The nature and role of insurance in risk management

What is insurance?

A financial tool where people or businesses transfer risk to an insurer, who pools risks and uses premiums to cover losses.

What is risk transfer in insurance?

It means transferring the financial burden of risk to an insurer, who agrees to compensate for covered losses.

What is indemnity?

Compensation for a loss, usually paid in money, as agreed in the insurance contract.

What is risk pooling?

A process where premiums from many insured individuals are combined to pay for the losses of the few who suffer them.

Why is risk classification important?

It ensures each insured pays a fair premium based on their level of risk, making pooling effective.

What are the six characteristics of an insurable risk?

1. Many similar units – The risk must affect many similar people or items.

2. Accidental loss – The event must happen by chance, not on purpose.

3. Clear and measurable loss – The loss must be easy to identify and value.

4. Limited impact – The loss shouldn’t affect too many at the same time.

5. Predictable chance of loss – It must be possible to estimate how often it happens.

6. Reasonable cost – The insurance premium must be affordable and fair.

Why must losses be accidental and unintentional?

To avoid moral hazard and ensure fairness; insurers don’t cover deliberate losses.

Why must losses be measurable?

To confirm the event occurred and calculate the correct payment.

Why are catastrophic losses difficult to insure?

Because they can cause massive, simultaneous losses, breaking the pooling system.

What does “calculable chance of loss” mean?

Insurers must be able to estimate how likely a loss is in order to set fair premiums.

Why must premiums be economically feasible?

So people can afford the insurance and see value in buying it.

What are the main categories of private insurance?

• Life/Health insurance

• Property/Casualty insurance

• Personal/Commercial lines

• Individual/Group insurance.

What is social insurance?

Government-managed insurance for specific perils with compulsory participation and income redistribution.

What are the types of insurers by structure?

• Stock insurers

• Mutual insurers

• Lloyd’s of London

• HMOs

• Captive insurers

• Bancassurance

What are personal lines of insurance? What are commercial lines of insurance?

• Policies for individuals and families (e.g., auto, home, life).

• Policies for businesses and organizations (e.g., liability, property).

What is individual insurance? What is group insurance?

• Bought by one person or family for personal needs.

• Provided by an employer or organization to a group of people.

How is social insurance funded?

Through contributions from employers, employees, and sometimes the government.

What makes social insurance different from private insurance?

It’s compulsory, not priced based on individual risk, and redistributes income.

What is a stock insurer?

An insurer owned by shareholders, aiming to earn profits.

What is a mutual insurer?

Insurance company where the customers (policyholders) are also the owners, focused on affordable coverage and profit-sharing.

What is demutualization?

When a mutual insurer becomes a stock insurer to raise capital and grow.

What is Lloyd’s of London?

A marketplace where syndicates insure specialized or unique risks.

What is an HMO?

A Health Maintenance Organization that provides medical care for a fixed prepaid fee.

What is a captive insurer?

An insurer created by a business to cover its own risks.

What is bancassurance?

A partnership between banks and insurers to sell insurance products through banks.

What are the main social benefits of insurance?

• Indemnification (financial recovery)

• Reduced fear and anxiety

• Funding for economic development via investments

• Incentives for loss prevention

• Facilitates credit and lending

What are the 5 main functions of an insurance company?

1. Distribution – Selling insurance through various channels

2. Underwriting – Assessing risks and determining premiums

3. Claims Management – Processing and paying claims
   

4. Investment Management – Investing premiums to generate returns
   

5. Risk Management – Identifying and mitigating risks for policyholders

What are the three main goals of claims settlement?

1. Verify that a covered loss has occurred
2. Pay claims fairly and promptly
3. Provide personal assistance to the insured

What is reinsurance?

When an insurance company transfers part of its risk to another insurer to reduce its exposure.

What is the primary insurer called in a reinsurance agreement?

The ceding company.

What is the insurer that takes on the risk called?

The reinsurer.

What is the retention limit (or line)?

The amount of risk the ceding company keeps.

What is the portion of the policy transferred to the reinsurer called?

The cession.

Why do insurers use reinsurance?

• To increase underwriting capacity – Reinsurance helps insurers cover more policies than they could on their own.

• Stabilize profits – It reduces the impact of big losses, helping keep earnings steady.

• Protect against catastrophic losses – It provides backup in case of major events like earthquakes or hurricanes.

• Exit a line of business or region – Reinsurance can help smoothly leave a market by transferring existing risks.

• Get advice on unfamiliar risks – Reinsurers often offer expert guidance on new or complex risks.

What is facultative reinsurance?

A case-by-case agreement for large or unusual risks that exceed the insurer’s retention limit.

What is treaty reinsurance?

A pre-agreed contract where the reinsurer automatically covers all eligible policies in a certain category.

What are the two basic ways losses are shared in reinsurance?

1. Pro rata method (share losses and premiums proportionally)
2. Excess-of-loss method (reinsurer pays only above a certain amount)

What is a quota-share treaty?

A type of pro rata agreement where losses and premiums are split in a fixed ratio (e.g. 50/50).

What is a surplus-share treaty?

The reinsurer takes losses above the insurer’s retention limit, up to a max, with shares calculated based on proportions.

How does excess-of-loss reinsurance work?

The reinsurer pays only when losses exceed a set limit.

What is a reinsurance pool?

A group of insurers that join together to underwrite high-risk exposures.

What is securitization of risk?

Turning insurance risk into investment products like catastrophe bonds.

What is a catastrophe bond? Why are catastrophe bonds useful?

A bond where the insurer can skip or reduce interest payments if a disaster occurs.

They provide extra funding during catastrophes and reduce reliance on traditional reinsurance.

What is asymmetric information?

When the insured knows more about their risk than the insurer.

What are the two main problems caused by asymmetric information?

• Adverse selection (before the contract)

• Moral hazard (after the contract)

What is adverse selection?

High-risk individuals buy more insurance because they’re charged the same as low-risk ones.

How can insurers fight adverse selection?

By collecting more individual information and using risk classification to set fair, risk-based premiums.

What is moral hazard?

When people behave more carelessly or misuse coverage because they are insured.

What are the two types of moral hazard?

Why does moral hazard happen?

• Ex-ante: less prevention before the loss

• Ex-post: overuse or fraud after the loss

Because the insured feels protected and doesn’t bear the full cost of the risk.

How do insurers reduce moral hazard?

• Use partial insurance like deductibles, co-insurance, and policy limits

• Link premiums to behavior

What is a deductible?

The part of the loss the insured must pay before insurance kicks in.

What is co-insurance?

The insured pays a percentage of the loss (e.g., 20%).

What is a policy limit?

The maximum amount the insurer will pay.

How does asymmetric information affect insurance markets?

Asymmetric information occurs when the insured knows more about their risk than the insurer. This leads to adverse selection, where high-risk individuals are more likely to buy insurance, making it harder for insurers to accurately assess risk. As a result, premiums may not reflect the true level of risk, making insurance less affordable or unavailable for some, and potentially causing market failures.

What are the two main types of reinsurance agreements, and how do they differ?

1. Facultative Reinsurance – Covers individual, high-risk policies on a case-by-case basis. It is optional andis typically used for specific risks that the primary insurer wants to limit exposure to.

2. Treaty Reinsurance – Covers a portfolio of risks automatically under agreed terms. It is mandatory for all policies within the scope of the treaty.