Risk Management &

Insurance
CHAPTER ONE
Risk and Risk Related Topics
Introduction
Business, which refers to all those activities which are
connected with production or purchase of goods and
services with the objective of selling them at profit.
It has some essential characteristics and one of these is
the fact that it involves an element of risk and
uncertainty.
Because the adverse effects of risk have affected
mankind since the beginning of time, individuals, groups,
and societies have developed various methods for
managing risk.
Meaning of Risk
• Risk is potential variation in outcomes. When risk is present,
outcomes cannot be forecasted with certainty. William, Smith and
Young
• Risk is the condition in which there is a possibility of adverse
deviant from desired outcome that is expected or hoped for.
Vaughen
• Risk is a possibility of unfavorable deviation from expectation. It
is a possibility that something we want to happen fail to happen
but something that we don’t want to happen is happened.
• Risk is a possibility that a sentient entity will incur loss. This
means that the same loss may or may not be a risk for different
individuals depending on the sentient entity’s (individual or
business organization) ability or capacity to continue operation
without difficulty after suffering a certain loss.
Cont’d
• Common threads of the above definitions
1. there is the underly­ing idea of uncertainty, what we
have referred to as doubt about the future.
2. there is the implication that there are differing levels
or de­grees of risk
3. there is the idea of a result having been brought about
by a cause or causes
Risk & Uncertainty
• Risk is uncertainty about the outcome in a given
situation.
• Uncertainty is at the very core of the concept of risk
• risk can exist in the ab­stract; it is not dependent on
being recognized as existing by those who may be most
directly in­volved
• Risk is linked more to the event itself, rather than to any
personal perception of the existence of uncertainty.
• Unlike risk, uncertainty depends on being recognized.
• the basis of risk is lack of knowledge, re­gardless of
whether the state of lack of knowledge is recognized.
Risk, Peril, and Hazard
• Risk mean both the event, which will give rise to some loss,
and the factors which may influence the outcome of a loss.
E.g think of a house on a riverbank and the risk of flood
• Flood is the cause of the loss, and
• the fact that one of the houses was right on the bank of the
river influences the outcome
• Flood is the peril and the proximity of the house to the river is
the hazard.
• The peril is the prime cause; it is what will give rise to the loss.
Often it is beyond the control of anyone who may be involved.
• E.g. storm, fire, theft, motor accident and explosion are all
perils.
Cont’d
• Hazards –factors which may influence the outcome
• Hazards -conditions that create or increase the chance
of loss.
• It would facilitate the occurrence of peril.
There are three major types of hazards:
I. Physical hazards
II. Moral hazard
III. Morale hazard
Cont’d
I. Physical hazard is a physical condition that increases
the likelihood of loss. It relates to the physical
characteristics of the item or the property exposed to
the risk.
II. Moral haz­ard is dishonesty or character defects in an
individual that increases the frequency or severity of
loss. It is related with the human aspects which may
influ­ence the outcome.
III. Morale hazard refers to the carelessness or
indifference to a loss because of the existence of
insurance. E,g leaving car keys in an unlocked car,
which increases the chance of theft; leaving a door
Risk & Probability
• Chance of loss (probability of loss) is closely
related to the concept of risk.
• Chance of loss is defined as the probability that
an event will occur.
• Objective risk is the relative variation of actual
loss from the expected los
Classification of Risk
A. Objective and Subjective Risk
Objective risk – is the relative variation of the actual loss
from expected loss.
Objective risk declines as the number of exposures increases.
Objective risk can be statistically measured. it can rely on the
law of large numbers
Subjective risk – is uncertainty based on a person’s mental
condition or state of mind. The impact of subjective risk varies
depending on the individual.
. High subjective risk often results more conservative conduct,
while low subjective risk may result in less conservative
conduct.
Cont’d
B. Financial and Non-Financial Risk
A financial risk is one where the outcome can be
measured in monetary terms. E.g. material damage to
property, theft of property or lost business profit following a fire
A non-financial risk is one where the outcome can’t be
measured in monetary terms.
E.g : the selection of a career, the choice of a marriage partner,
having children
C. Pure and Speculative Risk
-Pure risks involve two possible outcomes a loss or, at
best, no loss.
Cont’d
• Major types of pure risks that are associated with great financial
and economic insecurity include personal risks, property risks,
and liability risks.
i. Personal risk-concerned with death and the time of its
occurrence. incapacity through accident, injury, illness or old
age under which there is possibility of losing earning power.
ii. Property risk: losses associated with ownership of property
such as destruction of property by fire, lightening, windstorm,
flood and other forces of nature.
It leads to direct loss and consequential loss.
• Direct loss – a financial loss that results from the physical damage,
destruction, or theft of the property.
• Indirect or consequential loss – a financial loss that results indirectly from
the occurrence of a direct physical damage, destruction, or theft.
Cont’d
iii. Liability Risk-is the possibility of loss arising from
intentional or unintentional damage made to other
persons or to their property.
Speculative Risk- a risk with a possible outcomes of gain
or loss.
• Pure risks are insurable and speculative risks are
uninsurable.
• Law of large numbers can be applied more easily to
pure risks than to speculative risks.
• Society may benefit from a speculative risk even though
a loss occurs, but it is harmed if a pure risk is present
Cont’d
D. Static and Dynamic Risks
Dynamic risk originates from changes in the overall
economy such as price level changes, changes in
consumer taster, income distribution, technological
changes, political changes etc,
They are less predictable and hence beyond the control
of risk managers.
Static risks -those losses that can take place even though
there were no changes in the overall economy.
they are predictable and could be controlled to some
extent by taking loss prevention measures.
Cont’d
E. Fundamental and Particular Risks
Fundamental risks-arise from causes outside the
control of any one individual or even a group of
individuals. Its effect is felt by large numbers of people.
e.g. earthquakes, floods, famine, volcanoes and other
natural ‘disasters’
Particular risks are much more per­sonal both in their
cause and effect.
• Particular risks arise from indi­vidual causes and affect
individuals in their conse­quences.
E.g fire, theft, work related injury and motor accidents.
Burden of Risk on Society
The size of an emergency fund must be increased.
Society is deprived of certain goods and services.
Worry and fear are present.
CHAPTER TWO
RISK MANAGEMENT
 Definition of Risk Management
Definition 1
• Risk management refers to the identification; measurement and
treatment of exposure to potential accidental losses almost always in
situations where the only possible outcomes are losses or no change in
the status.
Definition 2
• Risk management is a general management function that seeks to
assess and address the causes and effects of uncertainty and risk on
an organization. The purpose of risk management is to enable an
organization to progress towards its goals and objectives in the most
direct, efficient, and effective path. It is concerned with all risks.
Definition 3
• Risk Management is the executive function of dealing with specified
risks facing the business enterprise. In general, the risk manager deals
with pure, not speculative risk.
Cont’d
Definition 4
• Risk management is a systematic process to identify loss
exposures faced by an individual or business organization,
measure the frequency and severity of losses and selecting
and monitoring appropriate techniques to treat such
exposures.
• It is a strategy of pre loss planning for post loss resources.
• The risk management process starts when someone in the
organization asks questions like
 What kind of event can damage my business?
 How much damage can be suffered?
 What should I do about it?
Cont’d
• Risk management is not a one-time task rather it is a
continuous process.
• The risk manager has certain specific duties. These include:
a) Recognizing exposures to loss;
b) Estimating the frequency and size of loss;
c) Deciding 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.
d) Administering the programs of risk management, including
the tracks of constant revaluation of the programs, record
keeping and the like.
Objectives of Risk Management
• Pre-Loss Objectives and Post-Loss Objectives
• Pre-loss objectives: A firm has several risk management
objectives prior to the occurrence of a loss.
• The most important include economy, the reduction of anxiety,
and meeting externally imposed obligations.
• Post-loss objectives
• survival of the firm.
• to continue operating
• Stability of earnings
• continued growth of the firm
• the goal of social responsibility is to minimize the impact that a
loss has on other persons and on society
Contributions of Risk Management

