5 Insurance

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Insurance


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RISK


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Risk

Risk is the uncertainty concerning theoccurrence of a loss.

Insurance industry often uses the term risk torefer to identify the property or life beinginsured.

That driver is a poor risk That building is an unacceptable risk


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Peril and Hazard

Peril is the cause of loss- if a house burns, fire is the peril. A hazard is a condition that creates or increases the

chance of loss Physical hazard- physical condition that increases the

chance of loss- icy roads increase the chance of auto

accident Moral hazard- dishonesty or character defects in an

individual that increases the frequency or severity of loss-faking an accident to claim from an insurer

Morale hazard- carelessness or indifference to a lossbecause of the existence of insurance

Legal hazard- characteristics of the legal system orregulatory environment that increase the frequency orseverity of losses


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Pure Risk and Speculative Risk Pure risk is a situation in which there are only the

possibilities of loss or no loss Speculative risk is a situation in which either

profit or loss is possible Insurers typically insure only pure risk Law of large numbers can be applied more easily

to pure risk than to speculative risk

Society may benefit from a speculative risk eventhough a loss occurs, but is harmed if a pure riskis present and a loss occurs


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Types of Pure Risk Personal Risks- risks that directly affect the individual.

Possibility of loss or reduction of earned income, extraexpenses or the depletion of financial assets

a) Risk of premature death- death of a family head with

unfulfilled financial obligationsb) Risk of insufficient income during retirementc) Risk of poor health- payment of medical bills and loss

of earned income

d) Risk of unemployment- unemployment can resultfrom business cycle downswings, technological andstructural changes in the economy, seasonal factors,imperfections in the labor market


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Types of Pure Risk contd..

Property Risks- risks of having propertydamaged or lost.

Direct loss- financial loss that results from thephysical damage, destruction or theft of theproperty

Indirect or consequential loss - a financial loss

that results indirectly from the occurrence of adirect physical damage or theft loss


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Types of Pure Risk contd.. Liability risks- Under the legal system, you can be held

legally liable if you do something that results in bodilyinjury or property damage to someone else.

A court of law may order to pay substantial damage tothe person injured

No maximum upper limit with respect to the amount of loss.

A Lien can be placed on income and financial assets tosatisfy a legal judgment

Legal defence costs can be enormous


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Methods of Handling Risk Avoidance - Avoid risk by not carrying out the activity Loss control- Consists of certain activities that reduce

the frequency and severity of losses Loss Prevention- reducing probability of loss-safe driving,

strict security measures, Loss Reduction- reducing severity of losses- seat belts, use

of fire resistant materials Retention - Retain all or part of a given risk

Active retention- consciously aware but deliberately retainrisk

Passive retention- unknowingly retained risks Non-insurance transfers- service contracts, hedging

price risks using derivatives Insurance


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INSURANCE AND RISK


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Insurance

Insurance is the pooling of money by acompany from a group of people ororganizations, to pay for the fortuitous losses

that any of them may suffer. The money that the people pay to the

insurance company is called the premium , andfor this premium, the company promises toindemnify any of its customers for coveredlosses.


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Insurance

Insurance is defined as the equitable transferof the risk of a loss, from one entity toanother, in exchange for payment.

an insurer is a company selling the insurance; an insured , or policyholder, is the person or entity

buying the insurance policy; the insurance rate is a factor used to determine

the amount to be charged for a certain amount of insurance coverage, called the premium .


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Basic characteristics of Insurance

1. Pooling of losses : Insurance spreads few lossesover the whole group so the average loss issubstituted for actual loss.

2. Compensation of Fortuitous Losses : Fortuitousloss is that type of loss which is unforeseen andunexpectedly occurs as a result of chance.

3. Risk transfer : Insurance helps to transfer riskfrom the insured to insurer.

4. Indemnification : The insured is restored to hisher appropriate financial position prior to theoccurrence of the loss.


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Pooling of losses

Pooling is the sharing of losses incurred by thefew over the entire group, so that in the process,average loss is substituted for actual loss.

Pooling involves the grouping of a large numberof exposure units so that the law of largenumbers can operate to provide a substantiallyaccurate prediction of future losses.

Sharing of losses by the entire group Prediction of future losses with some accuracy based

on the law of large numbers


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Pooling of losses contd..

The law of large number states that thegreater the number of exposures, the moreclosely will the actual result approach theprobable results that are expected from aninfinite number of exposures.


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Payment of fortuitous losses

A fortuitous loss is one that is unforeseen andunexpected and occurs as a result of chance.

The loss must be accidental The law of large numbers is based on the

assumption that losses are accidental andoccur randomly.


