02. The Insurance Device

Question 1

1. What is insurance?

Answer 1

The pooling of fortuitous losses by transfer of such risks to insurers who agree to indemnify insureds for such losses.

Question 2

2. What are the two main functions of insurance?

Answer 2

1. Transfer of the risk from individual to group

2. Pooling of losses on some equitable basis.

Question 3

3. From an individual’s viewpoint how is insurance defined?

Answer 3

As an economic device whereby the individual substitutes a small cost (premium) for a large uncertain loss

Question 4

4. From a social viewpoint, how is insurance defined?

Answer 4

As an economic device for reducing and eliminating risk through the process of combining a sufficient number of homogenous exposures into a group to make the losses predictable for the group

Question 5

5. Although insurance provides enormous social and economic benefits to society, there are also social and economic costs, what are they?

Answer 5

• Cost of doing business - economic resources are used to provide insurance (approx 12% of premium)
• Fraudulent claims - resulting in higher premiums to all
• Inflated claims - resulting in higher premiums

Question 6

6. Explain why the cost of doing business is justified for the insurance industry?

Answer 6

• Covers individuals against a financially destructive loss
• It is not wasteful if insurers engage in loss prevention activities
• The industry provides jobs which helps (but does not advance) the economy.

Question 7

7. What are the four basic characteristics of insurance?

Answer 7

• Pooling of losses
• Payment of fortuitous (unforeseen) losses
• Risk transfer to insurer
• Indemnification - individual restored to similar position prior to loss.

Question 8

08 - What are the six requirements of insurable risk?

Answer 8

1. A large number of homogenous exposure units
2. The loss must occur by chance
3. The loss must be definite and measurable
4. The loss must be predictable
5. The loss must not be catastrophic to the insurer
6. The premium must be economically feasible.

Question 9

9. What is mean by homogeneity and why is it required?

Answer 9

Having similar characteristics (loss) and is necessary for reasonably accurate forecasts of loss frequency and severity based on the law of large numbers.

Question 10

10. What three components of the loss must be definite and measurable?

Answer 10

• Cause - by an identifiable condition (in contract)
• Time - happened within period of policy
• Amount - the consequence of loss (in contract)

Question 11

11. What are some of the common difficulties faced in determining the cause?

Answer 11

• Cause of disability
• Work-related accidents or illness
• shock/stress issues in a motor vehicle accident
• Grey areas in liability insurance (pollution)

Question 12

12. To determine the premium, what must the insurer be able to predict in regards to the risk?

Answer 12

The number, size and timing of the losses.

Question 13

13. How do insurers avoid catastrophic losses?

Answer 13

Diversifying their insurance pools (not all houses in one area) and by transferring the risk to another insurer.

Question 14

14. To be economically feasible the premium must not..?

Answer 14

• Outweigh the benefits of the policy

* Be so high as to make it unaffordable to potential insureds.

Question 15

15. What is a ceding insurer and what do they do?

Answer 15

The ceding insurer is the insurer who is transferring part of their risk to another insurer (the reinsurer).

Question 16

16. What is the retention limit?

Answer 16

It is the maximum amount an insurer is willing to cover for any one particular life or event.

Question 17

17. What is underwriting?

Answer 17

It is the process of selecting and classifying applicants for insurance. It doesn’t avoid loss but hopes to avoid a disproportion number of bad risks.

Question 18

18. Besides selection, underwriting also involves the determination of what?

Answer 18

• Pricing - premiums vary based on classification
• Policy conditions - terms of cover
• Claim control - assessment & loss control measures
• retention and reinsurance

Question 19

19. What is adverse selection?

Answer 19

It is the tendency of persons with a higher than average chance of loss to seek insurance at standard or average rates.

Question 20

20. How is adverse selection controlled?

Answer 20

Through underwriting and policy conditions (eg suicide clause).

Question 21

21. What is Pre-selection?

Answer 21

It is the process of initial underwriting applied to new business proposals - the initial phase of examination and scrutiny by the insurer.

Question 22

22. What is post-selection?

Answer 22

It is the process of underwriting review undertaken for existing expiring business when renewal is negotiated.