To a Business
• risk management may make the difference between survival
and failure
• profits can be improved by reducing expenses as well as
increasing income, risk management can contribute directly
to business profits
• Indirectly
• peace of mind and confidence
• reduce the fluctuations in annual profits and cash flows
• Creditors, customers, and suppliers, all of whom contribute
to company profits, prefer to do business with a firm that
has sound protection against pure risks
Cont’d
• peace of mind made possible by sound management of pure
risks may itself be a valuable noneconomic asset
• help satisfy the firm’s sense of social responsibility or desire for a
good public image.
To a family
• enable a family to continue a lifestyle that might otherwise be
severely threatened or disrupted
• enable the family to reduce its expenditures for insurance
without reducing its protection
• if a family has adequate protection against the death or poor
health of a breadwinner; damage to or disappearance of their
property; or a liability law suit, they may be willing to assume
greater risks in equity investments or career commitments
Cont’d
• family members are relieved of some physical and
mental strain.
• families may also gain some satisfaction from a risk
management program that helps others as well as
themselves or that improves their image.
To the Society
• Society benefits from the more efficient use of risk
management through the reduction in social costs
associated with business and family financial reverses
The Risk Management Process
• The process involves four steps. These are:
1. Identifying loss exposures-is the first and perhaps the most difficult function that the
risk manager.
2. Measuring the losses-determination of the probability of losses, the impact the losses,
and the ability to predict the losses that will actually occur
3. Selection of the risk management tools-decision made with respect to the best
combination of tools to be used in attacking the problem (avoidance, loss prevention &
loss reduction, retention, transferring risk).
4. Monitor results of the decisions made and implemented to evaluate the wisdom of
those decisions and to determine whether changing conditions suggest different solutions.

Risk management may be described as both an art and a science.

Risk Identification
• A process by which an organization is able to learn areas in which it is
exposed to risk.
• Identification techniques are designed to develop information on
sources of risk, hazards, risk factors, perils, and exposures to loss.
Sources of Risk
Physical Environment-fundamental source of risk.
fully understand our environment and the effects we have on it - as well as
those it has on us.
E.g Earthquakes, drought, or excessive rainfall can all lead to loss.
Social Environment- Changing traditions and values, human behavior,
social structures, and institutions
Cont’d
Political Environment-A new party can move the nation into a policy
di­rection that might have dramatic effects on particular organizations
Legal Environment-expected laws and directives issued by the gov’t
Operational Environment-Processes and procedures of an
organization. procedure for promoting, hiring, or firing employees
may generate a legal liability. The manufacturing processes may put
employees at risk.
Economic Environment- local level, interest rates and credit policies
Cognitive Environment-difference between the perception of the risk
manager and reality. It is a challenging source of risk to identify and
analyze.
Identification of Exposures
• Physical asset-tangible assets and intangible assets (goodwill, political
support, intel­lectual property).
• Property may be damaged, de­stroyed, lost, or diminished in value in a number
of ways, e.g. time element loss.
• Financial asset-ownership of securities and financial instruments
• Such losses occur as a consequence of changing market conditions or changes
in the value of the rights
• Liability exposures-Obligations imposed by the legal system
• liability exposures do not have an upside unlike property exposures
• Human Asset (Personnel Loss) Exposures-Possible injury or death of
managers, employees, or other significant stakeholders.
• E.g. Economic insecurity, physical harm, unemployment, retirement
Risk Identification Techniques
• Organizational Charts-highlight broad areas of risk rather than
specific
• encourages the risk iden­tifier to take a birds-eye view of the organization
• Physical Inspections -inspection of plant processes or premises
• Checklists-deals with time consuming nature of physical inspection
• It implies a pro-forma is sent to the site for completion by someone there.
• It should be simple to understand, free from ambiguity, short, and should not
be threatening
• involves insurance policy checklist and exposure unit checklist
• Flow charts-production and distribution processes schematically.
• starts from raw materials end up with the final product
• It may be production, service, or money flow
Cont’d
• The Financial Statement Method- analyzing the balance sheet, operating
statements, and supporting documents
• Interactions with other Departments-oral or written reports from other
departments on their own initiative or in response to a regular reporting
system is helpful
• Interactions with Outside Suppliers and Professional Organizations-
accountants, lawyers, risk management consultants, actuaries or loss-
control specialists.
• Contract Analysis-examination of these contracts may reveal areas of
exposures
• Statistical Records of Losses
• Incident Reports
Risk Measurement
• the measurement of the potential loss as to its size and the probability
of occurrence.
Probability distributions
• risk manager, by using available data from past experience, tries to
construct a probability distribution of the number of events and/or the
probability distribution of total monetary losses.
Hypothetical Distribution of Vehicle Accident
Repair Costs in a Fleet of Vehicles
Year No. of Accident Amount of Loss Probability Expected Amount
of Loss
1 0 0 0.606 0
2 1 1000 0.273 273
3 2 2000 0.100 200
4 3 4000 0.015 60
5 3 10000 0.003 30
6 2 20000 0.002 40
7 5 40000 0.001 40
Sum 16 77000 1.000 643
Mean 2.29 11000
Required
A. Determine the average number of accident and total expected
amount of loss.
B. The probability that the business will incur some birr loss?
C. The probability that a sever loss will occur, If we assume a sever
loss is a loss that is equal or higher than 10000?
D. Determine the average loss per year.
The Poisson distribution
• a probability distribution that is often useful to in describing the
number of events that will occur in a given time period, area, volume
or any other unit of measurement.
Characteristics of a Poisson random variable
• The experiment consists of counting the number of times a certain
event occurs during a given time period, area, volume or any other
unit of measurement
• The probability that an event occurs in a give area, time or volume is
the same for all the units
• The numbers of event that occur are independent of each other; i.e. the
occurrence of one event will not affect the probable occurrence of the
Cont’d
• The only information required is number of accidents (Mean).

P(r) = where
e =2.71828
r = number of accidents
M =expected number of accident or M = n.p
n = number of exposure unit
P= probability
In a Poisson distribution mean equals variance; hence, standard deviation equals the square root
of the mean.
Example 1
• A can company reports that a number of breakdowns per 8 hour shift
on its machine operated assembly line follow a Poisson distribution
with mean of 2.6.
i. What is the standard deviation of the number of breakdowns?
ii. What is the probability that fewer than two breakdowns will occur
on the midnight shift?
iii. What is the probability that more than five breakdowns will occur
on the afternoon shift?
iv. What is the probability that exactly five breakdowns will occur on
the midnight shift? (Assume that the machine operates
independently across shifts).
Solution
a) The mean and variance of a Poisson distribution are equal; hence, standard deviation
equals the square root of the mean

σ= = =1.61
b) P(fewer than two defectives) = P(r < 2) = P(0) +P(1) using the formula

P(r) =

P (0) = =0.074

P (1) = = 0.193 then

P(r<2) = P (0) + P (1) = 0.074 + 0.193 = 0.267 this shows that there is a 26.7% chance that
fewer than two breakdowns will occur in the midnight shift.
Cont’d
a) P (more than five breakdowns) = P(r>5) = P(r > = 6) = 1-P(r < = 5)
P(r < = 5) = P (0) + P (1) + P (2) +P (3) +P (4) +P (5)

