BBMF2083 INSURANCE MANAGEMENT

CHAPTER 3 INSURANCE FUNDAMENTALS (ANSWERS)

1. Compare the risks of (a) fire with (b) unemployment in terms of how well they meet the
requirements of an ideally insurable risk.

ASW:

(a) Fire

Requirements Does the risk of fire satisfy the requirements?

1.Large no. of exposure units Yes. Numerous exposure units are present.

2. Accidental & unintentional loss Yes. With the exception of arson, most fire losses are
accidental & unintentional.

3. Determinable & measurable Yes. If there is disagreement over the amount paid, a
loss property policy has provisions for resolving disputes,

4. No catastrophic loss Yes. Although catastrophic fires have occurred, all

exposure units normally do not burn at the same time.

5. Calculable chance of loss Yes. Chance of fire can be calculated & the average
severity of a fire loss can be estimated in advance.

6. Economically feasible Yes. Premium rate for fire insurance is relatively low.
premium

(b) Unemployment

Requirements Does the risk of unemployment satisfy the requirements?

1.Large no. of Not completely. Although there is a large no. of employees,

exposure units predicting unemployment is difficult because of the different
types of unemployment & different types of labour.

2. Accidental & No. A large proportion of unemployment is due to individuals

unintentional loss who voluntarily quit their jobs.

3. Determinable & Not completely. The level of unemployment can be determined,

measurable loss but the measurement of loss is difficult. Some unemployment is
involuntary; however, some unemployment is voluntary.

4. No catastrophic loss No. A severe national recession / depressed local business

conditions could result in a catastrophic loss.

5. Calculable chance No. The different types of unemployment generally are too
of loss irregular to estimate the chance of loss accurately.

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 6. Economically No. Adverse selection, moral hazard & the potential for a
feasible premium catastrophic loss could make the premium unaffordable.

2.

a) How does the operation of the Law of Large Numbers enable insurers:

i) To establish premiums;

ii) To minimise fluctuations in their experience.

ASW:

i) According to the Law of Large Numbers, it is necessary for an insurer to accept a

considerable number of insureds in order to predict its losses fairly accurately. This enables
the calculation of premiums for insurance with greater accuracy.

ii) According to the Law of Large Numbers, the chance that the relative frequency of failures
will differ from the underlying probability by any stated amount approaches zero as the
number of trials increases. E.g. Suppose that out of 10,000 lives, on the average, 10 die per
year. The probability is, therefore 1/1,000, or 0.001. Suppose, however, that although the
average is 10 deaths, from year to year the figures vary, showing as few as 7 deaths in
some years & as many as 13 deaths in other years. The range is from 7 to 13 & the
variation from the average may be said, roughly, to be 3 in each direction. The degree of
risk may be crudely expressed relatively, then, by the fraction of 3/10,000, or 0.0003.
Suppose, then, that 1,000,000 lives are insured. The probability is 0.001. On a larger
number of lives, however, the variation from year to year will be relatively much less,
probably only from 970 to 1,030, a variation of 30 each way, or 0.00003. This is a figure
considerably smaller than 0.0003. The probability may remain the same, but the degree of
risk, according to the theory of large numbers & substantiated by considerable experience
& experiment, is considerably reduced with a larger exposure.

b) In applying the Law of Large Numbers, what precautions must insurers take, and what
difficulties do they face? T t

ASW:

Large catastrophes prevent the proper working of the Law of Large Numbers. E.g. An
influenza epidemic, a hurricane, etc. are exceptional happening that no one can foresee &
to which past experience furnishes no guide. One method of attempting to reduce the
consequences of such losses upon the financial standing of an insurance company is to
secure a wide distribution of insured exposure units, not only limited to a particular area
but over the entire world. A wide distribution of risks, furthermore, reduces the variation in
losses from year to year & consequently renders the operation of the insurance business
more certain & sure. Reinsurance is a way of attaining distribution.

It is also essential to the Law of Large Numbers that the size of the individual exposure
unit not vary too greatly. The losses of an insurance company could not be expected to
remain uniform if it insured 500,000 insureds for RM1 each & 5 insureds for RM100,000
each. A few losses on the latter would be sufficient to upset all the calculations that could
be made. It is customary in nearly every form of insurance to limit the size of the exposure

