The nature and role of insurance in risk management

Part 1: Basics of Insurance

What is insurance?
➔ Sharing costs of bad events by transferring risk to an insurer.

What is pooling in insurance?
➔ Collecting many people's risks and money together.

What does risk transfer mean?
➔ Giving your risk to the insurer.

Who is the insured?
➔ The person buying insurance.

Who is the insurer?
➔ The company accepting the risk.

What is a premium?
➔ The regular payment to the insurer.

Why must there be many similar exposure units?
➔ To predict losses accurately using the law of large numbers.

What happens if exposure units are very different?
➔ Predictions become inaccurate.

What is the law of large numbers?
➔ More similar risks = more accurate predictions.

Why must insurance losses be accidental?
➔ To avoid fraud and keep it fair.

Why must insurance losses be measurable?
➔ So the insurer can verify and pay the correct amount.

Why can't insurance easily cover catastrophic risks?
➔ A single giant loss could bankrupt the pool.

How does insurance promote economic growth?
➔ By investing premiums into businesses, real estate, and public projects.

Why must premiums be affordable?
➔ Otherwise people won't buy insurance.

Part 2: Risk Classification and Pricing

What is risk classification?
➔ Grouping people based on risk levels.

Why is discrimination necessary in insurance?
➔ To prevent adverse selection.

What is adverse selection?
➔ Risky people buying more insurance when prices are averaged.

What happens to premiums during adverse selection?
➔ They go up.

What can happen to the market if adverse selection is not controlled?
➔ Insurance becomes too expensive or unavailable.

How can risk classification prevent adverse selection?
➔ By charging premiums based on true risk.

Give an example of adverse selection.
➔ A very sick person buying maximum health insurance.

What kind of information is used for risk classification?
➔ Age, gender, smoking habits, location, prior claims.

What are legal restrictions on classification?
➔ No gender-based pricing (EU), no use of genetic tests (Germany, Switzerland).

Why is collecting risk classification data costly?
➔ It takes time and resources.

Part 3: Behavior and Moral Hazard

What is moral hazard?
➔ People behaving riskier once they have insurance.

When does moral hazard happen?
➔ After the insurance contract is signed (ex-post).

What is ex-ante moral hazard?
➔ Taking fewer preventive actions before a loss occurs.

What is ex-post moral hazard?
➔ Overusing services or exaggerating claims after a loss.

Give an example of moral hazard.
➔ Driving recklessly because you have full car insurance.

Why is moral hazard a problem for insurers?
➔ It increases the number and size of claims.

How can insurers fight moral hazard?
➔ By using partial insurance (deductibles, co-insurance, limits).

What is partial insurance?
➔ The insured shares the loss cost with the insurer.

What are the three main forms of partial insurance?
➔ Deductibles, co-insurance, and policy limits.

What is a deductible?
➔ The amount the insured must pay first before insurance kicks in.

What is co-insurance?
➔ The insured pays a percentage of each loss.

What is a policy limit?
➔ The maximum the insurer will pay for a loss.

Part 4: Asymmetric Information

What is asymmetric information?
➔ The insured knows more about their own risk than the insurer.

How does asymmetric information cause adverse selection?
➔ Riskier people buy more insurance secretly.

How does asymmetric information cause moral hazard?
➔ People act riskier because insurers can’t fully monitor them.

What is the selection effect?
➔ Risky people select more coverage (adverse selection).

What is the causality effect?
➔ Having insurance causes people to act riskier (moral hazard).

How does asymmetric information limit insurability?
➔ Premiums don’t reflect real risk; markets fail.

How can insurers fight asymmetric information?
➔ Risk classification, partial insurance, behavior-linked pricing.

Part 5: What Makes a Risk Insurable

What are the six characteristics of an insurable risk?
➔

• Large number of similar exposure units,

• Accidental and unintentional losses,

• Determinable and measurable losses,

• No catastrophic loss,

• Calculable chance of loss,

• Economically feasible premium.

Why must there be a large number of similar exposure units?
➔ To predict average loss accurately using the law of large numbers.

Why must losses be accidental and unintentional?
➔ To ensure events are random and fair.

Why must losses be determinable and measurable?
➔ So the insurer can verify and pay the right amount.

Why must losses not be catastrophic?
➔ To prevent a single event from collapsing the pool.

How can insurers manage catastrophic risks?
➔ Using reinsurance, spreading risks geographically, catastrophe bonds.

Why must the chance of loss be calculable?
➔ To set fair and sufficient premiums.