P (0) = =0.074

P (1) = = 0.193

P (2) = = 0.251
Cont’d

P (3) = = 0.218

P (4) = = 0.141

P (5) = = 0.074 then

P(r < = 5) = P (0) + P (1) + P (2) +P (3) +P (4) +P (5) = 0.074 + 0.193 + 0.251 + 0.218 +
0.141 + 0.074 = 0.951 hence,
P (r > 5) = 1- P (r <= 5) = 1- 0.951 = 0.049
Example
Example 2: The data presented below represents the number of cars operated (similar in type
of use) by a firm in each year, the corresponding number of accidents occurred and the total
monetary losses incurred in connection with the accidents.
Year Number of cars No. of Accidents Amount of loss
1 10 1 Birr 2500
2 12 2 4200
3 14 3 4500
4 15 3 6000
5 20 2 6500
6 20 3 6600
7 25 4 6000
8 25 5 8000
9 29 3 7500
10 30 4 10000
SUM 200 30 61800
MEAN 20 3 6180
Required
a. Calculate the probability of an accident?
b. Calculate the monetary loss per accident?
c. Suppose in year 11 the number of cars owned by the firm increased
to 40, construct the probability distribution of accidents?
d. Calculate expected number of accidents and expected amount of
loss.
e. Determine the probability of at least 13 accidents?
f. Calculate the probability of at least 3 at most 12 accidents?
g. Determine the Risk Relative to the Mean.
h. Risk Relative to the number of Exposure Units.
Binomial Probability Distribution
A binomial variable is an experiment that result in dichotomous
responses
Characteristics of binomial probabilities
• The experiment must have fixed number of trials
• The trials must be independent
• Each trial must have two possible outcomes
• The probability must remain constant for each trial
Cont’d
For a binomial random variable r, the probability of r can be obtained as

P (r) = .
Where n = number of experiment or trials
r = number of success observed
P = probability of success
q = probability of failure or q = 1- P
Mean (µ) = n.p
Variance ( ) = npq

Standard deviation (σ) =

Example 1
• The operation of a computer system is so critical that three of these
components are built for back up protection. The latest quality control
test indicates that this type of component has 10% failure rate.
Assuming that this is a binomial experiment, find the probability of
a. Among the 3 components at least 1 continues to work?
b. Among the 3 components, none continue to work?
Example 2
A fleet of 5 delivery trucks are operated by a business. If an accident happens to a
particular track, it becomes a total loss. New trucks are purchased at the beginning
of every year to make up the lost ones so that the firm always starts the new fiscal
period with a fleet of 5 delivery tracks.
Number of number of Total Monetary
Year Trucks accidents Loss

1 5 2 Birr 10000
2 5 2 10000
3 5 3 15000
4 5 2 10000
5 5 1 5000
SUM 25 10 50000
MEAN 5 2 10000
Required
Determine
a. Probability distribution of Number of accidents
b. Probability distribution of Total monetary losses
c. Probability distribution of expected number of accidents and
monetary losses
d. Risk relative to the mean number of accidents.
e. Risk relative to the mean monetary loss.
f. Risk relative to the number of exposure units
Normal Probability Distribution
• probability distributions of continuous random variables (variables that can
assume any value between two points).
• Represented by a bell shaped curve
• The entire distribution depends on two parameters; the mean and the standard
deviation.
• Standard normal distribution is a normal distribution that has a mean of 0 and
standard deviation of 1.
• A standard variable with a standard distribution, denoted by z is called a standard
normal random variable
• The area under a normal distribution corresponds to probabilities for the random
variable x.
Con’t
• For example the area A in the figure beneath the curve between the two points a and b,
which is the probability that x can assume a value between a and b (a < x < b).
• The normal curve is symmetric about its mean; z = 0 for standard normal distributions
and the area under the standard normal distribution is equal to 1.
• Consequently, the area on either side of the standard normal mean; z = 0 is equal to 0.5.
• That means the area to the right of z = 0 is 0.5 and the area to the left of z = 0 is also 0.5
F(x)

X
Exercises
• Example1 find the probability that the standard normal variable z falls between -1.33 and 1.33.
• Example2 find the probability that the standard normal variable z exceeds 1.64; that is find P (z>1.64)
• Example3 find the probability that the standard normal variable z lies to the right of – 0.74.
Con’t
Example 4
• A banker studying customer needs find that the number of times
people use automated teller machine (ATM) in a year is normally
distributed with a mean of 30.0 and standard deviation of 11.4. Find
the probability that the percentage of customers who use ATMs will be
between 40 and 50 times. Among 5000 customers how many are
expected to have between 40 and 50 uses in a year.
• In this example the mean is different from 0 and the standard deviation
is not 1. This indicates that this distribution is not a standard normal
distribution rather it is none standard normal distribution .
Con’t
• The normal curve table provides areas (probabilities) only for standard normal
distributions.
• Consequently we need a mechanism that change none standard normal
distribution to a standard normal distribution to use the normal curve tables.
• This can be done by using the formula

Z= where,

z = standard score; µ = mean; σ = standard deviation; x = none standard score.