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Risk transfer

Risk transfer means that a pure risk istransferred from the insured to the insurer,who typically is in a stronger financial positionto pay the loss than the insured.


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Indemnification

Indemnification means that the insured isrestored to his or her approximate financialposition prior to the occurrence of the loss.


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Insurable risk

Because insurance companies are businessesthat want to make a profit, there are onlycertain risks known as insurable risks thatprivate insurers are willing to cover.

Almost all risks insured by insurancecompanies are pure risks, which are riskswhere there is no possibility of profit.However, not all pure risks are insurable.


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Requirements of an insurable risk A risk is only insurable if there are a large number of exposure

units and if potential loss is fortuitous must have element of uncertainty has a determinable and measurable value- e.g. life

insurance

is not catastrophic (affecting a large number of exposure units at the same time), i.e., AIDS, otherwiseprinciple of pooling is not working

can be calculated in magnitude & frequency, so thatpremium can be determined

quantum of loss far bigger than premium; premium iseconomically feasible

is not against law/public interest, i.e., insure againstsoftware copyright violation


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TYPES OF INSURANCE

Life and Health Insurance Property and Liability Insurance


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Benefits of Insurance to Society Indemnification for loss- individuals and families

can maintain their financial security Reduction of worry and fear- true both before

and after a loss has occurred Source of investment funds- important source of

funds for capital investments Loss prevention- Insurance companies are

involved in numerous loss prevention programs Enhancement of credit- Insurance enhances a

persons credit - property insurance makes anindividual a better credit risk


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Costs of Insurance to Society

Cost of doing business- Insurance consumesscarce economic resources

Fraudulent claims Payment of fraudulentclaims results in higher premiums to allinsured.

Inflated claims- Premiums must be increasedto pay the additional losses.


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FUNDAMENTAL LEGAL

PRINCIPLES


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Principle of Indemnity

Principle of indemnity states that the insureragrees to pay no more than the actual amountof the loss.

The insured should not profit from a loss Purpose

Prevent the insured from profiting from a loss Reduce moral hazard


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Principle of Insurable Interest

The principle of insurable interest states thatthe insured must be in a position to losefinancially if a covered loss occurs

Purpose To prevent gambling To reduce moral hazard To measure the amount of insureds loss in

property insurance


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Principle of Subrogation

Subrogation means substitution of the insurerin place of the insured for the purpose of claiming indemnity from a third person for theloss covered by insurance

Insurer is entitled to recover from a negligent thirdparty any loss payments made to the insured.


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Principle of Utmost Good Faith

A higher degree of honesty is imposed onboth parties of an insurance contract than isimposed on parties to other contracts.

Principle of Utmost Good Faith is supportedby three important legal doctrines-representations, concealment and warranty.


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Principle of Utmost Good Faith

Representations Representations are statements made by the

applicant for insurance. The insurancecontract is voidable at the insurers option if

the representation is material, false and reliedon by the insurer. Material means that if the insurer knew the true facts,

the policy would not have been issued, or it would have

been issued on different terms; false means that thestatement is not true or misleading; reliance meansthat the insurer relies on the misrepresentation inissuing the policy at a specified premium


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Principle of Utmost Good FaithConcealment

A concealment is intentional failure of theapplicant for insurance to reveal a materialfact to the insurer.

Concealment is the same as non-disclosure.


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Principle of Utmost Good FaithWarranty

A warranty is a statement that becomes partof the insurance contract and is guaranteed bythe maker to be true in all respects.

In exchange for a reduced premium, a store ownermay warrant that an approved burglary alarmsystem will be operational at all times


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INSURANCE COMPANY

OPERATIONS


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Rate Making

Rate making refers to the pricing of insurance. Insurance pricing differs considerably from

pricing of other products. When otherproducts are sold, the company generallyknows in advance what its costs of producingthe products are.

Person who determines rates and premiums isknown as actuary .


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Underwriting

Underwriting refers to the process of selecting, classifying and pricing applicants forinsurance.


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Production

Production refers to the sales and marketingactivities of insurers.

Agents who sell insurance are frequentlyreferred to as producers.


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Claim Settlement

Verification of a covered loss Fair and prompt payment of claims Personal assistance to the insured


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Reinsurance Reinsurance is an arrangement by which the

primary insurer that initially writes the insurancetransfers to another insurer (called the reinsurer)part or all of the potential losses associated withsuch insurance.

Primary insurer ceding company; acceptinginsurer- reinsurer; amount of insurance retainedby the ceding company for its own account net

retention Reinsurer may reinsure part or all of the risk with

another insurer- retrocession ; retrocessionaire


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Investments

Premiums are paid in advance- they can beinvested until needed to pay claims andexpenses

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