability of 3 or more accidents?

To calculate m, multiply the frequency of loss times n. Thus , (0.1) x10 = 1.0, m =
1.

The probability distribution is calculated in the following manner:

Losses Probability
0 1
0 (1.0) e - = 1x0.3679 = 0.3679
01 1
1 1
1 (1.0) e - = 1x0 .3679 = 0.3679
1! 1
2 1
2 (1.0) e - = 1x0.3679 = 0.1839
2! 2x1
3 (1.0)2 e -1 = 1x0.3679 = 0.0613
25
 3! 3x2x1
4 (1.0)4 e -1 = 1x0.3679 = 0.0153
4! 4x3x2x1
To find the probability of 3 or more subtract the sum of the probabilities of 0,1, and 2
from 1. In this case, there is probability of 0.0803 (1 - 0.9197) for 3 or more losses.

The Poisson distribution is more appropriate than binomial distribution if the

exposure units can suffer more than one loss during the exposure period. This is a
common situation in risk management problems.

Number of Exposure Units Required to Predict the Future with a Specified Degree
of Accuracy

A question of considerable interest, both to the commercial insurer and the would-be self-
insurer, is how large an exposure (that is, what number of individual exposure units) is
necessary before a given degree of accuracy can be achieved in obtaining an actual loss
frequency that is sufficiently close to the expected loss frequency. As the number of
exposure units becomes infinitely large, the actual loss frequency will approach the
expected true loss frequency. But it is never possible for a single insurer, whether a
commercial insurer or a self insurer, to group together an infinitely large number of
exposure units.

A simple mathematical formula is available that enables insurers to estimate the

number of exposures required for a given degree of accuracy.
However, unless mathematical tools such as the one given below are used with great
caution and are interpreted by experienced persons, wrong conclusions may be reached.
The formula is given only as an illustration of how such tools can be of help in guiding an
insurer to9 reducer risk. The formula is based on the assumption that losses in an insured
population are distributed normally. The formula concerns only the occurrence of a loss,
and not the evaluation of the size of the loss.

The formula is based on the knowledge that the normal distribution is an

approximation of the binomial distribution, and that known percentages of losses will fall
within 1,2,3 or more standard deviations from the mean. The formula is:

N = S2 P(1-P)
E2
Where : N = the number of exposure units sufficient for a given degree of
Accuracy

E = the degree of accuracy required, expressing as a ratio of actual losses to the

number in the sample.

26
 S = the number of standard deviations of the distribution. The number of value
of S tells us what level f confidence we can state our results. Thus if S is 1, we know
with 68% confidence hat loses will be as predicted by the formula; if S is 2, we have 95%
confidence, etc.

As an example, suppsose our probability of loss us 0.30 and we want to be 95%

confident that the actual loss ration (number of losses divided by total number of insured
units) will not differ from the expected loss ratio of 0.30 by more than 2 percentage
points, that is 0.02. using the formula we can determine the number of exposure units for
the given degree of accuracy.

N = S2 P(1 - P)
E2

N = 22 (0.30) (0.70)
(0.02)2

The formula produces a very large number of exposure units required for the
degree of risk acceptable. Mathematical formulas such as the ones used in these
examples can assist the insurer considerably in making estimates of the degree of risk
assumed with given numbers in an exposure group.

Such a formulas as given above offer a way for an insurer to consider

simultaneously the relationship among numbers of exposure units, probability of loss,
errors in prediction, and confidence levels of future estimates of loss. Once any three of
these variables are ascertained, the fourth may be found. Using the formulas, a
commercial insurer may discover, for example, that a much larger penetration of an
insurance market is necessary to reduce the risk of acceptable levels. A decision to
withdraw from a given market or to send additional sums in promotional efforts may thus
be made with greater intelligence.

27
The following table simplifies the use of Poisson formula. This table gives the value of e -m that corresponds to selected values of m.
Figure -1 values of e-m
m e-m m e-m m e-m m e-m

.10 .9048 1.90 .1496 3.60 .0273 5.40 .0045

.20 .8187 2.00 .1353 3.70 .0247 5.50 .0041
.30 .7408 3.80 .0224
.40 .6703 2.10 .1225 3.90 .0202 5.60 .0037
.50 .6065 2.20 .1108 4.00 .0183 5.70 .0033
2.30 .1003 5.80 .0030
.60 .5488 2.40 .0907 4.10 .0166 5.90 .0025
.70 .4966 2.50 .0821 4.20 .0150 6.00
.80 .4493 4.30 .0136
.90 .4066 2.60 .0743 4.40 .0123 6.10 .0022
1.00 .3679 2.70 .0672 4.50 .0111 6.20 .0020
2.80 .0608 6.30 .0018

1.10 .3329 2.90 .0550 4.60 .0101 6.40 .0017

1.20 .3012 3.00 .0498 4.70 .0091 6.50 .0015
1.30 .2725 4.80 .0082
1.40 .2466 3.10 .0450 4.90 .0074 6.60 .0014
1.50 .2231 3.20 .0408 5.00 .0067 6.70 .0012
3.30 .0369 6.80 .0011
1.60 .2019 3.40 .0334 5.10 .0061 6.90 .0010
1.70 .1827 3.50 .0302 5.20 .0055 7.00 .0009
1.80 .1653 5.30 .0050

28
 CHAPTER THREE

RISK CONTROL TOOLS

Once the risk manager has identified and measured the risks facing the firm,
he must decide how to handle them.
Risk can be controlled (handled) through the following tools:
1. Avoidance
2. Loss Retention (Assumption)
3. Reduction/Prevention
4. Separation/Diversification
5. Combination /Pooling
6. Neutralization
7. Transfer

3.1. Avoidance

1) Refusing to assume it even momentarily or

2) Abandoning an exposure assumed earlier.

To illustrate, if a business does not want to be concerned about potential

property losses to a building or to a fleet of cars, it can avoid these risks by
never acquiring any interest in a building or fleet of cars.

The method of avoidance is widely used, particularly by those with a

high aversion toward risk. Thus, a person may not enter a certain business at
all, and avoid the risk of losing capital in that business. A person may not
use airplanes and thus avoid the risk of dying in an airplane crash. Another
example of avoidance is to delay taking responsibility for goods during
transportation. A customer may have choice of terms of sale, and may have
the seller assume all the risks of loss until the goods arive at the buyer's
warehouse. In this way the buyer never assumes the risk during
transportation and has avoided an insurance problem.

Avoidance is a useful and common approach to the handling of risk.

By avoiding a risk exposure the firm knows that it will not experience the
potential losses or uncertainties that exposure might generate. On the other
hand, it also loses the benefits that may have been derived from that
exposure.

29
Characteristics of avoidance should be noted:
1. Avoidance may be impossible. For example, the only way to avoid all
liability exposures is to cease to exist.

2. The potential benefits to be gained from employing certain persons,

owning a piece of property, or engaging in some activity may of far
outweigh the potential losses and uncertainties involved that the risk
manager will give little consideration to avoiding the exposure. For
example, most businesses would find it almost impossible to operate
without owning or renting a fleet of cars. Consequently they consider
avoidance to be an impractical approach.

3. Avoiding a risk may create another risk. For example, a firm may avoid
the risks associated with air shipments by substituting train and truck
shipments. In the process, however, it has created some new risks.

3.2. LOSS- RETENTION

The most common method of handling risk is retention by the individual or

the firm itself. Individuals or business firms face an almost unlimited array
of risks; in most cases nothing is done about them. Risk retention may be
planned or unplanned. Planned risk retention, often called self-insurance, is
conscious and deliberate assumption of recognized risk. The individual or
firm decides to pay losses out of currently available funds. In some cases a
reserve fund may be established to cover expected losses.

Unplanned risk retention exists when a person does not recognize that
a risk exists and unknowingly believes that no loss could occur. Such a
method does not deserve to be called a risk management device. It stems
from ignorance of risk.

Risk retention is a legitimate method of dealing with risk, in many

cases it is the best way. Each person must decide which risks to retain and
which to avoid or transfer on the basis of his margin for contingencies or
personal ability to bear loss. A loss that might be a financial disaster for one
individual, family or business might easily be borne by another. As a
general rule, risks that should b e retained are those that lead to relatively
small losses.

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 Self-insurance is a special case of active retention. It is distinguished
from the other type of retention usually referred to as non-insurance in that
the firm or family can predict fairly accurately the losses it will suffer during
some period because it has a large number of widely scattered and fairly
homogeneous exposure units. Self-insurance is not insurance, because there
is no transfer of the risk to an outsider. Self-insurer and insurer, however,
share the ability, though in different degrees, to predict their future loss
experience.

Prerequisites of Planned Retention

Planned retention should be considered only when at least one of the

following conditions exists:-
i) When it is impossible to transfer the risk to someone else or to prevent
the loss from occurring. The only possible alternative-avoidance-may
be undesirable for various reasons. For example, firms with plants
located in river valley may find that no other method of handling the
flood risk is available. Other firms will find that they are exposed to
larger potential liability losses than they can prevent or transfer (most
speculative risks fall into this category.)

The businessman does not want to avoid the venture, because

there are potential profits; he cannot prevent the loss from occurring,
although he may be able to reduce its likelihood, and he cannot
transfer the chance of loss to someone else.

ii) The maximum possible loss is so small that the firm can safely absorb
it as a current operating or out of small reserve funds.
iii) The chance of loss is extremely low that it can be ignored or is so high
that to transfer it would cost almost as much as the worst loss that
could occur. In some areas the chance of a flood loss is so small that
this peril can be safely ignored. The chance that a man, aged 97, will
die within a year is so high that an insurer would demand a premium
close to the amount it would pay upon his death.
iv) The firm controls so many independent, fairly homogeneous exposure
units that it can predict fairly well what its loss experience will be; in
other words, a retention program for this firm could properly be called
"self-insurance." In this instance one of the principal reasons for
transferring the risk to someone else does not exist.

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3.3. Reduction

Loss-prevention and reduction measures attack risk by lowering the chance

that a loss will occur or by reducing its severity if it does occur. Prevention
is defined as a measure taken before the misfortune occurs. This would
include fireproofing, burglar alarms, safety tires, and so on.

Loss reduction are measures taken to lower loss after the event occurs.
Automatic sprinklers, for example, are designed to minimize a fire loss by
spraying water or some other substance upon a fire soon after it starts in
order to confine the damage to a limited area.

Other examples of loss-reduction programs include immediate first

aid for persons injured on the premises, fire alarms, internal accounting
controls, and speed limits for motor vehicles.

Loss may be prevented or reduced in any of the following ways:-

i) Engineering Risks:- This approach of reducing loss emphasizes ofn
the mechanical causes of accidents such as defective wiring, improper
disposal of waste products, poorly designed highway intersections or
automobiles, and unguarded machinery. Regulating and elimination of
the mechanical failures that may be the causes of potential losses is an
essential part of any loss prevention and reduction program.
ii) Training or Personnel:- Machines or equipment need to be operated or
handled by qualified personnel to eliminate or reduce the loss due to
human failures. Workers should be acquainted with the machines they
are to operate through an adequate training to reduce losses.

Many risk mangers are in direct charge of their companies accident

prevention programs. Among their varied duties are:
a) Keeping accurate records of all accidents by number, type, cause and
total damage incurred.
b) Maintaining plan safety-inspection programs.
c) Devising ways and means to prevent recurrence of accidents.
d) Keeping top management accident conscious.
e) Seeing that proper credits are obtained in the insurance premium for
loss-prevention measures.
f) Minimizing losses by proper salvage techniques and other action at
the time of a loss.

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g) Working with company engineers and architects in planning new
construction to provide for maximum safety and to secure important
insurance premium credits when the structure is completed an in use.

Although the prevention of all losses would be desirable it is not

always possible or economically feasible. The potential gains from any loss-
prevention activity must be weighed against the costs involved. Unless the
gains equal or exceed the costs, the firm would be better off non to engage in
that activity. The firm, however, must be certain to consider all the gains and
all the costs.

3.4. Separation/Diversification

Another risk control tool is separation of the firms' exposures to loss instead
of concentrating them at one location where they might all be involved in the
same loss. For example, instead of placing its entire inventory in one
warehouse a firm may elect to separate this exposure by placing equal parts
of the inventory in ten widely separated warehouses. If fire destroys one
warehouse, the firm will have others from which to draw needed supplies.
Another example is to disperse work operations in such a way that explosion
or other catastrophe would not injure more than a limited number of persons.

To the extent that this separation of exposures reduces the maximum

probable loss to one event, it may be regarded as form of loss reduction.
Emphasis is placed here, however, on the fact that through this separation
the firm increases the number of independent exposure units under its
control. Other things being equal, because of the law of large numbers, this
increase reduces the risk, thus improving the firm's ability to predict what its
loss experience will be.

3.5. Combination

Combination or pooling makes loss experience more predictable by

increasing the number of exposure units. Unlike separation, which spreads a
specified number of exposure units, combination increases the number of
exposure units under the control of the firm.

When sufficiently large numbers are grouped, the actual loss

experience over a period of time will closely approximate the probable loss
experience.

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 One way a firm can combine risks is to expand through internal
growth. For example, a taxicab company may increase its fleet of
automobiles. Combination also occurs when two firms merge or one
acquires another. The new firm has more buildings, more automobiles, and
more employees than either of the original companies.

Combination of pure risks is seldom the major reason why a firm

expands its operations, but this combination may be an important by-product
of merger or growth. (An example of pooling with respect to speculative
risks, which may be a primary objective of a merger or expansion, is the
diversification of products by a business.) Insurers, on the other hand,
combine pure risks purposefully; they insure a large number of persons in
order to improve their ability to predict their losses.

3.6. Neutralization

Neutralization, which is closely related to transfer, is the process of

balancing a chance of loss against a chance of gain. For example, a person
who has bet that a certain team will win the world cup may neutralize the
risk involved by also placing a bet on the opposing team. In other words, he
transfers the risk to the person who accepts the second bet. A commercial
example of neutralization is hedging by manufacturers who are concerned
about changes in raw material prices. Because there is non-chance of gain
associated with pure risks, neutralization is not a tool of pure-risk
management.

Hedging is process of making commitments on both sides of a

transaction in such a way that the risks compensate each other. It tries to
avoid loss by making counterbalancing bets. Neutralization reduces the risk
of undesirable price rises from the buyer's point of view and equally
undesirable price declines for the seller.

3.7. Transfer

Risk may be transferred from one individual to another who is more willing
to bear the risk. Transfer of risk may be accomplished in three ways.

First, the property or activity responsible for the risk may be

transferred to some other person or group of persons. For example, a firm

34
that sells one of its buildings transfers the risks associated with ownership of
the building to the new owner. A contractor who is concerned about possible
increases in the cost of labor and materials needed for the electrical work on
a job to which he is already committed can transfer the risk by hiring a
subcontractor for this portion of the project. This type of transfer, which is
closely related to avoidance through abandonment, eliminates potential loss
that may strike the firm. It differs from avoidance through abandonment in
that to transfer a risk the firm must pass it to someone else.

Second, the risk, but not the property or activity may be transferred.
For example, under a lease, the tenant may be able to shift to the landlord
any responsibility the tenant may have for damage to the landlord's premises
caused by the tenant's negligence.

A person who leases or rents property rather than owns it shifts to the
lessor the ownership risk. The cost of shifting the risk is contained in the
rental payments, which must be high enough to compensate the lessor for
the risks as well as the costs of owning the property.

Third, insurance is also a means of shifting or transferring risk. In

consideration of a specific payment (premium) by one party, the second
party contracts to indemnify the first party up to a certain limit for the
specified loss, which may or may not occur. Hence, transfers of risk may be
grouped under two classifications: those involving transfer to an insurance
company, and those involving transfer to parties other than insurance
company.

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It is easy to confuse the transfer method of handling risk with the
combination method. The essential difference between the two lies in the
fact that in the transfer method, the risk is not necessarily reduced or
eliminated; where as in the combination method, the risk is actually greatly
reduced or perhaps completely. For Example, A furniture retailer may not
wish to stock large quantities of furniture for fear that prices may fall before
the stock can be sold, or that the stock will be unsalable due to style
changes. The retailer therefore buys only limited quantities of goods at a
time, thus forcing, a wholesaler to carry sufficient inventories to meet
demand. The wholesaler in this case is the bearer of risk of loss due to price
changes.

II Selecting of Risk Management Tools

3.8. Conventional Approach (Insurance method)

This approach, insurance coverage serves as a focal point of the analysis.

This approach is based on the assumption that the firm will prefer to buy
insurance whenever this mechanism is available. The "insurance–method" is
a two–step procedure:
i. Preparation of initial listing, and
ii. Preparation of revised listing

I. Preparation of initial listing

The risk manager must determine first what combination of insurance

coverage would provide the best protection against the losses to which the
business is exposed, on the assumption that the business would prefer to buy
insurance when ever it is available.

