CH3 Flashcards
In its simplest aspect, insurance has two fundamental characteristics:
Transfer or shift of risk from the individual to the group.
Sharing of losses, on some equitable basis, by all members of the group.
Potential difficulty:
some members might refuse to pay their assessment at the time of a loss.
This problem can be overcome by requiring advance payment for predicted future losses (based on past experience).
The amount of the advance payment depends on past experiences and future projections plus ( a cushion for) operation and administrative cost.
Insurance Defined: Individual Perspective
Insurance is an economic device whereby the individual substitutes a small certain cost (the premium) for a large uncertain financial loss (the contingency insured against) which would exist if it were not for the insurance.
Insurance from the Individual’s Perspective
Insurance does not decrease the risk or uncertainty for the individual as to whether the event will occur.
It does not change the probability of occurrence.
Rather, it reduces the probability of a financial loss associated with the event. It is a device that compensates for a loss.
Risk Reduction Through Pooling
If insurer could predict future losses with absolute precision, it would have no risk.
Accuracy of insurer’s prediction is based on the law of large numbers.
By combining a sufficiently large number of homogenous exposure units, the insurer is able to make predictions for the group as a whole using the theory of probability.
Probability Theory and Law of Large Numbers
Probability theory is the body of knowledge concerned with measuring the likelihood that something will happen and making predictions based on this likelihood.
The larger the size of the sample, the more accurate will be the estimate of the probability.
Two Interpretations of Probability
Relative frequency interpretation
signifies the relative frequency of occurrence expected, given a large number of separate independent trials (events that may be repeated for a long run may be governed by probabilities).
2. Subjective interpretation
probability is measured by the degree of belief in the likelihood of the given event’s occurrence (e.g., a student says she has a 50:50 chance of getting a B in the FINA3331 course
Determining the Probability of an Event
A priori estimates determined by examining the underlying conditions that cause the event:
A priori estimates not significant for us except in illustrating Law of Large Numbers.
Law of Large Numbers is:
The observed frequency of an event more nearly approaches the underlying probability of the population as the number of trials approaches infinity.
When probability cannot be determined by underlying conditions (i.e., a priori)
can be estimated based on past experience.
Probability Distribution
Probability distribution is an index of the relative frequency of all outcomes.
The probability assigned to the event is the average rate at which the outcome is expected to occur.
Probability distributions generally constructed on basis of a sample.
Dual Application of Law of Large Numbers
To estimate the underlying probability accurately, insurer must have a large sample of experience.
2. Once the estimate of probability has been made, it must be applied to a sufficiently large number of exposure units to permit the underlying probability “to work itself out.”
Insurance Defined from the Social Perspective
Insurance is an economic device for reducing and eliminating risk through the process of combining a sufficient number of homogeneous exposures to make the losses predictable for the group as a whole.
Insurance: Transfer or Pooling?
Insurance can exist without pooling, but not without transfer.
Even when risk is pooled or shared, it is transferred from the individual to the group.
Economic Contribution of Insurance
Creates certainty about the financial burden of loss.
Spreading losses that do occur.
Provides for an optimal utilization of capital.
Elements of an Insurable Risk
There must be a sufficiently large number of exposure units to make losses reasonably predictable.
Law of large numbers.
The loss produced by risk must be definite and measurable.
Must be able to tell when the loss took place and what is the value of it.
The loss must be fortuitous or accidental.
Must be a result of a contingency, and beyond the control of the insured.
The loss must not be catastrophic.
Must be unlikely to produce a loss to a large percentage of exposure units at the same time (e.g. war attacks, earthquakes).
Randomness-adverse selection
The losses predicted are based on average experience of the older group. Yet, naturally, some uncertainty exists to permit random composition of the group.
There always exists individuals who are worse than average risks.
Those whose chance of loss is higher than other society members desire insurance coverage more than others. This results in adverse selection.
Economic feasibility
The cost of insurance must not be high relative to the possible loss.
Self-Insurance
self-insurance program should:
have enough exposures for predictability (law of large numbers)
be financially dependable (sufficient funds must be accumulated to meet losses that occur).
have a geographic dispersion of units exposed to loss.
The Fields of Insurance
- Private insurance
voluntary programs designed to protect individual against financial loss - Social Insurance
compulsory insurance programs generally operated by government - Public Benefit Guarantee Programs
quasi-social coverages usually associated with regulation
Classification of Private Insurance
Life Insurance :
Protects against risks of premature death and superannuation (pension).
Accident and health Insurance
Insurance against loss by sickness or accidental bodily injury.
Covers income lost due to sickness or injury and/or doctor and hospital bills.
Property and liability insurance
Insurance against losses resulting from damage to or loss of property and losses arising from legal liability.
Property (fire) (named-peril coverage (e.g. fire) or open-peril coverage).
Marine (protect against financial loss resulting to damages to owned property: where the peril is associated with transportation)
Ocean marine and inland marine insurance
Automobile
Theft
Liability
Trade credit
Fidelity and surety bonds
Surety Bonds
Agreement by one party, the “surety,” to answer to a third person, the “obligee,” for the obligation of a party called the “principal.”
If the principal fails to perform in the manner guaranteed, the surety will be responsible to the obligee.
Social Insurance
Social insurance is a device for the pooling of risks by their transfer to an organization, usually the government, that is required to provide pecuniary or service benefits to or on behalf of covered persons upon the occurrence of certain predestinated losses
objective of social insurance is to redistribute income in favor of those who cannot individually cope with certain fundamental risks
Social insurance programs rest on the premise that if an individual cannot provide for a reasonable standard of living through personal efforts, society should assist.
Social Insurance Rules
Coverage is compulsory
- Eligibility derived from contributions: no requirement to demonstrate need
- Method of determining benefits prescribed by law
- Benefits not directly related to contributions
Definite long-range plan for financing
- Cost borne primarily by contributions
- Plan administered or supervised by government
- Plan not established solely for government employees
Public Guarantee Insurance Programs
Government-operated, compulsory, quasi social insurance programs, mainly in connection with financial institutions
Public Guarantee Insurance Programs are usually allied with the function of regulation
Insurance principle is used to protect lenders, depositors, or investors against loss resulting from failure of a financial institution
Similarities in Various Fields of Insurance
the programs discussed all use some form of pooling of exposure units.
The possibility of loss is transferred from the individual to the group where losses are shared on some prescribed basis.
Basic concepts of pooling and sharing of losses and individual’s substitution of small, certain cost for large uncertain loss are fundamental to all the programs.