Example 5
• Suppose an automobile manufacturer introduced a new model that has
an advertised mean in city mileage of 27 miles per gallon and standard
deviation of 3 miles per gallon. If you were to buy this model of
automobile, what is the probability that you would purchase one that
averages less than 20 miles per gallon for in city driving, assuming
that the in city mileage for this car model can be approximated by a
normal distribution with mean of 27 and standard deviation of 3.
Tools of Risk Management
• There are two basic approaches.
• First, the risk manager can use risk control measures to alter the
exposures
(1) to reduce the firm’s expected property, liability, and personnel
losses, or
(2) to make the annual loss experience more predictable.
Risk control measures include avoidance, loss prevention and reduction
measures, separation, combination, & some transfers.
Second, the risk manager can use risk-financing measures to finance the
losses that do occur. E.g. Purchase of insurance, retention/self-insurance
Risk Control Tools
i. Avoidance- means avoid the property, person, or activity with
which the exposure is associated by
(1) refusing to assume it even momentarily or
(2) an exposure assumed earlier
E.g. a firm that produces a highly toxic product may stop manufacturing
that product.
Advantage- the chance of loss is reduced to zero
Disadvantage- it may not be possible to avoid all losses; it may not be
practical or feasible to avoid the exposure.
Cont’d
ii. Loss Prevention and Reduction Measures
• the safety actions taken by the firm to prevent the occurrence of a loss or
reduce its severity if the loss has already occurred.
E.g. auto accidents can be prevented or reduced by having good roads,
better lights and sound traffic regulation and control, fast first-aid service
and control.
Loss Prevention Measures:
• Research on fire protection equipment and appliances.
• Construction using fire insensitive materials.
• Automatic smoke detectors, fire alarms.
• Burglar alarms in costly business situation, jewelry, and diamonds.
Cont’d
• Locational choice, avoiding construction near petrol stations, chemical reservoirs, waste
disposal areas, etc.
• Tight quality control to prevent risk of product liability.
• Educational programs to the public using available media.
• Multiple suppliers, buffer stocks.
• Safety measures, adequate lighting, ventilation, special work clothes to prevent
industrial accidents.
• Regular inspection of machinery to prevent explosions, breakdowns, etc..
• Accounting controls (Internal Control).
• Electronic metal detectors to check passengers for arms and explosives in the airline
business.
• Automatic gates at crossing lines to prevent collisions train and motor vehicles.
• Warning posters (NO SMOKING!! DANGER ZONE!!)
Cont’d
Loss Reduction Measures:
• Installing automatic sprinklers.
• First aid kit
• Evacuation of people,
• Immediate clean-up operations
• Fire extinguishers, guards.
N.B
To design effective LP and R measures, it may be helpful to identify the causes of
accidents.
The risk manager will have to design the LP and R measures in the most efficient
way in order to minimize such costs without reducing the desired safety level.
 Cont’d
Causes of accidents Loss prevention measures
-Working on dangerous equipment with less - Safety seminars, inspection at regular times
care
- Improper use of equipment - Training, safety seminars
-Violating Safety Procedures and - Safety seminars, warning, dismissal
Regulations.
- Human error, Negligence - Training, safety seminars
- Use of inappropriate tools - Provide appropriate tools
- Lack of protective clothing - Provide necessary protective clothing
- Use of defective equipment - Regular inspection and maintenance
- Inadequate Knowledge about the job Training
- Working while physically ill - Sick leave, don’t allow to work until
recovery
Cont’d
iii. Separation –Spreading the firm’s exposures to loss instead of
concentrating them at one location. “Don’t put all eggs in one basket”
 It is a loss reduction technique
 It reduces the maximum probable loss to one event
iv. Combination/Diversification
• Combination is a basic principle of insurance that follows the law of
large numbers.
• It increases the number of exposure units since it is a pooling process.
E.g. merger
Cont’d
• Diversification-another risk handling tool for most speculative risk
E.g. farmers diversify their products by growing different crops on their
land.
V. Non-insurance Transfer- it can be accomplished using two ways.
i. Transfer of the activity or the property.
ii. Transfer of the probable loss (The risk, but not the property or activity, may
be transferred)
Risk Financing Tools
a. Retention-the firm retains part or all of the losses that result from a
given loss exposure.
It can be used when;
First, no other method of treatment is available, insurance/ noninsurance
transfers may not be available.
Second, the worst possible loss is not serious.
Finally, losses are highly predictable.
b. Insurance-used for the treatment of loss exposures that have a low
probability of loss but the severity of a potential loss is high.
Cont’d
If the risk manager decided to use insurance, five key areas must be
emphasized.
• Selection of insurance coverage’s
• Selection of an insurer
• Negotiation of terms
• Dissemination of information concerning insurance coverage
• Periodic review of the insurance programs
CHAPTER THREE
INSURANCE
Chapter Objectives
• After completing this chapter you will be able to;
Define insurance
Explain the basic features of insurance
Describe the requirements of insurable risk
Compare and contrast insurance, speculation, and gambling
Discuss about the role of insurance
Chapter Outline
3.1 Introduction
3.2 Definitions
3.3 The basic characteristics of Insurance
3.4 The Requirements of insurable risks
3.5 Insurance, Speculation, and Gambling
3.5.1 Insurance Vs Speculation
3.5.2 Insurance Vs Gambling
3.6 Role and Importance of Insurance
Introduction
• Insurance plays an extremely important part in ensuring the economic
wellbeing of the country.
• Insurance service provided to industry, and individuals, has far
reaching benefits, both for those who insure and for the country as a
whole.
Definitions of Insurance
• Insurance can be defined from economic, legal, business, social and
mathematical point of views.
• Definition 1: insurance is a contract whereby, a consideration (price)
paid to a party adequate to the risk, becomes security to the other that
he shall not suffer loss, damage or prejudice by the happening of risks
specified in the contract for which he may be exposed to. (Legal
perspective).
• Insurance is a means of transferring risk for a premium (price) from the
insured to the insurer.
• Definition 2: insurance is an economic device where by individuals
substitute small certain cost (premium) for a large uncertain financial
loss that would exist if it were not for insurance. (Business perspective)
Cont’d
• Definition 3: insurance is an economic device for reducing and
eliminating risks through the process of combining sufficient number
of homogeneous exposures in to a group to make the losses more
predictable for the group as a whole. (Social perspective)
• Definition 4: insurance is an economic device by means of which the
risk of two or more firms or individuals are combined through actual
or promised contributions to a fund out of which claimants are paid.
• Definition 5: insurance is the pooling of fortuitous losses, by
transferring such risks to insurers, who agree to indemnify such losses,
to provide pecuniary benefits on their occurrence, or to render services
connected with the risk. (American risk and insurance association)
Basic Characteristics of Insurance
I. Pooling or sharing of losses: Pooling implies:
• The sharing of loss incurred by few by the entire group and
• Accurate prediction of losses based on the law of large numbers.
II. Payment for fortuitous losses:
• Fortuitous losses are losses that are unforeseen, accidental, unexpected or
something that happen as a result of chance. b/se
(1) the law of large numbers is based on random occurrence of events, and
(2) it helps to avoid moral hazard.
III. Risk transfer:
• transfer of pure risk from the insured to the insurer, who is in a better financial
position to pay the losses than the insured.
Cont’d
IV. Indemnification:
• the insurer restored the insured back in to his/ her former approximate
financial position before the loss.
V. Insurance is not charity:
• Charity is given without consideration, but insurance is not possible without
premium.
Requirements of Insurable Risk
• A risk can be insurable risk if it satisfies the following six conditions:
 Large Number of Exposure Units: there must be sufficiently large
number of homogeneous exposure units to make the losses reasonably
predictable. It can also enhance the financial capacity of the insurer.
 The loss must be accidental and unintentional: It must be something
that may or may not happen. The loss should be beyond the control of
the insured.
 This requirement is necessary for two reasons:
• First, if intentional losses were paid, moral hazard would be substantially
increased, and premium would rise as a result.
• Second, the loss should be accidental because the law of large numbers is
based on random occurrence of events.
Cont’d
 Determinable loss: requires the losses to be definite as to the cause,
place, time and amount.
 No catastrophic loss: happens when most of the covered exposures
experience loss at the same time.
• The problem of catastrophic loss can be minimized through the following ways;
• Re-insurance-insurance companies are indemnified by reinsurers for
catastrophic loss.
• Insurers can avoid the concentration of risk by dispersing their coverage over a
large geographic area.
• Calculable chance of loss: insurer must be able to calculate both the
average frequency and average severity of future losses with some
accuracy.
Cont’d
 Economically feasible premium: the cost of insurance should not be
too high compared to the possible loss. In order to have an economic
feasible premium, the probability of loss must be relatively low.
Based on these requirements, personal risks, property risks, and
liability risks can be privately insured, since the requirement of
insurable risk generally can be met.
While most financial risks, market risks, and political risks are
normally uninsurable by private insurers.
These risks are uninsurable because of the following reasons:
• These risks are speculative so are difficult to insure privately
• The potential of each to produce catastrophic loss is greater
Insurance, Speculation and Gambling

• Insurance Vs Speculation:
• Speculation is a transaction under which one party for a consideration agrees to
assume certain risks, usually in connection with business venture.
Insurance Speculation
It involves transfer of risk that is insurable It is a technique for handling a risk that is typically
uninsurable.

can reduce the objective risk of an insurer involves risk transfer not risk reduction.
by application of the law of large
numbers

only the risk will be transferred to the ownership can also be transferred to someone along with
insurer and the property or activity are the resulting potential losses and gains.
held as it is

predict losses based on law of large Speculators predict losses based on their skills
numbers
Insurance Vs Gambling
Gambling Insurance

