Ch. 1 - Basic Principles

Define risk in insurance terms.

The uncertainty or possibility of a loss occurring. Risk is what insurance exists to manage — not the loss itself, but the uncertainty about whether it will happen.

What is pure risk, and why is it the only insurable kind?

Pure risk involves only the chance of loss or no loss — never gain. It is insurable because there is no incentive to cause the loss for profit. Example: a house burning down.

What is speculative risk? Give two examples.

Risk involving the chance of loss, no loss, OR gain. NOT insurable. Examples: gambling, investing in stocks, starting a business.

Define peril.

The specific cause of a loss. Examples: fire, illness, accident, death. Think: peril = the 'what happened.'

Define hazard.

A condition or situation that increases the likelihood or severity of a loss. A hazard does not cause the loss — it makes the peril more likely.

Name the four types of hazard.

1) Physical • 2) Moral • 3) Morale • 4) Legal

What is a PHYSICAL hazard?

A tangible, physical characteristic that increases the chance of loss. Example: a heart condition, an icy sidewalk, storing gasoline in a garage.

What is a MORAL hazard? (High-yield distinction)

A tendency toward DISHONESTY that increases loss potential — the applicant's character. Example: a person who has previously committed insurance fraud, or lies on an application.

What is a MORALE hazard? (High-yield distinction)

Indifference or CARELESSNESS created by the existence of insurance. Not dishonest — just reckless. Example: leaving a car unlocked because 'insurance will cover it.'

Memory trick: Moral vs Morale hazard.

MorAL = a Lie (dishonesty). MorALE = 'Oh well, I'm covered' (carelessness/indifference).

What is a LEGAL hazard?

Characteristics of the legal or court system that increase the likelihood or size of a loss — e.g., a jurisdiction known for large jury awards.

Define loss.

The reduction, decrease, or disappearance of value of a person or property. In life insurance, the loss is the death of the insured.

Define exposure.

A unit of measure used to determine rates charged for insurance coverage — the measure of vulnerability to loss.

State the Law of Large Numbers.

The larger the number of similar exposure units, the more closely actual loss experience will match expected (predicted) loss experience. This is the statistical foundation that makes insurance possible.

Why does the Law of Large Numbers matter to an insurer?

It allows the insurer to predict losses accurately across a large group and set premiums accordingly — even though it cannot predict which individual will suffer a loss.

Define adverse selection.

The tendency of risks with a HIGHER-than-average chance of loss to seek or continue insurance to a greater extent than average risks. Insurers control it through underwriting.

Name the five methods of handling risk (STARR).

Sharing • Transfer • Avoidance • Reduction • Retention

Risk method: AVOIDANCE

Eliminating the risk entirely by not engaging in the activity. Example: never flying to avoid a plane crash. The most effective but least practical method.

Risk method: RETENTION

Accepting/keeping all or part of the risk yourself. Examples: deductibles, self-insurance, choosing to go without coverage.

Risk method: SHARING

A group shares in the cost of a loss. Example: a partnership, or reciprocal insurance where members pool funds.

Risk method: REDUCTION

Lessening the SEVERITY or frequency of a loss without eliminating it. Examples: smoke detectors, wearing a seatbelt, quitting smoking.

Risk method: TRANSFER

Shifting the risk from one party to another. Insurance is the most common method of risk transfer — the policy is the transfer device.

Insurance transfers risk from ___ to ___.

From the individual (insured) to the insurance company (insurer), in exchange for premium.

List the elements of an INSURABLE risk.

1) Due to chance (accidental, outside insured's control) • 2) Definite and measurable • 3) Statistically predictable • 4) NOT catastrophic • 5) Large number of homogeneous exposure units • 6) Randomly selected

Why must an insurable loss be 'definite and measurable'?

The loss must be definite as to cause, time, place, and amount so the insurer can determine benefits payable and calculate reserves.

Why must an insurable risk NOT be catastrophic?

