C3a - THE INSURANCE MECHANISM.pdf

7/26/2019 C3a - THE INSURANCE MECHANISM.pdf

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CHAPTER 2: INSURANCE

MECHANISMPrinciples of Risk Management and InsuranceBy G.E. Rejda

(Class 3)


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AGENDA

Definition and Basic Characteristics of

Insurance

Characteristics of an Ideal Insurable Risk

Adverse Selection and Insurance

Insurance vs. Gambling Compared

Insurance vs. Hedging Compared

Types of Insurance

Benefits and Costs of Insurance to

Society


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DEFINITION OF INSURANCE

There is no single definition of insurance. Insurancecan be defined from the viewpoint of severaldisciplines, such as law, actuarial science, sociologyetc.

As defined by the Commission on InsuranceTerminology of the American Risk and InsuranceAssociation, insurance is the pooling of fortuitous

losses by transfer of such risks to insurers, whoagree to indemnify insureds for such losses, toprovide other pecuniary benefits on theiroccurrence, or to render services connected withthe risk.


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BASIC CHARACTERISTICS OF

INSURANCE

Pooling (or sharing) of losses Spreading of losses incurred by the few over the

entire group, so that in the process, average loss issubstituted for actual loss;

Prediction of future losses with some accuracy basedon Law of Large Numbers;

The primary purpose of pooling, or the sharing oflosses, is to reduce the variation in possible outcomesas measured by the standard deviation or some othermeasure of dispersion, which reduces risk;

Example can be shown as per page 21 of Chapter 2


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BASIC CHARACTERISTICS OF

INSURANCE

Payment of fortuitous losses Insurance pays for losses that are unforeseen,

unexpected by the insured and occurs as a result ofchance;

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.


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CHARACTERSITICS OF AN IDEAL

INSURABLE RISK

There are 6 ideal characteristics of aninsurable risk:

Large number of exposure units

Large group of roughly similar, but notnecessarily identical, exposure units that aresubject to the same peril;

To predict average loss based on the law oflarge numbers.


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INSURABLE RISK

Accidental and unintentional loss

The loss should be unseen and unexpected andoutside of the insureds control; To control moral hazard;

To assure random occurrence of events.

Determinable and measurable loss Loss should be definite as to the cause, time,

place and amount;

To facilitate loss adjustment; Insurer must be able to determine if the loss is covered

and if so, how much should be paid.


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INSURABLE RISK

No catastrophic loss To allow the pooling technique to work

Exposures to catastrophic loss can be managedby: Using reinsurance;

Dispersing coverage over a large geographic area;

Dealing of catastrophic losses via financial instruments,such as catastrophe bonds.

Calculable chance of loss To establish an adequate premium by accurately

calculating the average frequency and severity offuture losses.


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INSURABLE RISK

Economically feasible premium So people can afford to buy;

Premium must be substantially less than the

face value of the policy.

Based on these preceding requirements:

Most personal, property and liability risks

can be insured; In contrast, market risks, financial risks,

production risks and political risks aredifficult to insure.


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EXHIBIT 2.1: RISK OF FIRE AS AN

INSURABLE RISK


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EXHIBIT 2.2: RISK OF UNEMPLOYMENT

AS AN INSURABLE RISK


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ADVERSE SELECTION AND

INSURANCE

Adverse selection is the tendency of personswith a higher-than-average chance of loss toseek insurance at standard rates, which if not

controlled by underwriting, results in higher-than-expected loss levels. For example

Adverse selection can be controlled by:

Careful underwriting (i.e. selection and classificationof applicants for insurance)

Policy provisions (e.g., suicide clause in life insuranceand pre-exiting condition clause in health insurance)


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INSURANCE VS HEDGING

Insurance

Risk is transferred by a

contract Insurance involves the

transfer of insurable risks

Insurance can reduce theobjective risk of aninsurer through the Lawof Large Numbers

Hedging

Risk is transferred by a

contract Hedging involves risks that

are typically uninsurable

Hedging does not result inreduced risk, it involvesonly risk transfer


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TYPES OF INSURANCE

Insurance can be classified as follow:

Private Insurance

Life and Health

Property and Liability

Government Insurance Social Insurance Programs

Other Government Insurance Plans


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TYPES OF INSURANCE

Private Insurance Life and Health

Life insurance pays death benefits to beneficiaries when theinsured dies;

Health insurance covers medical expenses because of sickness

or injury; Disability plans pay income benefits.

Property and Liability (or Casualty) Property insurance indemnifies property owners against the loss

or damage of real or personal property; Liability insurance covers the insureds legal liability arising out of

property damage or bodily injury to others;

Casualty insurance refers to insurance that covers whatever isnot covered by Fire, Marine, and Life insurance: Examples include Auto, Liability, Burglary and Theft etc.


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TYPES OF INSURANCE

Private Insurance

Private insurance coverages can be grouped

into 2 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, non-profit organizations and

government agencies.


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EXHIBIT 2.3: PROPERTY AND CASUALTY

INSURANCE COVERAGES


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TYPES OF INSURANCE

Government Insurance Social Insurance Programs

Financed entirely or in large part by contributionsfrom employers and / or employees;

Benefits are heavily weighted in favor of low-incomegroups;

Most programs are made compulsory;

Eligibility and benefits are prescribed by statute.Examples:

Social Security, Unemployment, Workers Compensation etc.

Other Government Insurance Plans Found at both the federal and state level.


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SOCIAL BENEFITS OF INSURANCE

Indemnification for Loss Contributes to family and business stability;

Reduction of Worry and Fear Insureds are less worried about losses;

Source of Investment Funds Premiums may be invested, promoting economic growth;

Loss Prevention Insurers support loss-prevention activities that reduce

direct and indirect losses;

Enhancement of Credit Insured individuals are better credit risks than individuals

without insurance.


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SOCIAL COSTS OF INSURANCE

Cost of Doing Business Insurers consume scarce economic resources in

providing insurance to society; In financial terms, an expense loading must be added

to the pure premium to cover expenses incurred (for

daily operations); An expense loading is the amount needed to pay allexpenses, including commissions, generaladministrative expenses, state premium taxes,acquisition expenses, and an allowance forcontingencies and profit.

Fraudulent and Inflated Claims Payment of fraudulent and inflated or padded claims

results in higher premiums to all insureds, thusreducing disposable income and consumption ofother goods and services.

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C3a - THE INSURANCE MECHANISM.pdf