Life and Health Insurance - FIN-3660
Introduction to Risk and Insurance
Life and Health Insurance FIN 3660
Chapter 1
Objectives
Distinguish between speculative risk and pure risk.
Describe various ways to manage financial risk.
Identify the five characteristics of insurable risks.
Define anti-selection and give examples of two factors that can increase or decrease the likelihood that an individual will suffer a loss.
Identify four risk classes for proposed insureds.
Define insurable interest and determine in a given situation whether the insurable interest requirement is met.
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Risk
Risk is defined as the possibility of a deviation between actual and expected outcomes;
Risk is the possibility of an unexpected result, either a gain or a loss.
Think of a risk scenario as one in which the outcome is not certain.
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3
Which applicant has more risk?
Imagine you are an insurance agent and two potential insureds enter your office seeking life insurance on themselves. One is a 20 year-old male and the other is a 99 year old male. Which applicant would entail more inherent risk?
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Answer
So, which man did you say had more risk?
Most of you probably said the 99 year-old man, right? Incorrect! Here is an explanation:
Which applicant’s life expectancy is closer to certain? How many more years do you expect the 99-year old to live? Unfortunately, not many. How many for the 20 year old? You really don’t know for him, do you?
Do not confuse risk with the amount of premium that should be charged. The 99 year-old would be charged significantly more premium but his outcome is almost certain.
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Pure vs Speculative Risk
Speculative risk involves three possible outcomes: loss, gain, or no change.
Pure Risk involves no possibility of gain; either a loss occurs or no loss occurs.
Pure risk is the only type of risk that can be insured.
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Risk Management
Risk Management is the process by which individuals and businesses identify and assess the risks they face and take measures to eliminate or reduce their exposure to those risks. There are four general techniques used to manage financial risk.
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Risk Management
Avoiding risk altogether is the first method of managing risk. If you don’t fly, the chances of a personal injury from a plane crash can be avoided, and financial loss in the stock market can be avoided by not investing in the stock market.
Sometimes risk cannot be avoided. For example, we cannot effectively avoid the risk of having our personal possessions destroyed or damaged.
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Risk Management
Controlling risk is a method in which you take steps to prevent or reduce potential losses. For example, a healthy diet and exercise regimen can decrease the chance of contracting a disease.
In another example, a business could install a smoke detector and sprinkler system to reduce fire damage in the event of an accident.
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Risk Management
Transferring risk involves shifting financial responsibility for a risk to another party.
As an example: consider a person taking out a loan, as they often have a cosigner, a person who will have to pay the loan if the borrower cannot pay.
The most common way for individuals, families, and businesses to transfer risk is to purchase insurance coverage.
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Risk Management
Accepting or Retaining risk is to assume all financial responsibility for that risk. Sometimes a financial loss is not great enough to warrant concern. Some people consciously choose to accept more significant risks.
Accepting a risk (Risk Retention) can also be an unconscious decision. Any risk you face that is not managed by the three other methods is always accepted, whether you are aware of it or not. Hacking, for example, was an unknown risk for a long time, and substantial financial losses were incurred.
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Insurance
Insurance is the most widely used risk management technique for both individuals and businesses.
Insurance is a device for reducing risk by combining a sufficient number of exposure units to make individual losses collectively predictable.
Insurance transfers from an individual or entity to an insurer the risk of financial loss from events such as accident, illness, or death.
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Key Insurance Terms
For an excellent glossary of Insurance Terms, please refer to Best’s Insurance Resources: http:// www.ambest.com/resource/glossary.html#I
Insurer – an insurance company that accepts risk and promises to pay a policy benefit if a loss occurs.
Policy benefit- A specific amount of money the insurer agrees to pay under an insurance policy when a specific loss occurs.
Insurance policy- A written document containing the terms of agreement between the insurer and the owner of the policy.
Premium- The specified amount of money an insurer charges in exchange for agreeing to pay a policy benefit when a specified loss occurs.
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Terms (cont.)
Applicant- A person or business that applies for an insurance policy
Policy owner- The person or business that owns the issued insurance policy
Insured- The person whose life, health, or property is insured under the policy
Third-party policy- A policy purchased by one person or business on the life of another person.
