Insurance Definition and Overview

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Questions and Answers

What is the benefit of insuring a large group of people?

It increases the number of claims from customers who suffer serious injuries

It reduces the confidence that policyholders will pay sufficient premiums

It allows for a more accurate prediction of future losses (correct)

It increases the risk of serious and expensive injuries

Why is an insurance company better off issuing 500 rather than 150 fire insurance policies?

Because it increases the chance of a serious and expensive injury

Because it is a company requirement

Because it increases the risk of loss exposure

Because it reduces the risk of loss exposure due to a stable and independent probability distribution (correct)

What is the primary purpose of pooling in insurance?

To reduce the variation in possible outcomes as measured by the standard deviation (correct)

To provide a higher premium for policyholders

To increase the variation in possible outcomes

To predict future losses with absolute certainty

What is a characteristic of a fortuitous loss?

It is unforeseen and unexpected by the insured Signup and view all the answers

What is the law of large numbers based on?

The assumption that losses are accidental and occur randomly Signup and view all the answers

What is the result of pooling a large number of exposure units?

A more accurate prediction of future losses Signup and view all the answers

What is the purpose of insurance in relation to fortuitous losses?

To provide payment for fortuitous losses Signup and view all the answers

Why can an insurance company be more confident that 150 policyholders will collectively pay sufficient premiums?

Because it allows for a more accurate prediction of future losses Signup and view all the answers

What is the literal meaning of the term 'Indemnity'?

Making good the loss Signup and view all the answers

What is the primary purpose of the principle of indemnity?

To prevent the insured from profiting from a loss Signup and view all the answers

What would happen if the insurer pays the full amount of the insurance policy despite the partial loss?

The principle of indemnity is violated Signup and view all the answers

What is the purpose of the principle of indemnity in relation to moral hazard?

To reduce moral hazard Signup and view all the answers

What is the exception to the principle of indemnity?

Life insurance Signup and view all the answers

How is the value of life determined in life insurance?

By certain qualitative factors and subjective opinion Signup and view all the answers

Why can't the principle of valuing material property be applied to determine the monetary value of life?

Because life is unique and can't be valued like material property Signup and view all the answers

What is the result of the insurer paying up to the amount of loss?

The insured is restored to the same financial position prior to the loss Signup and view all the answers

What is the principle of insurable interest based on?

A financial relationship recognized under the law Signup and view all the answers

What happens if the insured has no insurable interest over the life or a property?

The insurance contract is considered unenforceable Signup and view all the answers

What is the principle of utmost good faith based on?

The doctrine of Uberrimae Fides Signup and view all the answers

What type of products are sold in insurance?

Intangible products Signup and view all the answers

What is the duty of the parties to an insurance contract?

To have utmost good faith in each other Signup and view all the answers

What is required to be disclosed in an insurance contract?

All facts material to the risk being proposed Signup and view all the answers

Why is insurable interest necessary in insurance?

To ensure the insured's financial protection Signup and view all the answers

What is the consequence of non-disclosure of material facts in an insurance contract?

The insurance contract becomes unenforceable Signup and view all the answers

What is the consequence of concealing necessary facts in an insurance policy?

The policy will be considered void Signup and view all the answers

Which of the following facts need not be disclosed by the insured?

Circumstances that diminish the risk Signup and view all the answers

What is a representation in an insurance contract?

A statement made by the applicant for insurance Signup and view all the answers

When can the insurance contract be considered voidable by the insurer?

If the representation is material, false, and relied on by the insurer Signup and view all the answers

What is the primary mechanism of insurance?

Pooling of fortuitous losses by transferring risks to insurers Signup and view all the answers

What does 'material' mean in the context of insurance representations?

The insurer would not have issued the policy or would have issued it on different terms Signup and view all the answers

What is the main objective of the principle of indemnity?

To place the insured in the same pecuniary position after the loss as enjoyed just before it Signup and view all the answers

What principle explains the pooling of losses as an insurance mechanism?

