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Chapter 2

Insurance and Risk

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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

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Definition of Insurance

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

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Basic Characteristics of Insurance

Pooling of losses

Pooling involves spreading losses incurred by the few over the entire group

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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Transparency Master 1.2

Basic Characteristics of Insurance (Continued)

Example of Pooling:

Two business owners own identical buildings 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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Transparency Master 1.2

Basic Characteristics of Insurance (Continued)

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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Basic Characteristics of Insurance (Continued)

Payment of fortuitous losses

A fortuitous loss is one that is unforeseen, 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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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

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Transparency Master 1.2

Characteristics of an Ideally Insurable Risk (Continued)

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

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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

Characteristics of an Ideally Insurable Risk (Continued)

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Exhibit 2.1 Fire as an Insurable Risk

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Exhibit 2.2 Unemployment as an Insurable Risk

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Adverse Selection and Insurance

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)

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Insurance vs. Gambling

Insurance

Handles an already existing pure risk

Is always socially productive:

both parties have a common interest in the prevention of a loss

Gambling

Creates a new speculative risk

Is not socially productive

The winner’s gain comes at the expense of the loser

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Insurance vs. Hedging

Insurance

Risk is transferred by a contract

Involves the transfer of pure (insurable) risks

Moral hazard and adverse selection are more severe problems for insurers

Hedging

Risk is transferred by a contract

Involves risks that are typically uninsurable

Fewer problems of moral hazard and adverse selection for entities who buy or sell futures contracts

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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

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Types of Private Insurance (Continued)

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

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Types of Private Insurance (Continued)

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

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Types of Government Insurance

Social Insurance Programs

Financed entirely or in large part by 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

Other Government Insurance Programs

Found at both the federal and state level

Examples:Federal flood insurance, state health insurance pools

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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

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Social Costs of Insurance

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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