Revised Chp 3

8/2/2019 Revised Chp 3

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1

Nature & Functions of Insurance

In its simplest aspect, insurance has two

fundamental characteristics:

1. Transferof risk from the individual to the group.

2. Sharingof losses on some equitable basis.


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2

Operation of Insurance Illustrated

1. 1,000 dwellings valued at $100,000 each.

2. Each owner faces risk of a $100,000 loss.

3. Owners agree to share losses that occur.

4. Ifone house burns (total loss) each owner pays

($100 x 1,000 = $100,000).


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3

Insurance Defined: Individual

Perspective

Insurance is an economic device whereby the

individual substitutes a small certain cost (the

premium) for a large uncertain financial loss (the

contingency insured against) which would exist if

it were not for the insurance.


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4

Probability Theory and Law of

Large Numbers

Probability theory is the body of knowledge

concerned with measuring the likelihood that

something will happen and making predictions

based on this likelihood.


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5

Determining the Probability of an

Event 1. A prioriestimates determined from the underlying

conditions:

the probability of flipping a head is .5

the probability of drawing the Ace of Spades is 1/52

2. A prioriestimates not significant for us except inillustratingLaw of Large Numbers.

3. The type probability useful for Risk Management isreferred to as a posteriori probability


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6

Illustration of a Sampling of Losses

Experienced by an Insurance Company

Year Houses that Burn

1 7

2 11

3 10

4 9

5 13

Total 50

Average 10

Sample Size I


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Illustration of Sampling of Losses

Year Houses that Burn

1 16

2 4

3 10

4 12

5 8

Total 50

Average 10

Sample Size II


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Standard Deviation

Year Average ActualLosses Losses Differences

1 10 7 3 9

2 10 11 1 1

3 10 10 0 04 10 9 1 1

5 10 13 3 9

20

Variance = 4, Standard Deviation = 2

Sample Size I Deviation


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Standard Deviation

Year Average ActualLosses Losses Differences

1 10 16 6 36

2 10 4 6 36

3 10 10 0 0

4 10 12 2 4

5 10 8 2 4

80

Variance = 16, Standard Deviation = 4

Sample Size II Deviation


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Dual Application of Law of Large

Numbers

1. To estimate the underlying probability

accurately, insurer must have a large sample of

experience.

2. Once the estimate of probability has been

made, it must be applied to a large number of

exposure units to permit the underlyingprobability to work itself out.


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Elements of an Insurable Risk

1. Large numbers of exposure units

2. Definite and measurable loss

3. The loss must be fortuitous

4. The loss must not be catastrophic


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Additional Attributes of an Insurable Risk

Randomness- It is hoped that the risk will

approximate the general conditions found in

society in general. However, in real lifeAdverse

Selection complicatesthe entire situation

Economic FeasibilityThe cost of the

insurance must not be excessively high in

relation to the cost of the loss


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13

Classification of Private

Insurance 1. Life Insurance

2. Accident and health Insurance

3. Property and liability insurance

fire

marine

casualty fidelity and surety bonds


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Social Insurance Definition

1. Coverage is compulsory

2. Eligibility derived from contributions:

no requirement to demonstrate need

3. Method of determining benefits prescribed by law

4. Benefits not directly related to contributions


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Social Insurance Programs in the

U.S. 1. Old-Age, Survivors and Disability Insurance

2. Railroad Retirement, Disability and Unemployment

Insurance

3. Unemployment Insurance

4. Medicare

5. State Compulsory Temporary Disability


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Federal Public Guarantee

Programs

1. Federal Deposit Insurance Corporation

2. National Credit Union Administration

3. Securities Investor Protection Corporation

4. Pension Benefit Guarantee Corporation

Documents

Revised Chp 3