Chapter Two
The Insurance Mechanism
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.
Basic Characteristics of Insurance
Pooling of losses
Spreading losses incurred by the few over the entire group
Risk reduction based on the Law of Large Numbers
There should be a large number of similar but not identical
exposure units that are subject to the same peril.
Example:
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:
Basic Characteristics of Insurance
Expected loss 0.90 * $0 0.10 * $50,000 $5,000
Standard deviation 0.900 $5,000 0.10$50,000 $5,000
2 2
$15,000
Basic Characteristics of Insurance
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:
Basic Characteristics of Insurance
Expected loss 0.81* $0 0.09 * $25,000 0.09 * $25,000 0.01* $50,000
$5,000
Standard deviation 0.810 $5,000 (2)(0.09)$25,000 $5,000 0.01($50,000 $5,000) 2
2 2
$10,607
Basic Characteristics of Insurance
As additional individuals are added to the pooling
arrangement, the standard deviation continues to
decline while the expected value of the loss
remains unchanged.
Payment of fortuitous losses
Insurance pays for losses that are unforeseen,
unexpected, and occur as a result of chance
Basic Characteristics of Insurance
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
Characteristics of an Ideally Insurable Risk
1- Large number of exposure units
to predict average loss
The purpose of this requirement is to
enable the insurer to predict loss based on
the law of large number.
Characteristics of an Ideally Insurable Risk
2- Accidental and unintentional loss
to control moral hazard, because if an
intentional losses were paid, moral
hazard would be substantially
increased and premiums would rise as a
result.
to assure randomness, because law of
large number is based on the random
occurrence of events.
Characteristics of an Ideally Insurable Risk
3- Determinable and measurable loss
to facilitate loss adjustment
insurer must be able to determine if the
loss is covered and if so, how much should
be paid.
The loss should be definite as to cause, time,
place and amount.
Characteristics of an Ideally Insurable Risk
4- No catastrophic loss
to allow the pooling technique to work
exposures to catastrophic loss can be
managed by:
dispersing coverage over a large geographic area
using reinsurance
catastrophe bonds
Characteristics of an Ideally Insurable Risk
5- Calculable chance of loss
to establish an adequate premium to
pay all claims and expenses and yield a
profit during policy period.
The insurer should be able to calculate
both the average frequency and the
average severity of future losses with
some accuracy.
Characteristics of an Ideally Insurable Risk
6- Economically feasible premium
so people can afford to buy
Premium must be substantially less than
the face value of the policy
To have an economically feasible
premium, the chance of loss must
relatively be low.
Characteristics of an Ideally Insurable Risk
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
Exhibit 2.1 Risk of Fire as an Insurable
Risk
Exhibit 2.2 Risk of Unemployment as an
Insurable Risk
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, adverse selection result 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)
Insurance vs. Gambling
Insurance Gambling
Insurance is a technique for • Gambling creates a
handing an already existing new speculative risk
pure risk
Insurance is socially • Gambling is not
productive: socially productive
both parties have a common The winner’s gain
interest in the prevention of a comes at the expense
loss of the loser
Insurance vs. Hedging
Insurance Hedging
Risk is transferred by a
• Risk is transferred by a
contract contract
Insurance involves the
• Hedging involves risks that
transfer of insurable are typically uninsurable
risks
Insurance can reduce • Hedging does not result in
the objective risk of an reduced risk
insurer through the Law
of Large Numbers
Types of Insurance
I) Private Insurance
Life and Health
Property and Liability
II) Government Insurance
Social Insurance
Other Government Insurance
I) Private Insurance
Life and Health
Life insurance pays death benefits to
beneficiaries when the insured dies
Health insurance covers medical expenses
because of sickness or injury
Disability plans pay income benefits
I) Private Insurance
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
I) Private Insurance
Private insurance coverage can be grouped into
two major categories:
Personal lines
coverage that insure the real estate and personal
property of individuals and families or provide
protection against legal liability
Commercial lines
coverage for business firms, nonprofit organizations,
and government agencies
II) 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
Examples:
Social Security, Unemployment, Workers Compensation
Other Government Insurance Programs
Found at both the federal and state level
Examples:
Federal flood insurance, state health insurance pools
Social Benefits of Insurance
1- Indemnification for Loss
Contributes to family and business stability
2- Reduction of Worry and Fear
Insureds are less worried about losses
3- Source of Investment Funds
Premiums may be invested, promoting
economic growth
Social Benefits of Insurance
4- Loss Prevention
Insurers support loss-prevention activities that
reduce direct and indirect losses
5- Enhancement of Credit
Insured individuals are better credit risks than
individuals without insurance
Social Costs of Insurance
1- Cost of Doing Business
Insurers consume resources in providing insurance to
society
An expense loading is the amount needed to pay all
expenses, including commissions, general
administrative expenses, state premium taxes,
acquisition expenses, and an allowance for
contingencies and profit
2- Cost of Fraudulent and Inflated Claims
Payment of fraudulent or inflated claims results in
higher premiums to all insureds, thus reducing
disposable income and consumption of other goods
and services
