Chapter 2 Risk

Chapter 2
The Insurance
Mechanism
Topics Covered
• Definition and Basic Characteristics of

Insurance
• Characteristics of An Ideally Insurable Risk
• Adverse Selection and Insurance
• Insurance and Gambling Compared
• Insurance and Hedging Compared
• Benefits of Insurance to Society
Copyright ©2014 Pearson Education, Inc. All rights reserved. 2-2

Definition of Insurance
 Commission on Insurance Terminology of the

American Risk and Insurance Association :
“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
Based on the insurance definition, an insurance plan

typically includes the following characteristics:
 1-Pooling of losses
 2-Payment of fortuitous losses
 3-Risk transfer
 4-Indemnification

 1-Pooling of losses(sharing of losses)

Pooling involves spreading losses incurred by the few over
the entire group.
– Risk reduction is based on the Law of Large Numbers.
– According to 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.

• Example of Pooling:
– Two business owners own identical buildings
valued at $50,000
– There is a 10 percent chance each building will
be destroyed by a peril in any year
– Loss to either building is an independent event
– Expected value and standard deviation of the
loss for each owner is:
Expected loss  0.90 * $0  0.10 * $50,000  $5,000
Standard deviation  0.90 0  $5,000  0.10 $50,000  $5,000

2 2
 $15,000
• Example, continued:
– If the owners instead pool (combine) their loss
exposures, and each agrees to pay an equal share
of any loss that might occur:
Expected loss  0.81* $0  0.09 * $25,000  0.09 * $25,000  0.01* $50,000

 $5,000
Standard deviation  0.81 0  $5,000   (2)(0.09) $25,000  $5,000   0.01($50,000  $5,000) 2
2 2
 $10,607
– As additional individuals are added to the pool, the
standard deviation continues to decline while the
expected value of the loss remains unchanged

2-Payment of Fortuitous Losses
Fortuitous Losses or accidental losses
Insurance company pays for an “accidental” losses and
they must be “unforeseen” and “unexpected”. This kind of
loss is called fortuitous loss.
Example: a person may slip on an icy sidewalk and break a

leg. The loss would be fortuitous.
Law of large number is based on the assumption that

losses are accidental and occur randomly. Therefore,
Insurance policies don’t pay for intentional losses.

3-Risk Transfer
Risk transfer means that a pure risk is transferred

from insured to the insurer, who is in a stronger
financial position than the insured.
Pure risks such as the risk of premature death,

poor health, disability, destruction and theft of
property, and personal liability lawsuit.

4-Indemnification
The insurer puts the insured back to the same

financial position prior to the occurrence of loss.
Example: If your home burns in a fire, a

homeowner policy will indemnify you or restore
you to your previous position.
• If you hit somebody with your car and you are

liable for his bodily injury, insurer indemnify the
person by using the auto liability insurance.

Characteristics of an Ideally Insurable Risk
Private insurers only insure pure risks but not all pure
risks are insurable. A pure risk ideally should have
certain characteristics to be insurable.
 Large number of exposure units.

 Loss must be accidental and unintentional.
 Loss must be determinable and measurable.
 Loss should not be catastrophic.
 Chance of loss must be calculable.
 Premium must be economically feasible.

Large Number of Exposure Units
 The should be large number of similar but not

necessarily identical exposure units that are
subjected to the same peril or group of perils.
Example: Large number of houses in a city can be

insured through property insurance on houses.
Accurate prediction of losses based on the law of

large number is the purpose of first requirement.

Accidental and Unintentional Loss
The loss should be unintentional and unexpected by the
insured and outside the insured ‘s control.
If the cause of loss is intentionally, the

insurer dose not pay for the loss.
 Two reasons why the second requirement is necessary:
1-If the intentional loss paid by insurer, moral hazard

would be increased substantially and the premiums would
rise consequently (fake accident, fraudulent claim, inflating
the amount of a claim, Intentionally burning the unsold
merchandise).

 2-The loss should be accidental because the law
of large number is based on the random
occurrence of events whereby the intentional loss
is not a random event. Therefore, the aim of law of
large number is violated due to the prediction of
future experience may be highly inaccurate.