Law of Large Numbers Signup and view all the answers

What is the result of the law of large numbers in insurance?

The average of a large number of independent identically distributed random variables tends to fall close to the expected value Signup and view all the answers

Who has the duty of disclosure in an insurance contract?

Both the insured and the insurance agent and company authorities Signup and view all the answers

What happens to the probability that the pool's resources will be insufficient to pay all claims as more policyholders are added?

It decreases Signup and view all the answers

What is the consequence of laxity in disclosing necessary facts by the insured?

Judgments will be tilted in favor of the insured Signup and view all the answers

What is the effect of an increase in the number of policyholders on the insurance?

It strengthens the insurance by reducing the probability that the pool will fail Signup and view all the answers

What is the economic implication of the law of large numbers in insurance?

There are returns to scale in insurance production Signup and view all the answers

What is the result of the law of large numbers in practical terms?

It is easier to establish the correct premium and thereby reduce risk exposure for the insurer Signup and view all the answers

What is the primary advantage of having more policyholders in an insurance class?

It reduces the risk exposure for the insurer Signup and view all the answers

Study Notes

Definition of Insurance

Insurance can be defined from multiple disciplines, including law, economics, history, actuarial science, risk theory, and sociology.
Insurance is the pooling of fortuitous losses by transferring risks to insurers, who agree to indemnify insureds for such losses or provide other pecuniary benefits.

Law of Large Numbers in Insurance

The law of large numbers states that the average of a large number of independent, identically distributed random variables tends to fall close to the expected value.
This principle is used to show that the entry of additional risks to an insured pool tends to reduce the variation of the average loss per policyholder around the expected value.
As the number of policyholders increases, the probability that the actual loss per policyholder will equal the expected loss per policyholder is higher.
This means that there are returns to scale in insurance production, making it easier to establish the correct premium and reduce risk exposure for the insurer as more policies are issued.

Basic Characteristics of Insurance

Pooling of Losses

Pooling involves the grouping of a large number of exposure units to provide a substantially accurate prediction of future losses.
The primary purpose of pooling is to reduce the variation in possible outcomes, thereby reducing risk.
Pooling implies the sharing of losses by the entire group and prediction of future losses with some accuracy based on the law of large numbers.

Payment of Fortuitous Losses

A fortuitous loss is one that is unforeseen and unexpected by the insured and occurs as a result of chance.
The law of large numbers is based on the assumption that losses are accidental and occur randomly.

Principle of Insurable Interest

Insurable interest is the legal right to insure arising from a financial relationship recognized under the law, between the insured and the subject matter of insurance.
The insured must have a pecuniary or monetary interest in the property, which they have insured.
If the insured has no insurable interest over the life or property they insure, the insurance contract is considered unenforceable.

Principle of Utmost Good Faith

The principle of utmost good faith stems from the doctrine of "Uberrimae Fides".
It implies that in a contract of insurance, the concerned contracting parties must rely on each other's honesty.
There must be a positive duty to voluntarily disclose, accurately and fully, all facts material to the risk being proposed, whether requested or not.
Any concealment of necessary facts is deemed intentional and will make the policy void.

Principle of Indemnity

Indemnity is the protection or security against damage or loss, providing financial compensation to place the insured in the same pecuniary position after the loss as enjoyed just before it.
The principle of indemnity ensures that the insurer is liable to pay up to the amount of loss, but not more than that.
The two fundamental purposes of the principle of indemnity are:
- To prevent the insured from profiting from a loss.
- To reduce moral hazard, preventing dishonest policyholders from deliberately causing the loss to collect the insurance proceeds.
Exception to the principle of indemnity: life insurance, where the value of life is determined by qualitative factors and is subject to one's opinion.

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Description

Understanding the concept of insurance from multiple disciplines, including law, economics, and actuarial science. Learn about the pooling of fortuitous losses and the role of insurers.