FIN350 Test 1

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.

Explain the historical definition of risk

There is no single definition of risk. Historically, many insurance authors have defined risk in terms of uncertainty. Risk is uncertainty concerning the occurrence of a loss.

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 higher-than-expected loss levels.

what is payment of fortuitous losses?

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.

What are the legal characteristics of insurance contracts?

Aleatory contract Unilateral contract Conditional contract Personal contract Contract of adhesion

Diversification

This technique reduces the chance of loss by spreading the loss exposure across different parties.

Identify the major social insurance programs in the United States.

Old-age, survivors, and disability insurance (Social Security) Medicare Unemployment insurance Workers compensation Compulsory temporary disability insurance Railroad Retirement Act

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

List the four requirements that must be met to form a valid insurance contract.

(a) There must be an offer and acceptance. (b) There must be consideration to support the contract. (c) There must be competent parties. (d) To be enforced, the contract must be for a lawful purpose.

What are the two major differences between insurance and hedging?

1. 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. 2. moral hazard and adverse selection are more severe problems for insurers than for speculators who buy or sell futures contracts.

What are the two major differences between insurance and gambling?

1. gambling creates a new speculative risk that did not exist before, while insurance is a technique for handling an already existing pure risk. 2. 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.

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

1. many of these risks are speculative risks, which are difficult to insure privately. 2. the potential for a catastrophic loss is great; this is particularly true for political risks, such as the risk of war. 3. calculation of the correct premium may be difficult because the chance of loss cannot be accurately estimated.

Explain the difference between a direct loss and an indirect or consequential loss.

A direct loss is a financial loss that results from the physical damage, destruction, or theft of property. Indirect loss results from or is the consequence of a direct loss. For example, if a student's car is stolen (direct loss), he or she will lose the use of the car until it is replaced or recovered (indirect loss).

What is a loss exposure?

A loss exposure is any situation or circumstance in which a loss is possible, regardless of whether a loss occurs.

Personal contract

A property insurance contract is personal. Personal characteristics of the insured influence the insurer's willingness to issue a policy. Accordingly, these contracts can be validly assigned only with the consent of the insurer. A life insurance policy is not a personal contract and can be freely assigned.

What is a valued policy law?

A valued policy law requires payment of the face amount of insurance if a total loss to real property occurs from a peril specified in the law.

What is a valued policy? Why is it used?

A valued policy pays the face amount of insurance in the event of a total loss. Valued policies are used to insure valuable property, such as antiques, fine arts, rare paintings, and family heirlooms. Because of the difficulty of determining the actual value of the property at the time of loss, the insured and insurer both agree on the value of the property when the policy is first issued.

Insurance

An auto insurance policy can be purchased covering the negligent operation of an automobile.

Why is an insurable interest required in every insurance contract?

An insurable interest is required in every insurance contract to prevent gambling, to reduce moral hazard, and to measure the amount of the insured's loss in property insurance.

Loss Prevention

Certain activities are undertaken that reduce the frequency of a particular loss. One example of loss prevention is periodic inspection of steam boilers to prevent an explosion.

Define chance of loss.

Chance of loss can be defined as the probability that an event will occur

what is indemnification?

Compensation is given to the victim of a loss, in whole or in part, by payment, repair, or replacement.

Concealment

Concealment is the intentional failure of the applicant for insurance to reveal a material fact to the insurer. The legal effect of a material concealment is the same as a misrepresentation—the contract is voidable at the insurer's option.

How does diversifiable risk differ from nondiversifiable risk?

Diversifiable risk is a risk that affects only individuals or small groups and not the entire economy. It is a risk that can be reduced or eliminated by diversification. In contrast, nondiversifiable risk is a risk that affects the entire economy or large numbers of persons or groups within the economy. It is a risk that cannot be reduced or eliminated by diversification.

What is financial risk?

Financial risk is the uncertainty of loss because of adverse changes in commodity prices, interest rates, foreign exchange rates, and the value of money.

what is 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.

Contract of adhesion

Insurance is a contract of adhesion in that it is not bargained. Rather, the policy is offered on a "take-it-or-leave-it" basis, and any ambiguity is construed against the insurer.

How does the concept of actual cash value support the principle of indemnity?

Insureds are indemnified when they are restored to approximately the same financial position they were in before the loss occurred. Actual cash value, which is defined as replacement cost less depreciation, supports the principle of indemnity because it is designed to prevent profiting from insurance.

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.

Why is subrogation used?

It is used to support the principle of indemnity by preventing an insured from collecting twice, once from the insured, and a second time from the negligent party.

what is pooling of losses?

Losses incurred by the few are spread over the entire group so that in the process, average loss is substituted for actual loss.

What is the difference between objective probability and subjective probability?

Objective probability refers to the long-run relative frequency of an event based on the assumption of an infinite number of observations and no change in the underlying conditions. Subjective probability is the individual's personal estimate of the chance of loss.

