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Nature & Functions of Insurance: in Its Simplest Aspect, Insurance Has Two Fundamental Characteristics

This document discusses the key concepts of insurance. It defines insurance as transferring risk from individuals to a group and sharing losses on an equitable basis. Insurance allows individuals to substitute a small certain cost (premium) for a large uncertain financial loss. For risks to be insurable, they must affect a large number of exposure units and involve definite, measurable losses that are fortuitous and not catastrophic. The document also covers probability theory, social insurance programs, and public guarantee programs in the US.

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John Tyler Renevatio
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80 views16 pages

Nature & Functions of Insurance: in Its Simplest Aspect, Insurance Has Two Fundamental Characteristics

This document discusses the key concepts of insurance. It defines insurance as transferring risk from individuals to a group and sharing losses on an equitable basis. Insurance allows individuals to substitute a small certain cost (premium) for a large uncertain financial loss. For risks to be insurable, they must affect a large number of exposure units and involve definite, measurable losses that are fortuitous and not catastrophic. The document also covers probability theory, social insurance programs, and public guarantee programs in the US.

Uploaded by

John Tyler Renevatio
Copyright
© Attribution Non-Commercial (BY-NC)
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPT, PDF, TXT or read online on Scribd

Nature & Functions of Insurance

In

its simplest aspect, insurance has two fundamental characteristics:


1. 2.

Transfer of risk from the individual to the group. Sharing of losses on some equitable basis.

Operation of Insurance Illustrated


1. 1,000 dwellings valued at $100,000 each. 2. Each owner faces risk of a $100,000 loss. 3. Owners agree to share losses that occur.

4. If one house burns (total loss) each owner pays ($100 x 1,000 = $100,000).

Insurance Defined: Individual Perspective


Insurance

is an economic device whereby the

individual substitutes a small certain cost (the


premium) for a large uncertain financial loss (the

contingency insured against) which would exist if


it were not for the insurance.

Probability Theory and Law of Large Numbers


Probability

theory is the body of knowledge

concerned with measuring the likelihood that


something will happen and making predictions

based on this likelihood.

Determining the Probability of an Event

1. A priori estimates determined from the underlying conditions:

the probability of flipping a head is .5 the probability of drawing the Ace of Spades is 1/52

2. A priori estimates not significant for us except in illustrating Law of Large Numbers. 3. The type probability useful for Risk Management is referred to as a posteriori probability

Illustration of a Sampling of Losses Experienced by an Insurance Company

Year

Houses that Burn

1 2 3 4 5
Total Average

7 11 10 9 13
50 10

Sample Size I

Illustration of Sampling of Losses

Year

Houses that Burn

1 2 3 4 5
Total Average

16 4 10 12 8
50 10

Sample Size II

Standard Deviation
Year

Average Losses 10 10 10 10 10

Actual Losses 7 11 10 9 13

Differences 3 1 0 1 3 9 1 0 1 9 20

1 2 3 4 5

Variance

= 4, Standard Deviation = 2

Sample Size I Deviation


8

Standard Deviation
Year

Average Losses 10 10 10 10 10

Actual Losses 16 4 10 12 8

Differences 6 6 0 2 2 36 36 0 4 4 80

1 2 3 4 5
Variance

= 16, Standard Deviation = 4

Sample Size II Deviation


9

Dual Application of Law of Large Numbers

1. To estimate the underlying probability accurately, insurer must have a large sample of experience. 2. Once the estimate of probability has been made, it must be applied to a large number of exposure units to permit the underlying probability to work itself out.

10

Elements of an Insurable Risk

1. Large numbers of exposure units 2. Definite and measurable loss

3. The loss must be fortuitous


4. The loss must not be catastrophic

11

Additional Attributes of an Insurable Risk

Randomness- It is hoped that the risk will approximate the general conditions found in society in general. However, in real life Adverse Selection complicates the entire situation Economic Feasibility The cost of the insurance must not be excessively high in relation to the cost of the loss

12

Classification of Private Insurance

1. Life Insurance

2. Accident and health Insurance


3. Property and liability insurance

fire marine casualty

fidelity and surety bonds

13

Social Insurance Definition

1. 2.

Coverage is compulsory Eligibility derived from contributions: no requirement to demonstrate need

3.
4.

Method of determining benefits prescribed by law


Benefits not directly related to contributions

14

Social Insurance Programs in the U.S.

1. Old-Age, Survivors and Disability Insurance

2. Railroad Retirement, Disability and Unemployment Insurance


3. Unemployment Insurance 4. Medicare

5. State Compulsory Temporary Disability

15

Federal Public Guarantee Programs

1. Federal Deposit Insurance Corporation 2. National Credit Union Administration

3. Securities Investor Protection Corporation


4. Pension Benefit Guarantee Corporation

16

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