The nature and role of insurance in risk management
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98 Terms
What is insurance?
Sharing costs of bad events by transferring risk to an insurer. It provides financial protection against potential losses or damages.
What is pooling in insurance?
Collecting many people's risks and money together.
What does risk transfer mean?
Giving your risk to the insurer.
Who is the insured?
The person buying insurance.
Who is the insurer?
The company accepting the risk.
What is a premium?
The regular payment to the insurer.
Why must there be many similar exposure units?
To predict losses accurately using the law of large numbers.
What happens if exposure units are very different?
Predictions become inaccurate.
What is the law of large numbers?
More similar risks = more accurate predictions.
Why must insurance losses be accidental?
To avoid fraud and keep it fair.
Why must insurance losses be measurable?
So the insurer can verify and pay the correct amount.
Why can't insurance easily cover catastrophic risks?
A single giant loss could bankrupt the pool.
How does insurance promote economic growth?
By investing premiums into businesses, real estate, and public projects.
Why must premiums be affordable?
Otherwise people won't buy insurance.
What is risk classification?
Grouping people based on risk levels.
Why is discrimination necessary in insurance?
To prevent adverse selection.
What is adverse selection?
Risky people buying more insurance when prices are averaged.
What happens to premiums during adverse selection?
They go up.
What can happen to the market if adverse selection is not controlled?
Insurance becomes too expensive or unavailable.
How can risk classification prevent adverse selection?
By charging premiums based on true risk.
Give an example of adverse selection.
A very sick person buying maximum health insurance.
What kind of information is used for risk classification?
Age, gender, smoking habits, location, prior claims.
What are legal restrictions on classification?
No gender-based pricing (EU), no use of genetic tests (Germany, Switzerland).
Why is collecting risk classification data costly?
It takes time and resources.
What is moral hazard?
People behaving riskier once they have insurance.
When does moral hazard happen?
After the insurance contract is signed (ex-post).
What is ex-ante moral hazard?
Taking fewer preventive actions before a loss occurs.
What is ex-post moral hazard?
Overusing services or exaggerating claims after a loss.
Give an example of moral hazard.
Driving recklessly because you have full car insurance.
Why is moral hazard a problem for insurers?
It increases the number and size of claims.
How can insurers fight moral hazard?
By using partial insurance (deductibles, co-insurance, limits).
What is partial insurance?
The insured shares the loss cost with the insurer.
What are the three main forms of partial insurance?
Deductibles, co-insurance, and policy limits.
What is a deductible?
The amount the insured must pay first before insurance kicks in.
What is co-insurance?
The insured pays a percentage of each loss.
What is a policy limit?
The maximum the insurer will pay for a loss.
What is asymmetric information?
The insured knows more about their own risk than the insurer.
How does asymmetric information cause adverse selection?
Riskier people buy more insurance secretly.
How does asymmetric information cause moral hazard?
People act riskier because insurers can’t fully monitor them.
What is the selection effect?
Risky people select more coverage (adverse selection).
What is the causality effect?
Having insurance causes people to act riskier (moral hazard).
How does asymmetric information limit insurability?
Premiums don’t reflect real risk; markets fail.
How can insurers fight asymmetric information?
Risk classification, partial insurance, behavior-linked pricing.
What are the six characteristics of an insurable risk?
- Large number of similar exposure units. 2. Accidental and unintentional losses. 3. Determinable and measurable losses. 4. No catastrophic loss. 5. Calculable chance of loss. 6. Economically feasible premium.
Why must there be a large number of similar exposure units?
To predict average loss accurately using the law of large numbers.
Why must losses be accidental and unintentional?
To ensure events are random and fair.
Why must losses be determinable and measurable?
So the insurer can verify and pay the right amount.
Why must losses not be catastrophic?
To prevent a single event from collapsing the pool.
How can insurers manage catastrophic risks?
Using reinsurance, spreading risks geographically, catastrophe bonds.
Why must the chance of loss be calculable?
To set fair and sufficient premiums.
Why must premiums be economically feasible?
So customers can afford coverage and insurers stay solvent.
What is a loading factor?
Extra charges in the premium to cover expenses, profit, and risks.
Is a hailstorm that destroys a roof insurable?
Yes — accidental, measurable, manageable.
Is the life of an eighty-year-old man insurable?
Yes, but premiums are very high and might not be feasible.
Is unemployment insurable by private insurers?
No — because of moral hazard and difficult risk calculation.
Is flood risk insurable?
Yes, but special pricing and reinsurance are needed.
What are the two main categories of private insurance?
Life/Health and Property/Casualty.
What is life insurance?
Pays money upon death; can include pensions (annuities).
What is health insurance?
Pays medical expenses.
What is disability insurance?
Pays income if you cannot work due to illness or injury.
What is property insurance?
Protects real or personal property against damage or theft.
What is liability insurance?
Protects against legal responsibility for injuries or damages.
What is casualty insurance?
Covers risks not specifically named in property or life (e.g., auto, burglary).
What are personal lines insurance?
Insurance for individuals (homes, cars).
What are commercial lines insurance?
Insurance for businesses and nonprofits.
What is individual insurance?
You buy it for yourself.
What is group insurance?
Offered through employers or organizations.
What is a stock insurer?
Owned by shareholders.
What is a mutual insurer?
Owned by the policyholders.
What is Lloyd’s of London?
A marketplace where investors insure unique or large risks.
What is a Health Maintenance Organization (HMO)?
A health insurer providing both insurance and healthcare services.
What is a captive insurer?
An insurance company created by a business to insure its own risks.
What is bancassurance?
Banks selling insurance alongside financial services.
What is social insurance?
Government insurance to protect against life risks.
Why is participation mandatory?
To spread risk fairly.
Who finances social insurance?
Workers, employers, governments.
How does social insurance redistribute income?
From young/wealthy to old/poor.
Examples of social insurance?
Social Security, Medicare.
Why do insurers invest premiums?
To grow money for paying future claims.
What do life insurers invest in?
Safe, long-term assets (e.g., bonds).
What do property and casualty insurers invest in?
Short-term, flexible assets.
What is asset-liability matching?
Aligning investments with expected claim payments.
How do insurers support economic growth?
Financing businesses, real estate, public projects.
What are the goals of claims settlement?
Verify loss, pay fairly and quickly, assist the insured.
Why is quick claims settlement important?
To maintain customer trust and reputation.
What is reinsurance?
Insurance for insurance companies.
What is facultative reinsurance?
Reinsurance for individual cases.
What is treaty reinsurance?
Automatic reinsurance for groups of policies.
What is a retention limit?
The maximum risk the insurer keeps.
What is a line?
A unit of risk retention used to split policies.
What is a quota-share treaty?
Fixed % sharing of premiums and losses.
What is a surplus-share treaty?
Insurer keeps a fixed amount; reinsurer covers the rest.
What is excess-of-loss reinsurance?
Reinsurer pays only when losses exceed the retention.
What is a reinsurance pool?
Insurers sharing giant risks together.
What is securitization of insurance risk?
Turning insurance risks into financial products.
What are catastrophe bonds (cat bonds)?
Bonds where investors lose money if disasters happen.
Why use cat bonds?
To spread disaster risk to investors outside the insurance industry.
What are the operations of an insurance company?
Insurance company operations include distribution, underwriting and risk classification, investments, claim settlement, and reinsurance.