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 that will be accepted / retained. E.g. In life insurance, the amount written on any 1 life may
be limited. Naturally, the maximum exposure that will be accepted depends largely upon
the size of the insurer concerned. As a result of this limitation, the practice of reinsurance
has developed, whereby a company that has accepted an exposure greater in size than it
desires reinsures a portion in another company.
The proper working of the Law of Large Numbers is based also upon a random selection of
insureds. In most forms of insurance, however, there is a natural tendency for poorer-risk
applicants exclusively to present themselves for insurance & as a consequence, the
insurance company institutes a system of selection whereby substandard applicants are
rejected, or at least are charged a higher premium than the normal applicant. In recent
years, however, medical selection in life insurance has been dispensed with to a greater
degree. Group insurance & even general life insurance to some extent are written without
medical examination. In property insurance, some selection is exercised, but insurers rely
mainly on making the rates proportionate to the hazard involved. When insurance in 1
insurance company is compulsory, as under the workmen’s compensation laws, selection is
impossible. In compulsory insurance with a choice of insurers, as often found in
workmen’s compensation & automobile insurance, selection by all insurers is also plainly
impossible & the result is enforced acceptance of poor-risk applicants by some insurers.
When insurance is compulsory, therefore, “assigned-risk pools”/ reinsurance facilities must
usually be created to apportion the poorer applicants.

3.
a) Explain how a mortality table for calculating the cost of life insurance is constructed.

b) Why are different mortality tables used, rather than just one standard table for all
calculations? Discuss.

ASW:

a) The mortality table is the instrument by which the probability of living / dying is measured.
This is a table showing the probable death rate at each age, frequently in a form showing
how many persons, starting with a given number at a given age, will probably die during
each succeeding year.

Life insurance actuaries have been able to construct tables showing the mortality
experience of large groups of people. Applying the principles of the theory of probability
& the law of large numbers, they have found that they can readily anticipate the number of
deaths & the time of their occurrence in any large group. It is known that the accuracy of
predictions is greater, the greater the number of cases under observation. This being the
case, in calculating the ratio of deaths, the group, to be reliable, must be sufficiently large
to come within the operation of the law of large numbers & permit variations from the
average to cancel each other.

A completed mortality table seems to suggest that, in its construction, the actuary started
with the number of lives indicated in the radix (i.e. the number of living at the youngest
age) & then followed the history of that group from year to year until there were no
survivors. Actually, the actuary determines the mortality rates for all the ages to be
included in his table & from these, he builds up a table based upon such radix as he selects.
It is a scientific assembly of data in a convenient form in order to show the probabilities of
death & survival.

In assembling the data, a large group at each age is selected for observation, commencing
with the age at which the table is to begin. A record is made each year of the number who
dies in each group under observation. By knowing the number of persons constituting a

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 group of a given age & the number of persons dying during the year, the probability that a
person of a given age will live 1 year can be approximated. Applying the probability that a
person of that age will live 1 year to the number living at any given age, the expected
number living at the beginning of the next succeeding year may be determined. The
process is repeated for each age until a year is reached in which the number dying equals
the number living at the beginning of that ear. The data are then arranged in the familiar
tabular form.

b) Different tables are computed for different needs. E.g. For individual ordinary policies,
industrial contracts & annuities.

4. Liability Insurance Company writes a substantial amount of commercial liability insurance.

A large construction company requests RM100 million of liability insurance to cover its
business operations. Liability Insurance has a reinsurance contract with Bermuda Re that
enables the coverage to be written immediately. Under the terms of the contract, Liability
Insurance pays 25% of the losses and retains 25% of the premium. Bermuda Re pays 75%
of the losses and receives 75% of the premium, less a ceding commission that is paid to
Liability Insurance.

a) What type of reinsurance contract best describes the reinsurance arrangement that Liability
Insurance has with Bermuda Re?

b) If a RM50 million covered loss occurs, how much will Bermuda Re have to pay? Explain
your answer.

c) Why does Bermuda Re pay a ceding commission to Liability Insurance?

ASW:

a) Treaty Reinsurance (Automatic Reinsurance)

A standing relationship is set up between a primary insurer & a reinsurer in which a
portfolio of the primary insurer’s exposures is covered by reinsurance without specific
arrangements for any particular exposure. The treaty between the parties is subject to
(non)renewal but while it is in force, the primary insurer is committed to cede & the
reinsurer is committed to accept, all the business covered by the treaty. Treaty reinsurance
accounts for a majority of the risk that is reinsured globally.

Pro Rata Reinsurance (Proportional Coverages) (Quota-Share Treaty)

The primary insurer & the reinsurer proportionally divide the losses, premiums &
expenses. E.g. The primary insurer may retain 40% of the coverage & cede the remaining
60%. Income & expenses are then pro-rated, i.e. shared in the same proportions.

b) If a RM50 million covered loss occurs, Liability Insurance pays RM100,000 to the insured
but is reimbursed by Bermuda Re for RM37.5 million (RM50 million x 75%).

c) The reinsurer pays a ceding commission to the primary insurer to help compensate for the
expenses incurred in writing the business,