3. Insurance

Question 1

Insurance

Answer 1

A mechanism for providing security through the pooling of risks.

Question 2

Two essential elements of insurance:

Answer 2

• Pooling of risks

- Sharing of losses

Question 3

Principle of indemnity insurance

Answer 3

The benefit payment should return the insured to the same financial position that they would otherwise have experienced had the event insured against not occurred.

Question 4

Life insurance contract

Answer 4

A contract providing for the payment of a specified sum on the happening of an event which are dependent on human lives.

Question 5

Under which (8) criteria will the insurance mechanism function most efficiently?

Answer 5

• Limit on the liability undertaken by the insurer.
• “Insurable interest” must exist
• Event causing the loss should be well defined.
• Risk should be financial and the size (loss), measurable.
• Individual risk events should be independent.
• Probability of the event occurring should be small.
• Moral hazard should be eliminated
• Anti-selection should be eliminated as far as possible.
• Pool a large number of similar risks.

Question 6

What is meant by “insurable interest”

Answer 6

The insured must have a financial interest in the item being insured.

Question 7

Under what condition can events with certainty (e.g. death) be insured?

Answer 7

If the time until the occurrence of the insured event is unknown.

Question 8

Moral hazard

Answer 8

The situation where individuals may try to be dishonest.

Question 9

What can be done to eliminate moral hazard?

Answer 9

Individuals are place in a position where they will not benefit financially from the occurrence of the insured event.

Question 10

Why should similar risks be pooled?

Answer 10

To reduce the variance and hence achieve more certainty when estimating claims.

Question 11

Mutuality

Answer 11

The principle - in private insurance - whereby individuals pool risks and share losses and are charged a premium that reflects the risk they pose.

Question 12

Solidarity

Answer 12

The sharing of losses with “premiums” calculated by some other method, with social objectives in mind. Premiums are not related to the risk of the individual and lower risks subsidies higher risks e.g. Health insurance

Question 13

Explain selection

Answer 13

Insurers will attempt to select the individuals it feels are most appropriate for the risk pool. Not all risks will be acceptable.

Question 14

By what means can selection take place?

Answer 14

• The method of selling business
• Geographical region
• Class of business
• Medical assessment

Question 15

Explain anti-selection

Answer 15

Individuals will take out the insurance they feel is most appropriate to them (adverse selection).

Question 16

Why are cross-subsidies almost inevitable within any insurance arrangement?

Answer 16

The insurer does not have perfect knowledge of the circumstances of the individual being insured.

Question 17

Benefits of insurance to the economy

Answer 17

• Security,
• Creates a pool of funds available for investment in other productive pursuits
• Allows business to utilities capital more efficiently
• Mother, more predictable cash flows to individuals.
• Peace of mind

Question 18

Features that distinguish insurance from other consumer services

Answer 18

• Premiums are paid before the service is received.
• The seller of insurance insists on selecting the customers to whom it will sell and on what terms.
• The cost of providing the service not known in advance.
• Insurance is a collective enterprise which is redistributive by its very nature, as losses are “shared” between the insurance individuals.
• Insurance is a “social good”.
• Insurance may be an example of a “merit good”.
• Insurance is unusual. It competes in the usual ways for service industries, but also to select the best risks.

Question 19

What is meant by insurance being a “social good”

Answer 19

Insurance benefits society as a whole by it being available to certain individuals.

Question 20

What is meant by insurance possibly being a “merit good”

Answer 20

Insurance is a good which benefits individuals to such an extent that society considers that a certain amount should be available to everyone.

Question 21

Mutual Organisations

Answer 21

Insurance organisations that can return any profits to the individuals who purchased the insurance.
This is done either through lower premiums the following year or through bonuses.

Question 22

What is commonly done to prevent morale hazzard (behavioral changes)

Answer 22

Insurance policies do not fully indemnify the individual.

Question 23

Why can insurance companies charge more than the true risk premium?

Answer 23

Many individuals are risk averse.
They are willing to pay more to purchase an insurance contract than they expect to receive through insurance benefits to be secure.

Question 24

True risk premium

Answer 24

The premium required to cover the expected claims only.

Question 25

Why would an insured not be fully indemnified where morale hazard is likely to occur

Answer 25

• to encourage risk avoidance

- to reduce the total losses from the group of policies

Question 26

Why would it be incorrect to think that insurance is a waste of money if the event insured against does not occur

Answer 26

The individual gained from security or removal of risk during the period

Question 27

What is the justification for using social solidarity principles

Answer 27

The security provided improves the welfare of society and the functioning of the economy

Question 28

What might the disadvantages of insurance to the economy be

Answer 28

Behavioral changes may actually need to increased losses and there will be attempts to defraud insurance companies
The economy might incur additional costs to operate the insurance