Determinable and Measurable Loss
 The loss should be both determinable and
measurable meaning that time , place and amount
of loss should be distinguishable.
Example: In life insurance policies usually the time

and the cause of death can be determinable and
the death benefit is usually the face amount of life
insurance policy.

The basic purpose of third requirements is to
enable an insurer to determine if the loss is
covered under the policy, and if it is covered, how
much should be paid.
Example:
Shanon had an expensive fur coat that is insured under
homeowners policy. It makes a great deal of difference
to insurer if a thief breaks into her home and steals the
coat, or the coat is missing because her husband gave it
for dry-cleaning and forgot to tell her.
The loss is covered in the first example but not in the
second.

No Catastrophic Loss
 Catastrophic losses periodically result from floods,
hurricanes, tornadoes, earthquakes, forest fires, and
other natural disasters or acts of terrorism.
 The loss should not be catastrophic meaning that a
large number of exposure units should not incur losses
at the same time.
 Pooling techniques does not work if most or all of the
exposure units in a certain class simultaneously incur
a loss(losses of the few are no longer spread over the
entire group).

Calculable Chance of Loss
 Chance of loss should be calculable.
The average severity and average frequency of future losses
must be calculable by the insurer.
 Why chance of loss should be calculable?

If chance of loss is calculable, the proper premium can be
charged to pay all claims and expenses and yield a profit during
the policy period.
 The chance of loss for catastrophic event cannot be accurately

estimated. Why?
Catastrophic loss such as floods, wars, and cyclical
unemployment occur on an irregular basis and prediction of
severity and frequency of losses is difficult.

Economically Feasible Premiums
 The premium should be economically

feasible meaning that the insured
must be able to afford the premium
and indeed the premium must be
substantially less than the face value.

Based on these requirements:
Most personal, property and liability risks can be insured.
Market risks, financial risks, production risks and

political risks are difficult to insure.

Exhibit 2.1 Risk of Fire as an Insurable Risk

Exhibit 2.2 Risk of Unemployment as an
Insurable Risk

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.
• Adverse selection can be controlled by:
– careful underwriting (selection and classification of
applicants for insurance)
– policy provisions (e.g., suicide clause in life
insurance)

What dose underwriting mean ?
 Underwriting is the process of selecting and
classifying applicants for insurance.
 Those applicants that met the underwriting

standards are insured at standard rates,but
those applicants that have higher-than–average
chance of loss, the insurer denies to provide
insurance for them or they have to pay extra
premium.
 The problem of adverse selection arises when

applicants with a higher-than–average chance of
loss succeed in obtaining the coverage at
standard or average rates.
Insurance vs. Gambling
Insurance Gambling
• Insurance is a • Gambling creates a

technique for new speculative risk
handing an already • Gambling is not
existing pure risk socially productive
• Insurance is always – The winner’s gain
socially productive: comes at the
– both parties have a expense of the loser
common interest in
the prevention of a
loss

Insurance vs. Hedging
Insurance Hedging
• Risk is transferred by • Risk is transferred

a contract by a contract
• Insurance involves • Hedging involves
the transfer of pure
risks that are
(insurable) risks
typically uninsurable
• Insurance can reduce
the objective risk of • Hedging does not
an insurer result in reduced
– through the Law of risk
Large Numbers

Benefits of Insurance to Society
• 1- Indemnification of loss
• 2- Reduction of worry and fear
• 3- Source of investment funds
• 4-Loss prevention
• 5-Enhancement of credit
 1-Indemnification of loss
Indemnification permits individuals and families to be
restored to their former financial position after a loss
occurs.
 Indemnification to business firms also permits firms to
remain in business and employees to keep their jobs.
 2-Reduction of worry and fear
If a person has any insurance coverage one of the benefit
of insurance is that worry and fear are reduced.
Example:
-If family head has life insurance coverage, those who are
financially dependent are less likely to worry about the
financial security in the event of premature death.
-Owners of auto insurance policy or any other type of property

insurance enjoy greater peace of mind because they know
they are covered if a loss occurs.

 3-Source of Investment funds
The insurance industry is an important source of funds
for capital investment and accumulation.
• Premiums are collected in advance of the loss, and

funds not needed to pay immediate losses and
expenses can be loaded to business firms.
 Funds typically are invested in shopping centers,

hospitals , factories , housing developments , and new
machinery and equipment.