To make this determination the risk manager must understand

insurance contracts (policies) and insurance pricing, i.e., the risk manager
must identify the insurance policies, that would best cover the loss exposures
of the firm. The objective is to provide the most complete protection at
minimum cost. Because some of the risks faced by the firm may not be
insurable. Also the risk management must select policy limits that provide as
complete protections as possible.

36
 After the risk manager has determined the best combination of
coverages and policy limits, he/she divides (classifies) the insurance
contracts (policies) in this combination into three groups:

1. Essential coverages or Essential policies

2. Desirable coverages or Desirable policies, and
3. Available coverages or Available policies.

1. Essential contracts (Polices)

Essential insurance contracts (policies) include those that are compulsory

because they are required by law or by contract. For Example, automobile
liability insurance in some cases is required by low, a group life insurance
contract required under a union contract.

Coverage against high – severity losses that could result in a financial

catastrophe for the firm, For Example, liability losses are often included
under these contracts

2. Desirable Contracts (policies)

Desirable policies provide protection against losses that could seriously

impair the operations of the firm but probably would not put it out of
business, For Example, automobile physical damage.

3. Available Contracts

Available policies include all the types of protection that have not been
included in the first two classes. These contracts protect against types of
losses that would inconvenience the firm but would not seriously impair its
operations unless several of them occurred within one year. It is also called
plate – glass policy. For Example, insurance against breakage of glass due to
riots, fighting, etc. Hence, When a risk manager is to decide upon the
insurance policies, he should give priority to the compulsory ones and then
to the other polices according to their importance.

II Preparation of Revised Listing

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After the initial listing has been completed, the risk manager then reviews
the contracts in each group to determine which of these losses might be more
satisfactorily handled in other ways.

For example, contracts that might be dropped form the essential – category
would include contracts covering:
1. Losses that can be transferred to someone other than an insurer at a
smaller cost than the insurance premium.
Some contracts included in the essential class but can be transferred to
another body at a smaller cost than the insurance premium be dropped
by the risk manager from insuring in the insurer.
2. Losses that can be prevented or reduced to such an extent that they are
no longer severe.
3. Losses that happen so frequently that they are fairly predictable, thus
making self – insurance on attractive alternative because of expense
savings. Few, if any, contracts (policies) will be dropped from the
essential – category. Contracts covering potential catastrophic losses
will be purchased unless they satisfy one of the three conditions

Conditions stated above or if the premium for the insurance

seems unreasonably high relative to the frequency and severity of the
exposure.

3.9. Quantitative Approaches

The application of the quantitative approach is limited because.

1. Application of these modern techniques to insurance and particularly

to risk management problems is of still more recent in origin.
2. Their data requirement is difficult to meet.
3. Most risk managers are not well trained in the quantitative
application.

But these techniques are likely to be more widely applied in the future and it
is important to consider these quantitative methods in selecting the "proper"
tools of risk management. Therefore this section discusses some quantitative
approaches that may be used in selecting risk management tools.

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 PART – II INSURANCE

CHAPTER FOUR

NATURE AND FUNCTION OF INSURANCE

As stated earlier there are a number of ways of dealing with risk. Insurance
is one of the basic tools of risk management and it is also the most important
illustration of the transfer technique and the keystone of most risk
management programs.

Insurance is complicated and difficult to define. However, in its

simplest aspect it has two fundamental characteristics:
a) Transferring or shifting risk from an individual to a group.
b) Sharing losses, on some equitable basis, by all members of the
group.

To illustrate the way the insurance mechanism works, let us assume

that there are 1,000 dwellings in a given community and, for simplicity, the
value of each dwelling is birr 10,000. Each owner faces the risk that his
house may catch on fire. If a fire should break out, a financial loss of up to
birr 10,000 could result. Some houses will undoubtedly burn but the
probability that all will is remote. Now let us assume that the owners of
these dwellings enter into an agreement to share the cost of losses as they
occur, so that no single individual will be forced to bear an entire loss of birr
10,000 whenever a house burns each of the 1,000 owners contributes his
proportionate share of the amount of loss.

If the house is a total loss each of the 1,000 owners will pay birr 10
and the owner of the destroyed house will be indemnified for the birr 10,000
loss. Those who suffer losses are indemnified by those who do not. Most
who escape loss are willing to pay those who do not because by doing so
they help to eliminate the possibility that they themselves might suffer a
10,000 birr loss. Through the agreement to share the losses, the economic
burden these impose is spread throughout the group. This is essentially the

39
way insurance works, for what we have described is a pure assessment of
mutual insurance operation.

There are some potential difficulties with the operation of such a plan,
the most obvious being the possibility that some members of the group
might refuse to pay their assessment at the time of a loss. This problem can
be overcome by requiring payment in advance. To require payment in
advance for the loss that may take place, it will be necessary to have some
idea as to the amount of those losses. This may be calculated on the basis of
past experience.

Let us now assume that on the basis of past experience we are able to
predict with reasonable accuracy that two of the 1,000 houses will burn. We
could charge each member of the group birr 20, making a total of birr 20,
000. In addition to the cost of the losses, there would no doubt be some
expenses in the operation of the program. Also there is a possibility that our
predictions might not be entirely accurate. We might therefore, charge each
member of the group birr 40 instead of birr 20, thereby providing for the
payment of expenses and also providing a cushion against deviations from
our expectations.

Each of the 1,000 house owners will incur a small cost of birr 40 in
exchange for a promise of indemnification of the amount of birr 10,000 if
his house burns down. This birr 40 premium is in effect the individual’s
share of the total losses and expenses of the group.

Insurance Defined

Insurance can be defined from two points of view.

First, insurance is the protection against financial loss provided by an

insurer. It is an economic device whereby an individual substitutes a small
certain cost (the premium) for a large uncertain financial loss which would
exist if it were not for the insurance.

The primary function of insurance is the creation of the counterpart of

risk, which is security. Insurance does not decrease the uncertainty for the
individual as to whether or not the event will occur, nor does it alter the
probability of financial loss connected with the event. From the individual’s
point of view, the purchase of an adequate amount of insurance on a house

40
eliminates the uncertainty regarding a financial loss in the event that the
house should burn down.

Many persons consider an insurance contract to be a waste of money

unless a loss occurs and indemnity is received. Some even feel that if they
have not had a loss during the policy term, their premium should be
returned. Both view pints constitute the essence of ignorance. Relative to the
first, we already know that the insurance contract provides a valuable feature
in the freedom from the burden of uncertainty. Even if a loss is not sustained
during the policy term, the insured has received something for the premium:
the promise of indemnification in the event of a loss. With respect to the
second, one must appreciate the fact that the operation of the insurance
principle is based upon the contribution of the many paying the losses of the
unfortunate few. If the premiums were returned to the many who did not
have losses, there would be no funds available to pay for the losses of the
few who did. Basically then, the insurance device is a method of loss
distribution. What would be a devastating loss to an individual is spread in
an equitable manner to all members of the group, and it is on this basis that
insurance can exist.

Second, 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. From the viewpoint
of the insured insurance is a transfer device. From the viewpoint of the
insurer, insurance is a retention and combination device. The distinctive
feature of insurance as a transfer device is that it involves some pooling of
risks; i.e., the insurer combines the risks of many insureds. Through this
combination the insurer improves its ability to predict its expected losses.
Although most insurers collect in advance premiums that will be sufficient
to pay all their expected losses, some rely at least in part on assessments
levied on all insureds after losses occur.

Insurance does not prevent losses, nor does it reduce the cost of losses
to the economy as a whole. As a matter of fact, it may very well have the
opposite effect of causing losses and increasing the cost of losses for the
economy as a whole. The existence of insurance encourages some losses for
the purpose of defrauding the insurer, and in addition people are less careful
and may exert less effort to prevent losses then they might if it were not for
the existence of insurance contracts. Also, the economy incurs certain
additional costs in the operation of the insurance mechanism. Not only must

41
the cost of the losses be borne, but the expense of distributing the losses on
some equitable basis adds to this cost.

4.1. Insurance Not Gambling or Speculation

The purchase of insurance is sometimes confused with gambling. Both acts

do share one characteristic. Both the insured and the gambler may collect
more dollars than they pay out, the outcome being determined by some
chance event. However, through the purchase of insurance, the insured
transfers an existing pure risk. A gambler creates a new risk where none
existed before. Insurance is a method of eliminating or greatly reducing (to
one party anyway) an already existing risk.

Speculation is a transaction under which one party, for a

consideration, agrees to assume certain risks, usually in connection with a
business venture. Every business accepts the possibility of losing money in
order to make money.

4.2. Requisites of Insurable Risks

Unfortunately, not all risks are insurable. For practical reasons, insurers are
not willing to accept all the risks that others may wish to transfer to them. To
be considered a proper subject for insurance, there are certain characteristics
that should be present.

These requirements should not be considered absolute, as iron rules,

but rather as guides. They should be viewed as ideal standards, and not
necessarily as standards actually attained in practice. The prerequisites listed
below represent the “ideal” standards of an insurable risk.

1. There must be a sufficiently large number of homogeneous

exposure units to make the losses reasonably predictable. Insurance,
as we have seen, is based on the operation of the law of large
numbers. Unless we are able to calculate the probability of loss, we
cannot have a financially sound program.

2. The loss produced by the risk must be definite and measurable. The
loss must have financial measurement. In other words, we must be
able to tell when a loss has taken place, and we must be able to set
some value to it. Before the burden of risk can be safely assumed, the

42
 insurer must set up procedures to determine if loss has actually
occurred and, if so, its size.

3. The loss must be fortuitous or accidental. The loss must be the result
of a contingency, that is, it must be something that may or may not
happen. It must not be something that is certain to happen. If the
insurance company knows that an event in the future is inevitable, it
also knows that it must collect a premium equal to the certain loss that
it must pay, plus an additional amount for the expenses of
administering the operation. Wear and tear or depreciation which is a
certainty should not be insured. The law of large numbers is useful in
making predictions only if we can reasonably assume that future
occurrences will approximate past experience. Since we assume that
past experience was a result of chance happenings, the predictions
concerning the future will be valid only if future happenings are also a
result of chance.

4. The loss must not be catastrophic. All or most of the objects in the
group should not suffer loss at the same time. The insurance principle
is based on a notion of sharing losses, and inherent in this idea is the
assumption that only a small percentages of the group will suffer loss
at any one time. Damage which results from war would be
catastrophic in nature. Simultaneous disaster to insured objects can be
illustrated by reference to large fires, floods, and hurricanes that have
swept major geographical areas in the past. If an insurer is unlucky
enough to have on its books a great deal of property situated in such
an area, it obviously suffers a loss that was not contemplated when the
rates were formulated. Most insurers reduce this possibility by ample
dispersion of insured objects.

5. Large Loss. The risk to be insured against must be capable of

producing a large loss which the insured could not pay without
economic distress. The potential loss must be severe enough to cause
financial hardship. The large loss principle states that people should
insure potentially serious losses before relatively minor losses. To do
otherwise is uneconomical, since small losses tend to occur frequently
and are very costly to recover through insurance. Insurance against
breakage of shoestrings is unknown. If the loss involved is so small
that it is not worth the time, effort, and expense to enter into an
insurance contract to indemnify the loss.

43
6. Reasonable cost of Transfer. One of the insured’s requirements is not
to insure against a highly probable loss, because the cost of transfer
tends to be excessive. To be insurable the chance of loss must be
small. The more probable the loss, the more certain it is to occur. The
more certain it is, the greater the premium will be. A time is ultimately
reached when the loss becomes so certain that either the insurer
withdraws the protection or the cost of the premium becomes
prohibitive.

The cost of insurance policy consists of the pure premium, or

amount actually needed to make loss payments, and the expense
portion. If the chance of loss approaches 100%, the cost of the policy
will exceed the amount that the insurance company is obliged to pay
under the contract. For example, it would be possible for a life
insurance company to issue a birrr 1000 policy on a man aged 99. The
net premium, however, would be about birr 980, to which would have
to be added an amount for expenses which would bring the premium
total to more than the amount of insurance. To make insurance
attractive, the premium has to be far less than the face of the policy.

4.3. Benefits and Costs of Insurance

Insurance has peculiar advantages as a device to handle risk and so ought to

be extended as far as possible, in order to bring about the greatest economic
advantage to a given society. Insurance, like most institutions, presents
society with both benefits and costs.

Benefits

1. Indemnification. The direct advantage of insurance is indemnification

for those who suffer unexpected losses. These unfortunate businesses
and families are restored or at least moved closer to their former
economic position. The advantage to these individuals is obvious.
Society also gains because these persons are restored to production,
and tax revenues are increased.

2. Reduced Reserve Requirements. If there is an insurance protection

the amount of accumulated funds needed to meet possible losses is
reduced. One of the chief economic burdens of risk is the necessity for

44
 accumulating funds to meet possible losses. One of the great
advantages of the insurance mechanism is that it greatly reduces the
total of such reserves necessary for a given economy. Since 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
individual has to set aside such funds, there would be a need for a far
greater amount because the individual, not knowing precisely how
much would be required, would tend to be conservative.

For Example a birr 60,000 residence can be insured against fire

and other physical perils for about birr 200 a year. If insurance were
not available, the individual would probably feel a need to set aside
funds at a much higher rate than birr 200 a year.

3. Capital Freed for Investment. Cash reserves that insurers accumulate

are freed for investment purposes, thus bringing about a better
allocation of economic resources and increasing production. Insurers
as a group, and life insurance firms in particular, have become among
the largest and most important institutions to collect and distribute a
nation’s savings. A substantial part of the contributions of insurance
companies is derived from regular savings by individuals through life
insurance contracts. The provision of the life insurance mechanism,
which encourages individual savings, is a most important contribution
of insurance to the savings supply.

The insurance mechanism encourages new investment. For

example, if an individual knows that his family will be protected by
life insurance in the event of premature death, the insured may be
more willing to invest savings in a long-desired project, such as a
business venture, without feeling that the family is being robbed of its
basic income security. In this way a better allocation of economic
resources is achieved.

4. Reduced Cost of Capital. Since the supply of investable funds is

greater than it would be without insurance, capital is available at
lower cost than would otherwise be true. Other things being equal,
this 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

45
 would otherwise reject as too risky. Thus, society benefits by
increased services and new products, the hallmarks of increased living
standards.

5. Loss Control. Another benefit of insurance lies in its loss control or

loss- prevention activities. Insurers are actively engaged in loss-
prevention activities. While it is not the main function of insurance to
reduce loss, but merely to spread losses among members of the
insured group, nevertheless, insurers are vitally interested in keeping
losses at a minimum.

Insurers know that if no effort is made in this regard, losses and

premiums would have a tendency to rise, since it is human nature to
relax vigilance when it is known that the loss will be fully paid by the
insurer. Furthermore, in any given year, a rise in loss payments
reduces the profit to the insurer, and so loss prevention provides a
direct avenue of increased profit.

By charging extra for bad features and less for good, insurers
can induce the insured to make improvements, which have beneficial
effect on losses. This can clearly be seen, for example, in fire
insurance, where the installation of good-fighting equipment, such as
a sprinkler system, receives considerable reward by way of reduced
premiums.

6. Business and Social Stability. Insurance contributes to business and

social stability and to peace of mind by protecting business firms and
the family breadwinner. Adequately protected, a business need not
face the grim prospect of liquidation following a loss. A family need
not break up following the death or permanent disability of the
breadwinner. A business venture can be continued without interruption
even though a key person or the sole proprietor dies. A family need
not lose its life savings following a bank failure. Old-age dependency
can be avoided. Loss of a firm’s assets by theft can be reimbursed.
Whole cities ruined by a hurricane can be rebuilt from the proceeds of
insurance.

7. Aid to Small Business. Insurance encourages competition because

without an insurance industry, small business would be a less effective
competitor against big business. Big business may safely retain some

46
 of the risks that, if they resulted in loss, would destroy most small
businesses. Without insurance, small business would involve more
risks and would be a less attractive outlet for funds and energies.

8. Invisible Export. A valuable contribution towards Ethiopia’s balance

of payments is made by invisible exports. These include banking,
shipping and other services, as well as insurance transacted abroad by
the Ethiopian Insurance Corporation. Overseas insurance as an export
is enhanced when the insurer is selling 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.

Costs of Insurance

1. Operating Expenses. Insurers incur expenses such as loss control

costs, loss adjustment expenses, expenses involved in acquiring
insureds, state premium taxes and general administrative expenses.
These expenses, plus a reasonable amount for profit and
contingencies, must be covered by the premium charged. In real
terms, workers and other resources that might have been committed to
other uses are required by the insurance industry. The advantages of
insurance are not obtained for nothing. They should be weighed
against the cost of obtaining the services.

