1/D - Hazards and Risk

Question 1

Risk: 2 Meanings

Answer 1

The word “risk” has two meanings in the insurance industry:

1. The potential for financial loss; being exposed or open to damage
2. An insured item

Question 2

Speculative Risk

Answer 2

• Undertaken with no certainty of either gain or loss
• Made knowingly, by conscious choice
• Cannot be insured

Question 3

Pure Risk

Answer 3

• Risk with no chance of gain
• Only two possible results: 1) loss or 2) no loss
• No chance of gain
• Can be insured

Question 4

Exposure

Answer 4

The extent to which a person, item, or organization is open to damage or loss.

Insurers consider a risk’s exposure when deciding whether or not to insure it.

Question 5

Exposure

Answer 5

• Expressed in dollars or units

- A determining factor in issuing a policy and settling a premium

Question 6

Hazard

Answer 6

A condition increasing the likelihood or severity of a loss

Hazard vs. Exposure:

• Exposure is the possibility of loss
• Hazards are things that increase that possibility
• More Hazards = Higher Exposure

Question 7

Peril

Answer 7

The actual cause of loss or damage

Insurance Policies can be:

• Named Peril - lists each peril that is covered
• All Peril (Open Peril) - covers all perils except those specifically excluded

Question 8

Loss

Answer 8

1. Reduction in value of an insured item
2. Financial loss due to an occurrence or accident
3. For insurers: the amount paid out in a claim settlement

Question 9

Insurable Risk

Answer 9

• Risk: an item, person, or organization that has been insured
• Not everything is insurable
• Six qualifications determine what can be insured

Question 10

Adequate Premiums

Answer 10

Insurer must be able to cover claims with premium income

• Potential losses cannot be too much for the insurer to pay
• Insurer must be able to cover claims and expenses
• If premiums must be set too high, the risk is not insurable

Question 11

Definable Risk

Answer 11

The Risk must be definable:
1. The insurer can define the exact conditions under which the item is covered by the policy.
Example: Jewelry is covered up to a specified limit if stolen.
2. The item itself is definable (it can be precisely described).
Example: A house, car or diamond necklace can be defined. An entire riverbed cannot.
3. The item has precise value.
Example: A house or car does. A family photo does not.

Question 12

Unexpected Losses

Answer 12

The loss must be:

• Unforeseeable
• Unexpected
• Reasonably unpreventable
• Completely random in nature

Question 13

Substantial Losses

Answer 13

The loss must cause substantial economic hardship.

Question 14

Exclusions

Answer 14

The insurer must be able to exclude coverage for large-scale disasters and catastrophic events.

• Insurers have to charge adequate premiums
• Some losses would require such large premiums that it is impossible to insure them

Question 15

Law of Large Numbers

Answer 15

A large number of similar risks must be insured.

• Spreads the risk across more policies
• Helps the insurer predict losses more accurately
• “Similar risks” can mean: cars, houses, persons’ lives, similar businesses, etc.

Question 16

Law of Large Numbers

Answer 16

A large number of insured units reduces the possibility of variation from the expected number of claims.

If there are more units involved, there will be much less variation from statistics, which means the rate of claims will be more predictable.

Question 17

Adverse Selection

Answer 17

When someone decides to buy insurance because he knows he will probably have to file a claim, typically because of information about the risk that the insurer is unaware of or unable to discriminate against.

Question 18

Adverse Selection and the Spread of Risk

Answer 18

Problems with Adverse Selection:

• Insufficient premiums for level of risk exposure
• Leads to higher premiums, which might cause people to cancel policies

One solution: charging higher-risk individuals higher premiums