Beneficiary- The person or party the policy owner names to receive the life insurance policy benefit.
Claim- A request for payment under the terms of an insurance policy.
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Terms (cont.)
Contract of Indemnity - an insurance policy under which the amount of the policy benefit payable for a covered loss is based on the actual amount of financial loss that results from the covered event, as determined at the time of the event. (Example: hospital bills)
Valued contract - specifies the amount of policy benefit that will be payable when a covered loss occurs, regardless of the amount of actual loss that was incurred.
Most life insurance policies have a face amount, or face value, which is the amount of the policy benefit that is payable if an insured dies while the policy is in force.
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Types of Insurance
In general insurance policies will cover three types of risks: personal risk, property damage risk, and liability risk.
Personal risk is the risk of economic loss associated with death, poor health, injury, and outliving one’s economic resources.
Property damage risk is the result of economic loss resulting from damage to or loss of a person’s property.
Liability Risk is the risk of economic loss resulting from a person being held legally responsible for harming others or their property.
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Personal Risk Insurance
Usually personal risk is covered by life and health insurance companies. They sell products that insure against financial losses that result from personal risks such as death, disability, illness, accident, and outliving one’s savings.
Examples of this are life insurance, annuity contracts, and health insurance. See Figure 1.2 in your book for examples of each.
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Property Damage and Liability
Property insurance provides a benefit if insured items are damaged, destroyed, or lost because of very specific risks such as fire, theft, or accident, that the policy describes.
Liability insurance provides a benefit payable on behalf of a covered party who is legally responsible for unintentionally harming others or their property.
Property insurance and liability insurance are commonly marketed together in one policy.
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Property Damage and Liability
Property/casualty (P&C) insurance companies are insurers that issue and sell insurance policies that cover property damage risk and liability in the United States.
Generally automobile insurance is sold as property and casualty insurance.
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Managing Risks Through Insurance
Risk pooling is a method insurers use to be able to accept responsibility for the economic losses of their insureds. They have many clients, and the idea is that there are not going to be that many losses, so the cost is spread through all the clients.
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Successful Risk Pooling
What is necessary to make risk pooling via insurance a successful way to handle risk?
Let’s assume for a minute that our class has 100 students who all have identical homes in terms of construction (all brick) and location (all in same neighborhood). Let’s also say that we know each house is worth, say $100,000 and the chance of total loss is 1/100. We could just pool our money and each person contribute $1000 to a pot of funds. Right?
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Now suppose….
What if someone wanted to join our class homeowner pool whose house was completely different: his house has a vastly different location (less fire protection), different construction (frame vs our brick homes), and possibly the owner who has had 10 total fire losses to his home in the past? Would he still need to contribute the same $1000 to the pot?
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Suppose …(cont.)
If this person who is less homogeneous than our original pool joins the pool, then our calculations of the $1000 premium per person would be insufficient to cover the added new risk. The original pool would need to subsidize the new person, who would likely have a claim.
Last point: How would our decision to let him join our pool (called the Underwriting decision) be different if a new person wanted to join the pool whose house is already on fire? Should he be able to join to pool?
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Suppose…(cont.)
Thus, it is important to consider the factors that make the insurance pooling concept successful for all of the members in the pool, not just for the insurer.
What other factors must be considered for successful pooling and underwriting?
How would your acceptance of the new person change if
his 10 prior fire losses had been his own arson?
if he is 11 months behind on his mortgage payments?
And if this pool was for life insurance, he is not telling the truth about his age or health?
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Characteristics of Insurable Risks
The loss must occur by chance.
Losses have to result either from an unexpected event or from an event that the insured person did not intentionally cause.
For example, people generally cannot control whether they become seriously ill. Therefore, healthcare insurance can be offered.
However, the time of someone’s death is usually unknown, so the timing of it makes it chance.
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Characteristics of Insurable Risks
The loss must be definite.
An insurer must know when and how much of the policy benefits need to be paid. In many cases of loss, the time of the loss is easy to determine. The amount of financial loss can be subject to interpretation depending on the definition of loss used.
