Principles of Risk Management and Insurance PDF

Principles of Risk Management and Insurance Fourteenth Edition Chapter 2 Insurance and Risk Rubie Ling Copyright © 2020, 2017, 2014 Pearson Education, In...

Principles of Risk Management and Insurance Fourteenth Edition Chapter 2 Insurance and Risk Rubie Ling Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Learning Objectives (1 of 3) 2.1 a. Define insurance based on the definition drafted by the Commission on Insurance Terminology. b. Explain the basic characteristics of insurance based on the aforementioned definition. 2.2 Explain the law of large numbers. 2.3 a. Describe the characteristics of an ideally insurable risk from the viewpoint of a private insurer. b. Explain whether fire and unemployment meet the requirements of an insurable risk. Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Learning Objectives (2 of 3) 2.4 a. Understand how adverse selection can lead to higher- than-expected losses and unprofitable business for insurers. b. Explain the methods insurers use to control adverse selection. 2.5 a. Show how insurance is not the same thing as gambling. b. Understand how insurance differs from hedging as a technique for treating risk. Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Definition of Insurance Insurance is the pooling of fortuitous losses by transfer of such risks to insurers, who agree to indemnify insureds for such losses, to provide other pecuniary benefits on their occurrence, or to render services connected with the risk A fortuitous loss is one that is unforeseen and unexpected by the insured and occurs as a result of chance. Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Basic Characteristics of Insurance (1 of 4) An insurance plan or arrangement typically includes the following characteristics: – Pooling of losses – Payment of fortuitous losses – Risk transfer – indemnification Pooling involves spreading losses incurred by the few over the entire group Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Basic Characteristics of Insurance (2 of 4) Example of Pooling: – Two business owners own identical buildings valued at $50,000 – There is a 10 percent chance each building will be destroyed by a peril in any year – Loss to either building is an independent event – Expected value and standard deviation of the loss for each owner is: Expected loss = 0.90 $0 + 0.10 $ 50,000 = $ 5,000 Standard deviation = 0.90(0  $5,000)2 + 0.10($50,000  $5,000)2 = $15,000 Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Basic Characteristics of Insurance (3 of 4) Example, continued: – If the owners instead pool (combine) their loss exposures, and each agrees to pay an equal share of any loss that might occur: Expectedloss = 0.81$ 0 +0.09 $ 25,000+0.09 $ 25,000+ 0.01$ 50,000 = $ 5,000 Standard deviation = 0.81(0  $5,000)2 +(2)(0.09)($25,000  $5,000)2 + 0.01($50,000  $5,000)2 = $10,607 – As additional individuals are added to the pool, the standard deviation continues to decline while the expected value of the loss remains unchanged Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Basic Characteristics of Insurance Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Law of Large Numbers Risk reduction is based on the Law of Large Numbers According to the Law of Large Numbers, the greater the number of exposures, the more closely will the actual results approach the probable results that are expected from an infinite number of exposures. Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Basic Characteristics of Insurance (4 of 4) Payment of fortuitous losses – A fortuitous loss is one that is unforeseen, unexpected, and occur as a result of chance 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 Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Characteristics of an Ideally Insurable Risk (1 of 3) Large number of exposure units – to predict average loss based on the law of large numbers Accidental and unintentional loss – to assure random occurrence of events Determinable and measurable loss – to determine how much should be paid Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Characteristics of an Ideally Insurable Risk (2 of 3) No catastrophic loss – to allow the pooling technique to work – exposures to catastrophic loss can be managed by using reinsurance, dispersing coverage over a large geographic area, or using financial instruments, such as catastrophe bonds Calculable chance of loss – to establish a premium that is sufficient to pay all claims and expenses and yields a profit during the policy period Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Characteristics of an Ideally Insurable Risk (3 of 3) Economically feasible premium – so people can afford to purchase the policy – For insurance to be an attractive purchase, the premiums paid must be substantially less than the face value, or amount, of the policy Based on these requirements: – Most personal, property and liability risks can be insured – Market risks, financial risks, production risks and political risks are difficult to insure Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Exhibit 2.1 Fire as an Insurable Risk Requirements Does the risk of fire satisfy the requirements? 1. Large number of exposure units Yes. Numerous exposure units are present. Yes. With the exception of arson, most fire 2. Accidental and unintentional loss losses are accidental and unintentional. Yes. If there is disagreement over the amount 3. Determinable and measurable paid, a property insurance policy has loss provisions for resolving disputes. Yes. Although catastrophic fires have occurred, 4. No catastrophic loss all exposure units normally do not burn at the same time. Yes. Chance of fire can be calculated, and the 5. Calculable chance of loss average severity of a fire loss can be estimated in advance. Yes. Premium rate per $100 of fire insurance is 6. Economically feasible premium relatively low. Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Exhibit 2.2 Unemployment as an Insurable Risk Requirements Does the risk of unemployment satisfy the requirements? 1. Large number of exposure units Not completely. Although there are a large number of employees, predicting unemployment is often difficult because of the different types of unemployment and different types of labor. 