Nature Of Insurance: Chapter 2

Question 1

Adverse Selection:

Answer 1

Adverse selection is broadly defined as selection against the company. It includes the tendency of people with higher risks to seek or continue insurance to a greater extent than those with little or less risk. Adverse selection also includes the tendency of policyowners to take advantage of favorable options in insurance contracts.

Question 2

Hazard

Answer 2

Any factor, condition or situation that creates an increased possibility that a peril (cause of loss) will occur.

For example, icy roads, driving while intoxicated, improperly stored toxic waste.

3 types:

1. Physical
2. Moral
3. Morale

Question 3

Homogeneous Exposure Units:

Answer 3

Similar objects of insurance that are exposed to the same group of perils.

Question 4

Indemnity Contract

Answer 4

Attempt to return the insured to their original financial position

Question 5

Law of Large Numbers

Answer 5

A fundamental principle of insurance that the larger the number of individual risks combined into a group, the more certainty there is in predicting the degree or amount of loss that will be incurred in any given period.

Question 6

Loss

Answer 6

Unintentional decrease in the value of an asset due to peril.

Two types:

1. Direct
2. Indirect

Question 7

Loss exposure

Answer 7

The risk of possible loss.

Question 8

Moral Hazard

Answer 8

A hazard brought on by the effect of personal reputation, character, associates, personal living habits, financial responsibility, and environment, as distinguished from physical health, upon an individuals general insurability.

When a loss more likely to occur due to the dishonest character of the insured, who may be more disposed to either engage in criminal activity or cause a loss because of their negative habits. The chance of loss is higher because of who the insured is. It is due to the individual character of the insured. A moral hazard, properly defined, occurs when the insured is much more intentioned and conscious of participating in wrongdoing that is more likely to lead to a loss.

For example, a dishonest person is more likely to lie to the insurance company both on an application and when submitting a claim for loss, thus creating a higher likelihood of engaging in insurance fraud. Drug use and alcohol abuse are commonly associated with moral hazards.

Question 9

Morale Hazard

Answer 9

Hazard arising from indifference to loss because of the existence of insurance; often associated with having a careless attitude.

It is created based as a result of the personal or subjective thought process of the insured. It can arise from a state of mind related to the indifference of an insured to whatever loss may occur. The insured unintentionally creates a loss situation on an unconscious level. They just do not care about loss prevention since the property is insured.

For example, Alex leaves his car running unattended, with the doors unlocked to heat it up on a cold winter morning. This act makes it more likely that his car will be easily stolen by a passing car thief on the lookout for such vehicles. On some unintentional mental level, the insured simply does not care that this kind of loss might happen, probably because the vehicle is insured. Reckless driving, jumping off a cliff, stealing, racing motorcycles, carefree, careless lifestyle are often associated with morale hazards.

Question 10

Peril

Answer 10

The immediate, specific event causing loss and giving rise to risk.

Perils can also be referred to as the accident itself.

Two types:
Specified (named) perils (each covered is listed)
Special (open) perils (all covered, each excluded listed)

For example, fire, lightning, windstorm hail, earthquake, and flooding are all perils.

Question 11

Physical Hazard:

Answer 11

Physical or tangible conditions existing in a manner which makes a loss more likely to occur. Can be seen, touched, tasted, smelled, or tripped over, thus causing loss.

For example, let’s say Stan leaves a full can of gasoline near the furnace in his basement. When the furnace ignites, due to its close proximity to fuel, there is a greater likelihood an explosion will occur than if Stan left the gas can in his garage. Poor health, ice, and fire are often associated with physical hazards.

Question 12

Pure risk

Answer 12

Type of risk that involves the chance of loss only; there is no opportunity for gain; the only type of risk that is insurable.

Question 13

Reinsurance

Answer 13

The acceptance of risk by one or more insurers, (reinsurers) of a portion of the risk underwritten by another insurer who has contracted for the entire coverage.

Question 14

Risk

Answer 14

The uncertainty regarding loss, the probability of loss occurring for an insured or prospect.

Question 15

Risk avoidance

Answer 15

Occurs when individuals evade risk entirely. It is the act of not doing something that could potentially cause a loss or the inactivity of participation in an event that may potentially cause a loss situation.

Question 16

Risk management

Answer 16

Process of analyzing exposures that create risk and designing programs to handle them

Question 17

Risk Pooling/ Loss sharing

Answer 17

Spreading of risk by by sharing the possibility of loss over a large number of people; transfers risk from an individual to a group.

Question 18

Risk reduction

Answer 18

Takes place when the chances of a loss are lessened, or severity of potential loss is minimized.

