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Theory and Practice of Insurance

Book · January 1998

DOI: 10.1007/978-1-4615-6187-3

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THEORY AND PRACTICE
OF INSURANCE

By

J. François Outreville

KLUWER ACADEMIC PUBLISHERS

DORDRECHT/BOSTON/LONDON
"Les pièces empruntées d'autrui, il les
transformera et confondra, pour en faire
un ouvrage tout sien, à savoir son
jugement " ( Work borrowed from others,
he will adapt and mingle to create his own text,
namely his own thinking) Montaigne, Les
Essais. Chap XXVI.
 CONTENTS

Page
Preface ix

1. The Meaning of Risk 1

Part I Insurance in the Economy

2 . Insurance and Economic Development 15 29

3 . Insurance in the World Economy Today

Part II The Principles of Risk Management 47

4. Risk Management Concepts 73

5. Risk Analysis Fundamentals 91

6 . Risk Financing Decisions

Part III The Principles of Insurance 113

7 . Risk Aversion and Insurance 131

8 . Insurance Concepts 147

9 . Pricing Insurance Contracts

179
10. Retention, Self-Insurance
and Captive Insurance Companies
vin

Part IV The Characteristics of Insurance Operations

11. Organization of Insurance Markets 199
12 . Operations of Insurance Companies 221
13 . Reserves and Investments 233
1 4 . Reinsurance 263

Part V The Performance of Insurance Companies

15. Financial Reporting and Performance 29l
16 . Supervision of Insurance Operations 315

Index 335

About the Author 340

 PREFACE

Often students do not read the preface of a textbook, however it frequently

happens that the introduction clarifies the meaning of the text.

A Look at the Past, the Present and the Future

Risk! Uncertainty! Loss! these words are frequently in the minds of people
involved in decision taking. The first scholarly treatment of the area of risk in
relation to insurance was "The Economic Theory of Risk and Insurance" by
Allan H. Willett originally published as one of the Columbia University Studies
in History, Economies and Public Law.*
During most of the economic history, risk and uncertainty have been a
subject for sociologists but it was rather taken for granted in a given cultural
environment. In 1921, Frank Knight wrote a comprehensive book on the
subject of "Risk, Uncertainty and Profit"/ The risks that he discussed were
more or less limited to the "entrepreneurial" type. The field of the pure risk
linked to the vulnerability of Systems, was still considered too secondary to be
treated as a priority among the managerial objectives of the firm.
Classical economic theory was based on the assumption of certainty. This
was a deterministic approach which ignored the economic behavior of individual
agents. Thanks to the work by Allais, Arrow and Debreu in 1953, new
developments in economic theory analyze how the traditional competitive
analysis can be extended to treat uncertainty. By assumption there are risks,
"contingent goods" or "contingent claims", and there are contracts by which risks
are implicitly or explicitly transferred from one economic agent to another
economic agent, e.g. labor contacts, financial securities and insurance contracts.
The Traditional Approach
In the development of any academic discipline, several persons always stand out,
and their work is regarded as a significant contribution to that discipline. Dr.
Solomon Stephen Huebner introduced the first University-level insurance courses
when he was a professor at the Wharton School, University of Pennsylvania.
He also wrote the first University-level insurance textbooks.4 Most of the
"classic" insurance textbooks published in the United States have been largely
inspired by his work.
However, in the traditional approach, like finance in the 1940s and 1950s,
insurance is taught as a descriptive, institutional subject, viewed from the
outside rather than from within the firm's managerial point of view.

The Managerial Approach

Methods of managing risks are increasingly important in modem economic
Systems and Risk Management has become a major concem in the curriculum of
Business Schools.5 Recent growth in interest, understanding, and technical skill in
the field of risk analysis and assessment have worked to promote this change. It is
not so much a problem of avoiding risks and eliminating uncertainty, but of
understanding and controlling risks and of reducing the uncertainty to acceptable
levels in given situation.6
The objectives of risk management and insurance have been formulated in
the context of the objectives of the firm or the individual economic agent. In
many formulations, the objective is stated in terms of utility, the satisfactions
enjoyed by individuals that result in a set of preferences. Social responsibility is
another complex issue which bas to be taken into consideration by individual
economic agents, firms and government.

