TOPIC 2: INTRODUCTION TO

INSURANCE INSURABLE
RISKS

Chapter 2: Insurance and Risk

Chapter 5: Types of Insurers and Marketing Systems

Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved
Agenda
• Definition and Basic Characteristics of Insurance
• Requirements of an Insurable Risk
• Adverse Selection and Insurance
• Insurance vs. Gambling
• Insurance vs. Hedging
• Types of Insurance
• Benefits and Costs of Insurance to Society
• Types of Private Insurers and Marketing Systems

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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

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Basic Characteristics of Insurance

• Pooling of losses
– Spreading losses incurred by the few over the entire group
– Risk reduction based on the Law of Large Numbers ：
• The greater the number of exposures, the more likely the actual results will
approach the expected results.
• Payment of fortuitous losses
– Insurance pays for losses that are 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

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Example
Which statement(s) is (are) true with regard to the law of
large numbers?
I. By applying the law of large numbers, insurers prevent
losses from occurring.
II. According to the law of large numbers, as the sample size
increases, objective risk declines.
(a) I only
(b) II only
(c) both I and II
(d) neither I nor II

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Requirements of an Insurable Risk

• Large number of exposure units

– to predict average loss
• Accidental and unintentional loss
– to control moral hazard
– to assure randomness
• Determinable and measurable loss
– to facilitate loss adjustment
• insurer must be able to determine if the loss
is covered and if so, how much should be
paid.
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Requirements of an Insurable Risk

• No catastrophic loss
– to allow the pooling technique to work
– exposures to catastrophic loss can be managed
by:
• dispersing coverage over a large geographic area
• using reinsurance
• catastrophe bonds

• Calculable chance of loss

– to establish an adequate premium

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Requirements of an Insurable Risk

• Economically feasible premium

– so people can afford to buy
– Premium must be substantially less than the
face value 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

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Exhibit 2.1 Risk of Fire as an
Insurable Risk

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Exhibit 2.2 Risk of Unemployment
as an Insurable Risk

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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, adverse selection result 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)

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 Insurance vs. Gambling
Insurance Gambling

• Insurance is a technique • Gambling creates a new

for handing an already speculative risk
existing pure risk

• Insurance is socially • Gambling is not socially

productive: productive
– The winner’s gain comes
– both parties have a common
interest in the prevention of at the expense of the
a loss loser

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 Insurance vs. Hedging
Insurance Hedging

• Risk is transferred by a • Risk is transferred by a

contract contract
• Insurance involves the • Hedging involves risks
transfer of insurable risks that are typically
• Insurance can reduce the uninsurable
objective risk of an insurer • Hedging does not result in
through the Law of Large reduced risk
Numbers

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Types of Insurance

• Private Insurance
– Life and Health
– Property and Liability
• Government Insurance
– Social Insurance
– Other Government Insurance

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Private Insurance
• Life and Health
– Life insurance pays death benefits to beneficiaries when
the insured dies
– Health insurance covers medical expenses because of
sickness or injury
– Disability plans pay income benefits
• 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

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Private Insurance

• 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

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Exhibit 2.3 Property and Casualty
Insurance Coverages

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Example

All of the following risks are privately insurable

EXCEPT:
(a) the risk of premature death
(b) the risk of physical damage to your car
(c) the risk of unemployment
(d) the risk of poor health

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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

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Social Benefits of Insurance
• Indemnification for Loss
– Contributes to family and business stability
• Reduction of Worry and Fear
– Insureds are less worried about losses
• Source of Investment Funds
– Premiums may be invested, promoting economic growth
• Loss Prevention
– Insurers support loss-prevention activities that reduce direct and
indirect losses
• Enhancement of Credit
– Insured individuals are better credit risks than individuals without
insurance