2. Moral Hazard. A second cost of the insurance industry is the creation

of moral hazards. A moral hazard is a condition that increases the
chance that some person will intentionally (1) cause a loss or (2)
increase its severity. Some unscrupulous persons can make, or believe
that they can make, a profit by bringing about a loss. For example,
arson, inspired by the possibility of an insurance recovery, is a major
cause of fires. Others abuse the insurance protection by:
i) Making claims that are not warranted, thus spreading through
the
insurance system losses that they should bear themselves (eg.
claiming automobile liability when there is no negligence on
the part of the defendant).
ii) Over utilizing the services (eg. staying in a hospital beyond the
period required for treatment).
iii) Charging excessive fees for services rendered to insureds, as is
done by some doctors and garages, and

47
 iv) Granting larger awards in liability cases merely because the
defendant is insured. Some of these abuses are fraudulent;
others indicate a different (and indefensible) code of ethics
where insurance is involved.

3. Morale Hazard. Another related cost is the creation of morale

hazards. A morale hazard is a condition that causes persons to be less
careful than they would otherwise be. Some persons do not
consciously seek to bring about a loss, but the fact that they have
insurance causes them to take more chances than they would if they
had no insurance.

Opinions differ on the degree to which moral and morale

hazards are created by insurance, but all agree that some persons are
affected in each way and that morale hazards are more common than
moral hazards.

In weighing the social costs and the social values of insurance,

the advantages far exceed the disadvantages. Insurance is used
because of the great economic services attained thereby. These
services cost something, of course; but like most expenses, insurance
premiums are looked upon as essential to the successful maintenance
of a family or a business.

4.4. Functions and Organization of Insurers

As part of the study of the insurance mechanism and the way in which it
works, it will be helpful to examine some of the unique facets of insurance
company operations. In general, insurers operate in much the same manner
as other firms, however, the nature of the insurance transaction requires
certain specialized functions which require a suitable organization structure.
In this section, we will examine some of the specialized activities of
insurance companies and the general forms of organization structure.

Functions of Insurers

Although there are definite operational differences between life insurance

companies, and property and liability insurers, the major activities of all
insurers may be classified as follows:
i) Production (selling)

48
 ii) Underwriting (selection of risks)
iii) Rate making
iv) Managing claims
v) Investment

These functions are normally the responsibility of definite

departments or divisions within the firm. In addition to these functions there
are various other activities common to most business firms such as
accounting, personnel management, market research and so on.

Production

One of the most vital functions of an insurance firm is securing a sufficient

number of applicants for insurance to enable the company to operate. This
function, usually called production in an insurance company, corresponds to
the sales function in an industrial firm.

The term is a proper one for insurance because the act of selling is
production in its true sense. Insurance is an intangible item and does not
exist until a policy is sold.

The production department of any insurer supervises the relationships

with agents in the field. In firms such as direct writers, where a high degree
of control over field activities is maintained, the production department
recruits, trains and supervises the agents or salespersons.

Underwriting

Underwriting is the process of selecting risks offered to the insurer. It is an

essential element in the operation of any insurance program, for unless the
company selects from among its applicants, the inevitable result will be
adverse to the company. Hence, the main responsibility of the underwriter is
to guard against adverse selection. Underwriting is performed by home
office personnel who scrutinize applications for coverage and make
decisions as to whether they will be accepted, and by agents who produce
the applications initially in the field.

It is important to understand that underwriting does not have as its

goal the selection of risks that will not have losses, but merely to avoid a
disproportionate number of bad risks, thereby equalizing the actual losses

49
with the expected ones. While attempting to avoid adverse selection through
rejection of undesirable risks, the underwriter must secure an adequate
volume of exposures in each class. In addition, he must guard against
congestion or concentration of exposures that might result in a catastrophe.

Process of Underwriting

The underwriter must obtain as much information about the subject of the
insurance as possible within the limitations imposed by time and the cost of
obtaining additional data. The desk underwriter must rule on the exposure
submitted by the agents, accepting some and rejecting others that do not
meet the company’s underwriting requirements or policies. When a risk is
rejected, it is because the underwriter feels that the hazards connected with it
are excessive in relation to the rate.

There are four sources from which the underwriter obtains

information regarding the hazards inherent in an exposure:
i) The application containing the insured’s statements
ii) Information from the agent or broker
iii) Investigations
iv) Physical examinations or inspections.

The application. The basic source of underwriting information is the

application, which varies from each line of insurance and for each type of
coverage. The broader and more liberal the contract, usually the more
detailed the information required in the application. The questions on the
application are designed to give the underwriter the information needed to
decide if he would accept the exposure, reject it, or seek additional
information.

Information from Agent or Broker. In many cases the underwriter places

much weight on the recommendations of the agent or broker. This varies, of
course, with the experience the underwriter has had with the particular agent
in question. In certain cases the underwriter will agree to accept an exposure
that does not meet the underwriting requirements of the company. Such
exposures are referred to as “accommodation risk,” because they are
accepted to accommodate a valued client or agent.

Investigations. In some cases the underwriter will request a report from an

inspection organization that specializes in the investigation of personal

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matters. This inspection report may deal with a wide range of personal
characteristics of the applicant, including financial status, occupation,
character, and the extent to which he uses alcoholic beverages (or to which
neighbors say he uses them.) All the information is pertinent in the decision
to accept or reject the application.

For example, the financial status of the applicant is important in both

the property and liability field, and in life insurance field, although for
different reasons.

In the property and liability field, evidence of financial difficulty may

be an indication of a potential moral hazard. In life insurance, there is
concern because an individual who purchases more life insurance than he
can afford is likely to let the policy lapse, a practice which is costly to the
company.

Physical Examinations or Inspections. In life insurance, the primary focus

is on the health of the applicant. The medical director of the company lays
down principles to guide the agents and desk writers in the selection of risks,
and one of the most critical pieces of intelligence is the report of the
physician. Physicians selected by the insurance company or recognized
medical centers supply the insurer with medical reports after a physical
examination; this report is a very important source of underwriting
information. In the field of property and liability insurance, the equivalent of
the physical examination in life insurance is the inspection of the premises.
Although such inspections are not always conducted, the practice is
increasing. In some instances this inspection is performed by the agent, who
sends a report to the company with photographs of the property. In other
cases a company representative conducts the inspection.

Rate Making

An insurance rate is the price per unit of insurance. Like any other price, it is
a function of the cost of production. However, in insurance, unlike other
industries the cost of production is not known when the contract is sold, and
will not be known until some time in the future, when the policy has expired.
One of the fundamental differences between insurance pricing and the
pricing function in other industries is that the price for insurance must be
based on a prediction. The process of predicting future losses and future

51
expenses, and allocating these costs among the various classes of insureds is
called rate making.

A second important difference between the pricing of insurance and

pricing in other industries arises from the fact that insurance rates are subject
to government regulation. Because insurance is considered to be vested in
the public interest all nations have enacted laws imposing statutory restraints
on insurance rates. These laws require that insurance rates must not be
excessive, must be adequate, and may not be unfairly discriminatory.

Other characteristics considered desirable are that rates should be

relatively stable over time, so that the public is not subjected to wide
variations in cost from year to year. At the same time, rates should be
sufficiently responsive to changing conditions to avoid inadequacies in the
event of deteriorating loss experience.

Makeup of the Premium

A “rate” is the price charged for each unit of protection or exposure and
should be distinguished from a “premium”, which is determined by
multiplying the rate by the number of units of protection purchased. The unit
of protection to which a rate applies differs for the various lines of
insurance. In life insurance, for example, rates are computed for each 1,000
birr in protection; in fire insurance the rate applies to each 100 birr coverage.

The insurance rate is the amount charged per unit of exposure. The
premium is the product of the insurance rate and the number of units of
exposure. Thus, in life insurance, if the rate is 25 birr per 1,000 birr of face
amount of insurance, the premium for a 10,000 birr policy is 250 birr.
The premium is designed to cover two major costs:
i) The expected loss and
ii) The cost of doing business.

These are known as the pure premium and the loading, respectively.
The pure premium is determined by dividing the total expected loss by the
number of exposures. In automobile insurance, for example, if an insurer
expects to pay 100,000 birr of collision loss claims in a given territory, and
there are 1,000 autos in the insured group, the pure premium for collision
will be 100 birr per car, computed as follows.

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 Expected Loss birr 100,000
Pure premium = = = birr 100
Exposure units 1,000

The loading is made up of such items as agents’ commissions, general

company expenses, taxes and fees, and allowance for profit. The sum of the
pure premium and loading is termed as the gross premium. Usually the
loading is expressed as a percentage of the expected gross premium. In
property – liability insurance, a typical loading might be 33¯ percent. The
general formula for the gross premium, the amount charged the consumer, is
Pure Premium
Gross Premium =
1-Loading percentage

In the above example, where the pure premium was birr 100 per car,
the gross premium would be calculated as
birr 100
= birr 150
1 - 0.333

Rate - Making Methods

Two basic approaches to rate making, class and individual rating are
discussed below.

Manual or Class Rating. The manual or class rating method sets rates that
apply uniformly to each exposure unit falling within some predetermined
class or group. Everyone falling within a given class is charged the same
rate. For example a class rate might apply to all types of dwelling of a given
kind of construction in a specific city. Rates which apply to all individuals of
a given age and sex are also examples of class rates.

The major areas of insurance that emphasize use of the manual rate
making method include life, automobile, residential fire, etc. For example, in
life insurance the central classifications are by age and sex. In automobile
insurance the loss data are broken down territorially by type of automobile,
by age of driver, and by major use of automobile. In each case it is necessary
only to find the appropriate page in a manual to find out what the insurance
rate is to be, hence, the term “manual rate making.”

53
 The obvious advantage of the class rating system is that it permits the
insurer to apply a single rate to a large number of insureds, simplifying the
process of determining their premiums. Class rating is the most common
approach in use by the insurance industry today, and is used in various lines
of insurance.

Individual Rating. Under individual rating, each insured is charged a unique

premium based largely upon the judgement of the person setting the rate.
This rating is supplemented by whatever statistical data are available and by
a knowledge of the premiums charged similar insureds. It takes into account
all known factors affecting the exposure, including competition from other
insurers. If the characteristics of the units to be insured vary so widely it is
desirable to calculate rates for each unit depending on its loss producing
characteristics.

Managing Claims / Loss Adjustment /

The basic purpose of insurance is to provide indemnity to the members of

the group who suffer losses. This is accomplished on the loss-settlement
process, but it is sometimes more complicated than just passing out money.
The payment of losses that have occurred is the function of the claims
department. Life insurance companies refer to those employees who settle
losses as “claim representatives,” or “benefit representatives.” Employees of
the claims department in the field of property and liability insurance are
called “adjusters.”

The Adjustment Process

In determining whether to pay or contest a claim, the adjuster follows a

procedure with four main steps: notice of loss, investigation, proof of loss,
and payment or denial of the claim. The details of these steps vary with the
type of insurance.

Notice. The first step in the claim process is the notice by the insured to the
company that a loss has occurred. The requirement differ from one policy to
another, but in most cases the contract requires that the notice be given
“immediately” or “as soon as practicable.” The policy usually requires that
the notice be given in writing. Actually, however, oral notice to the insurer is
usually sufficient unless the insurer or its agent objects.

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 The insured may also be expected to notify someone other than the
insurer. Under a theft insurance, for example, the insured must tell the
police, as well as the insurer, about the loss.

Investigation. The investigation is designed to determine if there was

actually a loss covered by the policy, and if so, the amount of loss.
Following the loss the insured should assist the loss adjuster in the
investigation. The adjuster must determine:
i) Whether the loss actually occurred
ii) Whether it is covered under the contract, and
iii) The extent of the loss

Proof of Loss. Within a specific time after giving notice, the insured is
required to file a proof of loss. This is a sworn statement that the loss has
taken place, and states the amount of the claim and the circumstance
surrounding the loss. The adjuster normally assists the insured in the
preparation of this document.

Payment or Denial. If all goes well the insurance company draws a draft
reimbursing the insured for the loss. If not, it denies the claim. The claim
may be disallowed because there was no loss, the policy did not cover the
loss, or because the adjuster feels that the amount of the claim is
unreasonable.

Investment Function

When an insurance policy is written, the premium is generally paid in

advance for periods varying from six months to five or more years. This
advance payment of premiums gives rise to funds held for policyholders by
the insurer, funds that must be invested in some manner. When these are
added to the funds of the companies themselves, the assets would add up to
huge amounts. These funds should not remain idle, and it is the
responsibility of finance department or a finance committee of the company
to see that they are properly invested.

Not all the money collected by the insurer is to be invested. A certain

proportion of it should be kept aside to meet future claims. However, the
need for liquidity may vary from one state to another.

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Organization of Insurers

The type of organization used by a given insurer and the types of

departments created depend upon the particular problems it faces. The most
common basis is a centralized management with departments organized on a
functional basis. However, other bases, such as territorial, are commonly
used, often concurrently with the functional type. Thus, the form of
organization adopted depends on the scope of the line of business and the
activities performed by the insurance organization.

Based on the line of business, there are two basic forms of

organization of insurers; single line or product organization and all-line
organization. Single line insurance organizations are those who deal only
with one type business, say fire insurance or life insurance only. All-line
organization refers to that type of arrangement by which an insurer may
write literally all lines of insurance under one administrative frame work of a
single organization, example, the Ethiopian Insurance Corporation.

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 CHAPTER FIVE

LEGAL PRINCIPLES OF INSURANCE CONTRACTS

Insurance is effected by legal agreements known as contracts or policies. A

contract, contrary to the impressions of many, cannot be complete in itself,
but must be interpreted in light of the legal and social environment of the
society in which it is made. The specific legal doctrines that underlie the
insurance contract are the following.

5.1. Principle of Insurable Interest

A fundamental legal principle underlying all insurance contracts is insurable

interest. Under this principle an insured must demonstrate a personal loss or
the insured will be unable to collect amounts due when a loss due to the
insured peril occurs. Insurable interest is always a legal requirement because
to hold otherwise would mean that an insured could collect without personal
loss.

When we say that a businessman has an “interest in several

companies,” we usually imply that he has more than mere mental attraction
towards them. This is also the sense in which the term is used in insurable
interest.

The essentials of insurable interest are as follows:

i) Presence of subject matter to be insured.
ii) Existence of monetary relationship between the subject matter
and the would be policyholder.
iii) The relationship existing between the policyholder and the
subject matter need to be legal.
iv) The policyholder must be economically benefited by the
survival or suffer an economic-loss from the damage or
destruction of the subject matter.
An insurable interest may be applied on life, property, or potential
liability.
Life

i) Self insurance. An individual has an insurable interest in his own life,

and there is no limit to the sum for which a man may insure his own

57
 life. In practice, the sum insured is restricted by the insured’s ability to
pay premium.
ii) Husband and Wife. A wife may insure the life of her husband because
his continued existence is valuable to her and she would suffer a
financial loss upon his death. Likewise, a husband may insure the life
of his wife because her continued existence is valuable to him and he
could suffer a financial loss upon her death.
iii) Creditors and Debtors. A creditor stands to loss if his debtor dies
without paying the debt. Thus, he has the right to insure the debtor up
to the amount of the loan.
iv) Partners. The death of a partner could well cause financial loss to the
survivor(s), who therefore, have a right to insure him. This could arise
with a professional firm or perhaps with theatrical performers. The
amount of insurable interest would be difficult to ascertain, but legally
it is limited to the financial involvement in the person insured.

A father may insure the life of a minor child, but a brother may
not ordinarily insure the life of his sister. In the latter case there would
not usually be a financial loss to the brother upon the death of his
sister, but in the former case the father would suffer financial loss
upon the death of his child.

Property

Insurable interest in property may arise as follows:

i) Ownership. This is the most obvious form and in addition to full
ownership, part or joint ownership gives the right to insure. With part
ownership, the insurable interest is strictly limited to the financial
involvement, but a part owner may insure the property for the full
value, as he will be deemed to be acting as an agent for the other co-
owners. Any amount he receives from the insurance, over and above
his own interest, is to be held in trust for the co-owners.
ii) Husband and Wife. A husband has an insurable interest in his wife’s
property as he is legally entitled to share her enjoyment of it, and a
wife similarly has an insurable interest in her husband’s property as
their relationship is reciprocal.
iii) Administrators, Executors and Trustees. These are all persons
entrusted with the estate and affairs of others. They have a right to
insure the property for which they are responsible.
iv) Bailess. These are persons or entities legally in possession of goods

58
 belonging to others, for example, laundries, cobblers, and the like
have the right to insure for losses to goods in their custody
representing interest of the owner.
v) Agents. Provided the principal possesses an insurable interest, an
agent may effect an insurance on his behalf. The insurance must,
however, be authorized or ratified by the principal. A householder
may effect a policy, which extends to cover the belongings of
members of his family. Another example is with a private car
insurance, which normally extends to cover the liability of other
drivers using the vehicle with the insured’s permission.
vi) Mortgagees and Mortgagors. The interest of the mortgagee is limited
to the sum of money that he has advanced.

