Insurance is a social device for spreading the chance of financial loss among a large number of people. Insurance protects against pure risk. Risk is the possibility of losing economic security. Risk can be of two kinds: speculative or pure And only pure risks are insurable Pure risk involves only two possible outcomes: loss or no loss, with no possibility of gain or profit Speculative Risk involves three possible outcomes: loss, no loss or profit The Law of Large Numbers: The average of the results obtained from a large number of trials should be close to the expected value. Underwriting: The process of selecting certain types of risks that have historically produced a profit. Peril: A potential cause of loss. Accident, fire, and theft are common perils. Hazard: Anything that increases the seriousness of a loss or increases the likelihood that a loss will occur. Adverse Selection: Is the tendency of person with a higher than average chance of loss to seek insurance at the average state, which if not Controlled by underwriting, result in higher than expected Loss levels. Insurance is not same as gambling. Gambling is creat a new speculative risk and socially is unproductive but insurance Deals with pure risk and socially is productive. Insurance is not same as hedging. Insurance involves the Transfer of pure risk and reduce objective risk but hedging Involves just the transfer of speculative risk not risk Reduduction. Types of Insurance: Private insurance, consist of health insurance, property and liabilty insurance. Government Insurance, cnosist of social insurance and other Government insurance programs. How does insurance work? You pay a fee called a premium, and in exchange, the insurance company agrees to pay you a certain amount of money -Basic Characteristics Of Insurance Pooling of losses Payment of fortuitous losses Risk transfer Indemnification -Pooling of losses Spreading of losses incurred by the few over the entire group. • Key mechanism is “law of large number”. • Future losses are predicted based on law of large number. Note • Pooling of loss is the spreading of losses incurred by the few over the entire group so that in the process average loss is substituted for actual loss. • The primary purpose of pooling is to reduce the variation in possible Outcomes , which reduces risk. -Payment of fortuitous losses A fortuitous loss is one that is unforeseen and unexpected and occurs as a result of chance. Insurance policies do not cover intentional losses -Risk Transfer Risk transfer means that a pure risk is transferred from the insured to the insurer,who typically is in a stronger Financial position to pay the loss than the insured. -Indemnification Means that the insured is restored to his or her approximate financial position prior to the occurrence of the loss. - Insurable Risk Insurer normally insure only pure risk.

1. Insurance Practice and Procedure
by Maryam Sholevar
Presenting at
Department of Banking and Finance
Maryam Sholevar Jimma University

2. Chapter One
Introduction
Insurance is a social device for spreading the chance of financial loss among
a large number of people. Insurance protects against pure risk.
Risk is the possibility of losing economic security.
Risk can be of two kinds: speculative or pure And Maryam Sholevar Jimma University

3. Pure Risk
Pure risk involves only two possible outcomes:
loss or no loss, with no possibility of gain or profit
Maryam Sholevar Jimma University

4. The Law of Large Numbers:
The average of the results obtained from a large number of trials should
be close to the expected value.
Underwriting:
The process of selecting certain types of risks that have historically
produced a profit.
Peril:
A potential cause of loss. Accident, fire, and theft are common perils.
Hazard:
Anything that increases the seriousness of a loss or increases
the likelihood that a loss will occur.
Maryam Sholevar Jimma University

5. Adverse Selection:
Is the tendency of person with a higher than average chance
of loss to seek insurance at the average state, which if not
Controlled by underwriting, result in higher than expected
Loss levels.
Insurance is not same as gambling. Gambling is creat a new
speculative risk and socially is unproductive but insurance
Deals with pure risk and socially is productive.
Insurance is not same as hedging. Insurance involves the
Transfer of pure risk and reduce objective risk but hedging
Involves just the transfer of speculative risk not risk
Reduduction.
Maryam Sholevar Jimma University

6. Types of Insurance:
Private insurance, consist of health insurance, property and
liabilty insurance.
Government Insurance, cnosist of social insurance and other
Government insurance programs.
Maryam Sholevar Jimma University

7. How does insurance work?
You pay a fee called a premium, and in exchange,
the insurance company agrees to pay you a certain
amount of money
Maryam Sholevar Jimma University

8. HISTORY OF INSURANCE
Origins in China
Chinese merchants to reduce their risks,
split the shipment into smaller portions and
placed them on several boats.
They knew that if one did sink,
the majority of the cargo
would reach its destination safely.
Maryam Sholevar Jimma University

9. Basic Characteristics Of Insurance
Pooling of losses
Payment of fortuitous losses
Risk transfer
Indemnification
Maryam Sholevar Jimma University