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Social Costs of Insurance
• Cost of Doing Business
– Insurers consume resources in providing insurance to
society
– An expense loading is the amount needed to pay all
expenses, including commissions, general
administrative expenses, state premium taxes,
acquisition expenses, and an allowance for
contingencies and profit
• Fraudulent and Inflated Claims
– Payment of fraudulent or inflated claims results in
higher premiums to all insureds, thus reducing
disposable income and consumption of other goods
and services

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Example

Although insurance benefits society in many ways,

there are some social costs associated with
insurance. These social costs include all of the
following EXCEPT:
(a) insurers’ cost of doing business
(b) inflated claims
(c) indemnification of losses
(d) fraudulent claims

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Example
Which statement(s) is (are) true with regard to
insurance?
I. It involves the pooling of fortuitous losses.
II. It involves transfer of risk and indemnification of
loss.
(a) I only
(b) II only
(c) both I and II
(d) neither I nor II
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Types of Private Insurers
• A stock insurer is a corporation owned by stockholders
– Objective: earn profit for stockholders by increasing
the value of stock and paying dividends
– Stockholders elect board of directors
– Stockholders bear all losses
– Insurer cannot issue an assessable policy

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Types of Private Insurers
• A mutual insurer is a corporation owned by the policy
owners
– Policy owners elect board of directors, who have
effective management
– Policyholders may receive dividends or rate reductions

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Types of Private Insurers
– There are three main types of mutual insurers:
• An advance premium mutual is owned by the
policyowners; there are no stockholders, and the
insurer does not issue assessable policies
• An assessment mutual has the right to assess
policyowners an additional amount if the insurer’s
financial operations are unfavorable
• A fraternal insurer is a mutual insurer that provides
life and health insurance to members of a social or
religious organization

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Types of Private Insurers
• The corporate structure of mutual insurers is changing
due to:
– An increase in company mergers
– Demutualization, whereby a mutual company is
converted into a stock insurer
– The creation of mutual holding companies
– A holding company is a company that directly or
indirectly controls an authorized insurer

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Mutual Holding Company Illustration

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Types of Private Insurers

• Other types of insurers:

– Lloyd’s
– Reciprocal exchanges
– Blue Cross and Blue Shield Plans
– Managed care plans
– Captive insurance companies

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Agents and Brokers
• An agent is someone who legally represents the principal
and has the authority to act on the principal's behalf
• Authority may be:
– Expressed
– Implied
– Apparent
• The principal is legally responsible for all acts of an agent
when the agent is acting within the scope of authority

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Agents and Brokers
• A property and casualty agent has the power to bind the
insurer
– A binder provides temporary insurance until the policy
is actually written
• A life insurance agent normally does not have the
authority to bind the insurer
– The applicant for life insurance must be approved by
the insurer before the insurance becomes effective

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Agents and Brokers
• A broker is someone who legally represents the insured, and:
– solicits applications and attempts to place coverage
with an appropriate insurer
– is paid a commission from the insurers where the
business is placed
– does not have the authority to bind the insurer
• A surplus lines broker is licensed to place business with a
nonadmitted insurer
– Surplus lines refer to any type of insurance for which
there is no available market within the state, and
coverage must be placed with a nonadmitted insurer

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Agents and Brokers
• A managing general agent (MGA) is a specialized type of
“wholesale” producer that, unlike “retail” producers, is
vested with underwriting authority from an insurer
– MGAs are involved with unusual lines of coverage
– MGAs benefit insurers because they possess expertise
that is not always available within the insurer’s home
office
• The functions of MGAs and surplus lines have become
intertwined

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Types of Marketing Systems
• The major life insurance distribution systems used today
can be classified as follows:
– Personal selling systems
– Financial institution distribution systems
– Direct response system
– Other distribution systems:
• Worksite marketing
• Stock brokers
• Financial planners

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Types of Marketing Systems
The major distribution systems for marketing property and
casualty insurance include the following:
– Independent agency system
– Exclusive agency system
– Direct writer
– Direct response system
– Multiple distribution systems

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