Insurance Fundamentals A

What is Insurance?

"A method of handling pure risk by spreading it over a large number of similar individuals" "Insurance" is a contract in which an insurance company or government agency provides a guarantee of compensation for specified loss, damage, illness, or death in return for payment of a premium from an "insured person or group"

The Characteristics of an Insurable Risk

- The loss must be definite and definable - The loss must be accidental - The insurance company should be able to calculate the chance of the loss - The law of large numbers should apply - The loss must be great enough to create economic hardship - The insurance must be offered at a reasonable cost - The loss must not be catastrophic in nature All of these elements are not required to be present for every risk, but most of them should exist whenever possible

Speculative Risks

- The possibility of financial gain, or profit, exists with these types of risks. - Profit and loss are possible. Speculative risks are NOT INSURABLE.

Peril versus Hazard - The underlying cause of a loss may result from

- physical hazards - moral hazards - morale hazards

Pure Risks

- there is only the possibility of loss. - there is no possibility of financial gain. - Pure risks ARE INSURABLE

Risk Management - There are 5 methods of managing risk:

1. Risk Avoidance 2. Transfer of Risk 3. Sharing a Risk 4. Assumption of Risk/Risk Retention/Self-Insurance 5. Risk Reduction or Risk Control

Peril

A "peril" is what actually causes the loss. For example, a commercial building catches fire and is damaged. The fire is the peril that caused the loss.

Morale Hazard

A condition of inattention to, or disregard for, one's own life, health, or property by engaging in behavior that increases the frequency or severity of a loss. A morale hazard is "attitudinal" and involves an "apathetic disregard". An example of a moral hazard is an insured who has the option to drive on a paved road when leaving her home but instead drives off road and on terrain that can cause damage to the body of her car. The insured does not care because she knows that her insurance policy will cover the damage.

Moral Hazard

A condition that increases the probability that a person will intentionally cause, create, or inflate a loss. A moral hazard is generally an act created out of intent, and can be calculated or even premeditated. Stated differently, a moral hazard provides an incentive for one party to take risks that another party will pay for. Insurance can create a moral hazard.

Hazard

A condition that insurance the probability or "likelihood" that loss will occur. For example, a frayed electrical cord increases the likelihood that an electrical fire may occur.

Assumption of Risk/Risk Retention/Self-Insurance

An individual decides to create a risk, by doing something such as purchase a care or a home and retain the uncertainty of loss. This means that the individual would replace the care or house, at their own expense, if a loss occurred.

Why do Insurance Companies Use the Law of Large Numbers?

By using the law of large numbers, insurers can calculate their probably losses and establish accurate premium rates to cover losses and operating expenses.

Sharing a Risk

Even when a risk is transferred to an insurer, it is common to share some of the risk. For example, the deductibles and premiums an insured pays for insurance, are a form of risk sharing. The insured accepts responsibility for a small portion of the risk, while transferring the larger portion of the risk to the insurer.

Over-insurance

If an insured purchases an insurance policy that provides more coverage on a risk than the value of the possible loss Insureds can also create over-insurance by purchasing more than on policy to cover the same loss Over insurance violates the principle of indemnity

Reinsurance

Insurance companies will sometimes use "reinsurance" as a means of reducing their loss exposure on a particular risk. Reinsurance is insurance purchased by an insurance company, from another insurance company. Rather than one insurance company accepting a risk in its entirety, and possibly suffering a catastrophic loss, the risk is ceded to another insurance company or companies to spread the risk.

What does spreading the risk refer to?

Insurers can avoid adverse selection by pooling their risks from more than one source thereby "spreading the risk". This can be achieved by ensuring, during the same underwriting period, either a very large number of similar risks, multiple insured locations, or activities with dissimilar risks.

Are All Risks Insurable?

NO! All risks are NOT insurable.

What violates the Principle of Indemnity?

Over Insurance

The Categories of Risk

Pure Risk & Speculative Risk Most risks are neither completely "pure" nor completely "speculative"

Insurable Interest

Refers to the financial interest an individual, company or organization must have in the property, liability, or personal being insured. If no risk of financial loss is present, no insurable interest exists thus eliminating the need for insurance coverage.