2. Accidental and unintentional Not always. Some unemployment is due to individuals who voluntarily quit their loss jobs. 3. Determinable and measurable Not completely. The level of unemployment can be determined, but the loss measurement of loss may be difficult. Most unemployment is involuntary because of layoffs or because workers have completed temporary jobs. However, some unemployment is voluntary; workers voluntarily change jobs because of higher wages, a change in careers, family obligations, relocation to another state, or other reasons. 4. No catastrophic loss No. A severe national recession or depressed local business conditions in a town or city could result in a catastrophic loss. 5. Calculable chance of loss Not completely. The different types of unemployment in specific occupations can make it difficult for actuaries to estimate the chance of loss accurately. 6. Economically feasible premium Not completely. Adverse selection, moral hazard, policy design, and the potential for a catastrophic loss could make the insurance too expensive to purchase. Some plans, however, will pay unemployment benefits in certain cases where the unemployment is involuntary, and the loss payments are relatively small, such as waiver of life insurance premiums for six months, or payment of credit card minimum payments for a limited period. Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Adverse Selection and Insurance Adverse selection is the tendency of persons with a higher-than-average chance of loss to seek insurance at standard rates If not controlled by underwriting, adverse selection results in higher-than-expected loss levels Adverse selection can be controlled by: – careful underwriting (selection and classification of applicants for insurance) – policy provisions (e.g., suicide clause in life insurance) Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Insurance and Gambling Compared Insurance Handles an already existing pure risk Is always socially productive: – both parties have a common interest in the prevention of a loss Gambling Creates a new speculative risk Is not socially productive – The winner’s gain comes at the expense of the loser Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Insurance and Hedging Compared Insurance Risk is transferred by a contract Involves the transfer of pure (insurable) risks Moral hazard and adverse selection are more severe problems for insurers Hedging Risk is transferred by a contract Involves risks that are typically uninsurable Fewer problems of moral hazard and adverse selection for entities who buy or sell futures contracts Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Types of Insurance (1 of 5) Insurance can be classified as either private or government insurance – Private insurance includes life and health insurance as well as property and liability insurance – Government insurance includes social insurance programs and other government insurance plans Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Types of Insurance (2 of 5) Life and Health – Life insurance pays death benefits to beneficiaries when the insured dies – Health insurance covers medical expenses because of sickness or injury Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Types of Insurance (3 of 5) Property and Liability – Property insurance indemnifies property owners against the loss or damage of real or personal property – Liability insurance covers the insured’s legal liability arising out of property damage or bodily injury to others – Casualty insurance refers to insurance that covers whatever is not covered by fire, marine, and life insurance Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Types of Insurance (4 of 5) Private insurance coverages can be grouped into two major categories – Personal lines: coverages that insure the real estate and personal property of individuals and families or provide protection against legal liability – Commercial lines: coverages for business firms, nonprofit organizations, and government agencies Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Types of Insurance (5 of 5) Social Insurance Programs – Financed entirely or in large part by contributions from employers and/or employees – Benefits are heavily weighted in favor of low-income groups – Eligibility and benefits are prescribed by statute – Examples: Social Security, Unemployment, Workers Comp Other Government Insurance Programs – Found at both the federal and state/provincal level – Examples: Federal flood insurance, state health insurance pools Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Benefits of Insurance to Society Indemnification for Loss Reduction of Worry and Fear Source of Investment Funds Loss Prevention Enhancement of Credit Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Costs of Insurance to Society (1 of 2) The major social costs of insurance include: – Cost of Doing Business ▪ An expense loading is the amount needed to pay all expenses, including commissions, general administrative expenses, state/province premium taxes, acquisition expenses, and an allowance for contingencies and profit – Fraudulent Claims – Inflated Claims Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Costs of Insurance to Society (2 of 2) Higher premiums to cover additional losses reduce disposable income and consumption of other goods and services Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Quiz Examples 1) From the viewpoint of the insurer, all of the following are characteristics of an ideally insurable risk EXCEPT A) The loss must be accidental. B) The loss should be catastrophic. C) The premium must be economically feasible. D) There must be a large number of exposure units. 2) Which of the following types of risks is normally uninsurable by private insurers? A) personal risks B) property risks C) liability risks D) political risks Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Quiz Examples 3) If insurers were to provide indemnification for losses that were deliberately caused, which characteristic of ideally insurable risks would not be met? A) The loss must be accidental and unintentional. B) The loss must be determinable and measurable. C) The loss should not be catastrophic. D) There must be a large number of similar exposure units. Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved