Notes on Insurance and Risk - Chapter 2
Definition of Insurance
Insurance is the pooling of fortuitous losses by transfer of such risks to insurers, who agree to indemnify insureds for such losses, to provide other pecuniary benefits on their occurrence, or to render services connected with the risk.
Basic Characteristics of Insurance (1 of 4)
An insurance plan typically includes pooling of losses; payment of fortuitous losses; risk transfer; indemnification. Pooling involves spreading losses incurred by the few over the entire group.
Basic Characteristics of Insurance (2 of 4)
Example: Two business owners own identical buildings valued at . There is a probability each year that a building is destroyed by a peril. Loss to either building is an independent event. Pooling of losses reduces the risk per owner, and as more participants join, the standard deviation of losses declines while the expected loss remains unchanged.
Basic Characteristics of Insurance (3 of 4)
Payment of fortuitous losses — a fortuitous loss is unforeseen, unexpected, and occurs as a result of chance. Risk transfer — a pure risk is transferred from the insured to the insurer, who typically is in a stronger financial position. Indemnification — the insured is restored to his or her approximate financial position prior to the occurrence of the loss.
Basic Characteristics of Insurance (4 of 4)
These characteristics support the operation of pooling by spreading risk and aligning incentives for premium funding and risk management.
Law of Large Numbers
Risk reduction is based on the Law of Large Numbers. The greater the number of exposures, the more closely will the actual results approach the probable results that are expected from an infinite number of exposures.
Characteristics of an Ideally Insurable Risk (1 of 3)
Large number of exposure units — to predict average loss based on the law of large numbers; Accidental and unintentional loss — to assure random occurrence of events; Determinable and measurable loss — to determine how much should be paid.
Characteristics of an Ideally Insurable Risk (2 of 3)
No catastrophic loss — to allow pooling to work; exposures to catastrophic loss can be managed by reinsurance, dispersing coverage over a large geographic area, or using financial instruments such as catastrophe bonds; Calculable chance of loss — to establish a premium that covers claims, expenses, and profit.
Characteristics of an Ideally Insurable Risk (3 of 3)
Economically feasible premium — premiums must be affordable relative to the policy face value. Based on these requirements: most personal, property and liability risks can be insured; market, financial, production, and political risks are difficult to insure.
Fire as an Insurable Risk (Exhibit 2.1)
Does fire satisfy the requirements? 1. Large number of exposure units — Yes. 2. Accidental and unintentional loss — Yes (except arson). 3. Determinable and measurable loss — Yes. 4. No catastrophic loss — Yes. 5. Calculable chance of loss — Yes. 6. Economically feasible premium — Yes.
Unemployment as an Insurable Risk (Exhibit 2.2)
Does unemployment satisfy the requirements? 1. Large number of exposure units — Not completely (there are many types of unemployment). 2. Accidental and unintentional loss — Not always (some unemployment is voluntary). 3. Determinable and measurable loss — Not completely (measurement is difficult). 4. No catastrophic loss — No (a severe recession can affect many). 5. Calculable chance of loss — Not completely (different occupations have different unemployment rates). 6. Economically feasible premium — Not completely (adverse selection, moral hazard, policy design, and potential for catastrophic loss can make premiums high; some plans however pay benefits in certain involuntary unemployment cases).
Adverse Selection and Insurance
Adverse selection is the tendency of persons with a higher-than-average chance of loss to seek insurance at standard rates. If not controlled by underwriting, adverse selection results in higher-than-expected loss levels. It can be controlled by: careful underwriting (selection and classification of applicants for insurance) and policy provisions (e.g., suicide clause in life insurance).
Insurance and Gambling Compared
Insurance handles an already existing pure risk and is always socially productive; gambling creates a new speculative risk and is not socially productive, with the winner's gain coming at the expense of the loser.
Insurance and Hedging Compared
Insurance transfers risk by a contract and involves the transfer of pure (insurable) risks; moral hazard and adverse selection are more severe problems for insurers. Hedging transfers risk by a contract and involves risks that are typically uninsurable; fewer problems of moral hazard and adverse selection for those buying or selling futures contracts.
Types of Insurance (1 of 5)
Insurance can be classified as private or government. Private insurance includes life and health insurance as well as property and liability insurance. Government insurance includes social insurance programs and other government insurance plans.
Types of Insurance (2 of 5)
Life and Health — Life insurance pays death benefits to beneficiaries when the insured dies; Health insurance covers medical expenses because of sickness or injury.
Types of Insurance (3 of 5)
Property and Liability — Property insurance indemnifies property owners against loss or damage of real or personal property; Liability insurance covers the insured's 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.
Types of Insurance (4 of 5)
Private insurance coverages can be grouped into two major categories — Personal lines: coverages that insure the real estate and personal property of individuals and families or provide protection against legal liability — Commercial lines: coverages for business firms, nonprofit organizations, and government agencies.
Types of Insurance (5 of 5)
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 by statute; Examples: Social Security, Unemployment, Workers' Comp. Other Government Insurance Programs — Found at both the federal and state levels; Examples: Federal flood insurance, state health insurance pools.
Benefits of Insurance to Society
Indemnification for loss; Reduction of worry and fear; Source of investment funds; Loss prevention; Enhancement of credit.
Costs of Insurance to Society (1 of 2)
The major social costs of insurance include: Cost of Doing Business (an expense loading that covers commissions, general administrative expenses, state premium taxes, acquisition expenses, and an allowance for contingencies and profit); Fraudulent Claims; Inflated Claims.
Costs of Insurance to Society (2 of 2)
Higher premiums to cover additional losses reduce disposable income and consumption of other goods and services.