Risk Reduction or Risk Control

Risks can be reduced by employing loss prevention methods such as installing a sprinkler system in a building, no longer smoking cigarettes, or losing weight for health reasons.

What primary source of information is used during the underwriting process?

The application itself However, other sources of information are used, depending on the type of policy being underwritten. Those sources include: · Consumer reports · Inspection reports · Credit reports · Insurance maps · Insurance company records · Insurance industry statistics and reports

Physical Hazard

The material, structural, environmental, or operational features of an insured risk that may create or increase the opportunity for injury or damage. Defective building materials, exposure to toxic chemicals, or a slippery sidewalk are all physical hazards that increase the possibility that a loss will occur.

Fundamental Risk

These are risks that affect entire groups of people or property within society examples are floods, earthquakes, terrorism, and economic collapse.

Particular Risk

These are risks that affect only the individual person or family, and not the entire community or society. These risks arise from a situation that occurs simultaneously with another specific event that increases the chance of a loss.

Static Risk

These risk factors are historical factors that do not frequently fluctuate they result from a "static" or "unchanging" environment Static risk factors tend to be associated with long term risk, such as an area that may only flood every 100 years, or a genetic illness that may or may not express itself. Static risks are pure risks bc they may or may not occur and are therefore, insurable

Transfer of Risk

This is the most common and more popular method of handling risk. A person can transfer their risk to an insurance company, in exchange for paying a regular premium to the company.

Dynamic Risk

This is the type of risk associated with change. A new and fatal virus erupting into society, technological advances that may cause a business to lose market share, or a change in law regarding hazardous waste disposal that now leaves a business liable for practices that were previously acceptable. Dynamic risks are not insurable.

Law of Large Numbers

This law shows us that we can predict, fairly accurately, what will happen to a large group of similar individuals in a given time period.

"risk pools"

When large groups of similar individuals are combined

The Principle of Indemnity

assumes that an insured who has suffered a loss, should only be restored to the approximate financial condition that existed prior to the loss, no better or no worse.

an insured can purchase a policy to cover his dwelling for loss from fire because

bc he would suffer a financial loss if his dwelling burned.

an insured could not purchase a policy to cover his neighbor's dwelling from loss from fire why?

bc the insured would not suffer a financial loss if his neighbor's house burned

Risk

is the possibility that a loss might occur & is the reason that people buy insurance. If a certain event happens, - accident, sickness, or death - loss occurs. The loss can be of life, or the loss of a loved one in the event of death, or the loss of income due to accident or sickness. In the case of property and casualty insurance, a structure may burn or a commercial truck may be involved in an accident

Underwriting

is the process of selecting certain types of risks that have that have historically produced a profit and rejecting those risks that do not fit the underwriting criteria of the insurer, that have historically produced a loss. Good underwriting practices, normally produce a favorable loss ratio for an insurance company. This means the premium collected, minus the claims paid and operating expenses, produces a profit for the insurer.

Adverse selection

is the tendency of insureds with a greater-than-average chance of loss to purchase insurance. With adverse selection, the insurer is confronted with the possibility of loss due to risk factors that were not factored in at the time the policy was sold. Insurers must carefully underwrite all risks to avoid being the victim of adverse selection

"actuaries"

make mathematical predictions about things such as how many of the people in any given "risk pool" will have their home destroyed by a tornado, be stricken with cancer, or die in a given year.

With property and/or casualty (liability insurance) insurable interest

must exist at the time of the loss

With life or health insurance, insurable interest

must exist at the time the policy is purchased

An insured could purchase a life insurance policy to cover her business partner's life because ...

the insured would suffer a financial loss if her partner died Therefore, the insured holds an insurable interest in her business partner's life that exists at the time she purchases the life insurance policy.

If an insured makes a profit from their loss

the principle of indemnity has been violated

What are other sources of underwriting information used by insurance companies?

· Consumer reports · Inspection reports · Credit reports · Insurance maps · Insurance company records · Insurance industry statistics and reports