FIN 3305 Exam 2 Flashcards
Describe Risk Transfer by Insurance
- Risk transfer by insurance is a financial intermediation device in which individuals or entities (insureds) transfer a risk of loss to another party (the insurer) in exchange for a payment less than the expected loss (premium)
- And the insurer combines or pools the risks together
What value does insurance provide? (6 values)
- Less need for individuals/firms to fully pre-fund losses (reserve) (without insurance, we would need to save large amounts for eventual losses)
- Because reserves are lower, more capital is available for investment
- Reduced cost of capital due to increased capital flows
- Having insurance lowers an insured’s credit risk
- Insurers incentivize loss control (via premium discounts, warranties, etc.)
- Creates stability in society by preserving wealth and preventing bankruptcy
Define Risk Pooling (loss sharing)
- Sharing of losses by large number of those exposed to a risk
- Insurer acts as intermediary in assembling a pool of risks
- Money collected from all is used to cover financial losses of the few who suffer loss
- Effect is reduction of risk of loss for individual members in the risk pool
Risk reduction through pooling: The independent losses case
- Weighted average “(probability)(dollar amount)” to determine the “Expected Loss”
- Calculate variance
- Standard Deviation = square root of variance
Describe what happens to expected loss and standard deviation whenever risk is pooled.
- Expected loss remains the same ($500); Pooling does not change the expected payout
- Standard deviation went down (from 1000 to 707); Pooling makes outcomes per person more predictable for the insurer (Don’t know which insureds will suffer loss, but the overall loss in predictable)
What happens if the numbers of people in the pool increases infinitely?
Standard Deviation would approach 0
- Low of large numbers
- The greater the number of exposures, the more closely will actual results approach probable results expected from an infinite number of exposures
- As a sample of observations increases in size, the relative variation around the mean decreases
- The probability distribution of losses per person would approach the normal distribution
- While there is substantial variability in losses at the individual loss exposure level, once the risks are pooled together, the risk to the insurer, as shown by this reduced variability, is reduced
- Pooling and law of large numbers allows more accurate prediction of, and pricing for, losses due to risks
What are the parameters for the law of large numbers to be effective?
- Loss exposures must have approximately the same probability of loss
- Loss exposures must be independent
Describe the first parameter of the law of large numbers (Same probability of loss)
Who in an insurance firm carries out this process?
- Risk Classification (underwriting) - Insurers sort risk exposures into classes based on probability of loss
- Common Classes - Age, gender, health status, location, building use
- Classification depends on information: application, government records, wearables
What is the goal of risk classification?
The goal of risk classification is to avoid adverse selection
What is adverse selection?
- Tendency of persons or entities with higher-than-expected losses to seek insurance at the price charged to those with average losses
- Problem is insureds often have superior knowledge about risk exposure than the insured
What are some ways adverse selection is avoided?
- Exclusions for coverage of intentional actions
- Suicide
- Criminal behavior - Comprehensive information gathering
- application questions
- other sources: credit, driving, medical records - Avoiding or adjusting for inadvertent incentives
- more lenient underwriting standards for certain
conditions than competition
Independent Loss Exposures: What is the issue with positive correlation?
- The magnitude of risk reduction due to pooling is lower when losses are positively correlated
Are losses positively correlated?
- common root cause (illness, natural disaster)
- Common factors (inflation)
There is zero risk reduction if losses are perfectly positively correlated
What effect does diversification have on independent loss exposures?
Diversification helps reduce correlation and increase independence of losses
- Diversification means selecting risks that are unlikely to share many of the same characteristics. Factors like geography, profession, and business activities are examples of distinctive characteristics
- There is some tension between the concept of selecting risks with the same probability of loss and diversification. The relevant factors may change depending upon the characteristics most significant to the potential loss.