Liability

Insurance of liability seldom gives rise to any difficulty over the existence of
insurable interest. A person clearly has an interest in the sums he may be
called upon to pay to third parties as a result of accident.

When the Insurable Interest Must Exist

In property and liability insurance it is possible to effect coverage on

property in which the insured does not have an insurable interest at the time
the policy is written, but in which such an interest is expected in the future.
In marine insurance a shipper often obtains coverage on the cargo it has not
yet purchased in the anticipation of buying cargo for the return trip. As a
result the courts generally hold that in property insurance, insurable interest
need exist only at the time of the loss and not at the inception of the policy.

On the other hand, in life insurance it is the general rule that insurable
interest must exist at the inception of the policy, but it is not necessary at the
time of the loss. The courts view life insurance as an investment contract. To
illustrate, assume that a wife who owns a life insurance policy on her
husband later obtains a divorce. If she continues to maintain the insurance by
paying the premiums, she may collect on the subsequent death of her former
husband, even though she is remarried and suffers no particular financial
loss upon his death. It is sufficient that she had an insurable interest when
the policy was first issued.

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5.2. Principle of Indemnity

The principle of indemnity states that a person may not collect more than the
actual loss in the event of damage caused by an insured peril. Thus, while a
person may have purchased coverage in excess of the value of the property,
that person cannot make a profit by collecting more than the actual loss if
the property is destroyed. Many insurance practices result from this
important principle. Only contracts in property and liability insurance are
subject to this principle. Life and most health insurance policies are not
contracts of indemnity. No money payment can indemnify for loss of life or
for bodily injury to the insured, and that is why life insurance is an exception
to the general rule.

The principle of indemnity is closely related to insurable interest. The

problem in insurable interest is to determine whether any loss is suffered by
a person insured, whereas in indemnity the problem is to obtain a measure of
that loss. In the basic fire insurance contract, the measure of “actual cash
loss” is the current replacement cost of destroyed property less an allowance
for estimated depreciation. In liability insurance, the final measure of loss is
determined by reference to a court action concerning the amount of legal
liability of the insured for negligence. In any event, the purpose served by
the principle of indemnity is to place the insured in the same position as
before the loss.

One of the important results of the principle of indemnity is the

typical inclusion in insurance contracts of clauses regarding other insurance.
The purpose of such clauses is to prevent the insured from taking out
duplicating policies with different insurers in the expectation of recovering
more than the actual loss. Typically such clauses provide that all policies
covering the same risk will share pro rata in the loss. Thus, if Desta carries
4,000 birr fire insurance in Company A and 6, 000 birr in Company B, the
two insurers will divide a 1, 000 birr fire loss 40 percent and 60 percent,
respectively.

Methods of Providing Indemnity

There are four basic methods of providing an indemnity:

i) Cash. Many claims are settled by means of a cash payment to the

insured. All that insurers require is reasonable proof of the cause and

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 extent of the loss, and the cash payment is the measure of indemnity,
or extent of the insurer’s liability for any given loss.
ii) Repair. An adequate repair constitutes an indemnity. This form of
settlement is particularly common in motor insurance, where the
insurer settles the repair bill direct with the garage concerned.
iii) Replacement. It is sometimes advantageous for the insurer to replace
an article rather than to pay cash. With a very new item or with such
things as jewelry and furs, depreciation is likely to be negligible and
the insured may well be content with a new replacement, which might
possibly be acquired at a discount from the appropriate dealer. In glass
insurance, it is the usual rule to replace, and all insurers pride
themselves on the speed with which they replace shop windows so
that there is minimum disturbance of trade.
iv) Reinstatement. This is a term usually found in fire insurance and
concerns the restoration or rebuilding of premises (not necessarily on
the same site) to their former condition.

5.3. Principle of Subrogation

The principle of subrogation grows out of the principle of indemnity. Under

the principle of subrogation one who has indemnified another’s loss is
entitled to recovery from any liable third parties who are responsible. Thus,
subrogation in insurance is the transfer by an insured to an insurer of any
rights to proceed against a third party who has negligently caused the
occurrence of an insured loss. For example, an automobile insurer that has
paid a collision insurance claim obtains the right to collect reimbursement
from any negligent third party who caused the accident.

The insured who has been indemnified by the insurance company may
neglect to prosecute the wrongdoer where liability exists, or he might
prosecute in order to get double recovery. Double recovery would violate the
indemnity principle. By subrogation, the dilemma is resolved by assigning to
the insurance company the right to prosecute the action against the
wrongdoer and there by recoup a portion or all of the damages paid to the
insured. Such salvage by insurance companies helps to maintain lower rate
levels for insureds.

Subrogation is a corollary of the principle of indemnity and the right

of subrogation, therefore, applies only to policies which are contracts of
indemnity. Thus it does not apply to personal accident or life policies. For

61
instance, if the death of a life insured should be caused by the negligence of
a third party, his legal personal representatives may be able to recover
damages in addition to the policy moneys. The insurers have no right of
action against the third party and cannot benefit by any damages received.

5.4. Principle of Utmost Good Faith

Insurance is said to be a contract of utmost good faith. In effect, this

principle imposes a higher standard of honesty on parties to an insurance
agreement than is imposed in ordinary commercial contracts. Insurance
contracts are based upon mutual trust and confidence between the insurer
and the insured. Contracts of insurance are different because one party to the
contract alone the proposer-knows, or ought to know, all about the risk
proposed for insurance, and the other party-the insurer-has to rely largely
upon the information given by the proposer in his assessment of that risk.
For this reason, insurance contracts are contracts of the utmost good faith.
The application of this principle may best be explained in a discussion of
representations, concealments, and warrantees.

Representations

A representation is a statement made by an applicant for insurance before the

contract is effected. Although the representation need not be in writing, it is
usually embodied in a written application. It is a statement in response to a
question by the insurer. An example of representation in life insurance would
be “yes” or “no” to a question as to whether or not the applicant had ever
been treated for any physical condition by a doctor within the previous five
years. If a representation is relied upon by the insurer in entering into the
contract, and if it proves to be false at the time it is made or becomes false
before the contract is made, there exists legal grounds for the insurer to
avoid the contract.

Avoiding the contract does not follow unless the misrepresentation is

material to the risk. That is, if the truth had been known, the contract either
would not have been issued at all or would have been issued on different
terms. If the misrepresentation is inconsequential, its falsity will not affect
the contract. However, a misrepresentation of a material fact makes the
contract voidable at the option of the insurer. The insurer may decide to
affirm the contract or to avoid it. Failure to cancel a contract after first
learning about the falsity of a material misrepresentation may operate to

62
defeat to insurer’s rights to cancel at a later time, under the doctrines of
waiver (voluntary relinquishment of a known right) or estoppel (which
prevents a person from asserting a right because he has acted previously in
such a way as to deny any interest in that right).

Concealments

A concealment is defined as silence when obligated to speak. A concealment

has approximately the same legal effect as a misrepresentation of a material
fact. It is the failure of an applicant to reveal a fact that is material to the
risk. Because insurance is a contract of utmost good faith, it is not enough
that the applicant answer truthfully all questions asked by the insurer before
the contract is effected. The applicant must also volunteer material facts,
even if disclosure of such facts might result in rejection of the application or
the payment of a higher premium.

The applicant is often in a position to know material facts about the

risk that the insurer does not. To allow these facts to be concealed would be
unfair to the insurer. After all, the insurer does not ask questions such as “Is
your building now on fire?” or “Is your car now wrecked?”

The important, often crucial, question about concealments lies in

whether or not the applicant knew the fact withheld to be material. The tests
of a concealment are: (1) Did the insured know of a certain fact? (2) Was
this fact material? and (3) Was the insurer ignorant of this fact?

Warrantees

A warranty is a clause in an insurance contract holding that before the

insurer is liable, a certain fact, condition, or circumstance affecting the risk
must exist. For example, a marine insurance contract may state “warranted
free of capture or seizure.” This statement means that if the ship is involved
in a war skirmish, the insurance is void. Or a bank may be insured on
condition that a certain burglar alarm system be installed and maintained.
Such a clause is condition precedent and acts as a warranty.

A warranty creates a condition of the contract, and any breach of

warranty, event if immaterial, will void the contract. This is the central
distinction between a warranty and a representation. A misrepresentation
does not void the insurance unless it is material to the risk, while under

63
common law any breach of warranty, even if held to be minor, voids the
contract.

Warrantees may be express or implied. Express warranties are those

stated in the contract, while implied warranties are not found in the contract,
but are assumed by the parties to the contract. Implied warranties are found
in ocean marine insurance. For example, a shipper purchases insurance
under the implied condition that the ship is seaworthy, that the voyage is
legal, and that there shall be no deviation from the intended course. Unless
these conditions have been waived by the insurer (legally cannot be waived),
they are binding upon the shipper.

A warranty may be promissory or affirmative. A promissory warranty

describes a condition, fact, or circumstance to which the insured agrees to be
held during the life of the contract. An affirmative warranty is one that must
exist only at the time the contact is first put into effect. For example, an
insured may warrant that a certain ship left port under convoy-affirmative
warranty and the insured may warrant that the ship will continue to sail
under convoy promissory warranty.

5.5. Principle of Contribution

Contribution is the right of an insurer who has paid under a policy, to call
upon other insurers equally or otherwise liable for the same loss to
contribute to the payment. Where there is over-insurance because a loss is
covered by policies effected with two or more insurers, the principle of
indemnity still applies. In these circumstances, the insured will only be
entitled to recover the full amount of his loss and if one insurer has paid out
in full, he will be entitled to nothing more.

Like subrogation, contribution supports the principle of indemnity and

applies only to contracts of indemnity. There is, therefore, no contribution in
personal accident and life policies under which insurers contract to pay
specific sums on the happening of certain events. Such policies are not
contracts of indemnity, except to the extent that they may incorporate a
benefit by way of indemnity, e.g., payment of medical expenses incurred, in
which respect contribution would apply.

It is important to understand the difference between contribution and

subrogation. Subrogation is concerned with rights of recovery against third

64
parties or elsewhere in respect of payment of an indemnity, and need not
involve any other insurance, although it frequently does. Contribution
necessarily involves more than one insurance each covering the interest of
the same insured.

Basis of Contribution

At the time of a claim, insurers usually inquire whether any other insurance
exists covering the loss. Where other insurances do exist and each policy is
subject to a valid claim, contribution will apply so that the respective
insurers share the loss ratably. This term allows two constructions, both of
which are found in insurance:

i) Contribution According to Independent Liability. This means that the

amount payable by each insurer is assessed as if the other insurances
do not exist. If the aggregate of the amounts so calculated exceeds the
loss, each insurer’s contribution is scaled down proportionately, so
that an indemnity is provided. This method is usually found where for
some reason one or more of the policies will not cover the loss in full.
This happens particularly in many fire policy contributions.
ii) Contribution According to the Sums Insured. This is the normal
method of contribution. Insurers will pay proportionately to the cover
they have provided, in accordance with the following formula:

Sum insured with the particular insurer

X Loss = Contribution
Total sums insured with all insurers

Example: Assume that Ato Kebede has inured his house, which is worth
80,000 birr against fire insurers X, Y, and Z for 60,000 birr, 40,000 birr, and
20,000 birr respectively. Ato Kebede’s house was completely destroyed by a
fire caused by Ato Alemu’s negligence. The amount of indemnity that Ato
Kebede will be entitled to receive would be 80,000 birr, the value of the
actual loss or the amount of insurance carried.

The amount that each insurer is entitled to contribute would be as

follows:

Br. 60,000

65
 X’s share of the loss X Br. 80,000 = Br. 40,000
Br. 120,000

Br. 40,000
Y’s share of the loss X Br. 80,000 = Br. 26,667
Br. 120,000

Br. 20,000
Z’s share of the loss X Br. 80,000 = Br. 13,333
Br. 120,000
Total indemnity Br. 80,000

5.6. Essential Requirements of an Insurance Contract

A contract is an agreement embodying a set of promises that are enforceable

at law, or for breach of which the law provides a remedy. These promises
must have been made under certain conditions before they can be enforced
by law. In general, there are four such conditions, or requirements, that may
be stated as follows:

1. The agreement must be for a legal purpose; it must not be against

public policy or be otherwise illegal. For example a contract of
insurance that covers a risk promoting a business or venture
prohibited by law is void. Similarly a gambling contract will not be
enforced by law.
2. The parties must have legal capacity to contract. This requirement
excludes persons who have been deemed incapable of contracting,
such as those who have been judicially declared insane; and persons
who are legally incompetent such as infants, drunken persons, etc.
3. There must be evidence of agreement of the parties to the promises. In
general this is shown by an offer by one party and acceptance of that
offer by the other.
4. The promises must be supported by some consideration, which may
take the form of money, or by some action by the parties that would
not have been required had it not been for the agreement.

66
5.7. Events Covered Under Insurance Contracts

Most insurance contracts contain certain exclusions, such as for loss due to
war, loss to property of an extremely fragile character, and loss due to the
deliberate action of the named insured. Most property insurance contracts
require the insured to notify the insurer of loss as soon as practicable, and
usually require that the insured prove the loss.

Named Peril Versus All Risk. The named peril agreement, as the name
suggests, lists the perils that are proposed to be covered. Perils not named
are, of course, not covered. The other type, all risk, states that it is the
insurer’s intention to cover all risks of accidental loss to the described
property except those perils specifically excluded.

Excluded Losses. Most insurance contracts contain provisions excluding

certain types of losses even though the policy may cover the peril that causes
these losses. For example, the fire policy covers direct loss by fire, but
excludes indirect loss by fire. Thus, the policy will not cover loss of fixed
charges or profits resulting from the fact that fire has caused an interruption
in business. Separate insurance is necessary for this protection.

Excluded Property. A contract of insurance may be written to cover certain

perils and losses resulting from those perils, but it will be limited to certain
types of property. For example, the fire policy excludes fire losses to money,
deeds, bills, bullion, and manuscripts. Unless it is written to cover the
contents, the fire policy on a building includes only integral parts of the
building and excludes all contents.

Defining the insured. All policies of insurance name at least one person
who is to receive the benefit of the coverage provided. That person is
referred to as the named insured. In life insurance he is often called the
policyholder.
Third party Coverage. Many insurance contracts may provide coverage on
individuals who are not direct parties to the contract. Such persons are
known as third parties.

In life insurance the beneficiary is a third party and has the right to
receive the death proceeds of the policy.

67
 The beneficiary can be changed at any time by the insured, unless this
right has been formally given up-i.e., the insured has named the beneficiary
irrevocably. The beneficiary’s rights are thus contingent upon the death of
the insured.

Excluded Locations. The policy may restrict its coverage to certain

geographical locations. Relatively few property insurance contracts give
complete worldwide protection. For example automobile insurance may be
limited to cover the auto while it is in Ethiopia. If the car is, say, in Kenya
coverage is suspended.

Insurance contracts may be discharged by the lapse of time, failure to

pay premiums, failure to renew the contract, or cancellation of the contract.

68
 CHAPTER SIX

LIFE AND HEALTH INSURANCE

Human values, aside from being more important to us from a personal

standpoint, are far greater and more significant than all the different property
values combined. The true wealth of a nation lies not in its natural resources
or its accumulated property, but in the inherent capabilities of its population
and the way in which this population is employed. A careful study of the
specific types of economic loss caused by the destruction of life or health is
vital to an understanding of the insurance methods available to offset these
losses.

Life Values

A human life has value for may reasons. Many of these reasons are
philosophical in nature, and would lead us into the realm of religion,
esthetics, sociology, psychology, and other behavioural sciences. Of greatest
interest here are economic values, although it is very difficult to separate the
discussion in such a way that an economic analysis would have no
implications or overtones for other viewpoints.

A human life has economic value to all who depend on the earning
capacity of that life, particularly to two central economic groups-the family
and the employer. To the family, the economic value of a human life is
probably most easily measured by the value of the earning capacity of each
of its members. To the employer, the economic value of human life is
measured by the contributions of an employee to the success of the business
firm. If one argues that in a free competitive society a worker is paid
according to worth and is not exploited, the worker’s contribution again is
best measured by earning capacity. It develops that earning capacity is
probably the only feasible method of giving measurable economic value to
human life.

There are four main perils that can destroy, wholly or partially, the
economic value of a human life. These include premature death, loss of
health, old age, and unemployment.

69
6.1. Life Insurance

Every person faces two basic contingencies concerning life; he may die too
soon, or he may live too long, to suit himself; it means that he may outlive
his financial usefulness or his ability to provide for his needs. The first
category is physical death. The second is economic death. A man, who is
forced to retire at 55 from his job, unless he has substitute income, is
financially dead. Economic death may also occur at early ages if the person
becomes too disabled or ill to work. Life insurance is designed to provide
protection against these two distinct risks premature death and
superannuation. Thus, life insurance may be defined as a social and
economic device by which a group of people may cooperate to ameliorate
(make better) the loss resulting from the premature death or living too long
of members of the group.