The man who gambles creates a the man who purchase insurance
risk which did not exist before minimizes the risk which was
already in being
The gambler with the hope of the man who insures for the
gain goes out of his way to bring purpose of avoiding the loss goes
a risk in to being out of his way to hedge against a
risk which already exists
The man who gambles accepts the man who insure accepts
deliberately the risk of loss in deliberately small certain costs in
exchange for possibility of profit exchange for freedom from
catastrophic losses
The gambler bears the risk the insured transfers the risk.
Role and Importance of Insurance
Indemnification: permits individuals and families to be restored to
their former approximate financial position prior to the occurrence of
loss.
Less Worry & Fear: insurance can increase peace of mind.
Source of Investment Fund: funds (premium) not needed to pay for
immediate losses and expenses can be loaned to business firms.
Reduce Cost of Capital: Since the total supply of loanable fund is
increased by advance payment of insurance premiums, the cost of
capital to business firms that borrow is lower.
Loss Control: insurers are interested in keeping losses at minimum
although their main function is spreading of losses to members.
 CHAPTER FOUR
LEGAL PRINCIPLES OF
INSURANCE
Chapter Objectives
• Explain the principle of indemnity and its application
• Describe the concept of principle of insurable interest and its
application
• Explain how the legal concepts of representations, concealment, and
warranty support the principle of utmost good faith.
• Describe the essence of principle of subrogation
• Show the practice of principle of contribution and proximate cause
Contents
4.1 Principle of Indemnity
4.2 Principle of Insurable Interest
4.3 Principle of Subrogation
4.4 Principle of Utmost-Good Faith
4.5 Principle of Contribution
4.6 Principle of Proximate cause
4.1 Principle of Indemnity
• The principle of indemnity is one of the most important principles in
insurance.
• The principle of indemnity states that the insurer agrees to pay no
more than the actual amount of the loss; stated differently, the insured
should not profit from a loss.
• Most property and casualty insurance contracts are contracts of
indemnity.
• If a covered loss occurs, the insurer should not pay more than the
actual amount of the loss.
• The principle of indemnity does not apply to life insurance because the
value of human life cannot be measured in terms of money.
Purposes of principle of indemnity

• To prevent the insured profiting from the covered loss

• To reduce moral hazard- If the loss payment does not exceed the
actual amount of the loss, the temptation to be dishonest is reduced.
• Helps to maintain the premium at lower level.
Determination of Actual Cash Value
• The concept of actual cash value supports the principle of indemnity.
• Actual cash value means the monetary amount of cash for damage
during the loss.
Methods of determining actual cash value
1. Replacement cost less depreciation-it takes into consideration
inflation and depreciation of the property.
• ACV= Replacement cost-Depreciation
E.g. Purchasing price=$600
• Replacement cost=$700
• Depreciation=40%
• ACV= 700-0.4*700=$420
Cont’d
2. Fair market value-the price a willing buyer would pay a willing seller
under perfect/free market condition.
3. Broad evidence rule-the determination of actual cash value should
include all relevant factors (Replacement cost less depreciation, Fair
market value, present value of expected income from the property,
comparison sales of several property, opinions of appraisers etc).
There are several exceptions to the principle of indemnity:
a) Valued policies: is the one that pays the face amount of insurance
regardless of actual cash value if a total loss occurs.
b) Replacement cost insurance: means no deduction is taken for
depreciation in determining the amount paid for loss.
c) Life insurance: is an exception to the principle of indemnity.
4.2 Principle of insurable interest
• an insured must demonstrate the existence of financial relationship to the
subject matter insured; otherwise the insured will be unable to collect
amounts due when the insured peril occurs.
• The principle applies to both life and non-life insurance.
• Owner of property has a financial interest in the safety of the property
• Insurable interest of a wife in the life of husbands and vice versa
• A creditor has an insurable interest in the life of the debtor
Purposes of insurable interest
• To prevent gambling
• To reduce moral hazard
• To measure the loss
Cont’d…
• What constitutes insurable interest?
For property and liability insurance
• Legal title or ownership to a property
• Existence of potential legal liability
• Secured creditors; a commercial bank or savings and loan institution that
grants mortgages has an insurable interest in the property pledged.
For life insurance
• When purchasing life insurance in one’s own name, insurable interest is
not required.
• When purchasing life insurance in the name of others, insurable interest
is required.
Cont’d…
When insurable interest must exist?
• In life insurance contract -at the time of inception of the policy.
• In property insurance and liability insurance-the insured may not have
an insurable interest at the time the policy is written, but expected in
the future.
• In marine insurance -at the time of loss.
• In case of fire insurance insurable-at the time of inception of the
policy as well as at the time of loss.
4.3 principle of subrogation
• allows an insurer to sue a third party that has caused a loss to the insured and
pursue all methods of getting back some of the money that it has paid to the
insured as a result of the loss.
• For example, if you are injured in a road accident that is caused by the
reckless driving of another party, you will be compensated by your insurer.
However, your insurance company may also sue the reckless driver in an
attempt to recover that money.
• It doesn’t apply to life and personal accident insurance.
Purposes of subrogation
• Subrogation prevents the insured from collecting twice for the same loss.
• Subrogation is used to hold the guilty person responsible for loss.
• Subrogation tends to hold down insurance rates.
Cont’d…
Importance characteristics of subrogation
• The insurer is entitled only to the amount it has paid under the policy.
• The insured cannot impair the insurer’s subrogation right.
• The insurer can waive its subrogation right in the contract.
• The insurer cannot subrogate against its own insured.
• Subrogation is supplementary (corollary) to principle of indemnity.
• Subrogation does not apply to life and health insurance.
4.4 principle of utmost good faith
• imposes a higher standard of honesty on parties of insurance agreement than is
imposed on ordinary commercial contracts.
• Insurance contracts are based on mutual trust & Confidence.
• This means that both parties must make full disclosure of material facts that
have a bearing on the assessment of the risk.
• Intentional concealment, misrepresentations and fraud may lead to the
avoidance of the insurance contract.
• The application of this principle can be expressed in representation,
concealment and warranties.
• Representation: are the statements made by the insured on the insurance
application.
• Many of these representations are responses to questions to determine whether
the applicant is insurable and how much should be charged.
Cont’d…
• Concealment: it is the failure to disclose material information or
deliberately withholding material information from the insurer.
• Warranty: refers to a statement of fact or promise made by the
insured, which is part of the insurance contract and which must be true
if the insurer is to be liable at the time of loss.
4.5 Principle of contribution
• Principle of Contribution also supports the principle of indemnity.
• It applies to all contracts of indemnity, if the insured has taken out more than one
policy on the same subject matter.
Base of Contribution
1. pro-rata liability(contribution according to sum assured)
• each insurer’s share of the loss is based on the proportion that its insurance bears to the
total amount of insurance on the property.
2. Contribution by equal share
• Each insurers shares equally in the loss until the share paid by each insurer equals the
lowest limit of liability under any policy, or until the full amount of the loss is paid.
3. Primary and excess insurance
• In this case, the primary insurer pays first, and the excess insurer pays only after the
policy limits under the primary are exhausted.
Example
• Assume that Zoza Flour factory purchased three liability policies; the
first is with Ethiopian Insurance Corporation for Br. 30,000, the
second is with Awash Insurance corporation for Br. 40,000, and the
third is with Nyala Insurance for $Br. 10,000. Assume that Zoza incurs
a covered liability claim of $48,000. How much would each insurer
pay under each of the other-insurance provisions?
• Solution (pro rata liability)
Insurers Amount of coverage Proportion Amount of contribution
EIC Br. 30,000 3/8 3/8*48000= 18000br
Awash Br. 40,000 ½ ½*48000=24000
Nyala Br. 10,000 1/8 1/8*48000=6000
Total Br. 80,000 48,000
Cont’d
Equal Share contribution
Insurers Amount of coverage Proportion Amount of
contribution
EIC Br. 30,000 Br. 10,000+9000 Br. 19,000
Awash Br. 40,000 Br. 10,000+9000= Br. 19000
Nyala Br. 10,000 Br. 10,000 Br. 10,000
Total Br, 80,000 Br. 48,000