10. Pooling of losses
Spreading of losses incurred by the few over the entire group.
• Key mechanism is “law of large number”.
• Future losses are predicted based on law of large number.
Note
• Pooling of loss is the spreading of losses incurred by the few over the
entire group so that in the process average loss is substituted for actual loss.
• The primary purpose of pooling is to reduce the variation in possible
Outcomes , which reduces risk.
Maryam Sholevar Jimma University

11. Payment of fortuitous losses
A fortuitous loss is one that is unforeseen and
unexpected and occurs as a result of chance.
Insurance policies do not cover intentional losses
Maryam Sholevar Jimma University

12. Risk Transfer
Risk transfer means that a pure risk is transferred from
the insured to the insurer,who typically is in a stronger
Financial position to pay the loss than the insured.
Maryam Sholevar Jimma University

13. Indemnification
Means that the insured is restored to his or her approximate
financial position prior to the occurrence of the loss.
Maryam Sholevar Jimma University

14. Insurable Risk
Insurer normally insure only pure risk.
Not all pure risks are insurable
1. There must be a large number of exposure units.
2. The loss must be accidental and unintentional.
3. The loss must be determinable and measurable.
4. The loss should not be catastrophic.
5. The chance of loss must be calculable.
6. The premium must be economically feasible.
Maryam Sholevar Jimma University

15. Insurable Risk
1. There must be a large number of exposure units.
an insurance organization prefers to have a large
number of similar units when insuring
a possible loss exposure.
The concepts of mass and similarity are thus
considered before an insurer accepts a loss exposure.
Maryam Sholevar Jimma University

16. Insurable Risk
2. The loss must be accidental and unintentional.
Loss should be fortuitous and outside the insured’control.
Two purposes of this requirement are :
1. If intentional losses were paid, moral hazard
would be substantially increased.
2. Law of large number requires random occurrence
of events.
Maryam Sholevar Jimma University

17. Insurable Risk
3. The loss must be determinable and measurable.
Purpose of this requirement is to enable an insurer
to determine if the loss is covered under the policy,
and if it is covered, how much should be paid.
Maryam Sholevar Jimma University

18. Insurable Risk
4. The loss should not be catastrophic.
This is to ensure that a large proportion of
exposure units should not incur losses at the
same time.
Maryam Sholevar Jimma University

19. Insurable Risk
5. The chance of loss must be calculable.
Both average frequency and the average severity
of future losses with some accuracy.
Purpose of this requirement is to assess
the appropriate premium.
Maryam Sholevar Jimma University

20. Insurable Risk
6. The premium must be economically feasible.
For the insurance to be attractive purchase,
the premiums paid must be substantially less
than the face value
Maryam Sholevar Jimma University

21. unique characteristics of insurance contracts
• Insurance contracts are contracts of adhesion, which is a
take it or leave it contract.
• Insurance contracts are unilateral in that there is only one promise
made and it’s made by the insurer to pay in the event of a loss.
• Insurance contracts are conditional. Two types of conditions:
1) conditions precedent; and 2) conditions subsequent.
A condition precedent is a condition that must be fulfilled to activate
the contract.
Conditions subsequent
are acts or duties that must be adhered to in order to receive the benefits of
the policy.
Maryam Sholevar Jimma University

22. unique characteristics of insurance contracts
• The insured must have an insurable interest.
• It is a contract based on the principal of indemnity
(insured cannot make a profit from a claim on insurance).
• Insurance contracts are aleatory in nature, which means The performance
of one or both parties is contingent on the occurrence of an event that may
never materialize.
• Utmost Good Faith – Both parties to the insurance contract almost totally
rely on the honesty of the other party. The insurer relies on the honesty
of the insured in providing underwriting information; the insured relies on
the honesty of the insurer that they will pay when a covered loss occurs.
Maryam Sholevar Jimma University

23. COST AND BENEFITS OF INSURANCE
BENEFITS
*Indemnification for losses
*Reduction of worry and fear
*Source of investment fund
*Loss prevention
*Enhancement of credit
COST
*Cost of doing business
*Fraudulent claims
*Infalted Claims
Maryam Sholevar Jimma University

24. Function Of Insurance
(i) Primary Functions
* Insurance provides certainty
*Insurance provides protection
*Risk-Sharing
(ii) Secondary Functions
*Prevention of loss
*It Provides Capital
*It Improves Efficiency
*It helps Economic Progress
Maryam Sholevar Jimma University

25. Inurance