Unique Characteristics of Life Insurance

Life insurance is a risk pooling plan economic device through which the risk
of premature death or superannuation is transferred from the individual to
the group. However, the contingency insured against has certain
characteristics that make it peculiar, as a result, the contract insuring against
the contingency is different in many respects from other types of insurance.

First, the event insured against is an eventual certainty. No one lives

forever or maintains his economic value. Yet we do not violate the
requirements of an insurable risk in the case of life insurance, for it is not the
possibility of death itself that we insure against, but rather untimely death.
The uncertainty surrounding the risk in life insurance is not whether the
individual is going to die, but when.

Second, life insurance is not a contract of indemnity. The principle of

indemnity applies on a modified form in the case of life insurance. In most
lines of insurance, an attempt is made to put the individual back in exactly
the same financial position after a loss as before the loss. For obvious
reasons, this is not possible in life insurance, the simple fact of the matter is
that we cannot place a value on a human life.

Third, as a legal principle, every contract of insurance must be

supported by an insurable interest, but in life insurance the requirement of
insurable interest is applied somewhat differently than in property and

70
liability insurance. When the individual taking out the policy is also the
insured, there is no legal problem concerning insurable interest. The
important question of insurable interest arises when the person taking out the
insurance is someone other than the person whose life is concerned. In such
cases, the law requires that an insurable interest exists at the time the
contract is taken out. There are many relationships, as stated earlier, that
provide the basis for an insurable interest.

Fourth, life insurance contracts are long-term contracts. Nearly all life
policies, are intended to continue until the insured’s death or at least for
several years. Other forms of insurance policies may be renewed many
times, but are usually twelve-month contracts, which may be terminated by
either party.

Finally the question of over insurance is immaterial in life insurance

contracts.

6.1.1. Basic Types of Life Insurance Contracts

Not all people need exactly the same kind of protection from life insurance.
Their ages differ, their incomes and financial obligations differ, the number
of their dependents differ. To provide all the different types of protection that
are needed, insurance companies offer a variety of policies. The basic types
of contracts are:
1. Term insurance
2. Whole life insurance.
3. Endowment insurance, and
4. Annuities.

Term Insurance

Term insurance provides protection only for a definite period (term) of time.
A term insurance policy is a contract between the insured and the insurer
whereby the insurer promises to pay face amount of the policy to a third
party (the beneficiary) should the insured die within a given period of time.
If the insured does not die during the period for which the policy was taken,
the insurance company is not required to pay anything. Protection ends when
the term of years expires. In other words, term life insurance resembles
automobile insurance, fire insurance, and the like, which are always term
insurance. Term insurance is sometimes called temporary insurance.

71
Common types of term life insurance are 1-year term, 5-years term, 10-years
term, 20-years term, and term to age 60 or 65. There are different forms of
term insurance available to the potential purchaser, viz., straight term
insurance, renewable term insurance, and convertible term insurance.

Straight term insurance is written for a year or for a specified number of

years and terminates automatically at the end of the designated period.

Renewable term insurance is a type of contract under which the insured

may renew his policy before its expiration date without making another
medical examination or otherwise proving that he still is insurable. If the
policy is renewable, the insurer will renew the policy, regardless of the
insurability of the insured, for the number of times specified in the contract
commonly to age 60 or 65.

Convertible term insurance is available from most life insurance

companies. This insurance may be converted at any time during a specified
period into a permanent form of insurance without taking a physical
examination. Some insurance companies write a convertible term policy
which provides that at the expiration of certain period of time the term
insurance policy automatically will be converted into a permanent form of
insurance. This is called automatic convertible term insurance. In most
cases, these policies provide that term insurance will be converted to a
continuous-premium whole-life policy.

Term insurance is suitable for insuring any need for protection, which
is not life-long duration, non continuing needs for insurance. For example, a
man with a mortgage that will take ten years to amortize can use term
insurance to provide insurance protection during the mortgage period.
Mortgage insurance protects homeowners frobgm losing their homes in case
the insured person dies before the mortgage is payed off.

Whole Life Insurance

As the name suggests, it is a permanent insurance that extends over the

lifetime of the insured. The sum insured is payable on the death of the life
insured. In other words whole life insurance protects the beneficiary when
the insured dies, since the contract can be continued in force as long as the
insured lives.

72
 Whole life insurance contracts may be placed in two categories,
depending upon the premium payment period:
1. Straight life insurance , and
2. Limited payment life insurance

Under straight life insurance, the premiums are payable for the remainder of
the insured’s lifetime. Under limited payment life insurance, the premiums
are payable for the remainder of the insured’s lifetime or until the expiration
of a specified period, if earlier. A limited-payment life policy is one
arranged so that the insured pays a higher premium than would be required
on the straight life contract. Thus a definite termination date can be
established beyond which no further payments are due. Limited installment
plans could be 20-payment life, 30 payment life, and life paid up at age 65.

There are many different ways of arranging premium payments for

whole life insurance, ranging from continuous installments over a person’s
entire life to a single installment (single premium whole life). In other
words, an insured, at age 35, may pay a single sum, say 5,000 birr for a
10,000 birr policy, and never pay another premium. At the time of death the
insurer pays the insured’s beneficiary 10,000 birr. If the insured does not
have 5,000 birr with which to pay the single premium (and few do), it may
be paid by installments over whatever length of time is desired.

Whole life insurance is the ideal form of insurance for a person with
dependent relatives, as substantial life cover is obtainable for the amount of
premium payable.

Endowment Insurance

Endowment insurance promises to pay a stated amount of money to the

beneficiary at once if the insured dies during the life of the policy called the
“endowment period,” or to the insured himself if he survives to the end of
the endowment period. This is “you win if you live and you win if you die”
contract. The endowment policy is, in a sense, a savings plan, which also
gives insurance protection.

Under this type of contract the sum insured becomes payable at a

maturity date (on the expiry of a fixed term, say 10 or 20 years,) or at death
before that date.

73
 Endowment insurance may be a useful way for some persons to
accumulate a specified sum over a stated period of time whether they live or
die. The objective may be funds to finance a child’s college education, to
pay living expenses during retirement, or to retire a debt.

Annuity Contracts

An annuity may be defined as a periodic payment to commence at a stated

date and to continue for a fixed period or for the duration of a life. The
person whose life governs the duration of the payments is called the
annuitant. Annuity is insurance against living too long-against outliving
one’s ability to provide an income for oneself.

Annuities can be classified according to several characteristics. First,

annuities can be classified as immediate or deferred, depending upon
whether the benefits are payable immediately after the purchase of the
contract. The rent of an annuity can begin as soon as the annuity is
purchased, in which case the transaction is called an immediate annuity.
Alternatively, the rent can begin at some future time in which case the
annuity is called a deferred annuity. Often the rent begins at retirement.

Second, annuities may be paid for by a single premium or by annual

premiums. An annuity can be wholly paid up in a lump sum payment or it
can be purchased in installments over a period of years. If the annuity is paid
up at once, it is called a single-premium annuity. If it is paid for in
installments, it is known as an annual-premium annuity.

Third, annuities may cover one life or joint lives. If two or more lives
are covered, the payments may stop at the death of the first annuitant or at
the death of the last annuitant. An annuity may be issued on more than one
life. For example, the agreement might be to pay a given rent during the
lifetime of two individuals, as long as either shall live.

This, a very common arrangement, is known as a joint and last

survivorship annuity, because the rent is payable until the last survivor dies.
The rent may be constant during the entire period or may be arranged to be
reduced by, say, one-third upon the death of the first annuitant. Thus, a
husband and wife both age 65 may elect to receive the proceeds of a pension
plan on a joint and last survivorship basis, with an income guaranteed as
long as either shall live.

74
6.1.2. Life Insurance Premiums

There are three primary elements in life insurance rate making:

1. Mortality
2. Interest
3. Loading

The first two (that is, mortality and interest) are used to compute the net
premium. Most computations of rates in life insurance begin with the net
single premium and the net annual level premium, which measures only the
cost of claims and omits provisions for operating expenses. The net premium
plus an expense loading (which includes unit expense factor, profit factor,
etc) is the gross premium, which is the selling price of the contract and the
amount the insured pays.

Mortality

The mortality table is simply a convenient method of expressing the

probabilities of living or dying at any given age. It is a tabular expression of
the chance of losing the economic value of human life. Since the insurance
company assumes the risk of the individual, and since this risk is based on
life contingencies, it is important that the company know within reasonable
limits how many people will die at each age. On the basis of past experience
actuaries are able to predict the number of deaths among a given number of
people at some given age.

For large number of people actuaries have developed mortality tables

on which scientific life insurance rates may be based. These tables which are
revised periodically, state the probability of death both in terms of deaths per
1,000 and in terms of expectation of life.

Table 6 – 1 illustrates the mortality experience in current use. It shows

that a male age 20 has an expectation of living 52.37 years. At age 20 only
190 men (105 women) in every 100,000 are expected to die before they
become 21. The probability of death at age 20 is thus 0.19 percent. At age 96

75
the death rate is slightly over 38 percent, since 384 per 1,000 are expected to
die during that year. At age 100 it is assumed that death is certainty. The
probability of death expressed in a mortality table is based on insured lives
and not the whole population.

76
Table 6-1
Commissioners Standard Ordinary (CSO) Mortality Table (1980)
Male Female Male Female
Deaths Expectation Death Expectation Deaths Expectation Death Expectation
Per of life Per of Life Per of life Per of Life
Age 1,000 (Years) 1,000 (Years) 1,000 (Years) 1,000 (Years) Age
0 4.18 70.83 2.89 75.83 7.30 24.52 5.31 28.67 51
1 1.07 70.13 0.87 75.04 7.96 23.70 5.70 27.82 52
2 0.99 69.20 0.81 74.11 8.71 22.89 6.15 26.98 53
3 0.98 68.27 0.79 73.17 9.56 22.08 6.61 26.14 54
4 0.95 67.34 0.77 72.23 10.47 21.29 7.09 25.31 55
5 0.90 66.40 0.76 71.28 11.46 20.51 7.57 24.49 56
6 0.86 65.46 0.73 70.34 12.49 19.74 8.03 23.67 57
7 0.80 64.52 0.72 69.39 13.59 18.99 8.47 22.86 58
8 0.76 63.57 0.70 68.44 14.77 18.24 8.94 22.05 59
9 0.74 62.62 0.69 67.48 16.08 17.51 9.47 21.25 60
10 0.73 61.66 0.68 66.53 17.54 16.79 10.13 20.44 61
11 0.77 60.71 0.69 65.58 19.19 16.08 10.96 19.65 62
12 0.85 59.75 0.72 64.62 21.06 15.38 12.02 18.86 63
13 0.99 58.80 0.75 63.67 23.14 14.70 13.25 18.08 64
14 1.15 57.86 0.80 62.71 25.42 14.04 14.59 17.32 65
15 1.33 56.93 0.85 61.76 27.85 13.39 16.00 16.57 66
16 1.51 56.00 0.90 60.82 30.44 12.76 17.43 15.83 67
17 1.67 55.09 0.95 59.87 33.19 12.14 18.84 15.10 68
18 1.78 54.18 0.98 58.93 36.17 11.54 20.26 14.38 69
19 1.86 53.27 1.02 57.98 39.51 10.96 22.11 13.67 70
20 1.90 52.37 1.05 57.04 43.30 10.39 24.23 12.97 71
21 1.91 51.47 1.07 56.10 47.65 9.84 26.87 12.28 72
22 1.89 50.57 1.09 55.16 52.64 9.30 30.11 11.60 73
23 1.86 49.66 1.11 54.22 58.19 8.79 33.93 10.95 74
24 1.82 48.75 1.14 53.28 64.19 8.31 38.24 10.32 75
25 1.77 47.84 1.16 52.34 70.53 7.84 42.97 9.71 76
26 1.73 46.93 1.19 51.40 77.12 7.40 48.04 9.12 77
27 1.71 46.01 1.22 50.46 83.90 6.97 53.45 8.55 78
28 1.70 45.09 1.26 49.52 91.05 6.57 59.35 8.01 79
29 1.71 44.16 1.30 48.59 98.84 6.18 65.99 7.48 80
30 1.73 43.24 1.35 47.65 107.48 5.80 73.60 6.98 81
31 1.78 42.31 1.40 46.71 117.25 5.44 82.40 6.49 82
32 1.83 41.38 1.45 45.78 128.26 5.09 92.53 6.03 83
33 1.91 40.46 1.50 44.84 140.25 4.77 103.81 5.59 84
34 2.00 39.54 1.58 43.91 152.95 4.46 116.10 5.18 85
35 2.11 38.61 1.65 42.98 166.09 4.18 129.29 4.80 86
36 2.24 37.69 1.76 42.05 179.55 3.91 143.32 4.43 87
37 2.40 36.78 1.89 41.12 193.27 3.66 158.18 4.09 88
38 2.58 35.87 2.04 40.20 207.29 3.41 173.94 3.77 89
39 2.79 34.96 2.22 39.28 221.77 3.18 190.75 3.45 90
40 3.02 34.05 2.42 38.36 236.98 2.94 208.87 3.15 91
41 3.29 33.16 2.64 37.46 253.45 2.70 228.81 2.85 92
42 3.56 32.26 2.87 36.55 272.11 2.44 251.51 2.55 93
43 3.87 31.38 3.09 35.66 295.90 2.17 279.31 2.24 94
44 4.19 30.50 3.32 34.77 329.96 1.87 317.32 1.91 95
45 4.55 29.62 3.56 33.88 384.55 1.54 375.74 1.56 96
46 4.92 28.76 3.80 33.00 480.20 1.20 474.97 1.21 97
47 5.32 27.90 4.05 32.12 657.98 0.84 655.85 0.84 98
48 5.74 27.04 4.33 31.25 1,000.00 0.50 1,000.00 0.50 99
49 6.21 26.20 4.63 30.39
50 6.71 25.36 4.96 29.53

77
Interest

Since the insurance company collects the premium in advance and does not
pay claims until the future date, it has the use of the insured’s money for
some time, and it must be prepared to pay interest on it. The life insurance
companies collect vast sums of money, and since their obligations will not
mature until some time in the future, they invest this money and earn interest
on it.

Thus, the present value of a future birr is an important concept in the

computation of premiums. The present value of a future birr is computed by
dividing a birr by the future value of a birr at the specified rate of interest.
For example, Br, 1.00 invested at 3% for a year will be worth Br. 1.03 at the
end of the year. How much must we have now so that if we invest it at 3%
will equal Br. 1.00 at the end of the year?
Br. 1.00
= 0.97087379
Br. 1.03

So if we invest Br. 0.97087379 at 3% it will equal Br. 1.00 at the end

of the year. Table 6 – 2 represents the value of Br.1.00 to be received at the
end of some specified number of years at various rates of compound interest
(interest upon interest.) It tells how much an individual (or an insurance
company, for that matter) should have to invest at a given rate of interest to
receive Br. 1.00 at some time in the future. Reading down the table, we can
see that we should have to invest only about 55 cents at 3% to have Br. 1.00
at the end of 20 years.

