Insurance License - Chapter 2
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98 Terms
Q: How is insurance defined in generic terms?
A: Insurance is the transfer of risk from one party to another through a legal contract, where the insurer assumes the risk in exchange for premiums.
Q: What is risk pooling (or loss sharing) in insurance?
A: Risk pooling distributes risk by spreading the cost of possible losses over a large number of people, transferring risk from an individual to a group.
Q: How do insurance companies function in terms of risk?
A: Insurance companies operate through the concept of pooling, spreading one person’s risk of loss among many individuals.
Q: How does insurance reduce financial risk?
A: By spreading one individual’s risk of loss among many through the pooling of premiums.
Q: What benefit does the policy owner get from transferring risk through insurance?
A: The policy owner obtains a large quantity of coverage in return for a relatively small premium payment.
Q: What is the Principle of Indemnification in insurance?
A: It states that the goal is to restore an insured to the same financial position they were in before the loss occurred, without profiting from the loss.
Q: What does it mean for an insurance contract to indemnify an insured?
A: It means the insurance reimburses the insured for their loss, restoring them to their previous financial position without allowing a gain.
Q: Can an insured profit from a loss under the Principle of Indemnification?
A: No, indemnification ensures the insured does not profit or gain from their loss; they only recover what was lost.
Q: Which types of insurance contracts are considered contracts of indemnity?
A: Most accident, health, property, and casualty insurance contracts.
Q: What is the main purpose of contracts of indemnity?
A: To reimburse the insured for a covered loss.
Q: How are life insurance policies different from contracts of indemnity?
A: Life insurance policies are valued contracts, paying a predetermined amount regardless of the actual financial loss incurred.
Q: What does the Law of Large Numbers state in insurance?
A: It states that larger groups provide greater accuracy in predicting future losses based on experience.
Q: Why do larger groups of homogenous loss exposures improve loss predictions?
A: Because the greater the number of similar risks, the more accurately future losses can be predicted in aggregate.
Q: What is another term for predicting losses across a large group in insurance?
A: The "spread of risk" or "risk spreading."
Q: What is the principle behind actuarial science regarding risk pools?
A: The larger the number of risks insured in the same pool, the more predictable total losses become.
Q: Can insurers predict which specific individual will suffer a financial loss?
A: No, insurers can only predict the total amount of expected loss within the entire risk pool, not individual outcomes.
Q: Why is insuring a large number of homes safer for an insurance company than insuring a small number?
A: Because unexpected losses in a small pool can bankrupt a company, while losses in a large pool are more predictable and manageable.
Q: In the example given, why is insuring 100,000 homes better than insuring only 100?
A: The premiums from 100,000 homes provide enough funds to pay losses, cover overhead, and make a profit, while a few major losses in a small group could bankrupt the insurer.
Q: What is adverse selection in insurance?
A: The tendency for higher-than-average risks to seek out insurance, often because one party has more accurate information than the other.
Q: Why is adverse selection a problem for insurance companies?
A: Because it results in insurers taking on higher risks without being fairly compensated, potentially leading to financial losses.
Q: How does underwriting help insurers manage adverse selection?
A: Underwriting ensures insurers are fairly compensated for the actual risks they undertake by charging higher premiums for high-risk individuals or properties and sometimes avoiding certain risks altogether.
Q: What is a profitable distribution of exposure in insurance?
A: A balance where preferred risks, average risks, and poor risks are proportionally distributed, reducing the danger of adverse selection.
Q: How can adverse selection be minimized aside from underwriting?
A: By insuring large groups of individuals, such as through group life insurance, which helps balance out risk levels.
Q: What happens when a company takes on risk without accurate compensation for potential claims?
A: The company experiences adverse selection, which can jeopardize profitability and long-term business stability.
Q: What is a peril in insurance?
A: A peril is the immediate, specific event that causes a loss.
Q: What perils does property insurance typically cover?
A: Fire, lightning, windstorm, hail, earthquake, and vandalism.
Q: What does liability insurance cover?
A: An insured’s legal responsibility to indemnify a third party harmed due to the insured’s negligence.
Q: What perils are covered by accident and health insurance?
