Chapter 2 - Insurance and Risk

Question 1

What are the four characteristic of insurance?

Answer 1

Pooling of losses
payment of fortuitous losses
risk transfer
indemnification

Question 2

Define Pooling

Answer 2

Pooling is the spreading of losses incurred by the few over the entire group, so that in the process, average loss is substituted for actual loss. In addition, pooling involves the grouping of a large number of exposure units so that the law of large numbers can operate to provide a substantially accurate prediction of future losses.

Question 3

What is the primary purpose of pooling?

Answer 3

to reduce the variation in possible outcomes as measured be the standard deviation or some other measure of dispersion, which reduces risk.

Question 4

Define fortuitous loss?

Answer 4

is unforeseen and unexpected by the insured and occurs as a result of chance.

Question 5

Define risk transfer?

Answer 5

means that a pure risk is transferred from the insured to the insurer, who typically is in a stronger financial position to pay the loss than the insured. Ex: premature death, excessive longevity, poor health, disability, destruction and theft of property, and personal liability lawsuits.

Question 6

What are the six characteristics of an insurable risk?

Answer 6

• there must be a large number of exposure units
• the loss must be accidental and unintentional
• the loss must be determinable and measurable
• the loss should not be catastrophic
• the chance of loss must be calculable
• the premium must be economically feasible

Question 7

Define reinsurance

Answer 7

Is an arrangement by which the primary insurer that initially writes the insurance transfers to another insurer (called the re-insurer) part or all of the potential losses associated with such insurance.

Question 8

Define adverse selection

Answer 8

is the tendency of persons with a higher-than-average chance of loss to seek insurance at standard rates, which if not controlled by the underwriting, results in higher-than-expected loss levels.

Question 9

Define underwriting

Answer 9

refers to the process of selecting and classifying applicants for insurance.

Question 10

Define personal lines

Answer 10

refer to coverage that insure the real estate and personal property of individuals and families or provide them with protection against legal liability.

Question 11

What are the five major personal lines?

Answer 11

• private passenger
• homeowners insurance
• personal umbrella liability
• earthquake insurance
• flood insurance

Question 12

What are the five major social and economic benefits of insurance?

Answer 12

• indemnification for loss
• reduction of worry and fear
• source of investment funds
• loss prevention
• enhancement of credit

Question 13

What are the three major social cost of insurance?

Answer 13

• cost of doing business
• fraudulent claims
• inflated claims

Question 14

Define expense loading

Answer 14

the amount needed to pay all expenses, including commissions, general administrative expenses, state premium taxes, acquisition expenses, and an allowance for contingencies and profit.

Question 15

What are the two differences between insurance and hedging?

Answer 15

• insurance involves the transfer of pure risks, while hedging involves risks that are typically uninsurable.
• Insurance can reduce the objective risk of an insurer, while hedging does not result in reduced risk.

Question 16

What are the three characteristics of a social insurance program?

Answer 16

• financed entirely or large part by contributions from employers and/or employees
• benefits are heavily weighted in favor of low-income groups
• eligibility and benefits are prescribed by statute

Ex: social security, unemployment, workers comp