RMIN 4000 Chapter 2

Insurance and Risk Overview

• Course: RMIN 4000

• Instructor: Daniel Brown

• Institution: Terry College of Business, University of Georgia

• Year Established: 1785

Definition of Insurance

• Insurance is defined as the pooling of fortuitous (unforeseen) losses by transferring such risks to insurers.

• Insurers agree to indemnify (compensate) the insured for these losses and provide monetary benefits or render services related to the risk.

Law of Large Numbers

• Principle: The greater the number of exposures, the more closely actual results will approximate expected results from an infinite number of exposures.

• Example: Coin flip - flipping a coin many times leads to results closely aligning with the expected probability of 50% heads.

Pooling of Losses

• The process of spreading losses incurred by a few over the entire insured group.

• Objective: Reduces variation (measured by standard deviation) and thus decreases uncertainty.

• Explanation: Standard deviation measures the average distance of data points from the mean.

Payment of Fortuitous Losses

• Fortuitous: Refers to unforeseen and unexpected incidents occurring by chance.

• Example: If an insured person causes an injury intentionally, it is not fortuitous.

• Example: Attempting to insure a home right before a hurricane arises does not constitute a fortuitous loss.

Risk Transfer

• Pure risk (uncertain loss that does not involve a gain) is transferred from the insured to the insurer, typically transferring it to a financially stronger entity.

• Examples of pure risks transferred to insurers include natural disasters, accidents, or liability claims.

Indemnification

• The process of restoring the insured to approximately their financial position prior to the occurrence of the loss.

Characteristics of an Ideally Insurable Risk

1. Large Number of Exposure Units

• Essential for predicting average loss using the Law of Large Numbers.

• Insurance companies need a significant number of similar exposure units to operate effectively.

2. Loss Must Be Accidental and Unintentional

• Insured must not have control over the loss occurrence.

• Importance: The Law of Large Numbers relies on random occurrences.

3. Loss Must Be Determinable and Measurable

• Determinable: Ability to establish if a loss occurred.

• Measurable: Ability to quantify the amount of the loss.

4. Loss Should Not Be Catastrophic

• Catastrophic losses (e.g., terrorism, floods) hinder the pooling technique.

• Solutions: Insurers may utilize reinsurance and diversification to manage risk.

5. Chance of Loss Must Be Calculable

• Insurers must be able to calculate the average frequency and severity of losses.

6. Premium Must Be Economically Feasible

• The premium must be affordable for the insured, raising questions about insurability at higher risk levels.

Adverse Selection

• Definition: The tendency for individuals with a higher-than-average risk of loss to seek insurance at standard rates.

• Consequence: If unchecked by underwriting, this leads to higher than expected loss levels.

• Cause: Often results from asymmetric information between parties.

Asymmetric Information

• Occurs when one party has information pertinent to a transaction that the other lacks.

Credit-Based Insurance Score

• Uses a consumer’s credit history to predict future insurance losses.

• Not to be confused with a traditional credit score.

Comparison: Credit Score vs. Credit-Based Insurance Score

• Credit-Based Insurance Score: Predicts likelihood of an insurance loss (scores range 300-850).

• Credit Score: Predicts likelihood of debt repayment (scores typically 0-1000).

• Higher scores represent lower risk for premium calculations.

Pricing and Adverse Selection Example

• Insurance Company Premiums:

  • Poor Score (<400): Higher premiums due to perceived higher risk.

  • Average Score (400-700): Mid-range premiums.

  • Excellent Score (>700): Lower premiums for lower risk clients.

Impact of Adverse Selection on Insurance Companies

• Example: Agricultural Insurance Company (AIC) faced challenges by charging average rates yet having high-risk individuals attracted to lower premiums.

• Result: Increased claims and accidents led to poor underwriting outcomes.

Types of Private Insurance

• Life Insurance: Provides death benefits to beneficiaries.

• Health Insurance: Covers medical expenses from sickness or injuries.

• Property Insurance: Protects against loss/damage of property.

• Liability Insurance: Covers legal liabilities arising from damage or injury to others.

• Casualty Insurance: Covers various risks not included under other types, such as fire and marine.

Government Insurance Programs

• Funded largely by contributions from employers/employees.

• Focus: Benefits heavily favor low-income groups.

• Examples include Social Security, Unemployment, and Medicare.

Other Government Insurance Programs

• Various programs at federal and state levels:

  • Federal Deposit Insurance Corporation (FDIC)

  • National Flood Insurance Program (NFIP)

  • Fair Access to Insurance Requirements Plans (FAIR)

  • Beach and Windstorm Plans