78
 Table 6-2
Present Value of Br. 1.00 1
(1 + 1 ) n
Periods
0 .03(3%) .06(6%) .07(7%) .08(8%) .10(10
%)
1 0.9708 7379 0.9433 9623 0.9345 7944 0.9259 2593 0.9090 9091
2 0.9425 9591 0.8899 9644 0.8734 3873 0.8573 3882 0.8264 4628
3 0.9151 4166 0.8396 1928 0.8162 9788 0.7938 3224 0.7513 1480
4 0.8884 8705 0.7920 9366 0.7628 9521 0.7350 2985 0.6830 1345
5 0.8626 0878 0.7472 5817 0.7129 8618 0.6805 8320 0.6209 2132

6 0.8374 8426 0.7049 6054 0.6663 4222 0.6301 6963 0.5644 7393
7 0.8130 9151 0.6650 5711 0.6227 4974 0.5834 9040 0.5131 5812
8 0.7894 0923 0.6274 1237 0.5820 0910 0.5402 6888 0.4665 0738
9 0.7664 1673 0.5918 9846 0.5439 3374 0.5002 4897 0.4240 9762
10 0.7440 9391 0.5583 9478 0.5083 4929 0.4631 9349 0.3855 4329

11 0.7224 2128 0.5267 8753 0.4750 9280 0.4288 8286 0.3504 9390
12 0.7013 7988 0.4969 6936 0.4440 1196 0.3971 1376 0.3186 3082
13 0.6809 5134 0.4688 3902 0.4149 6445 0.3676 9792 0.2896 6438
14 0.6611 1781 0.4423 0096 0.3878 1724 0.3404 6104 0.2633 3125
15 0.6418 6195 0.4172 6506 0.3624 4602 0.3152 4170 0.2393 9205

16 0.6231 6694 0.3936 4628 0.3387 3460 0.2918 9047 0.2176 2914
17 0.6050 1645 0.3713 6442 0.3165 7439 0.2702 6895 0.1978 4467
18 0.5873 9461 0.3503 4379 0.2958 6392 0.2502 4903 0.1798 5879
19 0.5702 8603 0.3305 1301 0.2765 0833 0.2317 1206 0.1635 0799
20 0.5536 7575 0.3118 0473 0.2584 1900 0.2145 4821 0.1486 4363

21 0.5375 4928 0.2941 5540 0.2415 1309 0.1986 5575 0.1351 3057
22 0.5218 9250 0.2775 0510 0.2257 1317 0.1839 4051 0.1228 4597
23 0.5066 9175 0.2617 9726 0.2109 4688 0.1703 1528 0.1116 7816
24 0.4919 3374 0.2469 7855 0.1971 4662 0.1576 9934 0.1015 2560
25 0.4776 0557 0.2329 9863 0.1842 4918 0.1460 1790 0.0922 9600

26 0.4636 9473 0.2198 1003 0.1721 9549 0.1352 0176 0.0839 0545
27 0.4501 8906 0.2073 6795 0.1609 3037 0.1251 8682 0.0762 7768
28 0.4370 7675 0.1956 3014 0.1504 0221 0.1159 1372 0.0693 4335
29 0.4243 4636 0.1845 5674 0.1405 6282 0.1073 2752 0.0630 3941
30 0.4119 8676 0.1741 1013 0.1313 6712 0.0993 7733 0.0573 0855

31 0.3999 8715 0.1642 5484 0.1227 7301 0.0920 1605 0.0520 9868
32 0.3883 3703 0.1549 5740 0.1147 4113 0.0852 0005 0.0473 6244
33 0.3770 2625 0.1461 8622 0.1072 3470 0.0788 8893 0.0430 5676
34 0.3660 4490 0.1379 1153 0.1002 1934 0.0730 4531 0.0391 4251
35 0.3553 8340 0.1301 0522 0.0936 6294 0.0676 3454 0.0355 8410

36 0.3450 3243 0.1227 4077 0.0875 3546 0.0626 2458 0.0323 4918
37 0.3349 8294 0.1157 9318 0.0818 0884 0.0579 8572 0.0294 0835
38 0.3252 2615 0.1092 3885 0.0764 5686 0.0536 9048 0.0267 3486
39 0.3157 5355 0.1030 5552 0.0714 5501 0.0497 1341 0.0243 0442
40 0.3065 5684 0.0972 2219 0.0667 8038 0.0460 3093 0.0220 9493

41 0.2976 2800 0.0917 1904 0.0624 1157 0.0426 2123 0.0200 8630
42 0.2889 5922 0.0865 2740 0.0583 2857 0.0394 6411 0.0182 6027
43 0.2805 4294 0.0816 2962 0.0545 1268 0.0365 4084 0.0166 0025
44 0.2723 7178 0.0770 0908 0.0509 4643 0.0338 3411 0.0150 9113
45 0.2644 3862 0.0726 5007 0.0476 1349 0.0313 2788 0.0137 1921

46 0.2567 3653 0.0685 3781 0.0444 9859 0.0290 0730 0.0124 7201
47 0.2492 5876 0.0646 5831 0.0415 8746 0.0268 5861 0.0113 3819
48 0.2419 9880 0.0609 9840 0.0388 6679 0.0248 6908 0.0103 0745
49 0.2349 5029 0.0575 4566 0.0368 2410 0.0230 2693 0.0093 7041
50 0.2281 0708 0.0542 8836 0.0339 4776 0.0213 2123 0.0085 1855

79
80
Net Single Premium

The net single premium is the amount the insurer must collect in advance to
meet all the claims arising during the policy period. To illustrate the general
method of calculating the net single premium, we will assume that a given
insurer wishes to determine the premium for a one-year term insurance
contract with a face amount of birr 1,000 for a group of intrants, age 20.
Reference to the CSO 1980 table of mortality reveals that the probability of
death at age 20 for a male is 0.0019. This means that out of 100,000 men
living at the beginning of the year, 190 will die during the year. The rate-
maker in life insurance makes two assumptions in calculating the necessary
premium:

1. All premiums will be collected at the beginning of the year and

hence it will be possible to earn interest on the advance payment
for a full year.
2. Death claims are not paid until the end of the year in question. In
practice,
of course, death claims are paid whenever death occurs.

Calculation of the premium under these assumptions is simplified

because the insurer knows that if a 1,000 birr policy is issued to each of the
100,000 entrants, death claims of 190,000 will be payable at the end of the
year. The problem then is one of discounting the sum for one year at some
assumed rate of interest. Thus, if the insurer is to guarantee earnings of 3%,
birr 0.9708 must be on hand now in order to have birr 1.00 at the end of one
year.

Present value of birr 190,000 at the end of one year

= 190,000 birr X 0.9708
= 184,452 birr
The proportionate share of this obligation attached to each entrant is
= 184,452 birr
100,000
= 1.84 birr
If each entrant pays 1.84 birr, the insurer will have sufficient funds on hand
to pay for death costs under the policy. The 1.84 birr is known as the net
single premium.

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The formula for net single premium is:
Face value Mortality Discount
of policy X rate X factor

Br. 1,000 X 0.0019 X 0.9708 = Br. 1.84

Assume that the actuary must calculate the net single premium for Br.
1,000 one-year term insurance policy for a 35-year-old male at 3% interest
assumption and the C.S.O.1980 Table.

Net single premium = 1,000 birr x 0.00211 x 0.9708 = Br. 2.04

The net single premium for a birr 1,000 policy issued to 100,000
entrants at age 20, say, three years is calculated in a similar manner, except
that the calculation is carried out over a three year period instead of one.
The following table illustrates the method.

Number assumed Number Amount of Present value Present value

to be living at dying death claims of Br.1.00at 3% of death claims
interest

Age 20 100,000 190 Br.190,000 0.9708 Br.184,452

Age 21 99,810 191 191,000 0.9425 180,018
Age 22 99,619 189 189,000 0.9151 172,954
Br.537,424

The net single premium is then computed;

Br. 537,424
= Br. 5.37
100,000

It will be observed that each person must pay inadvance the sum of Br. 5.37
for three years of protection.

While the calculation above is a simple one, it illustrates the basic

method of premium calculation in life insurance. The net single premium for
a whole life policy, for example, is figured in exactly the same manner as the
example above, except that the calculations are made for each year from the
starting age to the end of the mortality table.

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 Alternatively the net single premium payable by an individual entrant
for Br. 1,000 policy of 3 years term could also be computed using the
following formula.
Face value of Mortality Discount
NSP = policy X rate X factor
1) Br. 1,000 X 0.0019 X 0.9708 = 1.8445
2) “ 1,000 X 0.00191 X 0.9425 = 1.8001
3) “ 1,000 X 0.00189 X 0.9151 = 1.7295
5.3741
Net Level Premium

It would be impractical to attempt to collect a net single premium from each

member of an insured group. Few people would have the necessary funds for
an advance payment of all future obligations. Therefore, actuaries must
calculate an annual premium.

Actuaries find the net level premium (NLP) by dividing the net single
premium (NSP) by an amount known as the present value of an annuity due
(PVAD).
NSP
NLP =
PVAD
The present value of an annuity due of Br. 1 a year for three years is
the present value of a series of payments of Br. 1 each year, the first payment
due immediately, adjusted for the probability of survival each year.

The calculation is shown in the following table.

Present value of Br. 1,

First payment due immediately, Number of entrant Discounted value
Age at 3% interest group still living of each payment

20 Br. 1.0000 100,000 Br.100,000

21 0.9708 99,810 96,896
22 0.9425 99,619 93,891
Br.290,787
The value per entrant can then be computed:
Br. 290,787
= Br.2.91
100,000

83
 The PVAD of Br. 1 a year for three years can also be calculated in the
following manner.
PVAD = Payments of X Discount X Survival
Each year Factor Rate

1) Br.1 X 1.0000 X 1.0000 = Br.1.0000

2) Br.1 X 0.9708 X 0.9981 = “ 0.9690
3) Br.1 X 0.9425 X 0.9962 = “ 0.9389
Br.2.91

The present value of an annuity due may be interpreted as follows:

What is the present value of a promise of a large group of people to pay a

sum of Br. 1 each year for three years? As the first payment is due
immediately (corresponding to the fact that life insurance premiums are
collected in advance), its present value is Br. 1. The second payment is due
one year from now. If everyone lived to pay his or her share, the present
value of the second payment would be Br. 0.9708. Not everyone will live,
however, and so the Br. 0.9708 must be reduced to reflect this fact. The
amount is therefore, reduced by a factor that specifies how many may be
expected to live to pay their share (i.e., the amount is multiplied by the
probability of survival of the original group of entrants).

This process is continued, and we find that the present value of the
promise is Br.2.91. If the sum is divided into the present value of the total
death claims (i.e., the net single premium), the insurer knows how much
must be collected annually from a specified group of insureds in order to
have a sum that will enable the insurer to pay all obligations. The net level
premium for the three-year term policy is, thus,
Br.5.3741
= Br. 1.85
Br. 2.91
Gross Premium

Gross premium is the pure premium plus loading for the necessary expenses
of the insurer. The net level premium for life insurance represents the pure
premium that is unadjusted for the expenses of doing business. The pure
premium is actually the contribution that each insured makes to the
aggregate insurance fund each year for the payment of both death and living
benefits.

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6.2. Health Insurance

Health insurance may be defined broadly as the type of insurance that

provides indemnification for expenditures and loss of income resulting from
loss of health. Health insurance is insurance against loss by sickness or
bodily injury. The loss may be the loss of wages caused by sickness or
accident, or it may be expenses for doctor bills, hospital bills, medicine, etc.

6.2.1. Types of Health Insurance

There are two types of insurance in the generic term health insurance:
1) Disability income insurance, and
2) Medical expense insurance.

Disability Income Insurance

Disability income insurance is a form of health insurance that provides

periodic payments when the insured is unable to work as a result of illness or
injury. It may pay benefits only in the event of sickness or only in the event
of accidental bodily injury or it may cover both contingencies in one
contract. Benefit eligibility presumes a loss of income, but in practice this is
usually defined as the inability to peruse an occupation. The fact that the
insured’s employer may continue his or her wages does not reduce the
insurance benefit.

The disability must be one that prevents the insured from carrying on
the usual occupation. Most policies continue payment of the benefits for
only a specified maximum number of years, but lifetime benefits are
available on some contracts. However, under all loss of income policies, the
benefits are terminated as soon as the disability ends.

Certain types of accidents are excluded, for example, losses caused by

war, suicide and intentionally inflicted injuries, and injuries while in military
service during wartime.

Medical Expense Insurance

Medical expense insurance provides for the payment of the cost of medical
care that result from sickness and injury. Its benefits help meet the expenses
of physicians, hospital, nursing and related services, as well as medications

85
and supplies. Benefits may be in the form of reimbursement of actual
expenses, up to a limit, cash payments or the direct provision of services.
The medical expenses may be paid directly to the provider of the services or
the insured.
Medical expense insurance is divided into four major classes:
1) Hospitalization expense contract
2) Surgical expense contract
3) Regular medical expense contract
4) Major medical expense contract

Hospitalization Contract:- The hospitalization contract is intended to

indemnify the insured for necessary hospitalization expenses, including
room and board in the hospital, laboratory fees, nursing care, use of
operating room, and certain medicines and supplies.

Hospitalization expense is usually written for a flat daily amount for a

specified number of days such as 30,120, or 365. The contract provides that
costs upto the maximum benefit per day (say 40 birr, 50 birr, 70 birr etc.)
will be paid for the number of day specified, while the insured or an eligible
dependent is in the hospital.

The agreement may set birr allowance for the different items or may
be on a service basis. Typical contracts offered by insurance companies, for
example, may state that the insured will be indemnified up to “X birr per
day” for necessary hospitalization.

Exclusions under hospitalization contracts:

Like all insurance policies, hospitalization contracts offered by

insurers are subject to exclusions. The following exclusions are typical of
hospitalization contracts:
1) Expenses resulting from war or any act of war.
2) Expenses resulting from self-inflicted injuries.
3) Expenses payable under worker’s compensation or any
occupational disease law.
4) Expenses incurred while on active duty with the armed forces.
5) Expenses incurred for purely cosmetic purposes.
6) Expenses incurred by individuals on an outpatient basis.
7) Services received in any government hospital not making a
charge for such services.

86
Surgical Contract: - The surgical contract provides set allowances for
different surgical procedures performed by duly licensed physicians. In
general, a schedule of operations is set forth together with the maximum
allowance for each operation. It reimburses the policyholder according to a
schedule that lists the amounts the policy will pay for a variety of operations.

Regular Medical Contract: - The regular medical expense insurance pays

part or all of a physicians ordinary bills, such as his calls at the patient’s
home or at a hospital or a patient’s visit to his office. It is a contract of health
insurance that covers physicians’ services other than surgical procedures.
Normally, regular medical insurance is written in conjunction with other
types of health insurance and is not written as a separate contract.

Major Medical Contract: - The major medical expense insurance provides

protection against the very large cost of a serious or long illness or injury.
The major medical policy is most appropriate for the large medical expenses
that would be financially unaffordable for the individual.

The contract is issued subject to substantial deductibles of different

sorts and with a high maximum limit. Since this kind of policy is designed to
cover only serious illness or accidents, a deductible is used to eliminate
small claims. A major medical policy might have a 5,000 birr maximum
limit for any one accident or illness, have a 200 birr deductible for any one
illness, and contain an agreement to indemnify the insured for a specified
percentage of the bills, such as 80% over and above the amount of the birr
deductible. This means the insurance company pays 80% of the loss in
excess of the deductible, and the insured pays the 20%. In the absence of the
coinsurance clause, there would be no incentive for the insured or the doctor
to keep expenses within reasonable limits.

87
 CHAPTER SEVEN

PROPERTY AND LIABILITY INSURANCE

Property and liability insurance consists of those forms of insurance that are
designed to provide protection against losses resulting from damage to or
loss of property and losses resulting from legal liability.

7.1. Property Insurance

Property may be exposed to a wide range of perils – fire, theft, perils of the
sea, and damage by persons (whether accidental or carelessness).

7.1.1. Fire Insurance

Fire insurance is designed to indemnify the insured for loss of, or damage to,
buildings ad personal property by fire, lighting, windstorm, hail, explosion,
and a vast array of other perils. Coverage may be provided for both the
direct loss (that is the actual loss represented by the destruction of the asset),
and indirect loss (defined as the loss of income and/or extra expenses caused
by the loss of use of the asset protected). Originally, only fire was an insured
peril, but the number of perils insured against has gradually been expended.

Business may therefore, purchase fire insurance contracts covering

their building and its contents, to both the perils of fire and lightning. The
standard fire policy promises in its insuring clause to indemnify the insured
for “direct loss by fire, lightning and by removal from premises endangered
by the perils insured against.”

Insurers, however, may offer protection against a very great number of perils
other than fire and lightning by extending the contract in relation to the
interest of the insured through additional premium payment. For additional
premium, the standard fire policy may be extended to cover any of the
following perils: windstorm, explosion, damage by aircraft, damage by
vehicle, flood, earthquake fire and shock, bursting of pipes and water
damage, etc.

Not all fires are covered under the fire insurance contract, but the exclusions
are few:

88
1. fires caused by war
2. fires intentionally set by public authorities, and
3. fires set intentionally by the insured.

Policy Format

Most of the first page of the standard fire policy is a declarations section in
which is printed such information as the insurerd's name and address, the
policy inception and expiration dates, the description and location of the
property covered, the perils insured against, the amount of insurance
applicable to each peril, and the code numbers of the forms and
endorsements that are attached. The standard fire policy plus the descriptive
form may be modified by one of more other forms or endorsements. These
other forms may add, for example, business interruption insurance or extra
expense insurance. Endorsements may increase or decrease the coverage.
For example, they may add additional perils or exclude some parts of a
covered building, such as the foundations.

The first page also contains a brief insuring agreement that states the
insurer’s basic promise. The second page describes such matters, as perils
not included, uninsurable and excepted, property, cancellation, and
requirements in case a loss occurs.