Question 23

23. What is the Statement of Underwriting Policy?

Answer 23

This defines the type and class of business that is acceptable, what items are borderline and how much borderline business can be accepted. Line underwriters are expected to follow this policy.

Question 24

24. The goal of underwriting is to produce a profitable book of business, to do this three important principles must be followed. What are they?

Answer 24

• Selection of insureds according to the underwriting standards
• Proper balance within each rate classification
• Equity among policy owners (one group should not unfairly subsidise another)

Question 25

25. What are the three major steps in underwriting?

Answer 25

• Field underwriting - Auth reps act as the first underwriter knowing who is acceptable
• Underwriting information gathered - including application, inspections, physicals
• Making the underwriting decision

Question 26

26. What are the three options for making an underwriting decision?

Answer 26

1. accept the application at standard rates and conditions
2. accept the application subject to certain restrictions, modifications and / or higher rates
3. reject the application.

Question 27

27. What are three other underwriting considerations?

Answer 27

• Rate adequacy and underwriting - If rates are adequate, underwriting profits are higher
• Reinsurance and underwriting - availability of reinsurance
• Renewal underwriting - whether the polices are cancellable or not

Question 28

28. The three major costs for an insurer, and therefore the three purposes why they need funds are what?

Answer 28

• To pay for losses suffered by policy holders
• To cover operating costs
• To provide a margin for contingencies and to generate profits

Question 29

29. What does rate making refer to and why is it so important to the insurer?

Answer 29

It refers to the pricing of insurance and determines the profitability of an insurance company.

Question 30

30. What are the difficulties in rate making?

Answer 30

• Past experience may not be a guide to future experience
• Small insurers may need to pool their experience in order to make accurate predictions
• The need for complex mathematical calculations requiring an actuary
• Determining what to allow for potential legal costs
• Factoring in different lines / classes of business
• Determining the loading to add for administration costs and reserve requirement

Question 31

31. What are the objectives of rate making?

Answer 31

Rates must be

• ADEQUATE to pay all losses and expenses and yield a profit
• REASONABLE, not too high
• EQUITABLE, not discriminatory
• SIMPLE, and easy to understand
• STABLE over the short period
• RESPONSIVE over time to changing loss exposures and economic conditions
• encourage LOSS CONTROL Activities

Question 32

32. What are the benefits of insurance to society?

Answer 32

• Indemnification for loss - peace of mind to society’s members
• Alleviates anxiety
• Provides more optimal utilisation of capital for the individual
• Deviations from expected results are lower in a pooled model than individually so lower reserves are required
• Source of investment funds for society
• Insurers promote and assist in loss prevention programs
• Enhancement of credit rating for an individual as there is a guarantee over the item

Question 33

33. What is reinsurance defined as?

Answer 33

The shifting of part or all of the insurance originally underwritten by one insurer to another insurer.

Question 34

34. What is the amount of insurance retained by the ceding company for its own account known as?

Answer 34

Cession

Question 35

35. What is retrocession?

Answer 35

Where the reinsurer obtains reinsurance from another insurer.

Question 36

36. What are the most important reasons why reinsurance is used?

Answer 36

• Increase underwriting capacity (so agent can place large amount of insurance with one provider)
• Stabilise profits (reducing fluctuations)
• Reduce the unearned premium reserve
• Provide protection against a catastrophic loss

Question 37

37. What is the unearned premium reserve?

Answer 37

It is a liability item on the insurer’s balance sheet that represents the unearned portion of gross premiums on all outstanding policies at the time of valuation.

Question 38

38. How does reinsurance reduce the unearned premium reserve?

Answer 38

By transferring this requirement to the reinsurer reducing the level of unearned premium reserve required by law and temporarily increasing the insurer’s surplus position.

Question 39

39. What are two reasons why the law of large number is important to insurance?

Answer 39

1. To estimate the underlying probability accurately, the insurance company must have a sufficiently large sample. (the larger the more accurate)
2. Once the estimate of the probability has been made it must be applied to a sufficiently large number of exposure units to permit the underlying probability to work.