Characteristics of the Ideal Insurable Risk
- The number of similar exposure units is large, and each is independent of any other (law of large numbers)
- The losses that occur are accidental or by chance (fortuitous losses)
- A catastrophic loss cannot occur (terrorism, pandemic)
- Losses are definite in time and measurable in loss size (pain and suffering damages, punitive damages in liability insurance)
- Severity of losses should be high compared to frequency (tendency to retain low severity losses eg. broken windows)
- The cost of coverage is economically feasible to provide and buy
What are the four key insurance principles?
- Indemnity
- Insurable interest
- Subrogation
- Utmost good faith
Indemnity Contract
The principle of indemnity means that the insurer agrees to pay no more or no less than the actual loss of the insured
What concepts support indemnity?
Insurable interest, subrogation, actual cash value provision, “other insurance” provision
Describe “Actual Cash Value”
- Typical property insurance allows the insured to recover “the actual cash value, not to exceed the replacement value”
- Actual cash value is equal to replacement cost minus physical depreciation, including obsolescence (ex. damage to a 10 year old roof would have a cash value equal to the replacement value of the roof minus 10 years of value due to normal wear and tear)
- Actual cash value can also incorporate “fair market value” (Cars)
- Many policies offer replacement cost for a higher premium
Describe “Other insurance provision”
A provision in the insurance contract describing how coverage will be prorated or applied if there is other coverage available for the loss
Insurable Interst
A financial interest in the life or property of insured
Property
- owner, lessor, creditor
Life
- your life, life of an immediate family member, creditor,
employer, business relationship
Time of Insurable Interest
Property: At the time of loss
Life: At the inception of the policy
Amount of Insurable Interest
Property: Up to the amount of the insured’s financial interest
Life: A valued policy - the value is agreed upon ahead of time by the parties since difficult to determine
Subrogation
The insurer has the right to assume any claim the insured has against a third party to recover a loss
(insurer “steps into the shoes” of the insured for purposes of recovering any loss from a third party)
Utmost Good Faith (uberriame fidei)
Both parties to an insurance contract are expected to act with the utmost good faith
- Most other contracts require only “good faith”
- Arose from the inequality of available information to the
insurance parties
Originally, statements of insured seeking coverage were treated as warranties - if not strictly true, the coverage could be voided
- present standard is that statements of the insured are
representations
- misrepresentation or concealment of a material fact can
cause the. contract to be voidable by the insurer
(smoking status, location of vehicles)
- certain warranties in property insurance are still
enforceable (existence of burglar alarms, sprinklers)
Requirements of a Contract
An insurance policy is a specific type of contract. For a contract to be legally enforceable, it must meet the following minimum requirements
1. There must be an offer and an acceptance
2. There must be consideration
3. The parties to the contract must be competent
4. Its purpose must be legal
Who makes the offer in the typical insurance transaction?
Application as an offer to purchase insurance
- Raises problem of time to underwrite from application information
- Significant terms such as the price and exact coverages are often unknown
Results in issuance of policy as a counteroffer or new offer to insured
What is the acceptance?
Often a temporary insurance agreement is made subject to revision from a final policy
- Binder in property and casualty insurance (agents often have binding authority)
- Conditional receipt or temporary insurance in life insurance
Acceptance of the final policy agreement is by payment of the premium
Define Consideration for both the insured and the insurer
Insured’s consideration is the payment of the initial premium; Subsequent premiums are conditions to the continuance of coverage
Insurer’s consideration is the agreement to insure
Competent Parties
What are conditions that might cause a party not to be competent to enter into a contract?
- Mental state (dementia, mental disability), intoxication, age (contracts entered into by minors are voidable)
For insurers, failure to have an insurance license might make the contract issued voidable by the insured
Legal Purpose
- Contract must be for performance of an activity not prohibited by law
- Insurance is a legal purpose
How are insurance and gambling different?
- Insurance is designed to protect against the financial consequences of a risk that the insured already has (insurable interest)
- Gambling creates a new risk for the gambler on the outcome of some event
4 Characteristics of Insurance Contracts
- Aleatory: The values exchanged may not be equal
- How many have never made an insurance claim?
