Exam 2 Part B

Question 1

Insurance Supply

Answer 1

• Insurers are willing to sell insurance at a particular price
• Pi = Price of Insurance
• Pi = P* + Risk Charge +Admin (Loading)

Question 2

Insurance Demand

Answer 2

• Will individuals pay for insurance at the stated premium
• Pmax = Most an individual is willing to pay for insurance at the particular risk
• Risk is insurable if: Pi less than or equal to Pmax, then market exists

Question 3

Why Might Pi be greater or = to Pmax

Answer 3

• Pi too high:
  1. Risk Charge is too high
  2. Loading costs are too high
• Pi too low
  1. Individuals underestimate the severity or frequency of the loss
• Moral hazard created by disaster relief (floods) where insurance like benefits exists

Question 4

Characteristics of Insurable Risk

Answer 4

1. Large Number of Similar Objects
2. Losses are accidental or unintentional
3. Losses can be determined and measured
4. Loss should not be catastrophic to insurance
5. Large Loss Principle
6. Insurable interest

Question 5

Large Number of Similar Objects

Answer 5

• Life insurance, automobiles
• Nature of objects similar so reliable statistics can be formed - is key
• Also need to be concerned with adverse selection

Question 6

Losses are Accidental or Unintentional

Answer 6

• Need to be fortuitous in nature
• Must be some uncertainty or no risk
• Insured should have no control over; increasing frequency or severity
• Must be accidental
• Avoid Moral Hazard and Gambling

Question 7

Why Must Losses Be Accidental/Unintentional and Solution

Answer 7

• P* goes up
• Pi goes down
• Pi greater than Pmax

Solution:

• Deductible or Co-pay
• Claims investigation
• Loss settlement Rules
• Policy Limits

Question 8

Losses Can Be Determined and Measured

Answer 8

• Did loss occur? Not always easy for insurer to determine

- What are Losses? How do we measure “pain and suffering”?

Question 9

Loss Should Not Be Catastrophic To Insurer

Answer 9

• Catastrophic to insured ok
• Normally one random event - one claim
• When one random event results in many, many losses - big problem
• Earthquake, Flood, Hurricane
• Avoid having all members of a group suffer loss at the same time
• Creates risk of insolvency for insurer
• Difficult for the insurer to predict overall cost
• Risk Charge goes up
• Pi goes up
• Pi greater than Pmax
• Law of large numbers assumes that random events in question are independent events

Question 10

Solutions to Catastrophic Loss

Answer 10

• Good underwriting
• Diversity risks
• Reinsurance - insurance for the insurance company

Question 11

Large Loss Principle

Answer 11

• Maximum possible loss needs to be sufficient

- Small losses better paid off through savings

Question 12

Insurable Interest

Answer 12

• Must demonstrate some personal loss
• In the event of a loss, the insured must lose financially or incur some other type of harm in order for their to be a valid contract
• All valid contracts must have an insurable interest

Question 13

Insurable Interest Purpose

Answer 13

• Reduces moral hazard - no gambling
• Unless the insured stands to lose financially in the event of a loss, they may actually cause losses
• Serves as a measure of recovery for the amount of recovery in the event of a loss
• Should not be able to collect more than insurable interest
• Strongly supports principle of indemnity

Question 14

What Constitutes Insurable Interest

Answer 14

• Property - liability insurance
• Ownership
• Leases
• Baliee/Bailor

Question 15

Life Insurance Interst

Answer 15

• Must be financial interest in the continuance of a life
• S = Subject of insured life
• O = Owner of Policy
• B = Beneficiary (receives $)
• For the requirement to be met “0” or “B” must have an insurable interest in “S”

Question 16

When Must Insurable Interest Exist

Answer 16

• In property - liability insurance; must exist at time of loss
• In Life Insurance: at the time of contract only