CH 2 INSURANCE AND RISK

Identify some methods that insurers use to control for adverse selection.

Adverse selection can be controlled by careful underwriting, by charging higher premiums to substandard applicants for insurance, and by certain policy provisions.

What is the meaning of adverse selection?

Adverse selection is 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 higherthan- expected loss levels.

What are the two major differences between insurance and gambling?

Insurance differs from gambling in two ways. First, gambling creates a new speculative risk that did not exist before, while insurance is a technique for handling an already existing pure risk. Second, gambling is socially unproductive, since the winner's gain comes at the expense of the loser. Insurance is always socially productive, since both the insured and insurer win if the loss does not occur.

What are the two major differences between insurance and hedging?

Insurance differs from hedging. An insurance transaction usually involves the transfer of risks that are insurable, since the requirements of an insurable risk can generally be met. Hedging is a technique for handling risks that are typically uninsurable, such as protection against a substantial decline in the price of commodities. A second difference is that insurance may reduce objective risk because of application of the law of large numbers. In contrast, hedging typically involves only risk transfer, not risk reduction.

Explain each of the following characteristics of a typical insurance plan. a. Pooling of losses b. Payment of fortuitous losses c. Risk transfer d. Indemnification

Insurance plans have four distinct characteristics: (a) Pooling. Losses incurred by the few are spread over the entire group so that in the process, average loss is substituted for actual loss. (b) Fortuitous loss. Insurance plans provide for the payment of fortuitous losses. A fortuitous loss is one that is unforeseen and unexpected and occurs as a result of chance. (c) Risk transfer. In private insurance, a pure risk is transferred from the insured to the insurer, which is typically in a better financial position to pay the loss than the insured. (d) Indemnification. Compensation is given to the victim of a loss, in whole or in part, by payment, repair, or replacement.

Identify the approaches that insurers can use to deal with the problem of catastrophic loss exposures.

Insurers can deal with the problem of a catastrophe loss by (1) reinsurance, (2) avoiding the concentration of risk by dispersing coverage over a large geographical area, and (3) use of certain financial instruments in the capital markets, such as catastrophe bonds.

Identify the major social insurance programs in the United States.

Major social insurance programs are the following: • Old-age, survivors, and disability insurance (Social Security) • Medicare • Unemployment insurance • Workers compensation • Compulsory temporary disability insurance • Railroad Retirement Act

Identify several property and casualty insurance coverages.

Property and casualty coverages can be divided into personal lines and commercial lines. Personal lines include private passenger auto insurance, homeowners insurance, personal umbrella liability insurance, earthquake insurance, and flood insurance. (Commercial lines include fire and allied lines insurance, commercial multiple peril insurance, general liability insurance, products liability insurance, workers compensation insurance, commercial auto insurance, accident and health insurance, inland marine and ocean marine insurance, professional liability insurance, directors and officers liability insurance, boiler and machinery insurance (also known as equipment breakdown insurance), fidelity and surety bonds, and crime insurance.)

Explain the basic characteristics of social insurance programs.

Social insurance programs are government insurance programs with certain characteristics. The programs are enacted into law to deal with social and economic problems. The programs generally are compulsory and financed by contributions from covered employers and employees; benefits are paid from specifically earmarked funds; benefits are skewed or weighted in favor of lower income groups; benefit amounts generally are related to the covered individual's earnings; and eligibility requirements and benefit rights are prescribed by statute.

Explain the law of large numbers.

The law of large numbers states that the greater the number of exposures, the more closely the actual results will approach the probable results expected from an infinite number of exposures. As the number of exposures increases, the relative variation of actual loss from expected loss will decline. Thus, the insurer can predict future losses with a greater degree of accuracy as the number of exposures increases. This is important, since an actuary must charge a premium that is adequate for paying all losses and expenses during the policy period. The lower the degree of objective risk, the more confidence an insurer has that the actual premium charged will be sufficient to pay all claims and expenses and leave a margin for profit.

Identify the major fields of private insurance.

The major fields of private insurance are life insurance, health insurance, and property and liability insurance (also called property and casualty insurance).

Pure risks ideally should have certain characteristics to be insurable by private insurers. List the six characteristics of an ideally insurable risk.

There are several requirements of an ideally insurable risk: (a) There must be a large number of exposure units. (b) The loss must be accidental and unintentional. (c) The loss must be determinable and measurable. (d) The loss should not be catastrophic. (e) The chance of loss must be calculable. (f) The premium must be economically feasible

Why are most market risks, financial risks, production risks, and political risks considered difficult to insure by private insurers?

These risks are generally uninsurable for several reasons. First, many of these risks are speculative risks, which are difficult to insure privately. Second, the potential for a catastrophic loss is great; this is particularly true for political risks, such as the risk of war. Finally, calculation of the correct premium may be difficult because the chance of loss cannot be accurately estimated.