Primary-Excess Insurer contribution

Insurers Amount of coverage Proportion Amount of
contribution
EIC (primary insurer) Br. 30,000 Br. 30,000 Br. 30,000
Awash (Excess insurer) Br. 40,000 Br. 18,000 Br. 18000
Nyala Br. 10,000 0 -
Total Br, 80,000 Br. 48,000
4.6 Doctrine of proximate cause
• Proximate cause is the primary cause of an injury/loss.
• Proximate cause produces particular, foreseeable consequences without the
intervention of any independent or unforeseeable cause. It is also known as
legal cause.
• Proximate cause is the efficient cause which brings about a loss with no
other intervening cause which breaks the chain of events.
Determination of proximate cause
• If there is a single cause of the loss, the cause will be proximate cause and
further if the peril was insured, the insurer will have to indemnify the loss.
• If there are concurrent causes, the insured peril and the excepted peril
should be segregated. The concurrent cause may be separable and
inseparable.
Cont’d
• In separable cause if any cause is excepted peril, the insurer will have to pay
up to the extent of loss which occurred due to insured peril.
• When the perils are inseparable, the insurers are not liable at all when there
exist any excepted peril.
If the cause occurred in the form of chain, they have to be observed seriously.
• If there is unbroken chain, the excepted and insured perils have to be
separated.
• If the excepted peril precedes the insured peril, there is no liability
• If the insured peril precedes the expected peril, there is valid liability.
• If there is broken chain of events with no expected peril involved, it is
possible to separate the losses.
• The insurer is only liable only for that loss which is caused by the insured peril.
4.7 Functions of Insurance
 Rate making(insurance pricing)-The process of predicting future losses and
expenses and allocating these costs among various classes of insured.
Regulatory objectives
• Adequate rate; rate should be high enough to pay all losses and expenses.
• Not excessive; rate should not be so high that the policy owners are paying more than
the actual value of their protection.
• Not unfairly discriminatory; exposure that is similar with respect to losses and
expenses should not be charged substantially different rates.
Business Objectives
• Simplicity: the rating system should be easy to understand.
• Stability: rates should be relatively stable over time so that the public is not subjected
to wide variations in cost from year.
• Responsiveness: the rate should be responsive to changing loss exposures and
changing economic conditions.
Cont’d
Underwriting(selection of risk)-process of selecting and classifying
applicants for insurance. It aims to guard against adverse selection.
Production function(selling of insurance policy)-the process of
securing a sufficient number of applicants for insurance.
Claim settlement/loss settlement/managing claims- process of
providing the indemnification of those members of the group who
suffer losses.
Steps in claim settlement
• Notice of loss
• Investigation proof of loss
• Payment or denial of the claim
Cont’d
Investment- advance payment of premiums gives rise to funds that
must be invested in some manner.
Reinsurance
CHAPTER FIVE
LIFE AND HEALTH
INSURANCE
 Life Insurance
Life insurance can be defined as a social & economic device by which a group of
people may operate to make better the losses resulted from premature death or
living too long of members of the group.
Life insurance is a protection against two contingencies concerning life: dying
soon or living too long.
The first contingency is physical death due to which dependents may suffer
financial ruin. This means that if a bread winner dies at early age with unfulfilled
financial obligation (a loan to repay or dependents to support) the family will face
financial problems
The second contingency is financial death or economic death. This happens
when the individual gets older and become unable to work and generate income.
In other words, due to age reasons individuals may loss their ability to work and
earn income which may force the person to live at a reduced life standard or loss
their smart life they had previously.
Some Unique Characteristics of Life Insurance
 The event insured is eventually certain: this means that human beings
are mortal and no one alive forever.
 There is no possibility of partial loss in life insurance as there is the
case in property and liability insurance
 Life insurance is not a contract of indemnity
 In life insurance insurable interest is required at time of inception.
Types of Life Insurance
• The basic types of life insurance contracts are
Term insurance
 Whole life insurance
 Endowment insurance
 Annuity contracts
1. Term Insurance Policy
 A term insurance policy is a contract between the insured and the insurer
where by the insurer promises to pay the face value of the policy to a third
party (beneficiary) if the insured dies within a given period of time (policy
period).
 If the insured does not die within the specified period of time, the contract
expires and the policy is at the end.
 Term insurance policies are always without profit because benefits are
payable following the death of the insured.
 The different forms of term insurance include: straight term insurance,
renewable term insurance, convertible term insurance, decreasing term
insurance, increasing term insurance and level term insurance
Types of Term Insurance Arrangements
Straight term insurance: it is a term insurance written for a year or a specified number
of years and terminates automatically at the end of the designed period.
Renewable term insurance: is a term insurance contract in which the insured can
renew the policy before its expiration date with out making another medical
examination or with out proving insurability but at a higher rate according to the
attained age.
Convertible term insurance: in such term insurance arrangements where the policy
holder has the option to convert the policy into whole life or endowment policies
Decreasing term insurance: in such arrangement the policy amount declines as time
passes
Increasing term insurance: in such arrangement the sum assured grows by a
predetermined amount every year.
Level term insurance: in this arrangement the sum assured remain constant
throughout the policy period.
2. Whole Life Insurance
A whole life insurance policy is a contract between the insured and the insurer
where by the insurer promises to pay the face value of the policy to a third
party (beneficiary) whenever the insured dies.
Based on premium payments, whole life insurance can be divided in to three:
I. Straight Whole Life Insurance: the premiums are payable for the remainder
(rest) of the insured life time. This means the policy holder continues paying
the premium until he/she die.
II. Limited Whole Life Insurance: the insured continues to pay the premium
for a specified period of years, after which time no further premium payment
is needed.
III.Single Premium Plan: it involves payment of relatively large sum at the
issuance of the policy which will be large enough to make future premium
payments necessary.
3. Endowment insurance
Under this arrangement the policy amount is payable whether the insured die
within the policy period or not. Endowment insurance can be broadly classified as
Pure Endowment: the sum assured is payable if the life assured survives the
endowment period.
Thus pure endowment policy is the direct opposite of term insurance because
 In term insurance the benefit is payable if the life assured die within the term
of the policy but in pure endowment the sum assured can be collected if the
policy holder manages to survive the endowment period.
 Pure endowment is designed for the benefit of the policy holder where as
term insurance is designed for the benefit of dependents or others.
 Therefore, pure endowment has the element of investment and term insurance
has the element of protection
Cont’d
Pure endowment grants protection against living too long where as term
insurance grants protection against living too short (dying soon).
Pure endowment is an old age protection while term insurance is family
protection.
Ordinary Endowment: it provides an ideal combination of protection and
investment. It can be written for a specified period of years and the sum assured
being payable either on
the life assureds’ death during the endowment period or
his survival to the end of the endowment period.
Cont’d
It is a combination of pure endowment and term insurance for which the net
premium under ordinary endowment is the sum of the net premium under term
and pure endowment policies
This policy provides solutions to various problems of life associated with living
too long or dying soon.
In other words old age provision and family protection are possible by purchasing
only this single policy..
4. Annuity Contracts
 Annuity is a contract, which provides regular and periodic payment for a
specified period or for the remainder of the annuitants’ life time in exchange for a
lump sum payment of money by the annuitant.

 The insurer in exchange thereof under takes to pay a fixed sum periodically up to
the death or expiry of the term of the annuity.