A single event that wipes out a large share of the insured pool at once (e.g., war, nuclear event) would make losses unpredictable and could bankrupt the insurer. This is why war and nuclear perils are commonly excluded.

What are homogeneous exposure units?

A large group of similar risks with similar loss potential, which allows the Law of Large Numbers to operate accurately.

Define insurable interest.

A legitimate financial interest in the continued life, health, or well-being of the insured — real potential to suffer loss or hardship if the insured dies.

TIMING RULE: When must insurable interest exist in a LIFE insurance policy? (Very high-yield)

ONLY at the time of application/policy inception. It does NOT need to exist at the time of loss (death). Contrast with property insurance, where it must exist at the time of loss.

Does a person have insurable interest in their own life?

Yes — unlimited insurable interest. Anyone may insure their own life for any amount and name any beneficiary they choose.

Who besides oneself may have insurable interest in an insured's life?

1) Family members with close blood/marriage ties (spouse, dependent children, parents) • 2) Business relationships (partners, key employees) • 3) Creditors, to the extent of the debt

If a policyowner insures a spouse and they later divorce, does the policy stay valid?

Yes. Because insurable interest in life insurance need only exist at application, the policy remains valid and enforceable after divorce.

Define the principle of indemnity.

Restoring the insured to approximately the same financial condition as before the loss — no more, no less. Insurance should not allow a person to profit from a loss.

Does life insurance strictly follow indemnity?

No. Life insurance is a VALUED contract — it pays a stated face amount agreed upon in advance, because human life cannot be assigned an exact dollar value.

Valued contract vs. reimbursement (indemnity) contract.

Valued: pays a stated amount regardless of actual loss (life insurance, AD&D). • Reimbursement: pays actual expenses incurred, up to a limit (most health/medical insurance).

Define underwriting.

The risk selection and classification process — evaluating applicants, deciding whether to accept the risk, and determining the appropriate premium rate.

What is field underwriting, and who performs it?

The first level of screening, performed by the producer/agent: completing the application accurately, obtaining a signature, observing the applicant, and avoiding submission of clearly uninsurable risks.

Name the standard underwriting risk classifications.

Preferred — better than average risk, lowest premium • Standard — average risk, standard premium • Substandard (rated) — higher than average risk, higher premium or restricted coverage • Declined — uninsurable

What is a rated policy?

A policy issued to a substandard risk at a higher-than-standard premium, or with reduced benefits, to account for the increased chance of loss.

Define rate vs. premium.

Rate: the cost of a given unit of insurance (e.g., per $1,000 of coverage). • Premium: rate × number of units = the total amount the policyowner actually pays.

What are the three primary factors in life insurance premium calculation?

1) Mortality — expected death claims • 2) Interest — earnings assumed on invested premiums • 3) Expense (loading) — insurer's cost of doing business

How does the INTEREST assumption affect premium?

The higher the interest the insurer assumes it will earn on invested premium, the LOWER the premium charged. Lower assumed interest = higher premium.

What is a mortality table?

A statistical table showing the death rate per 1,000 people at each age. Used to predict life insurance claims. (Morbidity tables predict sickness/disability rates for health insurance.)

Mortality vs. Morbidity.

Mortality = rate of DEATH (life insurance). • Morbidity = rate of SICKNESS and disability (health/disability insurance).

What is loading?

The amount added to the net premium to cover the insurer's operating expenses, commissions, taxes, and contingencies. Net premium + loading = gross premium.

What are reserves?

Funds an insurer is legally required to hold to guarantee payment of future claims. Reserves are a liability on the insurer's balance sheet and are regulated by the state.

How do insurers protect against adverse selection?

Through underwriting standards, medical exams and questions, exclusions and riders, waiting/probationary periods, and contestability provisions.

What is self-insurance?

A formal method of risk RETENTION where an entity sets aside its own funds to pay for anticipated losses rather than transferring the risk to an insurer.

Is the possibility of loss alone enough to make a risk insurable?

No. It must also be a pure risk, accidental, measurable, predictable across a large homogeneous group, non-catastrophic, and supported by insurable interest.