Ch 5 Insurance Principles

Question 1

What is insurance

Answer 1

A contract binding a party to indemnify another against a specified loss in return for premiums paid

Question 2

What is a contract

Answer 2

Specifies rights and obligations of each party in the agreement

Also known as the policy

Question 3

What are policy holders

Answer 3

People being insured

Question 4

What does indemnify mean

Answer 4

To put back into their original position as if the event hadn’t occurred

Question 5

What is the specified loss

Answer 5

The exacts risks which are covered by the policy

Question 6

What are premiums

Answer 6

Payment to the insurer in advance that help insurance companies pay costs and make profits

Question 7

What are reasons for why people use insurance

Answer 7

Risk aversion
Risk pooling
Economies of scale protection for, unacceptable risks
Better use of capital
Smoothing of cash flows
Social benefits

Question 8

What is risk aversion

Answer 8

Opposite of risk seeking, this is where one chooses the safer more certain outcome to avoid risk

Question 9

What is economies of scale

Answer 9

The fact that larger institutions can be more cost effective meaning that insurers can put more money is pricing and reserving and research that smaller groups or individuals cannot due

Question 10

What does protection from unacceptable risks entail

Answer 10

Insurers relieve people that may not be able to afford something in case disaster happens

Question 11

How does insurance make for better use of capital

Answer 11

Instead of saving money in case of disaster policyholders can now invest extra capital

Question 12

How does insurance smooth cash flows

Answer 12

It allows for smooth capital outflows unlike unpredictable uninsured risks that Cost a lot of money

Question 13

Why does insurance value society as a whole

Answer 13

It enables economic growth as people are able to take more risk with their own capital due to their assets being looked after

Helps alleviate poverty and dependence on the state

Question 14

Why is insurance bad

Answer 14

If big corporations dominate the market then prices for insurance may become too expensive for the general public

If insurers cannot pay liabilities this could be detrimental to society

Also insurance allows people to take unnecessary risks as their things are insured

Question 15

What makes a risk insurable

Answer 15

It has to be a risk
Pure risk
Static risk
Particular risk
It should be financial, quantifiable and be limited
Small probability of happening
Large pool of risks
Low moral hazard
Past data should be available

Question 16

Why does it have to be a risk

Answer 16

Risk pooling and transfer only work if an event is a risk

Question 17

Why should the risk be pure and not speculative

Answer 17

Insurers don’t want to insure people against speculative risks as people will seek out those risks costing insurers more money

Question 18

Why should the risk be static and not dynamic

Answer 18

Static risks have uncertainty and value that does not fluctuate over time whereas dynamic risks change with the economy and are to difficult to insure

Question 19

Why should the risk be particular and not fundamental

Answer 19

Fundamental risks affect large groups of people which would cost insurance companies way too much money. For particular risks they are insuring an independent risk which is not lie,LH to happen to many people at the same time.m

Question 20

What does it mean for it to be financial, quantifiable and limited

Answer 20

An insurer must be able to pay out a claim and therefore it must be quantifiable in financial terms. This can be managed by putting a limit on claim sizes

Question 21

Why should the probability be low

Answer 21

In order for insurance to work risks should have a small probability as high probability would mean more cash outflow more often

Question 22

What does their have to be a large pool

Answer 22

The concept of risk pooling and the law of large numbers only works if there is a large number of risks

Question 23

What is anti selection

Answer 23

If someone has more information about a risk then the insurer it allows for anti selection which means they can take advantage of the insurers by trying to claim more.

Question 24

What are moral hazards

Answer 24

Unethical behaviour by policy holders by pretending that more costs were suffered then there actually was in order to get a higher claim

Question 25

What is morale hazard

Answer 25

When policy holders act in a way where they increase the chance of the event happening because they are insured, for example driving recklessly due to car insurance or doing dangerous things due to having health insurance

Question 26

What can insurers do to avoid anti selection and moral hazard

Answer 26

Underwriting

Question 27

What is underwriting

Answer 27

Asking the insured questions to help understand the size and nature of the risk

Question 28

What is meant by availability of past data

Answer 28

Even if risks are suitable for insurance, without past data it is difficult to work out the uncertainty and value which makes it difficult to launch a product for that risk