RMIN 4000 Chapter 2 - Risk and Insurance PDF

RMIN 4000 Chapter 2 - Risk and Insurance 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 r...

RMIN 4000 Chapter 2 - Risk and Insurance 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. 2 Definition of Insurance (Restated) Insurance is the pooling of fortuitous accidental losses by transfer of such risks to insurers, who agree to indemnify compensate insureds for such losses, to provide other pecuniary monetary benefits on their occurrence, or to render services connected with the risk. 3 Basic Characteristics of Insurance 1. Pooling of losses 2. Payment of fortuitous losses 3. Risk Transfer 4. Indemnification 4 Law of Large Numbers The greater the number of exposures, the more closely will actual results approach the probable results expected from an infinite number of exposures. Example: A coin flip has a 50%/50% chance of heads o But you could flip it 10 times and get 8 heads (80%). o The more times you flip it, the closer the percentage of heads will get to 50%. 5 1. Pooling of Losses The spreading of losses incurred by a few over the entire group. Purpose is to reduce variation (as measured by standard deviation) which reduces uncertainty (risk). Think of standard deviation as the average distance from the mean. 6 2. Payment of Fortuitous Losses Fortuitous – unforeseen and unexpected by the insured and occurs a result of chance If you hit a bad shot on a golf course and your ball hits a house, is it fortuitous? If you attempt to buy homeowners insurance when a hurricane is approaching, is a wind loss fortuitous? 7 3. Risk Transfer A pure risk is transferred from the insured to the insurer, who typically is in a stronger financial position. What are some examples of pure risks that are transferred to insurers? 8 4. Indemnification The insured is restored to its approximate financial position prior to the occurrence of the loss. 9 Characteristics of an IDEALLY Insurable Risk 1) Large number of exposure units. 2) Loss must be accidental and unintentional. 3) Loss must be determinable and measurable. 4) Loss should not be catastrophic. 5) Chance of loss must be calculable. 6) Premium must be economically feasible. 10 1) Large Number of Exposure Units Enables the insurer to predict average loss based on the Law of Large Numbers. Large number of similar exposure units needed. Can an insurance company insure things that they don’t insure a large number of? 11 2) Loss Must be Accidental and Unintentional Loss should be outside of insured’s control. Why? o Law of Large Numbers is based on randomness. o If the insured can deliberately cause a loss that the insurer covers, what is increased? 12 3) Loss Must be Determinable and Measurable Determinable Can you determine if a loss occurred? When might this be easy? hard? Measurable Can you determine the amount of the loss? When might this be easy? hard? 13 4) Loss Should Not be Catastrophic (to the Insurer) Allows pooling technique to work. Examples of catastrophes Wildfires Terrorism Hurricane / Named Windstorm Flood Earthquake Why is a catastrophic loss problematic? Solutions for insurers o Reinsurance o Diversification 14 5) Chance of Loss Must be Calculable Must be able to calculate average frequency and average severity. Why? 15 6) Premium Must be Economically Feasible Insured must be able to afford it. Would the premium be economically feasible for a 99-year-old looking to buy life insurance? Exceptions? 16 Adverse Selection The tendency of persons with a higher-than- average chance of loss to seek insurance at standard (average) rates, which, if not controlled by underwriting, results in higher than expected loss levels. Typically results from asymmetric information. 17 Asymmetric Information Occurs when one party has information that is relevant to a transaction that the other party does not have. 18 Underwriting Risks Definition: Process of selecting and classifying applicants for insurance. Standards met Coverage terms / exclusions to consider Rates 19 Types of Insurance Private Insurance – Life, Health, Property & Casualty Government Insurance – Social insurance programs 20 Types of Private Insurance - Life and Health Life Insurance – Pays a death benefit to beneficiaries when an insured dies. Health Insurance – Pays medical expenses because of sickness or injury. (Non work related injuries) 21 Types of Private Insurance - Property & 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 – broad term that refers to insurance that covers whatever is not covered by fire, marine, and life insurance. Frequently it includes auto, liability and workers’ compensation. 22 Categories of Property &Liability Insurance Personal Lines Personal Auto Homeowners’ “package” Personal Articles Personal Umbrella Liability Flood Earthquake Coastal Windstorm 23 Categories of Property & Liability Insurance Commercial Lines Commercial Auto Workers’ Compensation Commercial General Liability Premise Liability Products Liability Commercial Umbrella / Excess Liability Flood Earthquake Coastal Windstorm 24 Categories of Property & Liability Insurance Commercial Lines (Continued) Inland Marine / Ocean Marine Surety Bonds Fidelity Bonds / Employee Dishonesty Crime Cyber Others 25 Government Insurance – 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 26 Government Insurance – Social Insurance Programs Examples 1. Old-Age, Survivors and Disability Insurance (Social Security) 2. Unemployment 3. Medicare 27 Other Government Insurance Programs Found at both the federal and state level. Examples o Federal Deposit Insurance Corporation (FDIC) o National Flood Insurance Program (NFIP) o Fair Access to Insurance Requirements Plans (FAIR) o Beach and Windstorm Plans o USDA Farm Programs 28