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