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Questions and Answers
What is the primary purpose of the principle of indemnity?
How does insurance reduce financial risk?
Which type of insurance contract is NOT a contract of indemnity?
What role do premiums play in an insurance contract?
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According to the law of large numbers, what happens as the number of risks in a pool increases?
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What is the result of transferring risk through the purchase of an insurance policy?
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Which principle allows premium charges to be very accurate?
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Why can't an insured profit from their loss according to the principle of indemnity?
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Study Notes
The Nature of Insurance
- Insurance is the transfer of risk from one party to another through a legal contract or the pooling of funds.
- The policyowner transfers the chance of a possible financial loss to the insurer in exchange for premium payments.
- Insurance spreads the risk of loss from one person to a large number of persons through the pooling of premiums.
- Insurance reduces financial risk and spreads the risk of loss from one individual to many.
Principle of Indemnity
- Accident, health, property, and casualty insurance contracts are contracts of indemnity.
- The purpose of indemnity is to make the insured "whole" again financially, without making them better off than they were prior to the loss.
- The principle of indemnity ensures that an insured shall not profit or gain by their loss.
- In contrast, life insurance policies are valued contracts and pay a stated sum regardless of the actual loss incurred.
Law of Large Numbers (Spread of Risk)
- The law of large numbers states that larger groups provide an increased degree of accuracy in loss predictions, based on past experience.
- The higher the exposure, the more likely the event can be predicted.
- The law of large numbers allows premium charges to be very accurate and insurers to be more financially stable when accepting insurable risks.
- Predicting expected loss across a large group is also known as the "spread of risk," or risk spreading.
- The law of large numbers provides safety in larger numbers, enabling insurers to cover losses and make a profit.
Adverse Selection
- Adverse selection is the tendency for higher-than-average risks to seek out insurance.
- Insurers must minimize adverse selection, which occurs when one party has superior accurate information over another party.
- Insurance underwriting is designed to ensure fair compensation for the actual risks undertaken by insurers.
- Premiums for higher-risk individuals or properties are greater than those for lower-risk ones.
- Insurers must avoid risks that run against their own best interest to remain profitable and in business.
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Description
This quiz covers the basics of insurance, including the concept of risk transfer, insurance contracts, and the roles of policyowners and insurers.
