Chapters 1 & 2 QUIZ review

What are the two major differences between insurance and hedging?

1) an insurance transaction typically involves the transfer of pure risks because the characteristics of an insurable risk generally can be met 2) insurance can reduce the objective risk of an insurer by application of the law of large numbers

Identify several property and casualty insurance coverages

1) personal lines (automobile, homeowners) 2) commercial lines

Difference between pure and speculative risk

1) private insurers generally concentrate on insuring certain pure risks. With certain exceptions, private insurers generally do not insure speculative risks 2) the law of large numbers can be applied more easily to pure risks than to speculative risks. The law of large numbers is important because it enables insurers to predict future loss experience 3) society may benefit from a speculative risk even though a loss occurs, but it is harmed if a pure risk is present and a loss occurs

Systemic risk

The possibility that an event at the company level could trigger severe instability or collapse an entire industry or economy

Identify some methods that insurers use to control for adverse selection

Underwriting

List the six characteristics of an ideally insurable risk

WCSHAVER

Hazard

a condition that creates or increases the frequency or severity of loss

An indirect loss

a financial loss that results indirectly from the occurrence of a direct physical damage or theft loss

physical hazard

a physical condition that increases the frequency or severity of loss

Diversifiable risk

a risk that affects only individuals or small groups and not the entire economy.

nondiversifiable risk

a risk that affects the entire economy or large numbers of persons or groups within the economy

Enterprise risk

a term that encompasses all major risks faced by a business firm. Such risks include pure risk, speculative risk, strategic risk, operational risk, and financial risk

A direct loss

defined as a financial loss that results from the physical damage, destruction, or theft of the property

Speculative risk

defined as a situation in which either profit or loss is possible

Pure risk

defined as a situation in which there are only the possibilities of loss or no loss

Objective risk (also called degree of risk)

defined as the relative variation of actual loss from expected loss

Subjective risk

defined as uncertainty based on a person's mental condition or state of mind

Attitudinal hazard

is carelessness or indifference to a loss, which increases the frequency or severity of a loss

Moral hazard

is dishonesty or character defects in an individual that increase the frequency or severity of loss.

Identify the major fields of private insurance

life / health / property & liability

Risk transfer

means that a pure risk is transferred from the insured to the insurer, who typically is in a stronger financial position to pay the loss than the insured

Indemnification

means that the insured is restored to his or her approximate financial position prior to the occurrence of the loss

Payment of fortuitous losses

one that is unforeseen and unexpected by the insured and occurs as a result of chance

List the major types of pure risk that are associated with economic insecurity

personal, property, liability

Legal hazard

refers to characteristics of the legal system or regulatory environment that increase the frequency or severity of losses. Examples include adverse jury verdicts or large damage awards in liability lawsuits

Financial risk

refers to the uncertainty of loss because of adverse changes in commodity prices, interest rates, foreign exchange rates, and the value of money

Insurance

risk is always there

Gambling

risk is created when you make a bet

law of large numbers

states that 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

Peril

the cause of loss

Pooling of losses

the spreading of losses incurred by the few over the entire group, so that in the process, average loss is substituted for actual loss

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

risk

uncertainty concerning the occurrence of a loss