 Thus annuity is a system of assured payment from insurer and is almost suitable
for the retiring person who does not want to take a risk of investing their hard
earned money in other forms of investment opportunity.
Cont’d
 An annuity is also beneficial to those who do not want to leave money for others
but to enjoy it during their life time.

 In annuity contract insurers do not require medical results.

 This is because at early death insurers do not suffer losses since payment will
stop following the death of the annuitant. However, evidence of age is essential at
time of proposal.

 The payment of annuity generally continues up to the life. Therefore, the

premium rate is determined based on longevity. The amount of premium is
higher at lower age and lower at advanced age.
 Difference Between Annuity and Other Life Insurance Contracts

Annuity Contracts Other life policies

Gradual liquidation of accumulated fund Provide gradual accumulation of funds
Designed for own benefit Designed for the benefit of
others/beneficiaries

Payment gradually stops at death Payment is usually made following death

Premium is calculated based on Premium is calculated based on mortality
longevity

It protection against living too long Provides protection against living too
short/dying soon
Underwriting Life Insurance/Selection of Risk
• Underwriting is the process of selecting and classifying applicants for
insurance. It involves
• Fixing standards of risk,
• Determining what risks are acceptable at standard rate,
• What risk at extra rate,
• What not to accept at all, and
• Assessing each individual case and putting it in one or the other class
of risk for the above purpose is called underwriting of insurance.
Purpose of Underwriting
The first and the foremost purpose of selection risk is to determine
whether the proposal should be accepted or rejected.
The second objective of selection of risk is to determine the rate of
premium to be charged on each policy holder
The third aim of selection of risk is to avoid any discrimination on the
part of the lives assured. Since the degree of risk is not the same for all
the persons, different premiums should be charged to different groups.
Underwriting is also essential to avoid adverse selection which refers
selection of persons for insurance who are not insurable, charging of
lesser premium or standard rate for those who are to be charged higher
premium.
 Factors to Be Considered In Life Insurance Underwriting

In life insurance, the factors which may affect the risk are usually
those factors which are affecting mortality/longevity which includes
 Age Sex
 Physical condition
Economic status
 Occupation
 Personal and family history  Defense service
 Residence  Martial status
 Present habits
 Insurable interest
Race and nationality
Health Insurance
Health insurance is defined as insurance against loss of sickness or accidental
bodily injury.
The loss may be loss of wage caused by sickness or accidental bodily injury or it
may be expenses of doctor bills, hospital bills, medicine and so forth.
There are two separate types of health insurance

1. Disability income insurance: this insurance provides regular and periodic

payment for those policy holders who lose their ability to work and generate
income due to sickness or bodily injury.

2. Medical expense insurance: this policy pays the cost of medical cares resulted
from sickness or bodily injury.
Life Insurance Premium
Determination
Insurance premium is the price of an insurance protection. It keeps the policy
enforce.
Premiums can be paid at one time as a single premium or periodically (annually,
semi annually or any else).
Types of Premium

• There are two types of premium: net premium and gross premium.
1. Net Premium: this is a premium rate determined on the basis of mortality rate and
interest rate.
It does not include the operating cost of the insurer.
It provides the insurer with the amount of money required to cover death claims.
Net premium can also be classified as net single premium and net level
premium.
Cont’d
A. Net Single Premium (NSP): when the total net premium of insurance policy is
to be paid as a single sum at the beginning of the policy it is called net single
premium (NSP).

NSP =

B. Net Level Premium (NLP): instead of paying the total NSP at one time policy
holders may prefer to pay a level premium periodically in an installment basis
throughout the term of the policy. This fixed amount of premium is called NLP.

NLP =
2. Gross Premium
 Gross Premium: It provides the insurer with the amount of money
required to cover death claim and cost of running the insurance
business.
 it is the sum of the entire insurer’s cost of running the business and the
net premium.
 The process of adding the cost of running the business on the net
premium is called loading.
Term Insurance Net Single Premium determination
The following information are required to determine the NSP
 Age and sex of the individual
 Mortality rate
 Interest rate
 Period of insurance policy
 Sum assured or face value of the policy
Example 1:
Nyala insurance company insures 100,000 males of age 30 for a death benefit of
10,000 birr each.
Assume that the premium is to be collected at the beginning when the policy is
issued and death benefits are to be paid at the end of the year.
Also assume that interest rate is 10% and each insured person is assumed to bring
the same level of risk to the underwriting class.
The mortality table given by the central statistics office is shown below for men
age 30 and above.
Age Mortality rate/
thousand
30 1.73
31 1.78
32 1.83
33 1.89
34 1.95
Cont’d
• Based on the above information
a) Calculate NSP if it is a one year term insurance contract

b) Calculate NSP if it is a three years term insurance contract

Cont’d
Solution a)
Step1: find probability of death = 1.73/1000 = 0.00173
Step2: find No. of insured dying = No. of living X probability of death
=0.00173 X 100,000 = 173
Step3: find expected amount of death claim = No. dying X face value of the policy
= 173 x 10,000 = 1,730,000

Step4: find Pv. factor of expected death claim = where, i interest rate and t time

Pv factor = = 0.9091
Cont’d
Step5: find Pv of expected death claim = Pv factor X expected death claim
= 0.9091 x 1,730,000 = 1, 572,743

Step6: apply the NSP formula NSP =

= 15.73
B) The Calculation of NSP for a Three Years Term Insurance

. Pv. of
Mortality Probability No. of No. of Face Death Pv. Death
year Age Rate/1000 of death Living dying value Claim Factor Claim
1 30 1.73 0.00173 100,000 173 10,000 1730000 0.9091 1572743
2 31 1.78 0.00178 99,827 178 10,000 1780000 0.8264 1470992
3 32 1.83 0.00183 99,649 182 10,000 1820000 0.7513 1367366
Total
4411101

NSP = = = 44.11
Term Insurance Net Level Premium determination (NLP)
• Instead of paying a single premium, the policy holder may prefer to pay
the net premium annually, quarterly, or monthly.
• In other words, the policy holder may want to make equal size of
payment annually, semiannually, quarterly or monthly.
• In net premium determination there are two points to be considered
 Not all policy holders will pay the annual premium, since some of them
are expected to die before the term of the policy
 The insurer is now collecting limited amount of money to invest at the
very beginning of the policy.
• Due to these facts the total annual level premium paid under level
arrangement is higher than the amount of premium under the net single
premium arrangement.
Cont’d
 Hence,

NLP =

Example 2: Ethiopian Insurance Corporation issues a three years term insurance

for 100,000 males of age 30 for a death benefit of 10,000 birr each.
Assume that premiums are to be collected throughout the term of the policy on an
installment basis and death benefits are to be paid at the end of the year.
Further assume that interest rate is 10% and each insured is assumed to bring the
same level of risk to the underwriting class.
By using the mortality rate table given in table 1, find the NSP to be paid by each
policy holder.
 Answer
1st assume that each insured person is paying level premium of birr 1
throughout the term of the policy.
2nd determine present value of birr 1 premium payment
3rd determine present value of birr 1 premium payment per insured
4th apply the formula, dived the NSP by the present value of birr 1
premium payment per insured

NLP =
 Summary of NLP Calculation
Year Age No of insured paying Total amount of birr Pv factor Pv of birr (1)
. birr (1)premium (1)level premium premium paid
1 30 100,000 100,000 1 100,000
2 31 99,827 99,827 0.9091 90,753
3 32 99,649 99,649 0.8264 82,350

Total 273,103

Pv of birr (1) premium/ insured = Pv of birr (1) premium paid/ No. of insured
= 273,103/100,000 = 2.731

