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Chapter 2bis: Insurance: Lecturer: Amadeus GABRIEL Bba4 La Rochelle Business School

The document defines insurance as pooling fortuitous losses through risk transfer to insurers who agree to indemnify insured losses. For risks to be insurable, they must affect a large number of exposure units and allow for accurate prediction of average losses. Adverse selection is controlled through careful underwriting. Insurance differs from gambling by creating social benefit through loss prevention, and from hedging by transferring pure risks. Common types of private insurance include life/health, property/liability, and personal/commercial lines. Government insurance includes social programs and other state/federal programs.

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63 views17 pages

Chapter 2bis: Insurance: Lecturer: Amadeus GABRIEL Bba4 La Rochelle Business School

The document defines insurance as pooling fortuitous losses through risk transfer to insurers who agree to indemnify insured losses. For risks to be insurable, they must affect a large number of exposure units and allow for accurate prediction of average losses. Adverse selection is controlled through careful underwriting. Insurance differs from gambling by creating social benefit through loss prevention, and from hedging by transferring pure risks. Common types of private insurance include life/health, property/liability, and personal/commercial lines. Government insurance includes social programs and other state/federal programs.

Uploaded by

Juana Bores
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Chapter 2bis: Insurance

Lecturer : Amadeus GABRIEL

BBA4

La Rochelle Business School


Definition of Insurance
• Insurance is 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
Basic Characteristics of
Insurance (1 of 4)
• Pooling of losses
– Pooling involves spreading losses incurred by the few
over the entire group
– Risk reduction is based on the Law of Large Numbers
– According to the Law of Large Numbers, the greater
the number of exposures, the more closely will the
actual results approach the probable results that are
expected from an infinite number of exposures.
Basic Characteristics of
Insurance (2 of 4)
• Example of Pooling:
– Two business owners own identical buildings valued at
$50,000
– There is a 10 percent chance each building will be
destroyed by a peril in any year
– Loss to either building is an independent event
– Expected value and standard deviation of the loss for each
owner is:
Expected loss =0.90  $0 + 0.10  $ 50,000 = $ 5,000

Standard deviation = 0.90(0 - $5,000)2 + 0.10($50,000 - $5,000)2


=$15,000
Basic Characteristics of
Insurance (3 of 4)
• Example, continued:
– If the owners instead pool (combine) their loss
exposures, and each agrees to pay an equal share of
any loss that might occur:
Expected loss =0.81 $ 0 + 0.09  $ 25,000 + 0.09  $ 25,000 + 0.01 $ 50,000
= $ 5,000

Standard deviation = 0.81(0 − $5,000)2 +(2)(0.09)($25,000 − $5,000)2 +0.01($50,000 − $5,000)2


=$10,607

‒ As additional individuals are added to the pool, the


standard deviation continues to decline while the
expected value of the loss remains unchanged
Basic Characteristics of
Insurance (4 of 4)
• Payment of fortuitous losses
– A fortuitous loss is one that is unforeseen,
unexpected, and occur as a result of chance
• Risk transfer
– A pure risk is transferred from the insured to the
insurer, who typically is in a stronger financial position
• Indemnification
– The insured is restored to his or her approximate
financial position prior to the occurrence of the loss
Characteristics of an Ideally Insurable
Risk (1 of 3)
• Large number of exposure units
– to predict average loss based on the law of large
numbers
• Accidental and unintentional loss
– to assure random occurrence of events
• Determinable and measurable loss
– to determine how much should be paid
Characteristics of an Ideally Insurable
Risk (2 of 3)
• No catastrophic loss
– to allow the pooling technique to work
– exposures to catastrophic loss can be managed by
using reinsurance, dispersing coverage over a large
geographic area, or using financial instruments, such
as catastrophe bonds
• Calculable chance of loss
– to establish a premium that is sufficient to pay all
claims and expenses and yields a profit during the
policy period
Characteristics of an Ideally Insurable
Risk (3 of 3)
• Economically feasible premium
– so people can afford to purchase the policy
– For insurance to be an attractive purchase, the
premiums paid must be substantially less than the face
value, or amount, of the policy
• Based on these requirements:
– Most personal, property and liability risks can be
insured
– Market risks, financial risks, production risks and
political risks are difficult to insure
Adverse Selection and Insurance
• Adverse selection is the tendency of persons with a
higher-than-average chance of loss to seek insurance at
standard rates
• If not controlled by underwriting, adverse selection results
in higher-than-expected loss levels
• Adverse selection can be controlled by:
– careful underwriting (selection and classification of
applicants for insurance)
– policy provisions (e.g., suicide clause in life insurance)
Insurance vs. Gambling

Insurance Gambling
• Handles an already • Creates a new speculative
existing pure risk risk
• Is always socially • Is not socially productive
productive: – The winner’s gain
– both parties have comes at the expense
a common interest of the loser
in the prevention
of a loss
Insurance vs. Hedging

Insurance Hedging
• Risk is transferred by a • Risk is transferred by a
contract contract
• Involves the transfer of • Involves risks that are
pure (insurable) risks typically uninsurable
• Moral hazard and adverse • Fewer problems of moral
selection are more severe hazard and adverse
problems for insurers selection for entities who
buy or sell futures
contracts
Types of Private Insurance (1 of 3)
• Life and Health
– Life insurance pays death benefits to beneficiaries
when the insured dies
– Health insurance covers medical expenses because
of sickness or injury
Types of Private Insurance (2 of 3)
• Property and Liability
– Property insurance indemnifies property owners
against the loss or damage of real or personal property
– Liability insurance covers the insured’s legal liability
arising out of property damage or bodily injury to others
– Casualty insurance refers to insurance that covers
whatever is not covered by fire, marine, and life
insurance
Types of Private Insurance (3 of 3)
• Private insurance coverages can be grouped into two
major categories
– Personal lines: coverages that insure the real estate
and personal property of individuals and families or
provide protection against legal liability
– Commercial lines: coverages for business firms,
nonprofit organizations, and government agencies
Types of Government Insurance
• Social Insurance Programs
– Financed entirely or in large part by contributions from
employers and/or employees
– Benefits are heavily weighted in favor of low-income groups
– Eligibility and benefits are prescribed by statute
– Examples: Social Security, Unemployment, Workers Comp
• Other Government Insurance Programs
– Found at both the federal and state level
– Examples: Federal flood insurance, state health insurance
pools
Social Benefits of Insurance
• Indemnification for Loss
• Reduction of Worry and Fear
• Source of Investment Funds
• Loss Prevention
• Enhancement of Credit

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