Lecture 4

Question 1

Expected Annual Loss (EAL)

Answer 1

Expected loss per year when averaged over a long period (for example, 1000 years). Computationally, EAL is the summation of products of event losses and event occurrence probabilities for all stochastic events in a loss model.

Question 2

Basis Risk

Answer 2

The risk, with index insurance, that the index measurements will not match individual losses. Some households that experience loss will not be covered, for example, and some households that experience no loss will receive indemnity payments, As the geographical area covered by the index increases, basis risk will increase as well.

Question 3

Catastrophe

Answer 3

A severe, usually sudden, disaster that results in heavy losses.

Question 4

Catastrophe Bond

Answer 4

High-yielding, insurance-linked security providing payment of interest and/or principal to be suspended or cancelled in the event of a specified catastrophe, such as an earthquake.

Question 5

Claim

Answer 5

An insurer’s application for indemnity payment after a covered loss has occurred.

Question 6

Direct Loss

Answer 6

Recovery cost of the damaged assets.

Question 7

Indirect Loss

Answer 7

Economic consequences of the damaged assets (e.g., foregone revenue).

Question 8

Indemnity

Answer 8

The amount payable by the insurer to the insured, in the form of cash, repair, replacement, or reinstatement, in the even of an insured loss. This amount is measured by the extent of the insured’s pecuniary loss. It is set at a figure equal to but not more than the actual value of the objects insured just before the loss, subject to the adequacy of the sum insured.

Question 9

Insurance

Answer 9

A financial mechanism that aims to reduce the uncertainty of loss by pooling a large number of uncertainties so that the burden of loss is distributed. Generally, each policyholder pays a contribution to a fund, in the form of a premium, commensurate with the risk he introduces. The insurer uses these funds to pay the losses (indemnities) suffered by any of the insured.

Question 10

Parametric Insurance

Answer 10

Parametric insurance makes indemnity payments based not on an assessment of the policyholder’s individual loss, but rather on measures of a parametric index that is assumed to proxy actual losses.

Question 11

Premium

Answer 11

The monetary sum payable by the insured to the insurers for the period (or term) of insurance granted by the policy. Premium = premium rate x amount of insurance.

Question 12

Risk financing

Answer 12

The process of managing risk and the consequences of residual risk through products such as insurance contracts, CAT bonds, reinsurance, or options.

Question 13

Reinsurance

Answer 13

When the total exposure of a risk or group of risks presents the potential for losses beyond the limit that is prudent for an insurance company to carry, the insurance company may purchase reinsurance (that is, insurance of the insurance). Reinsurance has many advantages, including:

1) levelling the results of the insurance company over a period of time;
2) limiting the exposure of individual risks and restricting losses paid out by the insurance company;
3) possibly increasing an insurance company’s solvency margin (percentage of capital and reserves to net premium income), hence the company’s financial strength;
4) enabling the reinsurer to participate in the profits of the insurance company, but also to contribute to the losses, the net result being a more stable loss ratio over the period of insurance.