A: Losses caused by illnesses and accidents.
Q: What is the covered peril in life insurance and annuities?
A: Mortality — life insurance protects against premature death, while annuities protect against outliving one’s assets.
Q: What are the two main ways insurance policies define covered perils?
A: Specified (Named) Perils and Special (Open) Perils.
Q: How do Specified (Named) Perils policies work?
A: They list the specific perils they cover, and losses caused by any peril not listed are not covered.
Q: Give an example of a Specified (Named) Peril policy.
A: A life insurance policy covering only accidental death or a property policy covering only fire and lightning.
Q: How do Special (Open) Perils policies work?
A: They cover all direct causes of loss except those perils explicitly excluded in the policy.
Q: What happens if a peril is not listed as excluded in a Special (Open) Peril policy?
A: The policy covers that peril.
Q: Give an example of a Special (Open) Peril policy.
A: Comprehensive medical insurance or standard life insurance, which covers most perils except those explicitly excluded.
Q: What is a loss in insurance terms?
A: An unintended and unforeseen reduction or destruction of financial or economic value due to a peril.
Q: What is a direct loss?
A: A loss where a person or property is directly damaged, destroyed, or killed by a peril without any intervening cause.
Q: What is an indirect loss (also called a consequential loss)?
A: A loss that is a consequence of, or results from, a direct loss.
Q: What types of insurance is the distinction between direct and indirect loss most relevant for?
A: Property and casualty insurance.
Q: How is an accident defined in insurance?
A: An unforeseen, unexpected, unintended, and sudden event occurring at a specific time and place.
Q: How is an occurrence defined in insurance?
A: Any event that causes a loss, including accidents, injuries, illnesses, or repeated/continuous exposure over time.
Q: What is an important exam tip about accidents and occurrences?
A: Every accident is an occurrence, but not every occurrence is an accident.
Q: What is a loss exposure?
A: The risk of a possible loss; any situation presenting the possibility of a loss.
Q: What are homogeneous exposure units?
A: Similar objects of insurance exposed to the same group of perils, which make it easier to predict losses as their number increases.
Q: What does a loss exposure consist of?
A: Loss exposure units — individual risks within a group of similar risks.
Q: What is a hazard in insurance?
A: A condition that increases the possibility that a peril (cause of loss) will occur.
Q: What are the three types of hazards in insurance?
A: Physical hazards, moral hazards, and morale hazards.
Q: What is a physical hazard?
A: A tangible, physical condition that makes a loss more likely to occur, such as icy roads or poor health.
Q: Give an example of a physical hazard.
A: Leaving a full can of gasoline near a furnace increases the chance of an explosion.
Q: What is a moral hazard?
A: A hazard caused by the dishonest character of the insured, who may intentionally engage in risky or criminal behavior.
Q: Give an example of a moral hazard.
A: A dishonest person lying to an insurance company to commit insurance fraud.
Q: What behaviors are commonly associated with moral hazards?
A: Drug use, alcohol abuse, and insurance fraud.
Q: What is a morale hazard?
A: A hazard arising from the insured’s careless, indifferent attitude toward loss because they know they’re insured.
Q: Give an example of a morale hazard.
A: Leaving a car running and unlocked on a cold morning because the driver doesn’t care if it gets stolen.
Q: What behaviors are commonly associated with morale hazards?
A: Reckless driving, jumping off cliffs, racing motorcycles, or a generally careless lifestyle.
Q: How is risk defined in insurance terms?
A: The potential for, or uncertainty of, loss.
Q: What is speculative risk?
A: A risk that presents the chance for both loss and gain.
Q: Are speculative risks insurable?
A: No, speculative risks are not insurable.
Q: Give examples of speculative risks.
A: Investing in the stock market and gambling.
Q: What is pure risk?
A: A risk that presents a potential for loss only, with no possibility of gain.
Q: Are pure risks insurable?
A: Yes, only pure risks are insurable.
Q: Give examples of pure risks.
A: Injuries, illnesses, and death.
Q: Can every type of risk be insured?
A: No, only certain pure risks that meet specific criteria are insurable.
Q: What are the general elements of an insurable risk?