NLP =

NLP = =16.15
Premium Determination for Whole Life Insurance
Home Work
Example 3: assume Nyala insurance company issues a whole life insurance for
10,000 males of age 80 for a face value of 1000 birr each.
Further assume that premium is to be collected at the beginning of the policy and
death claim is to be paid at the end of the year in which incident occurs.
If the market interest rate is 10% and the maximum age considered for premium
calculation is 99 years calculate

a) The NSP to be paid by each policy holder

b) The NLP to be paid by each policy holder

Cont’d
The table below is the mortality table given by the central statistics office.
year age M. rate/1000 year age M. rate/1000

1 80 104.4 11 90 361.1
2 81 120.8 12 91 412.6
3 82 133.6 13 92 468.8
4 83 148.5 14 93 528.1
5 84 166 15 94 591.5
6 85 187 16 95 656.3
7 86 221.4 17 96 722.4
8 87 241.5 18 97 787
9 88 275.3 19 98 850.2
10 89 315.2 20 99 910.1
Premium Determination for Endowment policy
Example 4: Nyala insurance company issued a five year endowment policy for
100,000 males of age 30 with a face amount of 1000. Taking the mortality rate
given in table1 and assuming interest rate is 10%, calculate the NLP for an ordinary
endowment.
• Note: ordinary endowment is the combination of term insurance and pure
endowment.
• Therefore, the net premium for an ordinary endowment is the sum of the net
premium under term and pure endowment insurances.

NLP =
Cont’d
• Step1: find the NSP for term insurance
• Table 7: Summary of NSP calculation for a five years term insurance
Pv. of
Mortality Probability No. of No. of Face Death Pv. Death
year Age Rate/1000 of death Living dying value Claim Factor Claim
1 30 1.73 0.00173 100,000 173 1,000 173000 0.9091 157274.3
2 31 1.78 0.00178 99,827 178 1,000 178000 0.8264 147099.2
3 32 1.83 0.00183 99,649 182 1,000 182000 0.7513 136736.6
4 33 1.89 0.00189 99,467 188 1,000 188,000 0.6830 128404.0
5 34 1.95 0.00195 99,279 194 1,000 194000 0.6209 120454.6
Total 689968.7

NSP for term = = = 6.89

Cont’d
Step 2: find the net single premium for pure endowment: in pure endowment only those
policy holders who survive the endowment period will collect the face value of the policy.
Hence, the net single premium can be calculated as follows
 No. of survivals to whom claims should be paid = 99,279-194 = 99,085
 The expected amount of claim to be paid = 99,085x1000 = 99,085,000

 Find Pv. of expected claim: 99,085,000 x = 61,521,877

 Apply the NSP formula:

NSP for pure end = = = 615.22 then

Cont’d
Step 3: find the NSP for ordinary endowment
•NSP for ordinary endowment = NSP for term + NSP for pure endowment
= 6.89 + 615.22 = 622.11
Step 4: determine the Pv of birr (1) premium per insured
Table 8: Summary of birr (1) premium per insured
Year Age No of insured paying Total amount of birr Pv factor Pv of birr (1)
birr (1)premium (1)level premium premium paid
1 30 100,000 100,000 1 100,000
2 31 99,827 99,827 0.9091 90,753
3 32 99,649 99,649 0.8264 82,350
4 33 99,467 99,467 0.7513 74,729
5 34 99,279 99,279 0.6830 67,808

Total 415,640
Cont’d
Pv of birr (1) premium per insured = = = 4.16
• Step 5: find the NLP for term insurance and pure endowment

NLP for term = == = 1.66

NLP for pure endowment = = = 147.8

Step 6: find the NLP for ordinary endowment

NLP for ordinary endowment = NLP of term + NLP of pure endowment
= 1.66 + 147.8 = 149.46
 CHAPTER 7
RE-INSURANCE
Re-insurance
• is a process of shifting part or all of the insurance originally written by one
insurer to another insurer.
• The insurer that originally writes the business and shifts it to the other insurer is
called ceding company/principal insurer/ original office.
• The insurer that accepts part or all of the insurance ceded by the ceding
company is called re-insurer.
• The amount of insurance retained by the ceding company is called net retention/
retention limit.
• The amount of insurance ceded to the reinsurer is called cession.
• Reinsurers may obtain reinsurance from another reinsurer; this situation is
called retrocession.
• Retrocedent is the reinsurance company that purchases reinsurance.
• Retrocessionair is the reinsurance company that sells the reinsurance.
Types of Reinsurance
• There are two principal types of reinsurance; facultative and treaty
reinsurances.
• Facultative reinsurance-is an optional case by case method used when
the principal insurer receives an application that exceeds its net
retention.
• Before the policy is issued, the primary insurer shops around for
reinsurance and contact several reinsurers with which it did business.
• Here, both the ceding company and the reinsurer are under no
obligation to cede and accept insurance.
• facultative reinsurance is necessary if the principal insurer receives an
application that requires a face value/amount that exceeds the
maximum retention of the insurance company.
Cont’d
Advantage of facultative re-insurance
 It is flexible
Disadvantage
 Uncertainty and delay
Treaty reinsurance-the ceding company and the reinsurer have agreed to
cede and accept insurance business respectively.
All businesses that fall under the range of their agreement will be
automatically reinsured.
Advantage of treaty reinsurance
 It avoids uncertainty and delay
Disadvantage
 Unprofitable-b/se it has no knowledge about the applicant and dependent on the
underwriting judgment of primary insurers
Types of treaty reinsurance arrangements
Quota share treaty-the ceding company and the reinsurer agreed to
share premiums and losses on some proportion expressed in terms of
percentage.
ceding company’s retention limit is expressed in terms of percentage not in
terms of birr amount.
Surplus share treaty: under this treaty the reinsurer agrees to accept
insurance in excess of the ceding company’s retention limit up to some
maximum amount.
The retention limit is referred to as a line and is stated as a birr amount.
Cont’d
• For example, assume that apex fire has a retention limit of birr 200,000 (called a line) for a single
policy, and that four lines, or birr 800,000 are ceded to general reinsurance. Assume that a birr 500,000
property insurance policy is issued and a loss of birr 5000 occurred.
• The contribution is summarized as follows:
Apex fire birr 200,000(one line)

general reinsurance 800,000(four

line)
Total underwriting capacity birr 1,000,000
• For birr 500,000 policies
Apex fire birr 200,000(2/5)

general reinsurance 300,000(3/5)

• For birr 5,000 losses
Apex fire birr 2,000(2/5)

general reinsurance 3,000(3/5)

Cont’d
Excess of loss treaty: designed largely for catastrophic protection.
 Losses in excess of retention limit are paid by the reinsurer up to some maximum
limit.
 The excess of loss treaty covers ;a single exposure, a single occurrence, such as a
catastrophic loss from a windstorm, or Excess losses when the primary insurer’s
cumulative losses exceed a certain amount during some stated time period, such as a
year.
• Example; assume that the reinsurer agrees to pay for all losses in excess of birr
50,000 up to a further birr 200,000. The way in which various losses are divided is
shown below:
Loss Direct insurer Excess treaty
Birr 10,000 birr 10,000 nil
50,000 50,000 nil
100,000 50,000 50,000
Cont’d
Reinsurance pool: is an organization of insurers that
underwrites insurance on a joint basis.
A pools have been formed because a single insurer alone may not
have the financial capacity to write large amounts of insurance.
Reasons/advantages of reinsurance
• Increase underwriting capacity
• Stability of profit
• Reduce unearned premium reserve
• Provide protection against catastrophic loss
• Other reasons like retiring from insurance business and obtaining underwriting
advice & assistance from the reinsurer
END OF THE COURSE
THANK YOU!!!