Types of Policies

There are different types of fire policies, some of the important policies
include the following:
1. Valued Policy: This is a policy where the value of the property to be
insured against fire and allied perils is determined at the time the policy
is issued. Under valued policy also referred to as “ordinary fire
insurance policy,” the insurer pays the total value of damaged property
irrespective of the market value of the property at the time of destruction
or loss.
2. Valuable (Automatic Reporting) policy: Under this policy the indemnity
to be paid by the insurer is to be determined at the time of the loss or
after the loss has taken place. This policy is often used for properties
where their value cannot be accurately determined at the inception of the
contract, example, a building in process.
3. Floating Policy: Under this policy the insurer covers the interest of the

89
 insured on assets in different locations. Comprehensive Policy: This form
of fire insurance policy gives full protection, not only against the risk of
fire but all related perils such as riot; theft; damage by vehicles, animals
or articles from the air, including aircraft and the like.

Rating

The rate of any given policy of protection varies in relation to the nature of
the property, location, type of perils insured against, the actual cash value of
the property, duration of the policy, and other similar factors that will have a
bearing impact on the risk to be assumed by the insurer. In general, after
consideration of such factors, fire insurance basic rates are expressed in
terms of cents per 100 birr value for a base of one year. In other words the
rules of percentages is used in the computation of the premium rates.

To illustrate, assume that a property valued at 80,000 birr was insured at 60¢
per one hundred for a protection of one year, the premium required can be
computed as follows:
Value of the property
Premium = X Protection rate
100

Birr 80,000
= X 0.60
100

= Birr 480, premium for one year

Once the premium for one year is determined, it can be extended for any
number of years as required by multiplying the annual rate and the long-term
rate that can be determined by the company as in case of the mortality rate
for different stages of age. To illustrate let us assume that the long-term
rates for a given insurer are determined as follows:

Term Long-term rates

2 years 1.85 times the annual rate
3 “ 2.70 “ “ “
4 “ 3.50 “ “ “
5 “ 4.40 “ “ “

90
 Further, if we assume that there is an insured who wants to have an
insurance policy for his 20,000 birr worth at the annual rate of 25¢ per one
hundred birr value, we can determine the premium required for one year or
three years policy as follows:
Br. 20,000
Premium for one year = X 0.25 = Br. 50
100

Premium for three years = Br. 50 X 2.70 = Br. 135

Similarly, a house valued at 24,000 Br. is insured annually for 80

percent of its value at 36 ¢ per one hundred birr, the premium for four years
can be computed as follows:
Premium base (insurable value) is:
Br. 24,000 X 80 = Br. 19,200
100

Annual premium = 19,200 X 0.36 = Br.69.12

100

Premium for four years = Br. 69.12 X 3.5 = Br. 241.92

Settlement of Losses

Settlement of loss depends on the type of policy carried or the agreement

made at the inception of the policy between the insurer and the insured. For
illustration consider the following cases:
1) Settlement under ordinary fire insurance policy (OFIP) or
standard fire insurance policy. Here the insurer pays the full
amount of the loss up to the face value of the policy.
Example: A house that was valued at Br. 30,000 was insured for Br.
25,000. If a loss of 20,000 birr 25,000 birr and 30,000 birr has
occurred, the insurer will pay 20,000 birr, 25,000 birr and
25,000 birr respectively.

2) Settlement of loss from more than one insurer: when the

insured has carried insurance from more than one insurer and a
loss has occurred the different insurers would contribute to the
loss on pro rata basis up to the amount of the face value of the
policy on the amount of the actual loss.

91
Example: An apartment building was insured under the following: with
insurer ‘A’ for Br. 50,000 and with insurer ‘B’ for Br. 30,000.
Assuming a loss of Br. 32,000 has occurred, the two insurers
would contribute to the loss as follows:
A = Br. 50,000 X Br. 32,000 = Br. 20,000
Br. 80,000

B = Br. 30,000 X Br. 32,000 = Br. 12,000

Br. 80,000

Total indemnity for the insured = Br. 32,000

3) Settlement under coinsurance fire policy. When the policy is

carried on the basis of coinsurance clause the insurer will have
the right to make the insured pay part of the loss if he is
underinsured.

Example: Assume that an insured six months ago purchased Br.100,000

of insurance on property with an actual cash value of Br.150,000. Assume
further that the insurance contract contained an 80 percent coinsurance
clause. If the property is worth 200,000 birr today, the amount the insurer
would pay toward a loss today would be computed as follows:
Amount of insurance carried
Indemnity = X loss
(Coinsurance %) value at time of loss

But not to exceed the loss or the amount of insurance, or

Br. 100,000
X loss
0.80(Br. 200,000)

= 5/8 X loss

If the loss were Br. 80,000 the insurer would pay Br. 50,000.
If the loss were Br. 170,000, the insurer would pay Br. 100,000, the
amount of insurance. The answer will always be the amount of
insurance when the loss exceeds the required insurance.

92
The term coinsurance has different meanings in insurance. In health
insurance the coinsurance clause is simply a straight, deductible, expressed
as a percentage. Its purpose in health is to make the insured bear a given
proportion, say 20%, of every loss, because it has been found through
experience that without such a control, the charges for doctors and other
medical services tend to be greatly enlarged, thus increasing the premium to
a prohibitive level. The insured that must personally bear a substantial share
of the loss is less inclined to be extravagant in this regard.

In fire insurance, the coinsurance clause is a device to make the

insured bear a portion of every loss only when underinsured.

7.1.2. Marine Insurance

Marine insurance is designed to protect against financial loss resulting from

damage to, or destruction of owned property, due to the perils primarily
connected with transportation. It is a contract of transport insurance whereby
the insurer undertakes to indemnify the insured in the manner and to the
extent thereby agreed, against losses and damages involved in being
transported. In consideration of the payment of a certain sum called the
“premium,” the insurer (underwriter), agrees to indemnify the insured (the
client) against loss or damage caused by certain specified perils, termed
“maritime perils.

The marine Cargo Policies of Ethiopian Insurance Corporation are

internationally accepted, worded and standardized insurance policies.
Accordingly, the coverage it affords is to indemnify the insuring public as
per the terms, conditions, warranties, and exceptions of the policy in respect
of loss of or damage to the cargo insured mainly resulting from maritime
perils: (heavy weather, stranding, collision, etc.) or inland-transit accident
(such as collision, overturning of the carrying conveyance, explosion, fire,
theft, non-delivery of the goods, etc.)

Marine insurance is divided into two classes: ocean marine and inland
marine.

93
Ocean Marine Insurance

Contracts concerned primarily with water transportation are considered to be

ocean marine insurance. For a considerable time ocean marine insurance was
the only kind of modern insurance.

Insurance has been developed and has attained a high degree of

refinement in modern-day commerce. As world trade grew and values at risk
became larger, the need for coverage become more apparent. Larger ships
and more refined instruments of navigation made long voyages possible, and
with this development insurance protection was looked upon as almost a
necessity.

Major Types of Coverage

The four chief interests to be insured in an ocean voyage are:

1. The vessel, or the hull
2. The cargo
3. The shipping revenue or freight received by the ship owners
4. Legal liability for proved negligence

If a peril of the sea causes the sinking of a ship in deep water, one or more of
these losses can result. However, each of these potential losses can be
covered under various insurance policies.

Hull Policies

Policies covering the vessel itself or hull insurance are written in several
different ways. The policy may cover the ship only during a given period of
time, usually not to exceed one year. The insurance is commonly subject to
geographical limits. If the ship is laid up in port for an extended period of
time, the contract may be written at a reduced premium under the condition
that the ships remain in port. The contract may cover a builder’s risk while
the vessel is constructed.

Cargo Policies

Contracts insuring cargo against various types of loss may be written to

cover only during a specified voyage, as in the case of a hull contract, or on
an open basis. Under the open contract, there is no termination date, but

94
either party may cancel upon giving 30 days’ written notice to the other;
otherwise the insurance is continuous. All shipments, both incoming and
outgoing, are automatically covered. The shipper reports to the insurer at
regular intervals as to the values shipped or received during the previous
period.

Cargo policies written on a voyage basis cover that single voyage, but
open policies usually cover all shipments made on and after a certain date. If
an open policy is cancelled, the coverage continues on shipments made prior
to the cancellation date.

Freight Coverage

The money paid for the transportation of the goods, known as freight, is an
insurable interest because in the event that freight charges are not paid,
someone has lost income with which to reimburse expenses incurred in
preparation for a voyage. The earning of freight by the hull owner is
dependent on the delivery of cargo unless this is altered by contractual
agreements between the parties. If a ship sinks, the freight is lost and the
vessel owner loses the expenses incurred plus the expected profit on the
venture. The carrier’s right to earn freight may be defeated by the occurrence
of losses due to perils ordinarily insured against in an ocean marine
insurance policy. The hull may be damaged so that it is uneconomical to
complete the voyage, or the cargo may be destroyed, in which case, of
course, it cannot be delivered. Also the owner of cargo has an interest in
freight arising from the obligation to pay transportation charges. Freight
insurance is normally made a part of the regular hull or cargo coverage
instead of being written as a separate contract.

Legal Liability for Proved Negligence

In ocean marine insurance policies the hull owner is protected against third –
party liability claims that arise from collisions. Collision loss to the hull
itself is included in the peril clause as one of the perils of the sea. The
liability insurance is intended to give protection in case the ship owner is
held liable for negligent operation of the vessel which is the proximate cause
of damage to certain property of others. The vessel owner or agent of that
owner who fails to exercise the proper degree of care in the operation of the
ship may be legally liable for damage to the other ship and for loss of freight
revenues.

95
Loss Settlement

If the cargo is totally destroyed, the insurer must pay the face value of the
policy. If the cargo is only partially damaged the insured and the insurer
must agree on the percentage of damage. If they cannot agree, the damaged
cargo is to be sold for the account of the owner and the amount received
compared, with what would have been received had the cargo been in sound
condition. In either case, the liability of the insurer is determined by
applying the percentage of damage to the amount of insurance.

For example, assume that a cargo insured for 4,000 birr could have been sold
for 6,000 birr in sound condition but are worth only 4,500 birr in damaged
condition. Since, the damage is 25 percent, the insurer must be pay 25
percent of 4,000 birr. Note that if the amount of insurance is less than the
value of the cargo in sound condition, the amount of the insurance payment
is equal to the amount under a 100 percent coinsurance clause.

Inland Marine Insurance

Inland marine cargo insurance covers shipments primarily by land or by air.

Although the trucker, railroad, or airline may be a common carrier with the
extensive liability (balled liability exposures), the shipper may still be
interested in cargo insurance because:
1. It is usually more convenient to collect from an insurer than a carrier,
2. A common carrier is not responsible for perils such as an act of war,
exercise of public authority, or inherent defects in the cargo.

No one cargo insurance contract exists. Instead, different insurers may issue
different contracts, and a given insurer will tailor the contract to the
insured’s needs. A convenient way to classify the contracts is according to
the type of transportation covered. One or more of the following modes of
transportation may be covered-railroad, motor truck, or air. Shipments by
mail are covered under separate first- class mail, parcel port, or registered
mil insurance.

7.1.3. Fidelity Guarantee Insurance

Fidelity guarantee insurance indemnifies an employer for any loss suffered
at the hands of dishonest employees. It provides guarantee against loss
through the dishonesty or incapacity of individuals who are trusted with
money or other property and who violate this trust.

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 Cashiers and others who handle money, and other persons employed
in positions of trust, are frequently required by their employers to provide
security as protection against their personal dishonesty usually in the form of
fidelity guarantee policy. The policy indemnifies the employer against losses
from the dishonesty of his employees. The employer himself often takes out
the policy. He may insure a number of employees either individually or in a
group basis under a variety of policies.

Unlike other policies, fidelity guarantee policies specify a time limit

to discover the loss and report it to the insurer after the resignation,
dismissal, retirement, or death of the employee in question. Hence, while the
insurer undertakes to make the insured’s financial losses lighter, it is also a
requirement that the insured should
1) Inform the insurer of such fraudulent act immediately upon
discovery
2) Either obtain admission of fraud or take appropriate legal action
to establish fraud, and
3) Cooperate with the insurer to bring the defaulter before the
court of law.

In addition, before accepting the risk the insurer considers employer’s type
of establishment, methods of selecting employees, working conditions,
emoluments and benefits in relation to the responsibility assigned,
supervision and control measures effectiveness.

7.1.4. Theft Insurance

Although theft is generally one of the perils covered under an all risks
policy, the contract usually excludes or limits the amount of protection on
certain types of property, such as money, that is highly susceptible to theft
losses.

Theft insurance protects a business against losses by burglary,

robbery, or some other form of theft by persons other than employees.
Fidelity guarantee insurance or dishonesty insurance covers losses caused by
dishonest acts of employees.

Burglary is the act of unauthorized entry, with criminal intentions into

any building or residence. It is the unlawful taking of property from within

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premises closed for business, entry to which has been obtained by force.
There must be visible marks of the forcible entry. Thus, if a customer hides
in a store until after closing hours, or enters by an unlocked door, steals
some goods, and leaves without having to force a door or a window, the
definition of burglary is not met under a burglary policy.

Robbery, on the other hand, is defined to mean the unlawful taking of

property from another person by force, by threat of force, or by violence.
Personal contract is the key to understanding the basic characteristic of the
robbery peril. However, if a burglar enters a premise and steals the wallet of
a sleeping night guard, this crime is not one of robbery because there was no
violence or threat thereof. The person robbed must be cognizant of this fact.
On the other hand if the thief knocks out or kills the guard and then robs the
guard or the owner, the crime would be classed as robbery. Robbery thus
means the forcible taking of property from a messenger or a custodian.

According to the EIC burglary policy it does not cover losses or theft
committed by:
1) Members of the insured’s household,
2) The insured himself or his assignee,
3) Theft connected with war (declared or undeclared) or any kind
of population uprising, or
4) Theft of valuables including documents and works of art unless
agreed pre hand. In addition, failure to disclose material facts at
the time of writing the policy will also make any theft claims
null and void.

7.2. Liability Insurance

Liability insurance is a contract that protects the insured against legal

responsibility for losses to the person or property of others.

7.2.1. Automobile Insurance

Most automobile insurance contracts are schedule contracts that permit the
insured to purchase both property and liability insurance under one policy.
The contract can be divided, however, into two separate contracts one
providing insurance against physical damage to automobiles and the other
protecting against potential liability arising out of the ownership or use of an
automobile.

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 The object of automobile insurance is to indemnify the insured against
accidental loss or damage to his auto and/or his liability at law for bodily
injury or material damage caused by the use of the motor vehicle, subject to
the terms and conditions and to the cover granted.

There are two main types of insurance covers in both motor

commercial and motor private insurance, viz.
Comprehensive cover and third party cover.
a) Comprehensive Cover:- A comprehensive cover provides
protection against a wide range of contingencies. It includes
indemnity in respect of the insured’s legal liability for death or
bodily injury or damange caused to the property of third parties
arising out of the insured’s vehicle. The policy also indemnifies
the insured in respect of all damages to the vehicle caused by an
accidental, external physical means as a result of collision,
overturning, fire, self-ignition, lightning, explosion, and
burglary.

The policy excludes, among other things, the following:-

- Consequential loss sustained by the insured,
- Wear and tear /depreciation/ of motor vehicle,
- Mechanical or electrical breakdown of failure of any part of a
motor vehicle,
- Death of or injury to members of insured family or his
employees,
- Damage to property of the insured or held by him in trust or in
custody.

b) Third Party Cover: - There are two parties involved in an

insurance contract, the insurer and the insured. Accordingly,
any other person who may become linked in some way with the
insurance is regarded as third party. A third party only policy
covers the insured’s legal liability (i.e., property damage, death,
and injury) towards other people in the event of an accident
arising out of the use of a motor vehicle.

A third party policy may be extended to include at an additional

premium the policy holder’s vehicle against the risks of fire and
theft as follows:-

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 - Third party, fire and theft
- Third party and fire
- Third party and theft.
The basic cover guaranteed by the Ethiopian Insurance
Corporation’s policies can be extended to cover additional risks
at an additional premium.

Classification of Risks

There are various categories of automobile risks and a distinction is made in

accordance with the use and type of the vehicles. The main classifications
are as follows:-

1. Private Vehicles: - A motor vehicle used solely for private (social,

domestic, pleasure, professional purpose or business calls of the
insured) purposes are classified as “private vehicles” and are insured
under the “private motor vehicles policy.” The term “private
purposes” does not include use for hiring, racing, and carriage of
goods in connection with any trade or business.
2. Commercial Vehicles:- A wide rage of vehicles which carry goods and
passengers are classified under this heading and different rates of
premium are applied depending on their use and type.

7.2.2. Aviation Insurance

Aviation insurance is a comparatively recent phenomenon that has been

developing with the development of passenger planes, particularly “Jumbo
Jets.” The overall increase in the number of different passenger planes and
the increase in their value called for aviation insurance. Aviation insurance is
an insurance that provides protection against loss of or damage to the
different types of passenger and cargo planes, and associated losses.

Like automobile insurance, aviation insurance includes both property

insurance, on the planes and liability insurance.

Types of Policies

The most common types of policies under aviation insurance are:-

1) Aircraft comprehensive policy
2) Freight liability policy which includes airmail liability policy.

