Insurance: meaning and principles: WASSCE Commerce

A fire in a market stall can wipe out a trader's savings in an hour. Fires are rare for any one trader, but across thousands of traders some happen every year. Insurance turns that unpredictable, ruinous loss into a small, predictable payment. It is the aid to trade that removes the hindrance of risk.

Learning objectives

By the end of this lesson you should be able to:

define insurance and explain how the pooling of risk works
distinguish insurance from assurance
explain the key terms used in insurance
distinguish insurable from non-insurable risks
explain the principles of insurance: utmost good faith, insurable interest, indemnity, contribution, subrogation and proximate cause
explain the importance of insurance to business

Meaning of insurance

Definition

Insurance is a contract in which one party (the insurer) agrees, in return for a payment called a premium, to compensate another party (the insured) for a loss caused by a specified risk.

Pooling of risk

Many traders each pay a small premium into a common fund held by the insurer; the few who suffer a loss are compensated from the fund

Figure 1. The pooling of risk: the premiums of many pay the losses of the few. WASSCE Tutor diagram.

Worked example

Setting a premium. 2,000 shop owners in Freetown each have a shop worth NLe 50,000. Past records show that on average 6 shops a year are destroyed by fire.

Expected yearly losses $= 6 \times 50000 =$ NLe 300,000
Share per shop owner $= 300000 \div 2000 =$ NLe 150
Add 20% for the insurer's expenses and profit: $150 \times 1.2 =$ NLe 180 premium a year

Each owner pays NLe 180 a year, a small certain cost, instead of risking an uncertain loss of NLe 50,000. The law of large numbers lets the insurer predict losses accurately across many policyholders.

Insurance and assurance

Insurance	Assurance
Covers a risk that may or may not happen (fire, theft, accident)	Covers an event that will certainly happen (death), or a fixed date
Compensates for the actual loss (indemnity)	Pays an agreed sum
Examples: fire, motor, marine, burglary	Examples: life assurance, endowment policies

Key terms

Term	Meaning
Insurer (underwriter)	The company that accepts the risk
Insured (policyholder)	The person or firm whose risk is covered
Premium	The payment for cover, usually yearly
Proposal form	The form the person seeking insurance fills in, giving full details of the risk
Cover note	A temporary document giving cover until the policy is issued
Policy	The written contract, stating the terms and the risks covered
Sum insured	The maximum the insurer will pay
Claim	A demand by the insured for compensation after a loss
Actuary	An expert who calculates risks and premiums from statistics
Insurance broker	An agent who arranges insurance for clients with insurers, for a commission
Loss adjuster / assessor	A person who investigates a claim and assesses the loss
Excess	The first part of any loss, which the insured pays
Renewal notice	A reminder that the policy is due for renewal

Insurable and non-insurable risks

Insurable risks	Non-insurable risks
Losses that can be calculated from past records	Losses that cannot be calculated
Fire, theft, burglary, accidents, death, damage to goods at sea	Changes in fashion or taste, trade losses from poor management or competition, speculation and gambling losses, a fall in demand, war (normally excluded), new inventions that make products out of date

Non-insurable risks are borne by the entrepreneur; profit is the reward for bearing them.

The principles of insurance

Principle	Meaning	Example
Utmost good faith (uberrimae fidei)	Both parties must disclose all material facts honestly. Hiding a fact makes the contract voidable.	A trader who hides that the shop stores petrol cannot claim after a fire
Insurable interest	The insured must suffer a financial loss if the event happens; you can insure only what you have an interest in.	You can insure your own shop but not your neighbour's
Indemnity	The insured is restored to the same financial position as before the loss, no better. Insurance must not be a source of profit. (Does not apply to life assurance.)	Goods worth NLe 10,000 destroyed: the claim is NLe 10,000, not their price new
Contribution	If the same property is insured with several insurers, they share the loss; the insured cannot collect from each.	Two insurers each covering half pay half the loss each
Subrogation	After paying a claim, the insurer takes over the insured's rights against third parties, and any salvage.	The insurer sues the driver who caused the accident
Proximate cause	The insurer pays only if the main (nearest) cause of the loss is a risk covered by the policy.	A fire policy pays for fire damage, including water used to put it out, but not for theft during the fire

Common mistake

Indemnity does not apply to life assurance, because a human life cannot be valued in money. The agreed sum is paid instead. Contribution and subrogation follow from indemnity, so they also do not apply to life policies.

Importance of insurance to business

Removes the hindrance of risk: traders can operate knowing losses will be met.
Encourages investment and large-scale production, because risks are spread.
Security for loans: banks lend more readily on insured assets.
Foreign trade: marine insurance makes shipping goods possible.
Mobilises savings: premiums are invested in government securities, shares and property.
Promotes loss prevention: insurers advise on fire safety and security, and charge lower premiums for safer premises.
Creates employment for insurers, brokers, agents and loss adjusters.
Peace of mind for business owners and their families.

In Sierra Leone

In Sierra Leone, insurance companies are licensed and supervised by the Sierra Leone Insurance Commission (SLICOM). Motor third-party insurance is compulsory, so every vehicle on the road must carry it. Many market traders still do not insure their stock. Fires in markets therefore often ruin traders, a strong case for affordable micro-insurance.

Key points

Insurance compensates for loss from a specified risk in return for a premium; it works by pooling risk.
Insurance covers possible events (indemnity); assurance covers certain events (agreed sum).
Only calculable risks are insurable; fashion changes, trade losses and gambling are not.
Principles: utmost good faith, insurable interest, indemnity, contribution, subrogation, proximate cause.

WASSCE examination focus

WAEC tests this

Every WASSCE Commerce paper tests insurance. Expect to explain the principles of insurance with examples, to distinguish insurance from assurance, to distinguish insurable from non-insurable risks, and to explain insurance terms (premium, policy, cover note, proposal form). Give an example with each principle.

Quick check

What is the pooling of risk?
State the principle of indemnity.
Give two examples of non-insurable risks.
What is subrogation?

Answers: 1. Many people pay small premiums into a common fund, from which the few who suffer a loss are compensated. 2. The insured should be restored to the same financial position as before the loss, and no better. 3. Any two: changes in fashion, trade losses from poor management or competition, speculation or gambling, fall in demand, war, new inventions. 4. After paying a claim, the insurer takes over the insured's rights against third parties who caused the loss, and any salvage.

Insurance: meaning and principles