fin360 chapter 2 - insurance and risk

INSURANCE

FINANCIAL SAFETY NET THAT TRADES A SMALL REGULAR PAYMENT FOR PROTECTION AGAINST LARGE, UNEXPECTED LOSSES

BASIC CHARACTERISTICS OF INSURANCE

• POOLING OF LOSSES

• PAYMENT OF FORTUITOUS LOSSES

• RISK TRANSFER

• INDEMNIFICATION

POOLING OF LOSSES

INVOLVES SPREADING LOSSES INCURRED BY THE FEW OVER THE ENTIRE GROUP

• financial burdens of a few unfortunate people are spread across a large group of policyholders

PAYMENT OF FORTUITOUS LOSSES

A FORTUITOUS LOSS IS ONE THAT IS UNFORESEEN, UNEXPETED, AND OCCUR AS A RESULT OF CHANCE

RISK TRANSFER

RISK MANAGEMENT STRATEGY WHERE YOU SHIFT FINANCIAL RESPONSIBILITY FROM YOURSELF TO A THIRD PARTY

INDEMNIFICATION

PERSON COMPENSATES ANOTHER OF A LASS BROUGHT BY A THRID PARTY

CHARACTERISTICS OF AN IDEALLY INSURABLE RISK

1. LOSS MUST OCCUR BY CHANCE

2. LOSS MUST BE DEFINITE IN TERMS OF TIME AND ACCOUNT

3. LOSS MUST BE SIGNIFICANT 

4. LOST RATE MUST BE PREDICTABLE 

5. LOSS MUST NOT BE CATASTROPHIC TO THE INSURER

ADVERSE SELECTION (ANTI-SELECTION)

THE TENDENCY OF PERSONS WITH A HIGHER THAN AVERAGE CHANCE OF LOSS TO SEEK INSURANCE (AT STANDARD RATES)

• risky people are more eager to buy insurance

• when there is a lack of symmetry of the information thats given (buyer knows more about their risk than insurer does)

WHY IS ADVERSE SELECTION IMPORTANT? ??????

• LOSSES COME IN HIGHER THAN EXPECTED

  • INSURERS SET PRICES BASED ON THE AVERAGE RISK OF THE POPULATION 

  • IF MOSTLY HIGH RISK PEOPLE BUY, THE INSURER PAYS OUT FAR MORE THAN IT PLANNED FOR PREMIUMS GO UP

• PREMIUM GOES UP

  • TO COVER EXTRA LOSSES, THE INSURER HAS TO CHARGE MORE, WHICH HURTS EVERYONE

HOW CAN ADVERSE SELECTION BE CONTROLLED?

• CAREFUL UNDERWRITING (SELECTION AND CLASSIFICATION OF APPLICANTS FOR INSURANCE)

• POLICY PROVISIONS (SUICIDE CLAUSE IN LIFE INSURANCE)

PRIVATE INSURANCE ????

•  INCLUDES LIFE AND HEALTH INSURANCE AS WELL AS PROPERTY AND LIABILITY INSURANCE 

  • PRIMARILY VOLUNTARY

IS ANTI-SELECTION PREVALENT WITH BOTH PRIVATE AND SOCIAL INSURANCE? (AND WHY)

NOT PREVALENT FOR SOCIAL INSURANCE BECAUSE ITS MANDATORY SO ITS ONLY FOR HEALTH INSURANCE

GOVERNMENT INSURANCE

INCLUDES SOCIAL INSURANCE PROGRAMS AND OTHER GOVERNMENT INSURANCE PLANS

• PRIMARILY MANDATORY

LIFE INSURANCE

PAYS DEATH BENEFITS TO BENEFICIARIES WHEN THE INSURED DIES

HEALTH INSURANCE

COVERS MEDICAL EXPENSES BECAUSE OF SICKNESS OR INJURY

PROPERTY INSURANCE

INDEMNIFY/COMPENSATE PROPERTY OWNERS AGAINST THE LOSS OR DAMAGE OF REAL OR PERSONAL PROPERTY

LIABILITY INSURANCE

COVERS THE INSUREDS 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

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

• EX: SOCIAL SECURITY, UNEMPLOYMENT, WORKERS COMP

• PARTICIPATION IS MANDATORY

OTHER GOVERNMENT INSURANCE PROGRAMS

FOUND OUT AT BOTH THE FEDERAL AND STATE LEVEL

• EX: FEDERAL FLOOD INSURANCE, STATE HEALTH INSURANCE