CHAPTER THREE
INSURANCE
1
OUTLINES
Insurance Defined
Basic characteristics of insurance
Fundamentals of insurable risk
Insurance and gambling compared
Insurance and Speculation compared.
Benefits and costs of insurance
Benefits of insurance to the society
Cost of insurance to society 2
Insurance Defined
Insurance is a contractual agreement between two
parties: the insurer and the insured.
Under the agreement, the insurer agrees to reimburse
loss (as defined in the insurance contract) in return for
the insured's premium payment
Insurance is a system used to handle risk (transfer) risk.
Insurance is a device used to spread the loss suffered by
an individual or firm to the members in the group. 3
The following three points must be considered
regarding insurance contracts
1. There are usually two parties in the contract:
the insurer and the insured.
2. The insured transfers his risk to the insurer.
To this effect, he will have to pay premium.
3. If the specified risk materializes (happened to
the insurance), within a specified period, the
insurer will make financial compensation to
the insured or his beneficiary.
The insured is restored to his former position
called Indemnification.
4
Basic Characteristics of Insurance
An insurance plan or arrangement typically has certain
characteristics.
Pooling of losses
– Spreading losses incurred by the few over the entire
group
– Risk reduction based on the Law of Large Numbers
Payment of fortuitous losses
– Insurance pays for losses that are unforeseen,
unexpected, and occur as a result of chance
– The loss must be accidental
5
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
6
Fundamentals of insurable risks
Not all risks are commercially insurable.
Insurers normally insure only pure risks.
However, not all pure risks are insurable.
A risk could be considered an ideally insurable
risk if it satisfies the six conditions below.
1) There must be large number of exposure units
2) The loss must be accidental and unintentional
3) The loss must be determinable and measurable
4) The loss should not be catastrophic
5) The chance of loss must be calculable
6) The premium must be economically feasible 7
1) There must be a large number of exposure units
– There must be a sufficiently large number of
homogeneous exposure units to make the losses
reasonably predictable.
– Example: Large number of houses in a city can be insured
through property insurance on houses.
2) The loss must be accidental and unintentional
2) The loss must be the result of a contingency
3) The loss must not be something that is certain to happen
Two reasons why the second requirement is necessary:
-1- To control moral hazard
• 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). 8
2- To assure randomness
– 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.
3) The loss must be determinable and measurable
– 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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4) No catastrophic loss
– Losses occurred from earth quakes, floods and other natural
disasters will not be insured.
– The loss should not be catastrophic meaning that a large number of
exposure units should not incur losses at the same time
– To allow the pooling technique to work
– Exposures to catastrophic loss can be managed by:
• dispersing coverage over a large geographic area
• using reinsurance
5) Calculable chance of loss
– The insurer must be able to calculate both the average
frequency and the average severity of future losses with
some accuracy
– to establish an adequate premium
6) Economically feasible premium
– The cost of insurance must not be high in relation to the possible
loss.
– So people can afford to buy 10
QUESTIONS
? Dose the risk of Fire satisfy these
requirements?
? Dose the risk of unemployment
satisfy these requirements?
11
Adverse Selection and Insurance
• When the insurance is sold, insurers must deal with the
problem of Adverse Selection.
• Adverse selection is the tendency of persons with a higher
than-average chance of loss to seek insurance at standard
rates “
Examples
1- High drivers who seek auto insurance at standard rates
2- Persons with serious health problems who seek life or health
insurance at standard rates
3- Business firms that have been repeatedly robbed or
burglarized seek crime insurance at standard rates.
Hence, insurance companies try to control adverse selection by:
– Careful underwriting (selection and classification of applicants for
insurance)
– Policy provisions
12
Insurance vs. Gambling
Insurance Gambling
• Insurance is a • Gambling creates a new
technique for handing speculative risk
already existing pure
risk.
• Gambling is not socially
• Insurance is socially productive
productive: – The winner’s gain comes
– both parties have a at the expense of the loser
common interest in the
prevention of a loss
13
Insurance vs. Speculation
Insurance Speculation
• Risk is transferred by a • Risk is transferred by a
contract contract
• Insurance involves the • Speculation involves
transfer of insurable risks that are typically
risks uninsurable
• Insurance can reduce • Speculation involves
the objective risk of an only risk transfer, not
insurer through the risk reduction.
Law of Large Numbers
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Benefits and Costs of Insurance
Benefits of Insurance
Indemnification for Loss
– To provide financial compensation to those insured
who suffered losses due to accidental misfortune
– Contributes to family and business stability
Source of Investment Funds
– Premiums may be invested, promoting economic growth
Reduction of Worry
– Insurance reduces the physical and mental stress that
insured’s face concerning the possibility or financial loss.
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Encourages Saving
– In life insurance, certain policies have dual
advantages: Financial protection in the event of
death, and saving in the event of survival.
Enhances Efficient Utilization of Resources
16
Limitations of Insurance
Insurance deals with only pure risks.
- Not all pure risks are insurable.
- Examples include Flood, earthquake …
Cost of Doing Business
– Insurers consume resources in providing
insurance to society
– An expense loading is the amount needed to pay
all expenses, including commissions, general
administrative expenses, state premium taxes,
acquisition expenses, and an allowance for
contingencies and profit.
17
Fraudulent Claims
Examples include the following:
Auto accidents are faked or staged to collect
benefits.
Dishonest claimants fake slip-and-fall accidents.
Inflated Claims
Another cost of insurance relates to the
submission of inflated or “padded” claims.
Although the loss is not intentionally caused by
the insured, the dollar amount of the claim may
exceed the actual financial loss. 18
END OF
CHAPTER
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