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Aircraft Comprehensive Policy:- This policy covers against three type’s of
potential losses:
a) Accidental damage to the aircraft, where protection is provided
for damage to the aircraft by accidents except those that are
specifically excluded on the policy;
b) Third party legal liability, where the insurer assumes the
responsibility to indemnify the insured for death of or bodily
injuries to, third parties (excluding passengers) and ground
damage;
c) Legal liability of the insured in respect of death of, or bodily
injuries to, passengers. Passengers’ baggage and personal
effects, which are registered, are also covered by the insurance.

Freight Liability:- In addition to passengers and crew an aircraft

carries cargo and mail. The airline operating the aircraft is liable if the
cargo or mail is lost or damage. The freight liability policy provision
requires the insurers to indemnify the insured against all sums which
the insured may become legally liable to pay to the owner of the cargo
as a result of loss or damage or mishandling of the cargo. The limit to
the amount of indemnity is generally stated in the freight liability
policy.

7.2.3. Workers’ Compensation/Employers’ Liability/ Insurance

Workers’ compensation insurance covers loss of income, medical, and

rehabilitation expenses that result from work related-accidents and
occupational disease. Insured workmen always retain the right to claim
damages. Employers’ liability claims become much more common, aided by
Trade Unions.

If an employee is killed or injured at work as a result of an accident

arising from defective premises or equipment than a court may award
damages against the employer. Any employer is liable for an employee who
suffers accidental bodily injury or disease while working for him. The
employee is thus entitled to compensation for injuries that may be temporary
or permanent. This compensation being unforeseen expenditure, the
employer finds it difficult to compensation such losses especially when it
involves a huge amount. An employer may therefore, take out an insurance
policy insuring himself against such claims by his employees.

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 The insurance which provided protection for injuries to employees
while at work, and a s a result make the employer liable for the loss, is called
workers’ compensation insurance.

In addition to buying insurance, the insured (employer) can lower the

loss claims by:
a) Providing a safe place of work to his employees,
b) Proper plant tolls, machinery and working implements, and
c) Hiring competent and sober fellow employees.

7.2.4. Public Liability Insurance

Public liability insurance was developed with employees’ liability insurance.

Once, public opinion had accepted the morality of being able to insure one’s
liability, and the availability of such insurance became known, the business
grew rapidly.

The policy provides compensation for legal liability for death, injury,
or disease to people other than employees (which should be covered by
employers’ liability policy). Public liability insurance provides what is
popularly termed “third party cover”. It indemnifies the insured in respect of
his legal liability for accidents to members of the public, or for damage to
their property, occurring in circumstances set out in the policy.

Under public liability insurance, policies are available to cover

liabilities attaching to:
a) Pedal cyclists
b) Private individuals. The so called “personal liability” policy is
available to protect private persons from claims arising due to
injury caused by such things as polished floor, a loose rooftile
or by pet animal. A pedestrian, for example, can incur heavy
liabilities by causing a serious road accident.
c) Product liability: liability arising out of defects of goods
produced or sold.
d) Professional men such as doctors, dentists, solicitors, and
bankers may take out policies to protect themselves from claims
arising out of negligence or mistake committed in the exercise
of their professional duties.

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 It should be noted that this form of cover might include or be included
with other risks. For example, a householder’s policy covering loss or
damage to the building an/or contents can be extended to cover the personal
liability of the owner and his family towards the public. Whereas liability
arising from the use of motor vehicles is always exclude, and must be
covered by a separate motor policy.

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 CHAPTER EIGHT

REINSURANCE

There are many risks in all classes of business which are too great for one
insurer to bear solely on his won account. Reinsurance is a method created
to divide the task of handling risk among several insurers. Naturally, the
insuring public wishes to effect cover with one insurer and the insurer who
in these circumstances accepts a risk greater than he considers it prudent to
bear, reinsures all or part of the risk with other direct insurers or with
companies which transact reinsurance business only.

Reinsurance may be defined as the shifting by a primary insurer,

called the ceding company, of a part of the risk it assumes to another
company, called the re-insurer. That portion of the risk kept by the ceding
company is known as the line, or retention, and varies with the financial
position of the insurer and the nature of the exposure. When a re-insurer
passes on risks to another re-insurer, the process is known as retrocession.

It is not good business to refuse to write insurance in excess of the

retention amount. Imaging the displeasure of the applicant and particularly
of the producer when the application is rejected or accepted in part. For
these and other reasons insurers commonly insure that portion of their
liability under their contracts in excess of their retention with one or more
insurers. This process is called reinsurance, the originating insurer is the
“primary insurer”, or “direct insurer”, and the accepting insurer is the “re-
insurer”.

8.1. Methods of Reinsurance

There are two main methods in which risks can be shared: facultative
reinsurance and automatic treaty.

Facultative Reinsurance

Facultative reinsurance is reinsurance on an optional basis. There is no

advance agreement between the ceding company and the re-insurer
regarding the sharing of risks and premiums. Under this arrangement a
primary insurer, in considering the acceptance of a certain risk, shops around
for reinsurance on it, attempting to negotiate coverage specifically on this

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particular contract. Each risk, which is offered, is described and this is
shown to the prospective re-insurers who are free to accept or decline as they
see fit. A life insurer, for example, may receive an application for birr 1
million of life insurance on a single life. Not wishing to reject this business,
but still unwilling to accept the entire risk, the primary insurer
communicates full details on this application to another insurer with whom it
has done business in the past. The other insurer may agree to assume 40%
of any loss for a corresponding percentage of the premium. The primary
insurer then puts the contract in force.

The reinsurance agreement does not affect the insured in any way.
The insured is generally not aware of the reinsurance process and the
primary insurer remains fully liable to the insured in event of loss.

As stated earlier the insurer retains the right to decide whether and
how much of his risk to submit for reinsurance. The re-insurer also retains
the right to accept or reject any business offered by the insurer.

Automatic Treaty

Under an automatic reinsurance treaty the ceding insurer agrees to pass on to

the re-insurer all business included within the scope of the treaty, the re-
insurer agrees to accept this business, and the terms e.g., the premium rates
and the method of sharing the insurance and the losses-of the agreement are
set. The ceding company is required to cede some certain amounts of
business, and the re-insurer is required to accept them. The ceding company
known in advance that it will be able to obtain reinsurance for all exposures
that meet the conditions specified in the treaty. The amount that the ceding
company keeps for its own account is known as its retention, and the amount
ceded to others is known as cession.

Forms of Reinsurance

The most important types of reinsurance treaties include:

a. Quota-share reinsurance
b. Surplus-share reinsurance
c. Excess of loss reinsurance

Quota Share Reinsurance: by this method the direct office arranges with re-
insurers to cede a fixed proportion of all its business of a certain class and

105
the re-insurer accepts that proportion in return for a corresponding
proportion of the premiums. Under a quota share split, the insurance and the
loss are shared according to some pre-agreed percentage. For example, if a
100,000 birr policy is written and the agreed split is 50-50, the re-insurer
assumes one-half of the liability; the insurer and the re-insurer each pays
one-half on any loss.

The method is not greatly favored because it means paying away a

proportion of the premium income where the direct office might safely retain
the whole of a risk. It is, however, a useful method for small offices or those
starting up a new class of business where in the early days one or two heavy
losses could swallow up all the income. The method is sometimes also used
between parent and subsidiary companies.

Surplus Share Reinsurance: Under surplus share reinsurance the

ceding company decides what its net retention will be for each class of
business. The direct office cedes to the re-insurer only those amounts, which
it does not wish to hold for its own account-the surplus or its retention. The
re-insurer does not participate unless the policy amount exceeds this net
retention. This retention is known also as a “line” and reinsures have a
maximum capacity of so many lines, or so many times the direct office’s
retention.

For example, if the agreement calls for cession of up to “ten lines” and
the direct office retains 25,000 birr, then ten times this amount can be ceded
to the re-insurer, i.e., 250,000 birr: in this way sums insured up to 275,000
birr can be accepted by the direct insurer knowing that he automatically has
the reinsurance he requires. It is of course not necessary (or possible) to fill
the whole capacity of the reinsurance treaty on each individual acceptance:
sometimes the acceptance will be entirely within the direct insurer’s
retention and the treaty will not be interested at all, and on other occasional
the treaty underwriters will only be ceded a limited amount which they
divide equally between them.

Using the earlier example of a ten line reinsurance treaty the position
of the treaty (reinsures) in different circumstances would be as follows:

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Original sum Direct insurer’s Ceded to Proportion to
insured retention treaty (reinsure) treaty (reinsure)
Br. 25,000 Br. 25,000 Nil Nil
50,000 25,000 Br. 25,000 50%
100,000 25,000 75,000 75%
275,000 25,000 250,000 90.9%
300,000 25,000 250,000* 83.3%
*The balance of 25,000 would have to be reinsured facultative of under a
second reinsurance treaty.

Excess of Loss Reinsurance. In this form of reinsurance the direct

insurer decides the maximum loss arising from any event or series of events
he is prepared to bear, and then arranges with re-insurers for them to pay the
excess of that amount up to an upper limit. The re-insurer agrees to be liable
for all losses exceeding a certain amount on a given class of business during
a specific period.

For example, the primary insurer may be prepared to pay up to 50,000 birr
any one loss, and he secures reinsurance for the excess of 50,000 birr up to a
further 200,000 the way in which various losses are divided is shown below:

Loss Direct insurer Excess treaty (Re-insurer)

Br. 10,000 Br. 10,000 Nil
50,000 50,000 Nil
70,000 50,000 Br. 20,000
100,000 50,000 50,000
250,000 50,000 200,000
300,000 100,000* 200,000

*I.e., its original retention of birr 50,000 plus a further birr 50,000 in excess
of the treaty’s (reinsurer’s) liability.

Such a contract is simple to administer because the re-insurers are

liable only after the ceding company has actually suffered the agreed
amounts of loss. Since the probability of large losses is small, premiums for
this reinsurance are likewise small.

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8.2. Government Regulation of Insurance

Government has laid down rules governing the conduct of business, and
insurance is no exception.

In the case of insurance (as one component of business activities)

special attention was given by the government to restructure and organize it
in a new form to satisfy social and economic interests of the general public
through the proclamation No. 68 of 1975, to provide for the establishment of
Ethiopian Insurance Corporation with an initial capital of 11 million dollars.
Thus, the insurance industry was challenged and stimulated by the
government to do its best.

Why Insurance is regulated

There are characteristics of insurance that set it apart from tangible-goods

industries and that account for the special interest in government regulation.

First, insurance is a commodity people pay for in advance and whose

benefits are reaped in the future (sometimes in the far distant future), often
by someone entirely different from the insured and who is not present to
protect self-interest when the contract is made.

Second, insurance is effected by a complex agreement that few lay people

understand and by which the insurer could achieve a great and unfair
advantage if disposed to do so.

Third, insurance costs are unknown at the time the premium is agreed upon,
and there exists a temptation for unregulated insurers to charge too little or
too much. Charging too little results in the long run in removing the very
security the insured thought was being purchased; changing too much results
in unwarranted profits to the insurer.

Finally, insurance is regulated to control abuses in the industry. As in any

line of business, abuses of power and violations of public trust occur in
insurance. These include failure by the insurer to live up to contract
provisions, during up contracts that are misleading and that seem to offer
benefits they really do not cover, refusal to pay legitimates claims, improper
investments of policyholders’ funds, false advertising, and many others.

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 The Ethiopian Insurance Corporation is the sole entity, which is
responsible for all affairs and practices of the insurance industry in the
country. The general objectives and function of the corporation being to:

1. Engage in all classes of insurance business in Ethiopia

2. Ensure that insurance services reach the bread masses of the people.
3. Subject to government regulations and provisions, promote efficient
utilization of both material and fanatical insurance resources.
4. Enter into contract.
5. Appoint agents or act as an agent for others in matters related to its
activities.
6. Manage, administer, supervise, and direct all insurance business
transactions and
7. Negotiate, arrange, underwrite and contract reinsurance treaties and with
foreign re-insurers.

109
 REFERENCE BOOKS
1. Greene, Mark R. & James Treschmann, Risk & Insurance, 6th ed. Cincinnati;
South - Western Publishing Co. 1984.
2. Williams, C. Arthur, Jr. and Heins, M. Richard, Risk Management and Insurance,
5th ed. New York, McGraw - Hill Book Co.1985.
3. George E. Redja, Principles of Risk Management & Insurance, Harper Collins
College Publishers, 1995.
4. C. Arthur Williams, Jr., Michael L. Smith, and Peter C. Young 8th ed., Irwin
McGraw-Hill, 1998.

110
CONTENTS PAGE

PART – I RISK AND RELATED TOPICS 1

CHAPTER ………………………………………………………… 1
INTRODUCTION……………………………………………………… 1
1.1 Risk Defined………………………………………. 1
1.2 Risk Versus Probability ………………………….. 2
1.3 Risk Versus Uncertainty …………………………. 2
1.4 Risk, Peril, and Hazard …………………………… 3
1.5 Classification of Risk …………………………….. 4
1.5.1. Financial Versus Non-financial Risks …. …... 4

1.5.2. Static Versus Dynamic Risks ………………. 5

1.5.3. Pure Versus Speculative Risks …………….. 5
1.5.4. Fundamental Versus Particular Risks ……… 8
1.5.5. Objective Versus Subjective Risks…………. 9

CHAPTER 2. RISK MANAGEMENT ………………………………… 12

2.1 What is Risk Management?………………….…… 12
2.2 Risk Identification ………………………………. 14
2.3 Risk Measurement ………………………………. 16
2.4 Risk Management &Probability Distribution …... 18

CHAPTER 3. I. RISK CONTROL TOOLS……………………… 34

3.1 Avoidance………………………………………. 34
3.2 Loss Retention (Assumption) ………………….. 35
3.3 Reduction and Prevention Measures …………… 37
3.4 Separation (Diversification) …………………… 38
3.5 Combination……………………………………. 38
3.6 Neutralization ………………………………….. 39
3.7 Transfer ……………………………………………….. 39
II. Selecting of Risk Management Tools ……………. 41
3.8. Conventional Approach (Insurance Method)… 41
3.9. Quantitative Approach …………………………… 43

PART - II INSURANCE 53

CHAPTER 4. NATURE AND FUNCTIONS OF INSURANCE ….53

4.1 Insurance not Gambling or Speculation ………… 56

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 4.2 Requisites of insurable Risk ……………………. 56
4.3 Benefits and costs of Insurance …………….…… 58
4.4 Functions and organization of Insurance ……….. 62

CHAPTETR 5. LEGAL PRINCIPLES OF INSURANCE

CONTRACTS …………………………………. 71
5.1 Principles of Insurable Interest ………………… 71
5.2 Principles of Indemnity ………………………… 74
5.3 Principles of Subrogation ………………………. 75
5.4 Principles of Utmost Good Faith……………….. 76
5.5 Principles of Contribution ……………………… 78
5.6 Essential Requirements of an Insurance
Contract …………………………………….…... 80
5.7 Events to be Covered Under Insurance
Contracts ……………………………………….. 81

CHAPTER 6. LIFE AND HEALTH INSURANCE……………… 83

6.1 Life Insurance …………………………………. 84
6.1.1. Basic Types of Life Insurance
Contracts………………………………… 85
6.1.2. Life Insurance Premiums ………………. 89
6.2. Health Insurance ………………………………. 98
6.2.1. Types of Health Insurance …………….. 98

CHAPTER 7. PROPERTY AND LIABILITY INSURANCE…. 101

7.1 Property Insurance…………………………….. 101
7.1.1. Fire Insurance …………………………. 101
7.1.2. Marine Insurance ……………………… 106
7.1.3. Fidelity Guarantee Insurance …………. 109
7.1.4. Theft Insurance ……………………….. 110
7.2 Liability Insurance………………………….… 111
7.2.1. Automobile Insurance…………………. 111
7.2.2. Aviation Insurance ……………………. 113
7.2.3. Worker’s Compensation Insurance …… 114
7.2.4. Public Liability Insurance …………….. 115

CHAPTER 8. REINSURANCE…………………………………………… 117

8.1 Methods of Reinsurance ……………………… 117
8.2 Government Regulation of Insurance ……….. 121

112
REFERENCE BOOKS …………………………………………… 123

REFERENCE BOOKS
5. Greene, Mark R. & James Treschmann, Risk & Insurance, 6th ed. Cincinnati;
South - Western Publishing Co. 1984.
6. Williams, C. Arthur, Jr. and Heins, M. Richard, Risk Management and Insurance,
5th ed. New York, McGraw - Hill Book Co.1985.
7. George E. Redja, Principles of Risk Management & Insurance, Harper Collins
College Publishers, 1995.
8. C. Arthur Williams, Jr., Michael L. Smith, and Peter C. Young 8th ed., Irwin
McGraw-Hill, 1998.

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