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Characteristics of Insurable Risks
The loss must be significant
Usually people don’t insure losses that are smaller than the amount of money they would pay on a policy.
More significant losses are insurable. For example, a person injured in an accident may lose a significant amount of income if she is unable to work, and insurance coverage protects against that loss.
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Characteristics of Insurable Risks
The loss rate must be predictable
Although individual losses cannot be predicted, insurers can provide a specific type of insurance coverage if they can predict the loss rate, or the frequency of losses, that the insureds are likely to experience.
Insurers can predict with a fairly high degree of accuracy the number of people in a given large group who will die, become disabled, or require hospitalization during a given period of time.
The law of large numbers states that, typically, the more times we observe a particular event, the more likely that our observed results will approximate the true probability, or likelihood, that the event will occur.
Example: coin toss.
Insurers collect information about specific groups of people in order to predict how many of them will suffer a certain loss.
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Characteristics of Insurable Risks
The loss must not be catastrophic to the insurer.
A potential loss is not considered insurable if a single occurrence is likely to cause or contribute to catastrophic financial damage to the insurer.
In order to avoid catastrophic financial damage (example: hurricanes), insurers today usually limit the number of properties they will insure in any particular geographic area.
The Insurer will purchase reinsurance, insurance that one insurance company purchases from another.
The purchaser is called the direct writer and the seller is called the reinsurer.
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Measuring the Risks
Mortality tables are charts that indicate with great accuracy the number of people in a large group who are likely to die at each age.
Mortality tables display the mortality rates, which are the rates at which death occurs among a specified group of people during a specified period, typically one year.
Insurance companies have also developed similar charts called morbidity tables, which display the morbidity rates, or incidence of sickness and accidents, by age occurring among a given group of people.
Insurers then use the loss rates they have predicted to establish premium rates that will be adequate to pay claims.
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Insurance Underwriting
When an insurer receives an application for insurance, the company must assess the degree of risk it will be accepting if it issues the policy.
Underwriting is the process of identifying and classifying the degree of risk represented by a proposed insured.
Underwriters are responsible for evaluating proposed risks.
The greater the risk an insured represents, the higher a premium the insurer must charge.
Adverse Selection (also called Anti-selection) is the tendency of individuals who believe they have a greater-than-average likelihood of loss to seek insurance protection to a greater extent than other individuals.
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Hazards
There are a number of factors that increase or decrease the likelihood that an individual will incur a loss.
A physical hazard is a physical characteristic that may increase the likelihood of loss.
A moral hazard is a characteristic that exists when the reputation, financial position, or criminal record of an applicant or a proposed insured indicates that the person may act dishonestly in the insurance transaction.
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Classifying Risks
A risk class is a grouping of insureds who represent a similar level of risk to the insurer. This helps establish premium rates.
Underwriting guidelines are general rules each specific insurer uses when assigning proposed insureds to an appropriate risk class. There are at least four risk classes.
Standard risks are proposed insureds who have a likelihood of loss that is not significantly greater than average, and they are charged standard premium rates.
Preferred risks are insureds who present a significantly lower-than-average likelihood of loss, and are charged lower-than-standard premium rates known as preferred premium rates.
Substandard risks or special class risks are those who have a significantly greater-than-average likelihood of loss. Typically they are charged higher than standard premium rates known as substandard premium rates.
Declined risk are those who are considered too risky for the insurer to cover.
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Insurable Interest
An insurable interest -means that the policy owner must suffer a genuine loss or detriment should the event insured against occur.
Example: would you suffer a loss if a random house down the street burned? If not, then you should not be able to purchase a homeowners’ policy on that house. You would gain financially if you were able to purchase that policy and the home burned.
An insurance interest is required to make the insurance pool successful. The insurable interest must be proven either at the time the policy is purchased or at the time of loss, depending on the type of insurance policy covering the loss.
Insurance is intended to compensate someone for a loss, not to provide an opportunity for gain.
The practice of purchasing insurance as a wager is now considered against public policy. Laws require that the insured have an insurable interest in the risk that is insured at the time.
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