Chapter 2: Insurance and Risk Flashcards
What is insurance?
Insurance is the pooling of fortuitous losses by transfer of such risks to insurers, who agree to indemnify insureds for such losses, to provide other pecuniary benefits on their occurrence, or to render services connected with the risk
Insurance provides financial protection against unforeseen events.
What is meant by pooling of losses in insurance?
Pooling of losses spreads losses incurred by the few over entire group
This mechanism allows insurance to function effectively by distributing risk.
Define fortuitous loss.
Fortuitous loss is one that is unforeseen, unexpected, and occurs as a result of chance
Such losses are essential for insurance to operate.
What is risk transfer in insurance?
Risk transfer involves a pure risk being transferred from the insured to the insurer, who typically is in a stronger financial position
This allows individuals to mitigate their financial exposure.
What does indemnification mean in the context of insurance?
Indemnification means the insured is restored to his or her approximate financial position prior to the occurrence of the loss
This is a core function of insurance.
What is the Law of Large Numbers?
The greater the number of exposures, the more closely will the actual results approach the probable results that are expected from an infinite number of exposures
This principle underpins the predictability of insurance losses.
List the characteristics of an ideally insurable risk.
- Large number of exposure units - predict avg loss
- Accidental and unintentional loss - assure random occurrence of events
- Determinable and measurable loss - determine how much paid
- No catastrophic loss - allow pooling technique to work
- Calculable chance of loss - establish premium enough to pay claims + profit
- Economically feasible premium - affordable policy
These characteristics ensure that insurance can function effectively.
What types of risks are typically difficult to insure?
Market risks
Financial risks
Production risks
Political risks
These risks often do not meet the criteria for insurability.
What is adverse selection in insurance?
Adverse selection is the tendency of persons with a higher-than-average chance of loss to seek insurance at standard rates
This can lead to higher-than-expected loss levels if not controlled.
How can adverse selection be controlled?
Careful underwriting
Policy provisions (e.g., suicide clause in life insurance)
These measures help maintain the balance of risk within insurance pools.
True or False: Insurance creates a new speculative risk.
False
Insurance handles existing pure risks, while gambling creates new speculative risks.
What is the primary difference between insurance and hedging?
Insurance involves the transfer of pure (insurable) risks, while hedging involves risks that are typically uninsurable
Insurance more moral hazard and adverse selection problems, hedging less
This distinction affects the types of risks covered and the associated challenges.
What are the two major categories of private insurance?
Personal lines: coverages that insure the real estate and personal property of individuals and families or provide protection against legal liability
Commercial lines: coverages for business firms, nonprofit organizations, and government agencies
Personal lines cover individuals and families, while commercial lines cover businesses and organizations.
Property and Liability insurance (types)
Property insurance indemnifies property owners against the loss or damage of real or personal property
Liability insurance covers the insured’s legal liability arising out of property damage or bodily injury to others
Casualty insurance refers to insurance that covers whatever is not covered by fire, marine, and life insurance
This type of insurance is crucial for financial planning.
List the benefits of insurance to society.
Indemnification for loss
Reduction of worry and fear
Source of investment funds
Loss prevention
Enhancement of credit
These benefits contribute to overall economic stability.
What are the major social costs of insurance?
Cost of doing business
Fraudulent claims
Inflated claims
Higher premiums
These costs can impact consumers and the economy.
Basic Characteristics of Insurance
pooling of losses
payment of fortuitous losses
risk transfer
indemnification
Insurance vs Gambling
Insurance
Handles an already existing pure risk
Is always socially productive: both parties have a common interest in the prevention of a loss
Gambling
Creates a new speculative risk
Is not socially productive: The winner’s gain comes at the expense of the loser
Which of the following is a basic characteristic of insurance?
pooling of losses
avoidance of risk
payment of intentional losses
certainty about specific losses that will occur
pooling of losses
Characteristics of a fortuitous loss include which of the following?
I. The loss is certain to occur.
II. The loss occurs as a result of chance.
II only
Which of the following is implied by the requirement that a loss should be determinable and measurable to be insurable?
I. The loss must be definite as to place.
II. The loss must be definite as to amount.
Both
Which of the following is a result of adverse selection?
The insurer’s financial results will be substantially improved.
Persons most likely to have losses are also most likely to seek insurance at standard rates
It is unnecessary for the insurance company to use underwriting.
Insurance can be written only by the federal government.
Persons most likely to have losses are also most likely to seek insurance at standard rates
All of the following are social costs associated with insurance EXCEPT
insurance company operating expenses.
fraudulent claims.
inflated claims.
increased cost of capital.
increased cost of capital.
Which of the following is a form of casualty insurance?
fire insurance
general liability insurance
inland marine insurance
ocean marine insurance
general liability insurance
LMN Insurance sells homeowners insurance. The LMN homeowners policy combines property and casualty insurance in the same contract. Insurance policies combining property and casualty coverage in the same contract are called
multiple-line policies
Apex Insurance Company wrote a large number of property insurance policies in an area where earthquake losses could occur. When the president of Apex was asked if she feared that a severe earthquake might put the company out of business, she responded, “Not a chance. We transferred most of that risk to other insurance companies.” An arrangement by which an insurer that initially writes insurance transfers to another insurer part or all of the potential losses associated with such insurance is called
reinsurance
Adverse selection occurs
when applicants with a higher-than-average chance of loss seek insurance at standard rates
The premium that insurance companies charge does not cover the cost of expected losses only. The premium must also cover the cost of compensating agents and other costs of doing business. The amount added to the pure premium to cover these costs is called the
expense loading
