Definition and Characteristics of InsuranceBUS 200Introduction to Risk Management and Insurance

Jin Park

Definition of Insurance A social device in which a group of

individuals (called “insureds”) transfer risk to another party (called an “insurer”) in order to combine loss experience, which permits statistical prediction of losses and provides for payment of losses from funds contributed (premiums) by all members who transferred risk.

Definition of Insurance 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.

Definition of Insurance A formal social device for reducing

risk by transferring the risks of several individual entities to an insurer. The insurer agrees, for a consideration, to assume, to a specified extent, the losses suffered by the insured.

Definition of Insurance A system under which individuals,

businesses, and other organizations or entities, in exchange for payment of a sum of money (a premium), are guaranteed compensation for losses resulting from certain perils under specified conditions.

Characteristics of Insurance Risk Transfer Loss Sharing

Insurance is about spreading the financial responsibilities.

Discrimination via underwriting

Characteristics of Insurance Risk Transfer

An insurer, a professional risk-bearer, assumes the financial aspects of risks transferred to it by insureds.

In return, the insurer receives a premium.

Insurer is typically in a stronger financial condition to pay the loss.

Characteristics of Insurance Loss sharing (pooling)

Loss sharing is accomplished through premiums; therefore, group losses are shared by the group’s members. This is the essence of pooling.

Pooling arrangement changes the probability distribution of accident costs facing each person.

Characteristics of Insurance Loss sharing (pooling)

Assume 1,000 individuals each have homes worth $100,000

On average, 1 home burns down per year Without insurance: max loss = $100,000 Suppose all agree to share the loss

average loss = 100,000 / 1,000 = $100 Trading between “$100 sure loss” and

“chance of losing $100,000”

Characteristics of Insurance

Outcomes

Prob.

$ 0 0.80 0

$ 2,500 0.20 500

Expected Loss = $500Std. Dev. = $1,000

No pooling between two persons

Person A Person B

Expected Loss = $500Std. Dev. = $1,000

Outcomes

Prob.

$ 0 0.80 0

$ 2,500 0.20 500

Characteristics of Insurance

Scenarios Total cost A Loss B Loss Prob.

Neither loss $0 $0 $0 .64 0

A loss – B no loss

$2,500 $1,250

$1,250

.16 200

A no loss – B loss

$2,500 $1,250

$1,250

.16 200

Both losses $5,000 $2,500

$2,500

.04 100

Two-person pooling arrangement

Each individual’s expected loss amount = $500Std. Dev. = $707 compare this with $1,000

Characteristics of Insurance

Scenario Total cost Participant’s share Prob.

No loss $0

1 loss $2,500

2 losses $2,500

3 losses $7,500

1.00

Three-person pooling arrangement

Each individual’s expected loss amount = $500Std. Dev. = $577.35 compare with $1,000 or $707

Discrimination via underwriting Underwriting

The process of selecting risks (insurance applicants) and classifying them according to their degrees of insurability so that the appropriate rates may be assigned. The process also includes rejection of those risks that do not qualify.

Note: insurance profits may come from both underwriting and investment.

Discrimination via underwriting Life/Health Insurance

Type of policies Face amount Insured’s age, gender Tobacco use Residence Health status Family diagnosis Driving records … and more

Property/Liability Type of policies Limit of insurance Nature of business Location Past claim history Total revenue Type of property Construction type Credit history … and more

Discrimination via underwriting Underwriting Decisions

Accept the application Accept the application subject to

certain restrictions or modifications Reject the application

Discrimination via underwriting Young person

Expected Claim ($)= 0 x (.95) + (10,000) x (.95)= $ 500

Old personExpected Claim ($)= 0 x (.90) + (10,000) x (.10)= $ 1,000

Outcome Payment Prob.

No Claim $ 0 .95

Claim $10,000 .05

Outcome Payment Prob.

No Claim $ 0 .90

Claim $10,000 .10

Discrimination via underwritingIf they are put into the same pool and share the losses, then total expected claim for the pool= $0x(.855) + $10,000x(.095) + $10,000x(.045) + $20,000x(.005) = $1,500. Thus, the share for each participant in the pool is $750.

Scenarios Total cost Prob.

Neither claims $0 .855 $ 0

Only Young claims

$10,000 .095 $950

Only Old claims $10,000 .045 $450

Both claim $20,000 .005 $100

Discrimination via underwriting If you were the young person, paying

$750, what would you do????___________

If you were the old person, paying $750, what would you do????___________

Then, what will happen to the insurer that sets the pure premium at $750????___________

Discrimination via underwriting Adverse Selection

The phenomenon of selecting an insurer that charges lower rates for a specific risk exposures.

The tendency of persons with a higher-than-average chance of loss to seek insurance at standard (average) rate, which if not controlled by underwriting, results in higher-than-expected loss levels.

To mitigate the adverse selection Detailed application Medical examination On-Site investigation Suicide clause Preexisting conditions provision