Ch 5 Insurance Principles Flashcards
What is insurance
A contract binding a party to indemnify another against a specified loss in return for premiums paid
What is a contract
Specifies rights and obligations of each party in the agreement
Also known as the policy
What are policy holders
People being insured
What does indemnify mean
To put back into their original position as if the event hadn’t occurred
What is the specified loss
The exacts risks which are covered by the policy
What are premiums
Payment to the insurer in advance that help insurance companies pay costs and make profits
What are reasons for why people use insurance
Risk aversion
Risk pooling
Economies of scale protection for, unacceptable risks
Better use of capital
Smoothing of cash flows
Social benefits
What is risk aversion
Opposite of risk seeking, this is where one chooses the safer more certain outcome to avoid risk
What is economies of scale
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
What does protection from unacceptable risks entail
Insurers relieve people that may not be able to afford something in case disaster happens
How does insurance make for better use of capital
Instead of saving money in case of disaster policyholders can now invest extra capital
How does insurance smooth cash flows
It allows for smooth capital outflows unlike unpredictable uninsured risks that Cost a lot of money
Why does insurance value society as a whole
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
Why is insurance bad
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
What makes a risk insurable
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
Why does it have to be a risk
Risk pooling and transfer only work if an event is a risk
Why should the risk be pure and not speculative
Insurers don’t want to insure people against speculative risks as people will seek out those risks costing insurers more money
Why should the risk be static and not dynamic
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
Why should the risk be particular and not fundamental
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
What does it mean for it to be financial, quantifiable and limited
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
Why should the probability be low
In order for insurance to work risks should have a small probability as high probability would mean more cash outflow more often
What does their have to be a large pool
The concept of risk pooling and the law of large numbers only works if there is a large number of risks
What is anti selection
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.
What are moral hazards
Unethical behaviour by policy holders by pretending that more costs were suffered then there actually was in order to get a higher claim
What is morale hazard
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
What can insurers do to avoid anti selection and moral hazard
Underwriting
What is underwriting
Asking the insured questions to help understand the size and nature of the risk
What is meant by availability of past data
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
