Insurance Terminology Flashcards
Insurance Risk
Almost all risks insured by insurance companies are pure risks, which are risks where there is no possibility of a gain by the insured. Only risks that would result in financial loss are insurable; insurance companies do not insure against predictable losses, such as events related to pre-existing conditions. Actuaries set the premium for insurable risks, with loadings added where there is a particular factor in a person’s health or lifestyle that means there is a greater chance they will need to claim.
Examples to explain the meaning of risk:
- A person may unexpectedly die. They may become critically ill, which means they have to finish working and give up their career.
- A person, through no fault of their own, but on the advice of a surgeon, may have to be treated with an experimental medical procedure which is not covered by the health system.
Insurance is the transfer of a pure risk (see above) to an entity that pools the risk of loss and provides payment if loss occurs.
Perils and Hazards
The two related terms, “peril” and “hazard,” are often used in reference to the insurance industry. Essentially, a peril is something that causes, or can cause, a loss, while a hazard is something that makes the occurrence of peril or loss more likely.
Perils
A peril is an event or circumstance that causes or may potentially cause a loss. Examples of perils in the life, disability and health insurance industry may be:
- Premature death, accidental or otherwise due to ill-health
- Premature death of a partner or family member
- Onset of chronic illness or disease
- Accidental injury
- Congenital, inherited genetic conditions that may affect health, wellbeing or ability to undertake any or some types of work, in the future
- Onset of a health condition that, if untreated, will cause disability or worse
- Loss of a job
- Inability to meet financial obligations (which may be mortgages or other personal debt)
Hazard
A hazard is an action, condition, circumstance, or situation that makes a peril more likely to occur or a loss more likely to be suffered as the result of a peril. Examples of hazards may include being overweight, smoking or drinking excessively, dangerous pursuits, such as skydiving or base jumping, that increase the likelihood of injury, or dangerous occupations, such as deep-sea engineering. Hazards are commonly divided into three classifications: physical, moral and morale.
- Physical Hazards: - Physical hazards refer to actions, behaviours, or physical conditions that constitute a hazard. Smoking is considered a physical hazard in regard to health insurance (Read More [1]) because it increases the probability of severe illness.
- Moral Hazards: - Moral hazards refer to hazards resulting from immoral behaviour such as lying or fraud. Health insurance companies are concerned with moral hazards that may lead to fraudulent claims, such as an auto accident victim who exaggerates the injuries they suffered.
- Morale Hazards: - Morale hazards (Read More [2]) are those hazards that result from conditions or circumstances that tend to lead people or organisations to adopt a more careless or reckless attitude and exercise less caution to prevent injury, thus increasing the possibility an injury or loss occurs. An example is riding a bike without a safety helmet.
The insurance industry itself is sometimes considered a morale hazard, in that having insurance tends to make people less careful about avoiding injuries or illness, due to the fact they know they have insurance to cover medical costs.
Utmost good faith
The client and adviser are under an obligation not to attempt to deceive or withhold information from each other, or the underwriter when completing an application, or making a claim. Utmost good faith is a legal doctrine which applies to all parties to a contract. The insured and insurer have this obligation as they are the parties to an insurance contract; the adviser has this obligation as a representative (or agent) of the insurer.
In simple terms, utmost good faith means each party interacts with each honestly, declaring all material facts in relation to an insurance proposal.
Compensation not enrichment
A client (or the insured) should not be in a better situation (enrichment) after an event such as a disability claim but should only be compensated fairly for any loss. The event could relate to a life, disability or health insurance claim. A life insurance sum insured, for example, should be based on ensuring the surviving beneficiaries can maintain their existing standard of living without the deceased rather than dramatically improving their lifestyle. A life insurance policy of $3 million for a 45 year old person with a mortgage of $300,000 and a salary of $50,000 for example, would be enrichment, as the cover is 60 times their expected earnings – far more than they are likely to earn over their remaining worklife.