A Conceptual Approach
Recent developments in North-American academic institutions have given rise to
many questions about how collegiate insurance education is faring and what its
future direction will be. In many other countries including developing countries,
attempts are being made to popularize insurance subjects in colleges and
universities. However, contrary to other fields like Finance or Marketing, there is
a lack of material available on general concepts.
The emphasis on decision making has progressed in recent years. However,
most of the existing insurance textbooks have been written exclusively for the
US market and still follow a descriptive sectorial approach of insurance
institutions and contracts rather than a conceptual approach. '
 XI

Objective of this Text

Regardless of the manner in which risk and insurance problems are approached,
their existence affect the economic performance of ail economic agents and
therefore imposes constraints on the optimum allocation of resources and on the
economic development of ail nations.
Insurance is a major tool of risk management and plays an important role in
the economic, social and political life of ail countries. Economic growth
throughout the world has even expanded the role of insurance. At its first
session in June 1964, The United Nations Conference on Trade and Development
formally acknowledged the role of insurance in economic development.8
Insurance is a concept, a technique and an economic institution. It is
therefore important that the reader understand why insurance markets matters and
how insurance institutions exist and function. This text does not claim to
develop a new approach to the presentation of insurance. In fact, the author has
been largely inspired by the major textbooks on insurance written in the United
States.
Because insurance is international by nature, a description of the
fundamental principles should be emphasized. A detailed analysis of insurance in a
particular country or a detailed description of specific insurance contracts has
been avoided. The text is readily adaptable to the particular characteristics of
each country and this approach in an introductory text is of greatest value to
advanced undergraduate and graduate students.

Acknowledgments
Students who have read the draft chapters of this text when I was a visiting
professor in Singapore at the National University and in The Netherlands at
Nijenrode University.

Disclaimer
The content of this book does not relate to the purpose, activities or interests of
the United Nations.

J. François Outreville
 Xll

Notes

Allan H. Willett, The Economic Theory of Risk and Insurance, New York:
Columbia University Press, 1901, reprinted by The University of Pennsylvania
Press, 1951.
- Frank H. Knight, Risk, Uncertainty and Profit, Boston: Houghton Mifflin, 1921. '
Maurice Allais, "L'extension des théories de l'équilibre économique général et du
rendement social en cas de risque," Paris, CNRS: Econométrie, 1953, p. 81-110.
Kenneth J. Arrow, "Le rôle des valeurs boursières pour la répartition la meilleure du
risque," Paris, CNRS: Econométrie, 1953, p. 41-47; translated as "The rôle of
securities in the optimal allocation of risk-bearing," Review of Economie Studies,
vol. 31, 1964, p. 91-96.
Gérard Debreu, "Une économie de l'incertain," Paris, EDF: Mimeo, 1953; revised and
published in Economie Appliquée, vol. 12, 1960, p. 111-116. "* Huebner S.S.,
Property and Liability Insurance, New York: Appleton and Co., 1911 and The
Economies of Life Insurance, New York: Appleton and Co., 1915.
5 The American Risk and Insurance Association published in November 1990 a
position paper entitled: "Risk Management: an essential part of the common body of
knowledge for Business."
6 It should be noted here that Allan Willett's book is probably the first modem
textbook on risk management when comparison is made with the approach suggested
today in Business Schools. The chapters of his book could easily be considered for
any new risk management textbook:
(I) The Nature of Risk, (II) Classes of Risk, (III) The Cost of Risk, (IV) The
Assumption of Risk, (V) The Reward for Risk Taking, (VI) Ways of Meeting Risk,
(VII) Insurance.
7 One notable exception is the book by Neil A. Doherty, Corporate Risk
Management: A Financial Exposure, New York: McGraw-Hill Co., 1985.
8 United Nations, Proceedings of the United Nations Conference on Trade and
Development, First Session, vol.l, Final Act and Report, 1964.

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