Chapter 2

Question 1

Adverse Selection:

Answer 1

Adverse selection is broadly defined as selection against the company. It includes the tendency of people with higher risks to seek or continue insurance to a greater extent than those with little or less risk. Adverse selection also includes the tendency of policyowners to take advantage of favorable options in insurance contracts. Adverse selection occurs when a company takes on risk without being accurately compensated for the actual amount they must ultimately pay in claims. Companies must avoid adverse selection to be profitable and stay in business

Question 2

Hazard:

Answer 2

A hazard is any factor, condition, or situation that creates an increased possibility that a peril (a cause of a loss) will actually occur. Examples of hazards include icy roads, driving while intoxicated, and improperly stored toxic waste

Question 3

Homogeneous Exposure Units

Answer 3

Homogeneous exposure units are similar objects of insurance that are exposed to the same group of perils. (Similar risks, such as wood houses in a fire rather than brick houses)

Question 4

Indemnity contract:

Answer 4

Contracts of indemnity attempt to return the insured to their original financial position. They will not profit from heir loss, however just be compensated for the loss and nothing more.

Question 5

Law of Large Numbers:

Answer 5

The law of large numbers is a fundamental principle of insurance that the larger the number of individual risks combined into a group, the more certainty there is in predicting the degree or amount of loss that will be incurred in any given period. For example, suppose an insurance company insures one hundred thousand homes (instead of only 100 homes) against fire and collects $1,000 in premium from each homeowner. In this situation, the premiums should provide enough money so the insurer can pay all losses to policyholders during the year while at the same time covering all overhead costs and still making a profit. Suppose an insurer only insured 100 homes, and five of them were total losses in the same year. That type of loss might bankrupt the carrier, especially if an unexpected event increased the losses. No matter what, there is safety in larger numbers

Question 6

Loss:

Answer 6

Loss is the unintentional decrease in the value of an asset due to a peril.

Question 7

Accident vs. Occurrence

Answer 7

if Sally needs a knee replacement from being involved in a car accident, there likely are some witnesses that saw the accident and, in theory, could provide the exact time and location of the accident that caused the injury. Suppose Sally needs a knee replacement from years of intense physical activity. In that case, there are no witnesses that could provide the specific time and location of the occurrence that resulted in the need for Sally’s knee replacement. Every accident is an occurrence, but not every occurrence is an accident.

Question 8

Loss Exposure:

Answer 8

Loss exposure is the risk of a possible loss.

Question 9

Moral Hazard:

Answer 9

Moral hazard is a hazard brought on by the effect of personal reputation, character, associates, personal living habits, financial responsibility, and environment, as distinguished from physical health, upon an individual’s general insurability. For example, a dishonest person is more likely to lie to an insurance company—both on an application and when submitting a claim for loss, thus creating a higher likelihood of engaging in insurance fraud. Drug use and alcohol abuse are commonly associated with moral hazards. Moral hazards make the loss more likely to occur due to the dishonest character of the insured

Question 10

Morale Hazard:

Answer 10

Morale hazard is a hazard arising from indifference to loss because of the existence of insurance. Morale hazards are often associated with having a careless attitude. For example, Alex leaves his car running unattended, with the doors unlocked to heat it on a cold winter morning. This act makes it more likely that his car will be easily stolen by a passing car thief looking for such vehicles. On some unintentional mental level, the insured simply does not care that this kind of loss might happen, probably because the vehicle is insured. Reckless driving, jumping off a cliff, stealing, racing motorcycles, carefree, careless lifestyle are often associated with morale hazards. They just do not care about loss prevention since the property is insured

Question 11

Peril:

Answer 11

Peril is the immediate, specific event causing loss and giving rise to risk.

Question 12

Specified (named) perils

Answer 12

Insurance contracts that cover Specified or Named Perils individually list those perils that they cover. If a loss is caused by a peril that is not listed within the insurance policy, then the loss is not covered.

Question 13

Special (Open) Perils:

Answer 13

Special or Open Peril insurance policies do not name the perils they cover. Instead, such policies begin by saying they cover all direct causes of loss. These policies then list all the perils that they exclude from coverage.

Question 14

Physical Hazard:

Answer 14

Physical hazards are physical or tangible conditions existing in a manner that makes a loss more likely to occur.

Question 15

Pure risk

Answer 15

A type of risk that involves the chance of loss only; theres no opportunity for gain; it is insurable. For example, Injuries, illness, and death represent pure risks because an individual can only suffer a loss in the form of missed work and medical bills or burden survivors through the untimely loss of one’s life.

Question 16

Reinsurance:

Answer 16

Reinsurance is the acceptance by one or more insurers, called reinsurers, of a portion of the risk underwritten by another insurer who has contracted for the entire coverage.

Question 17

Risk:

Answer 17

Risk is the uncertainty regarding loss, the probability of a loss occurring for an insured or prospect.

Question 18

Risk Avoidance

Answer 18

Risk avoidance occurs when individuals evade risk entirely. It is the act of not doing something that could possibly cause a loss or the inactivity of participation in an event that may potentially cause a loss situation.

Question 19

Risk Management:

Answer 19

: Risk management is the process of analyzing exposures that create risk and designing programs to handle them is called risk management.

Question 20

Risk Pooling/Loss sharing

Answer 20

Risk pooling and loss sharing spread risk by sharing the possibility of loss over a large number of people. It transfers risk from an individual to a group. Insurance companies function through the concept of pooling. Insurance spreads one person’s risk of loss among a large number of individuals through the pooling of premiums. In other words, insurance reduces financial risk by spreading one individual’s risk of loss among many.

Question 21

Risk Reduction:

Answer 21

Risk reduction takes place when the chances of a loss are lessened, or the severity of a potential loss is minimized.

Question 22

Risk Retention:

Answer 22

Risk retention is the act of analyzing the loss exposure presented by a risk and determining that the potential loss is acceptable. Risk retention is often associated with self-insurance

Question 23

Risk Transfer

Answer 23

Risk transfer is the act of shifting the responsibility of risk to another in the form of an insurance contract.

Question 24

Speculative Risk

Answer 24

Speculative risk is a type of risk that involves the chance of both loss and gain; its not insurable. For example, investing in the stock market and gambling are speculative risks individuals can realize a financial gain or they can lose all their money.