Chapter 2 Insurance and Risk

Law of Large Numbers

**Central Limit Theorem: Avg losses from a random sample of exposure units will follow a normal distribution Regardless of the population distribution, the distribution of sample means will approach the normal distribution as the sample size decreases The standard error of the sample mean distribution declines as the sample size increases **as the # of exposure units becomes infinitely large, the actual loss frequency approaches the expected true loss frquency EX) coin flip

Basic Characteristics of Insurance: POOLING OF LOSSES

*spreading losses incurred by the few over the entire group *risk reduction based on Law of Large Numbers

Requirements of an 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

Distributions are characterized by:

-a measure of CENTRAL TENDENCY the mean, or expected value is found by multiplying each outcome by the probability of occurrence, and then summing the results products -DISPERSION the variance is the sum of the squared differences b/w the possible outcomes and the expected value, weighted by the probability of the outcomes

Adverse Selection can be controlled by:

1) CAREFUL UNDERWRITING - selection and classification of applicants for insurance 2) POLICY PROVISIONS - suicide clause in life insurance

Types of Insurance

1) PRIVATE INSURANCE - Life and Health - Property and Liability 2) GOVERNMENT INSURANCE -Social insurance -Other Gov't Insurance

Social Benefits of Insurance

1. Indemnification of 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) 4. Loss Prevention (insurers support loss-prevention activities that decrease direct/indirect losses) 5. Enhancement of Credit (insured individuals are better credit risks than individuals w/o insurance)

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

Other Government Insurance Programs

Found at both federal and state levels EX) federal flood insurance, state health insurance pools

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

Requirements of an Insurable Risk

Most personal, property and liability risks are insured Market risks, financial risks, production risks, and political risks are difficult to insure

Basic Characteristics of Insurance: INDEMNIFICATION

The insured is restored to his or her approx financial position prior to the occurrence of loss

Private Insurance two major categories: COMMERCIAL LINES

coverage for business firms, NFP org, and gov't agencies

Private Insurance two major categories: PERSONAL LINE

coverages that insure the real estate and personal property of individuals and families or provide protection against legal liability

Health Insurance

covers medical expense because of sickness or injury

Liability Insurance

covers the insured's legal liability arising out of property damage or bodily injury to others

Insurance vs Gambling GAMBLING

creates a new speculative risk is NOT socially productive: The winner's gain comes at the expense of the loser

Social Insurance Programs

financed entirely or in large in part by contributions from employers and/or employees benefits are heavily weighted in favor of low-income families Eligibility and benefits are prescribed by statute EX) SS, unemployment, Work Comp

Property Insurance

indemnifies property owners against loss or damage or real or personal property

Basic Characteristics of Insurance: PAYMENT OF FORTUITOUS LOSSES

insurance pays for losses that are unforeseen, unexpected, and occur as a result of chance

Social Costs of Insurance 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, gen admin expenses, state prem. taxes, acquisition expenses, and an allowance for contingencies

Insurance vs Gambling INSURANCE

is a technique for handling an already existing pure risk is socially productive: Both parties have an interest in the prevention of a loss

Social Costs of Insurance 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

Life Insurance

pays death benefits to beneficiaries when the insured dies

Disability Plans

pays income benefits

Insurance vs Hedging INSURANCE

risk is transferred by a contract involves the transfer of insurable risks can reduce the objective risk of an insurer through the Law of Large Numbers

Insurance vs Hedging HEDGING

risk is transferred by contract involves risk that are typically uninsurable doesnt result in reduced risk

Requirements of an Insurable Risk: 6) Economically feasible premium

so people can afford to buy premium must be substantially less than the face value of the policy

Probability and Statistics

the PROBABILITY of an event is the long-run frequency of the event, given an infinite number of trials with no changes in the underlying conditions Events and probabilities are summarized through a probability distribution

Adverse Selection

the tendency of persons with a higher-than-average chance of loss to seek insurance at standard rates *if not controlled, AS results in higher than expected loss levels

Requirements of an Insurable Risk: 4) No catastrophic loss

to allow the pooling technique to work exposures to catastrophic loss can be managed EX) dispersing coverage over a large geo area

Requirements of an Insurable Risk: 2) Accidental and Unintentional Loss

to control moral hazard to assure randomness

Requirements of an Insurable Risk: 5) Calculable chance of loss

to establish an adequate premium

Requirements of an Insurable Risk: 1) Large number of exposure units

to predict average loss