Agenda
• Definition and Basic Characteristics of Insurance
• Characteristics of An Ideally Insurable Risk
• Adverse Selection and Insurance
• Insurance and Gambling Compared
• Insurance and Hedging Compared
• Types of Insurance
• Benefits and Costs of Insurance to Society
Chapter 2
Insurance and Risk
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Insurance is the pooling of fortuitous losses by transfer of such risks to insurers, who agree to indemnify insureds for such losses, to provide other pecuniary benefits on their occurrence, or to render services connected with the risk
Basic Characteristics of Insurance
Pooling of losses
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Pooling involves spreading losses incurred by the few over the entire group
Definition of Insurance
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Risk reduction is based on the Law of Large Numbers
According to the Law of Large Numbers, the greater the number of exposures, the more closely will the actual results approach the probable results that are expected from an infinite number of exposures.
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Example of Pooling:
Two business owners own identical buildings
Basic Characteristics of Insurance
valued at $50,000
There is a 10 percent chance each building will
be destroyed by a peril in any year
Loss to either building is an independent event Expected value and standard deviation of the
loss for each owner is:
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Basic Characteristics of Insurance
Example, continued:
If the owners instead pool (combine) their loss
exposures, and each agrees to pay an equal share of any loss that might occur:
As additional individuals are added to the pool, the standard deviation continues to decline while the expected value of the loss remains unchanged
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Copyright ©2014 Pearson Education, Inc. All rights reserved. 2-0
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Payment of fortuitous losses
A fortuitous loss is one that is unforeseen,
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Characteristics of an Ideally Insurable Risk
Large number of exposure units
to predict average loss based on the law
of large numbers
Accidental and unintentional loss
to assure random occurrence of events
Determinable and measurable loss to determine how much should be paid
Basic Characteristics of Insurance
unexpected, and occur as a result of chance
Risk transfer
A pure risk is transferred from the insured to
the insurer, who typically is in a stronger financial position
Indemnification
The insured is restored to his or her
approximate financial position prior to the occurrence of the loss
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Copyright ©2014 Pearson Education, Inc. All rights reserved. 2-0
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Characteristics of an Ideally Insurable Risk
No catastrophic loss
to allow the pooling technique to work exposures to catastrophic loss can be managed
by using reinsurance, dispersing coverage over a large geographic area, or using financial instruments, such as catastrophe bonds
Calculable chance of loss
to establish a premium that is sufficient to pay
all claims and expenses and yields a profit during the policy period
Characteristics of an Ideally Insurable Risk
Economically feasible premium
so people can afford to purchase the policy For insurance to be an attractive purchase, the
premiums paid must be substantially less than the face value, or amount, of the policy
Based on these requirements:
Most personal, property and liability risks can be
insured
Market risks, financial risks, production risks
and political risks are difficult to insure
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Exhibit 2.1 Risk of Fire as an Insurable Risk
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Exhibit 2.2 Risk of Unemployment as an Insurable Risk
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Adverse selection is the tendency of persons with a higher-than-average chance of loss to seek insurance at standard rates
If not controlled by underwriting, adverse selection results in higher-than-expected loss levels
Adverse selection can be controlled by: careful underwriting (selection and classification
of applicants for insurance)
policy provisions (e.g., suicide clause in life
insurance)
Insurance vs. Gambling
Adverse Selection and Insurance
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Insurance
Gambling
Gambling creates a new speculative risk
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Insurance is a technique for handing an already • existing pure risk
Insurance is always – socially productive:
Gambling is not socially productive
both parties have a common interest in the prevention of a loss
The winner’s gain comes at the expense of the loser
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Insurance vs. Hedging
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Insurance
Risk is transferred by a contract
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Hedging
Risk is transferred by a contract
Hedging involves risks that are
typically uninsurable
Hedging does not result in reduced risk
Insurance involves • the transfer of pure
(insurable) risks
Insurance can
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reduce the objective
risk of an insurer through the Law of
Large Numbers
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Types of Private Insurance
Life and Health
Life insurance pays death benefits to
beneficiaries when the insured dies
Health insurance covers medical expenses
because of sickness or injury Disability plans pay income benefits
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Property and Liability
Property insurance indemnifies property owners
against the loss or damage of real or personal property
Liability insurance covers the insured’s legal liability arising out of property damage or bodily injury to others
Casualty insurance refers to insurance that covers whatever is not covered by fire, marine, and life insurance
Types of Private Insurance
Private insurance coverages can be grouped
into two major categories
Personal lines: coverages that insure the real
estate and personal property of individuals and families or provide protection against legal liability
Commercial lines: coverages for business firms, nonprofit organizations, and government agencies
Types of Private Insurance
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Other Government Insurance Programs Found at both the federal and state level Examples:Federal flood insurance, state health
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insurance pools
Exhibit 2.3
Property and Casualty Insurance Coverages
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Social Insurance Programs Financed entirely or in large part by
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Types of Government Insurance
contributions from employers and/or employees Benefits are heavily weighted in favor of low-
income groups
Eligibility and benefits are prescribed by statute Examples: Social Security, Unemployment,
Workers Comp
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Social Benefits of Insurance
• Indemnification for Loss
• Reduction of Worry and Fear
• Source of Investment Funds
• Loss Prevention
• Enhancement of Credit
Social Costs of Insurance
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• Cost of Doing Business
– An expense loading is the amount needed to
pay all expenses, including commissions, general administrative expenses, state premium taxes, acquisition expenses, and an allowance for contingencies and profit
• Fraudulent Claims
• Inflated Claims
Higher premiums to cover additional losses reduce disposable income and consumption of other goods and services
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