Why must premiums be economically feasible?
➔ So customers can afford coverage and insurers stay solvent.

What is a loading factor?
➔ Extra charges in the premium to cover expenses, profit, and risks.

Part 6: Practical Exercise - Is This Risk Insurable?

Is a hailstorm that destroys a roof insurable?
➔ Yes — accidental, measurable, manageable.

Is the life of an eighty-year-old man insurable?
➔ Yes, but premiums are very high and might not be feasible.

Is unemployment insurable by private insurers?
➔ No — because of moral hazard and difficult risk calculation.

Is flood risk insurable?
➔ Yes, but special pricing and reinsurance are needed.

Part 7: Types of Insurance and Insurers

A) Private Insurance Types

What are the two main categories of private insurance?
➔ Life/Health and Property/Casualty.

What is life insurance?
➔ Pays money upon death; can include pensions (annuities).

What is health insurance?
➔ Pays medical expenses.

What is disability insurance?
➔ Pays income if you cannot work due to illness or injury.

What is property insurance?
➔ Protects real or personal property against damage or theft.

What is liability insurance?
➔ Protects against legal responsibility for injuries or damages.

What is casualty insurance?
➔ Covers risks not specifically named in property or life (e.g., auto, burglary).

B) Personal vs Commercial Insurance

What are personal lines insurance?
➔ Insurance for individuals (homes, cars).

What are commercial lines insurance?
➔ Insurance for businesses and nonprofits.

What is individual insurance?
➔ You buy it for yourself.

What is group insurance?
➔ Offered through employers or organizations.

C) Types of Insurers

What is a stock insurer?
➔ Owned by shareholders.

What is a mutual insurer?
➔ Owned by the policyholders.

What is Lloyd’s of London?
➔ A marketplace where investors insure unique or large risks.

What is a Health Maintenance Organization (HMO)?
➔ A health insurer providing both insurance and healthcare services.

What is a captive insurer?
➔ An insurance company created by a business to insure its own risks.

What is bancassurance?
➔ Banks selling insurance alongside financial services.

Part 8: Social Insurance

What is social insurance?
➔ Government insurance to protect against life risks.

Why is participation mandatory?
➔ To spread risk fairly.

Who finances social insurance?
➔ Workers, employers, governments.

How does social insurance redistribute income?
➔ From young/wealthy to old/poor.

Examples of social insurance?
➔ Social Security, Medicare.

Part 9: Investments by Insurers

Why do insurers invest premiums?
➔ To grow money for paying future claims.

What do life insurers invest in?
➔ Safe, long-term assets (e.g., bonds).

What do property and casualty insurers invest in?
➔ Short-term, flexible assets.

What is asset-liability matching?
➔ Aligning investments with expected claim payments.

How do insurers support economic growth?
➔ Financing businesses, real estate, public projects.

Part 10: Claims Settlement

What are the goals of claims settlement?
➔ Verify loss, pay fairly and quickly, assist the insured.

Why is quick claims settlement important?
➔ To maintain customer trust and reputation.

Part 11: Reinsurance and Loss Sharing

What is reinsurance?
➔ Insurance for insurance companies.

What is facultative reinsurance?
➔ Reinsurance for individual cases.

What is treaty reinsurance?
➔ Automatic reinsurance for groups of policies.

What is a retention limit?
➔ The maximum risk the insurer keeps.

What is a line?
➔ A unit of risk retention used to split policies.

What is a quota-share treaty?
➔ Fixed % sharing of premiums and losses.

Example: 60%-40% quota share, $100k loss.
➔ Insurer pays $60k; reinsurer pays $40k.

What is a surplus-share treaty?
➔ Insurer keeps a fixed amount; reinsurer covers the rest.

Example: $200k retention, $800k policy.
➔ Insurer keeps $200k; reinsurer takes $600k.

What is excess-of-loss reinsurance?
➔ Reinsurer pays only when losses exceed the retention.

Example: $5M loss, $1M retention.
➔ Insurer pays $1M, reinsurer pays $4M.

What is a reinsurance pool?
➔ Insurers sharing giant risks together.

Risks covered by pools?
➔ Nuclear plants, marine risks, natural disasters.

Part 12: Capital Markets and Securitization

What is securitization of insurance risk?
➔ Turning insurance risks into financial products.

What are catastrophe bonds (cat bonds)?
➔ Bonds where investors lose money if disasters happen.

Why use cat bonds?
➔ To spread disaster risk to investors outside the insurance industry.