Insurance and Risk - Topic 7 Study Guide Notes

Risk Pooling and Overall Risk Reduction

• Risk pooling combines multiple risks to reduce overall risk.
• This is achieved by diversifying individual uncertainties.
• It results in more predictable and stable outcomes.

Law of Large Numbers

• The Law of Large Numbers states that as the number of exposure units increases, the predicted loss becomes more accurate.
• This law forms the foundation of insurance.

Homogeneous and Heterogeneous Risk Pools

• Homogeneous risk pools consist of similar risks, allowing for accurate loss predictions.
• Heterogeneous risk pools contain diverse risks, increasing the potential for adverse selection.

Definition of Insurance

• Insurance is a contractual arrangement.
• The insurer indemnifies the insured against financial losses from specified risks.
• This is done in exchange for premium payments.

Income or Wealth Transfer in Risk Pools

• Insurance redistributes income or wealth from those who do not experience losses to those who do.
• This stabilizes financial outcomes for all participants.

Requirements for a Risk to be Insurable (P* vs. Pmax)

• For a risk to be insurable, the expected loss ($P*$) must be less than or equal to the maximum premium ($P_{\text{max}}$) that an individual is willing to pay.

Reasons a Risk May Not Be Insurable

• High probability of loss.
• Catastrophic losses.
• Moral hazard.
• Adverse selection.
• Insufficient data.

Specific Requirements of an Insurable Risk

• Large number of exposure units.
• Accidental and measurable losses.
• Feasible premiums.
• No catastrophic loss potential.

Adverse Selection

• Adverse selection occurs when higher-risk individuals are more likely to seek insurance.
• This leads to higher claims and potential insurer losses.

Evaluating Insurable Risks

• Risks are evaluated based on loss predictability.
• Accidental nature of losses.
• The ability to measure and quantify the loss accurately.

Purpose of Insurance

• The purpose of insurance is to provide financial protection.
• It achieves this by transferring risk from the insured to the insurer.
• Exchanging uncertainty for certainty.

Indemnification

• Indemnification restores the insured to their financial position prior to a loss.
• Preventing profit from the insurance transaction.

Forms of Indemnification

• Cash payment.
• Repair or replacement.
• Reimbursement.
• Agreed value settlement.