How does objective risk differ from subjective risk?

Objective risk is the relative variation of actual loss from expected loss. As the number of exposure units under observation increases, objective risk declines. Subjective risk is uncertainty based on one's mental condition or state of mind. Accordingly, objective risk is measurable and statistical; subjective risk is personal and not easily measured.

What is the difference between peril and hazard?

Peril is the cause of loss. Hazard is a condition that creates or increases the chance of loss

Define physical hazard, moral hazard, attitudinal hazard, and legal hazard.

Physical hazard is a physical condition that increases the chance of loss. Moral hazard is dishonesty or character defects in an individual that increase the chance of loss. Attitudinal hazard (morale hazard) is carelessness or indifference to a loss. Legal hazard refers to characteristics of the legal system or regulatory environment that increase the frequency or severity of losses.

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.

Describe the major social and economic burdens of risk on society.

Pure risk is a burden to society for at least three reasons: (a) The size of an emergency fund must be increased. (b) Society may be deprived of needed goods and services. (c) Worry and fear are present.

Explain the difference between pure risk and speculative risk.

Pure risk is defined as a situation in which there are only the possibilities of loss or no loss. Speculative risk is defined as a situation where either profit or loss is possible.

Identify the major types of personal risks that are associated with economic insecurity.

Pure risks associated with great financial and economic insecurity include the risks of premature death, insufficient income during retirement, old age, poor health, and unemployment. In addition, persons owning property are exposed to the risk of having their property damaged or lost from numerous perils. Finally, liability risks are also associated with great financial and economic insecurity.

What is a replacement cost policy?

Replacement cost insurance means there is no deduction for depreciation in determining the amount paid for a loss.

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 principle of subrogation.

Subrogation is taking over another person's right to recover in a legal action against a negligent third party.

What is systemic risk?

Systemic risk is the risk of collapse of an entire system or entire market due to the failure of a single entity or group of entities that can result in the breakdown of the entire financial system.

Separation

The assets exposed to loss are separated or divided to minimize the financial loss from a single event.

Conditional contract

The contract is conditional. In order to collect, a number of duties must be complied with, such as giving prompt notice of loss and submitting proof of loss.

Aleatory contract

The insurance contract is aleatory. The values exchanged are not equal. If a loss occurs, the insured may recover an amount in excess of the premiums paid. In a commutative contract, theoretically, there is an equal exchange of values.

Unilateral contract

The insurance contract is unilateral since only the insurer makes a legally binding promise. Most ordinary contracts are bilateral, and either party may be sued for breach of contract.

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.

How is actual cash value calculated?

The normal rule for determining actual cash value is replacement cost less depreciation. However, some courts have ruled that fair market value should be used to determine the actual cash value. Finally, some states use the broad evidence rule to determine the actual cash value. The broad evidence rule means that the determination of actual cash value should include all relevant factors an expert would use to determine the value of the property.

Explain the principle of indemnity.

The principle of indemnity states that the insurer agrees to pay no more than the actual amount of the loss; stated differently, the insured should not profit from a loss.

Explain the meaning of an insurable interest.

The principle of insurable interest means that the insured must stand to lose financially if a loss occurs.

Avoidance

This means a certain loss exposure is never acquired, or an existing loss exposure is abandoned. For example, a drug manufacturer can avoid lawsuits associated with a dangerous drug by not producing the drug.

Noninsurance Transfers

This means that a risk is transferred to another party other than an insurance company. For example, the risk of a defective television set can be shifted or transferred to the retailer by the purchase of a service contract by which the retailer is responsible for all repairs after the warranty expires.

Retention

This means that an individual or business firm retains part or all of the losses that can result from a given loss exposure. For example, a motorist may retain the first $500 of a physical damage loss to his or her automobile by purchasing an auto insurance collision policy with a $500 deductible.

Loss Reduction

This refers to measures that reduce the severity of a loss after it occurs. One example of loss reduction is an automatic sprinkler system in a department store that can reduce the severity of a fire loss.

Duplication

This technique refers to have back-up or duplicate copies of important documents or property in the event a loss occurs.

Warranty

a statement that becomes part of the insurance contract and is guaranteed by the maker to be true in all respects. For example, a bank may warrant that a guard will be on the premises 24 hours a day. In the past, under the common law, any breach of the warranty, even if slight, permitted the insurer to deny liability for the claim. However, this harsh doctrine has been substantially modified by court decisions and legislation.

Misrepresentation

a statement that is material, false, and relied on by the insurer. A material misrepresentation allows the insurer to void the policy.

Identify the major fields of private insurance.

life insurance, health insurance, and property and liability insurance (also called property and casualty insurance).

What are the characteristics of a typical insurance plan?

pooling of losses, payment of fortuitous losses, risk transfer, indemnification