 4- Loss Prevention
Insurance companies are actively involved in numerous
loss-prevention activities and also employ a wide
variety of loss-prevention personnel , including safety
engineers and specialists in fire prevention ,
occupational safety and health, and products liability.
 Examples of loss-prevention activities that property and

casualty insurers strongly support:
• Highway safety and reduction of automobile deaths
• Fire prevention
• Prevention of auto thefts
• Prevention of defective products that could injure the user
Society benefits because both types of direct and

indirect losses are reduced by loss-prevention activities.
 5- Enhancement of Credit
Insurance makes a borrower a better credit risk
because it guarantees the value of the borrower‘s
collateral or gives greater assurance that the loan
will be paid.
Example:
 When a house is purchased , the lending institution requires property
insurance on the house before the mortgage is granted. The property
insurance protects the lender’s financial interest if the property is
damaged or destroyed.
 If a new car is purchased and financed by a bank or other lending
institution , auto insurance policy may be required before the loan is
made.

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Chapter 2

• Definition and Basic Characteristics of

Copyright ©2014 Pearson Education, Inc. All rights reserved. 2-2

 Commission on Insurance Terminology of the

“Insurance is the pooling of fortuitous losses by

Copyright ©2014 Pearson Education, Inc. All rights reserved. 2-3

Based on the insurance definition, an insurance plan

Copyright ©2014 Pearson Education, Inc. All rights reserved. 2-4

 1-Pooling of losses(sharing of losses)

– Risk reduction is based on the Law of Large Numbers.

– According to the Law of Large Numbers, the greater the

Copyright ©2014 Pearson Education, Inc. All rights reserved. 2-5

Expected loss  0.90 * $0  0.10 * $50,000  $5,000

Standard deviation  0.90 0  $5,000  0.10 $50,000  $5,000

Expected loss  0.81* $0  0.09 * $25,000  0.09 * $25,000  0.01* $50,000

Copyright ©2014 Pearson Education, Inc. All rights reserved. 2-7

Example: a person may slip on an icy sidewalk and break a

Law of large number is based on the assumption that

Copyright ©2014 Pearson Education, Inc. All rights reserved. 2-8

Risk transfer means that a pure risk is transferred

Pure risks such as the risk of premature death,

Copyright ©2014 Pearson Education, Inc. All rights reserved. 2-9

The insurer puts the insured back to the same

Example: If your home burns in a fire, a

• If you hit somebody with your car and you are

Copyright ©2014 Pearson Education, Inc. All rights reserved. 2-10

 Large number of exposure units.

Copyright ©2014 Pearson Education, Inc. All rights reserved. 2-11

 The should be large number of similar but not

Example: Large number of houses in a city can be

Accurate prediction of losses based on the law of

Copyright ©2014 Pearson Education, Inc. All rights reserved. 2-12

If the cause of loss is intentionally, the

 Two reasons why the second requirement is necessary:

1-If the intentional loss paid by insurer, moral hazard

Copyright ©2014 Pearson Education, Inc. All rights reserved. 2-13

Copyright ©2014 Pearson Education, Inc. All rights reserved. 2-14

Example: In life insurance policies usually the time

Copyright ©2014 Pearson Education, Inc. All rights reserved. 2-15

Copyright ©2014 Pearson Education, Inc. All rights reserved. 2-16

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 Why chance of loss should be calculable?

 The chance of loss for catastrophic event cannot be accurately

Copyright ©2014 Pearson Education, Inc. All rights reserved. 2-18

 The premium should be economically

Copyright ©2014 Pearson Education, Inc. All rights reserved. 2-19

Most personal, property and liability risks can be insured.

Market risks, financial risks, production risks and

Copyright ©2014 Pearson Education, Inc. All rights reserved. 2-20

Copyright ©2014 Pearson Education, Inc. All rights reserved. 2-21

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• Adverse selection is the tendency of persons

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 Those applicants that met the underwriting

 The problem of adverse selection arises when

• Insurance is a • Gambling creates a

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• Risk is transferred by • Risk is transferred

Copyright ©2014 Pearson Education, Inc. All rights reserved. 2-26