A: The loss must be due to chance, definite and measurable, predictable, non-catastrophic, have a substantial number of exposure units, and have economically feasible premiums.
Q: What does it mean for a loss to be "due to chance"?
A: It must be accidental and outside the insured's control.
Q: Give an example of a loss that is "due to chance."
A: An insured catching a cold.
Q: What does it mean for a loss to be "definite and measurable"?
A: The time, place, amount, and claim details must be clearly documented.
Q: Give an example of a "definite and measurable" loss.
A: An automobile accident at 2:00 p.m. causing $2,000 in damage.
Q: What does it mean for a loss to be "predictable"?
A: The average frequency and severity of future losses can be calculated using a large group of similar risks.
Q: Give an example of a predictable loss statistic.
A: 18% of accidents involve distracted driving.
Q: What does it mean for a loss to be "non-catastrophic"?
A: The loss should be reasonable and not so large or uncertain that it threatens the insurer’s financial stability.
Q: Give an example of a catastrophic loss insurers won’t cover.
A: War, nuclear disaster, or a $1 trillion life insurance policy.
Q: Why must there be a substantial number of exposure units for a risk to be insurable?
A: To effectively apply the law of large numbers for loss prediction.
Q: What makes a premium economically feasible?
A: It must be affordable and small compared to the potential loss.
Q: Give an example of an economically feasible premium.
A: A healthy 45-year-old male qualifying for a $250,000 term life policy for less than $500 a year.
Q: What do insurers use underwriting techniques for?
A: To evaluate risks and assign them to risk classifications.
Q: What are the three common risk classifications insurers use?
A: Standard Risks, Substandard Risks, and Preferred Risks.
Q: What is a Standard Risk?
A: A risk considered to have an average potential for loss, typically insured at a standard premium.
Q: What is a Substandard Risk?
A: A risk judged to have a higher-than-average potential for loss, often insured with a higher premium, lower benefits, or declined coverage.
Q: What is a Preferred Risk?
A: A risk considered better than average with a lower potential for loss, typically offered coverage at a lower-than-average premium.
Q: What is risk management?
A: The process of analyzing exposures that create risk and designing programs to handle them.
Q: What are the four steps in the risk management process?
A: 1) Detect potential loss exposure, 2) Select a method to reduce risk, 3) Execute a course of action, 4) Periodically review the measures taken.
Q: How can risk be reduced or managed?
A: By purchasing an insurance contract.
Q: What is risk sharing?
A: Spreading risk among multiple parties, with each assuming a portion of the risk.
Q: What is an example of risk sharing?
A: Co-insurance in a medical policy (e.g., 80% insurer / 20% insured) or reciprocal insurance companies like USAA.
Q: What is risk transfer?
A: A legal contract transferring risk from one party to another, typically through insurance.
Q: What is the best example of risk transfer?
A: Buying an insurance policy.
Q: What is reinsurance?
A: The transfer of risk from one insurer to one or more other insurers to minimize exposure to substantial loss.
Q: What is risk avoidance?
A: Eliminating an activity or condition that exposes a person to risk.
Q: What is an example of risk avoidance?
A: Not going skydiving to avoid the risk of a skydiving accident.
Q: What is risk reduction?
A: Taking deliberate actions to reduce the likelihood or severity of a loss.
Q: What is an example of risk reduction?
A: Installing smoke alarms and sprinklers to reduce fire risk.
Q: What is risk retention?
A: A strategy where a person or business keeps a certain amount of financial reserves to cover unexpected losses.
Q: What is an example of risk retention?
A: Choosing a $1,000 deductible on an auto insurance policy, retaining that amount of risk.
Q: How is self-insurance different from having no insurance?
A: Self-insurance is a planned strategy with financial reserves; no insurance ignores the risk entirely.
Q: What acronym helps remember the five methods of handling risk?
A: STARR — Shared, Transferred, Avoided, Reduction, Retention.
Q: What is loss prevention?
A: A risk management tool involving actions taken to eliminate or reduce damage or loss.
Q: What are examples of loss prevention?
A: Using masonry instead of wood in construction, removing flammable materials, and de-icing aircraft wings before takeoff.