Nature of Insurance

Question 1

Hazard:

Answer 1

A condition or situation that creates or increases a chance of loss. For example, icy roads, driving while intoxicated,
improperly stored toxic waste. Types of Hazards include:
• Physical – Poor health, overweight, blind.
• Moral – Dishonesty, drugs, alcohol abuse.
• Morale – Careless attitude – reckless driving, jumping off a cliff, stealing, racing motorcycles, carefree, careless
lifestyle. This attitude causes an indifference to loss.

Question 2

Loss

Answer 2

is the unintentional decrease in the value of an asset due to a peril.

Question 3

Peril:

Answer 3

: an immediate, specific event which causes loss, such as an earthquake or tornado. Perils can also be referred to as the
accident itself.

Question 4

Risk:

Answer 4

the potential for loss

Question 5

Speculative Risk

Answer 5

: is a risk that presents both the chance for loss or gain. Gambling is an example. Speculative risks are not
insurable.

Question 6

Pure Risk:

Answer 6

is the only insurable risk and present a potential for loss only, such as injury, illness, and death.

Question 7

ELEMENTS OF INSURABLE RISK

Answer 7

• Loss must be due to chance – Causeless, outside the insured’s control.
• Loss must be definite and measurable – Time, place, amount, and when payable.
• Loss must be predictable – Statistically able to estimate the average frequency and severity.
• Loss cannot be catastrophic – Must be reasonable, 1 trillion-dollar policy is not reasonable.
• Loss exposure to be insured must be large – Ideally, common enough that the insurer can pool many homogeneous,
or similar, exposure units (law of large numbers).
• Loss must be randomly selected – Fair proportion of good and poor risks (adverse selection).

Question 8

Law of Large Numbers

Answer 8

The larger the amount of exposures that are combined into a group, the more certainty there is to
the amount of loss incurred in any given period. The Law of Large Numbers allows:

• Prediction of individual and group losses based on past experience
• An increased degree of accuracy in predicting losses in large groups

Question 9

Homogeneous exposure units:

Answer 9

are similar objects of insurance that are exposed to the same group of perils. For example,
insuring a large number of homes in the same geographical area against hail damage.

Question 10

Adverse Selection

Answer 10

Insurers must minimize adverse selection, which is defined as the tendency for poorer than average risks
to seek out insurance.

For example, a person who takes 12 prescriptions is a poor risk. If an insurer cannot compensate poor
risks with better than average risks, then its loss experience will increase and its ability to pay claims may be compromised

Question 11

Risk Management:

Answer 11

is the process of analyzing exposures that create risk and designing programs to handle them