Adverse selection
The client (or possibly the adviser) knows more about their situation than they are prepared to reveal and may not reveal the full extent of the risk (often to the product provider and/or underwriter). Adverse selection occurs when one party in a negotiation has relevant information the other party lacks. An insurance contract relies on the honesty of the potential insured, as well as the insurer asking relevant questions.
A smoker declaring that they are a non-smoker, for example, is adverse selection, as they are paying a lower premium than they should be, for their level of cover. Of course, this may lead to a declined claim in the future, but not if the smoking were not the cause of the claimable event.
Anti-Selection
A type of adverse selection, basically means acting on known information to gain an advantage on either securing or denying an insurance policy. Anti-selection is a term that is often used in conjunction with adverse selection. It is defined as an increase in the chance for a person to take out an insurance contract because they believe they have a higher health risk than what the insurance company may be pricing for. For example, someone who suspects they may be suffering from a serious illness, may take out insurance, before seeking medical advice.
Law of large numbers
The law of large numbers is a statistical concept that calculates the average number of events or risks in a sample or population to predict something. The larger the population that is calculated, the more accurate the predictions are. In the field of insurance, the Law of Large Numbers is used to predict the risk of loss or claims of some participants so that the premium can be calculated appropriately.
In life insurance terms, for example, the actuary cannot tell who is going to die at a certain age but can tell approximately what percentage of people that age will die. The law of large numbers is like a probability statistic, and while there will be variation, the expected losses are generally quite predictable, which allows then for accurate premium pricing to ensure the company doesn’t run at a loss.
Risk Tolerance
Those with a high risk tolerance are often seen as the opposite of those with a low risk tolerance. Those with a low tolerance, also called risk-averse or have an aversion for risk. The distinction is justified only by the person’s level of comfort.
A risk-taker would rather have as much money as possible so that they can enjoy life today. At the other end of the scale, a risk-averse person is more conservative. They are more likely to be concerned that financially, life will continue if someone dies, suffers a traumatic event or is disabled.
Risk tolerance is a measure of how much risk a client is prepared to take themselves. This is not necessarily the same as the appropriate amount of risk they should take. Risk tolerance is a matter of personal belief, but it may also be a matter of having to accept a higher risk tolerance because they cannot afford the cost of the premiums which would cover all the financial risks they have.
Wait periods and excesses selected can also indicate someone’s risk tolerance; while this is also linked to capacity to cope with risk, it is also a way of reducing the premium, which may enable them to at least have some cover in place, even if they are accepting a bit more of the risk themselves.
Capacity to cope with risk
Capacity to cope with risk refers to the financial ability of the client to cover the costs associated with the loss (capacity to cope with risk). What this means is, does the client have the ability to pay for the financial costs associated with a risk event occurring. A person’s debt situation, dependants, assets and savings all influence their capacity to take on risk. A person with 3 months emergency savings will have a higher capacity to meet a longer income protection wait period, than a person who lives pay packet to pay packet.
A couple that has two incomes and the ability to survive on one income has a higher capacity to cope with a loss of income than a couple where only one of the parties is working, and they are solely reliant on that income to pay the mortgage and their costs of living.
Capacity to cope with risk also reflects in wait periods, excesses and benefit periods. A person with no savings would need a shorter wait period, as they could not cope financially with no income coming in, even for a short period of time, while someone with three months saving may be able to have a longer wait period. Someone who has a high net asset base may also have a higher risk capacity. For example, if they have a number of rental properties and then unexpectedly were off work for an extended period of time with no income, they might choose to sell one of the rental properties to reduce debt and provide some money, rather than pay the costs of an insurance premium.
Capacity to cope with risk is influenced by a person’s disposable income. A client may not have the financial capacity to withstand a loss but may also not have the financial capacity to cover the cost of transferring the costs of a loss. Often a client will have a “wish list” of all the outcomes they would like to achieve in the event of death, disability or ill health. However, the cost of meeting everything on that list would mean that other living expenses would not be met, and the client is not prepared to forfeit these. The client, working with the adviser, would then decide on priorities, and meet the highest priorities first.
