Insurance and Risks

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Insurance and Risks

• Lecture 2

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Insurance

• 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 to the risk

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Insurance Characteristics

• Pooling of loses
• Payment of fortuitous losses
• Risk transfer
• Indemnification

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Pooling of Losses

• Spreading of losses incurred by the few over the
  entire group
• Grouping of a large number of exposure units so
  that law of large numbers can work to improve
  prediction (reduce risk) of future losses

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Loss Spreading Example

• Assume 1,000 individuals each have homes worth
  100,000
• On average, 1 home burns per year
• W/O Insurance max loss 100,000
• Suppose all agree to share the loss (insurance) ?
  average loss 100,000 / 1,000 100
• Trading 100 loss for sure for chance of losing
  100,000 (See Expected Utility notes)

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Law of Large Numbers

• As number of exposures is increased, the more
  closely will actual results approach the probable
  results expected from an infinite number of
  exposures
• Example Flip a coin 10 times might get 8 heads
• Flip a coin 1,000,000 times, will get very close
  to 500,000

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Payment of Fortuitous Losses

• Fortuitous Loss one that is unforeseen and
  occurs as a result of chance
• Loss must be accidental
• Law of large numbers based on assumption that
  losses are accidental and random (not correlated)

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Risk Transfer

• A pure risk is transferred from the insured to
  the insurer
• Insurer is typically in a stronger financial
  condition to pay the loss
• Premature death, poor health, disability, theft,
  liability
• Self-insurance no risk transfer (risk retention)

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Indemnification

• The insured is restored to his or her approximate
  financial condition prior to occurrence of the
  loss
• Fire insurance meant to restore to original
  position

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Insurable Risk

• Large number of exposure units
• Loss must be accidental and unintentional
• Loss must be determinable measurable
• Loss should not be catastrophic
• Chance of loss should be calculable
• Premium must be economically feasible

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Insurable Risk

• Large number of exposure units
• Roughly similar, subject to same perils, and
  preferably independent of each other
• Allows for predictability based on the law of
  large numbers (See Stat lecture)
• Loss must be accidental and unintentional
• Moral hazard problem
• Law of large numbers depends on randomness

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Insurable Risk

• Loss must be determinable measurable
• Should be definite as to
• Cause
• Time
• Place
• Amount
• Disability is difficult to determine and measure

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Insurable Risk

• Loss should not be catastrophic
• Large number of units should not incur loss at
  same time
• Pooling breaks down premiums become prohibitive
• Insurers use reinsurance
• Selling the risk to another insurer
• Spread coverage over larger geographical area

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Insurable Risk

• Chance of loss should be calculable
• Insurer should be able to calculate average
• Frequency of loss
• Severity of loss
• Floods, wars, unemployment difficult
• Premiums should be economically feasible
• Should be much less than face of policy
• Chance of loss should be relatively low

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Insurable Risk

• Personal, property and liability risks can be
  insured because requirements are met, generally
• Market, financial and political risks are not
• Speculative
• Potential for catastrophic loss too high
• Calculation of premium difficult
• Example Risks of fire and unemployment

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Risk of Fire as an Insurable Risk
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Risk of Unemployment as an Insurable Risk
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Adverse Selection

• Tendency of persons with higher than average
  chance of loss to seek insurance at average rates
• Controlled through underwriting
• The process of selecting, classifying and pricing
  applicants for insurance
• No problem if correctly priced

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Insurance v. Gambling

• Gambling creates a speculative risk
• Insurance is a technique for dealing with an
  existing risk
• With gambling there is a loser for every winner
  (no benefit to society)
• Both parties gain, on average, with insurance

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Insurance v. Hedging

• Both transfer risk no new risk created
• Insurance involves insurable risks hedging
  generally is used for uninsurable risks
• Insurance can reduce the the objective risk of
  the insurer through the law of large numbers
• Hedging does not involve risk reduction only
  risk transfer

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Types of Insurance

• Private
• Life and Health
• Property and Liability
• Government
• Social insurance
• Other govt. insurance (FDIC, FSLIC)

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Property and Liability Insurance

• Fire insurance and allied lines
• loss or damage to real estate and personal
  property due to fire
• Can add indirect losses and other perils
• Marine
• Transportation ? ocean for ocean going vessels
  and cargo inland for goods shipped on land
• Casualty Broad covers everything else

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Property and Liability Insurance
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Property and Liability

• Multiple Lines combines property and casualty
  into one contract
• Ex homeowners combines fire insurance and other
  perils with liability insurance in one contract
• Fidelity bonds provide protection against loss
  caused by dishonest employees
• Surety bonds monetary compensation for failure
  to perform

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Government Insurance

• Social usually compulsory with prescribed
  benefits
• Social Security (OASDI)
• Medicare
• Unemployment
• Workers compensation
• Railroad retirement and unemployment
• Other FDIC, flood, crop, etc.

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Benefits to Society

• Indemnification for loss restores insured to
  their previous financial position after a loss
• Less worry and fear both before and after the
  loss
• Source of investment funds provides capital
  financial intermediary

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Benefits to Society

• Loss prevention insurance companies are very
  active in loss prevention programs and activities
• Safety engineers and specialists
• Enhancement of credit
• Guarantees value of borrowers collateral
• Homes, cars, inventories, etc.

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Costs to Society

• Costs of doing business
• Expense loading
• Commissions
• Taxes
• Administrative expenses
• Profit (return on capital)
• Fraudulent claims (public attitude?)
• Inflated claims

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Examples of Insurance Fraud