- How many have had a large claim? - Conditional: insureds must perform certain acts to be indemnified
- report losses within a certain time, provide proof of loss - Unilateral: Only the insurer makes a legally enforceable promise
- If insured doesn’t perform their duties, contract just gets
voided - Contracts of Adhesion: Any ambiguity in contract language will be decided in favor of the insured
- insurers (and their lawyers) have the advantage in writing
the contract
Agents and Brokers
Agents
- Represent the insurer
- Typically arrange insurance for individuals and small businesses
- Have authority from the insurer to bind coverage (exception: life insurance)
Brokers
- Represent the insured
- Typically arrange insurance for medium/large businesses
- Do not have authority to bind coverage
What are the 5 major elements of the insurance contract?
- Declarations
- Insuring Agreement
- Exclusions
- Conditions
- Endorsements and Riders
Limits of Liability
The maximum amount payable for a specific loss
Limits of Liability on Property Insurance
May be modified by actual cash value, replacement cost, or amount of insurable interest due to principles of indemnity
Limits of Liability on Health Insurance
Affordable care act has eliminated most medical expense limitations
Limits of Liability on Life Insurance
Valued policy - amount is agreed to by the parties
Limits of Liability on Liability Insurance
May be a dollar limitations on amount of liability paid but cost of defense is in addition to limit
Retained Losses
Deductibles, coinsurance, copayments, elimination periods
These all affect the cost of the insurance. The more responsibility an insured accepts for the loss through these mechanisms lowers the premium
Insuring Agreement for Property Damage
We will pay for direct physical loss of or damage to covered property at the premises described in the Declarations caused by or resulting from any covered cause of loss
Insuring Agreement for General Liability Insurance
We will pay those sums that the insured becomes legally obligated to pay as damages because of “bodily injury” or “property damage” to which insurance applies
Insuring Agreement - 2 Types of Perils
- Named-Perils Policy - Covers only losses caused by perils listed in the policy
- Open-Perils Policy (all risk) - Covers losses caused by all perils except those excluded
Exclusions
In contrast to the insuring agreement, this is a list of things that are NOT covered
- Perils (e.g. war)
- Types of losses (indirect loss, intentional loss)
- Types of property (cash)
- Locations (certain countries)
The Exclusions sections is NOT a comprehensive list of all things not covered; Even the insuring agreement may exclude coverage by saying “We cover X, but do not cover Y”
Why are some perils excluded?
Reason for Exclusion:
1. Uninsurable (does not meet requisites of insurable risk; war, earthquake, maintenance)
2. Should be covered under a different policy (maintain principle of indemnity; damage to insured’s vehicle excluded under homeowner’s policy)
3. Poses a risk that is not priced in the policy (premiums would be inaccurate; Personal auto policies exclude business activities (ex. rideshare)
Conditions
Provisions of a policy that describe the duties of the parties. Conditions must be fulfilled for the contract to continue in force; We will focus on conditions affecting the insured
What are some conditions in insurance contracts that affect the insured?
- Notice and Proof of Loss
- Protection of Property after a loss (make necessary repairs)
- Examination (insurance company can examine scene)
- Cooperation of the Insured (insured must cooperate)
Coinsurance in Property Insurance
- Insured must bear a portion of loss ONLY when underinsured (limits are less than the required amount of insurance)
- For commercial insurance, it is common to insure for less than the total property value, as total losses are rare
- The insurer specifies the amount of coverage required by setting coinsurance %, which is expressed as a % of property value
Property Insurance Coverages
- Basic Form covers only causes 1-11
- Water damage does not include floods
- “Collapse” is also covered whether due to the named perils, weight of people o personal property, weight of water, or defective materials
- Broad form would have higher premium than basic
- One advantage of special form is coverage for theft (but excludes employee theft or mysterious disappearance)
Difference in Conditions (DIC) Insurance
Adds all-risk coverage to basic cause of loss form in BPP
- Large deductible, no coinsurance
- Can be expanded to cover earthquake, flood, and other
perils
Insuring Clause
Guidelines for Using Different Risk Management Techniques