Question 19

Risk Retention

Answer 19

The act of analyzing the loss exposure presented by a risk and determining that the potential loss is acceptable. Often associated with self- insurance

Question 20

Risk transfer

Answer 20

The act of shifting the responsibility of risk to another in the form of an insurance contract

Question 21

Speculative Risk

Answer 21

Involves the chance of both loss and gain; it is not insurable.

Question 22

5 ways to handle risk:

Answer 22

1. Avoidance (effective, not always practical)
2. Reduction: lessening possibility or severity of loss (like a smoke detector)
3. Sharing: groupings of individuals or businesses of similar exposure to share losses (reciprocal insurance exchange)
4. Retention (self insurance) when individuals have financial ability to cover losses by themselves
5. Transfer (most effective way to handle risk, insurance is example)

Question 23

Elements of insurable risk:

Answer 23

Not all risk is insurable, insurance company only insure PURE RISK.

PURE RISK-
Must be due to chance, cannot be catastrophic and must be randomly selected or occuring.

Question 24

What is insurance?

Answer 24

The concept of insurance is the transfer of risk from one party to another through a legal contract, or the transfer of risk through the pooling (accumulation) of funds.

Question 25

Insurance Contract

Answer 25

Applicant/policyowner is transferring the chance of a possible financial loss to another party, the insurer. In contrast, the insurer assumes the risk in exchange for the payment of premiums. The policyowner and insurer ultimately arrive at an agreement for insurance protection.

Question 26

How does insurance reduce risk of loss for an individual ?

Answer 26

Insurance spreads the risk of loss from one person to a large number of persons through the pooling of premiums. In other words, insurance reduces financial risk and spreads the risk of loss from one individual to many.

Question 27

Contracts of Indemnity

Answer 27

Accident, health, property, and casualty insurance

Question 28

What is the purpose of contracts of Indemnity (accident, health, property and casualty insurance)?

Answer 28

to make the insured “whole” again financially; to reimburse the loss while not making the insured better off than they were prior to the loss.

Question 29

Principle of Indemnification

Answer 29

restore” the insured to the same financial position that he or she was in prior to the loss occurrence; an insured shall not profit or gain by their loss.

Question 30

How is life insurance different than accident, health, property and casualty insurance?

Answer 30

Life insurance contracts are valued contracts and pay a stated sum regardless of actual loss incurred.

Question 31

What does the Law of Large Numbers state and why is it important?

Answer 31

Actuarial science principle that states that large groups provide an increased degree of accuracy in loss predictions, based on past experience. The higher the exposure, the more likely the event can be predicted.

the larger the number of risks insured in the same risk pool; the more predictable losses become.

While the company can predict the expected loss in total, there is no way to predict which individual will suffer financial loss.

allows premium charges to be very accurate and insurers to be more financially stable when accepting insurable risks.

Question 32

Spread of Risk (Risk spreading)

Answer 32

Highly accurate predicting of expected loss across a large group

(Ie safety in large numbers. $1000 premioum across 1 million homes would allow insurer to cover all losses plus overhead and have profit but insuring only 100 homes and losing 5 would likely bankrupt.

Question 33

What is insurance underwriting designed to ensure?

Answer 33

that insurers are fairly compensated for the actual risks they undertake when issuing contracts of insurance. Therefore, the premium for a higher risk person or property is greater than the premium for a lower risk. Adverse Selection (tendency for higher risk to seek/keep insurance) must be minimized.

Question 34

How are perils handled by insurance contracts?

Answer 34

Typically, insurance policies define the perils protected against in one of two ways Specified (Named) Perils and Special (Open) Perils. Additionally, policies typically list perils that are expressly excluded or not protected.

Insurance contracts that cover Specified or Named Perils individually list perils that they cover. If a loss is caused by a peril that is not listed within the insurance policy, then the loss is not covered.

Special or Open Peril insurance policies do not name the perils they cover but instead begin by saying they cover all direct causes of loss. These policies then list any perils which are excluded from coverage. Since an open peril policy spells out the causes of loss that are not covered under the policy, it, therefore, covers any peril not explicitly identified as being excluded from coverage.

Question 35

Special or Open Peril

Answer 35

Special or Open Perilinsurance policies do not name the perils they cover but instead begin by saying they cover all direct causes of loss. These policies then list any perils which are excluded from coverage. Since an open peril policy spells out the causes of loss that are not covered under the policy, it, therefore, covers any peril not explicitly identified as being excluded from coverage.

Example: comprehensive medical insurance and standard life insurance usually will cover medical bills and pay death claims related to perils other than those expressly excluded. Examples of perils commonly excluded in life and health contracts include suicide, acts of war, and injury or death sustained while committing an illegal act.

Question 36

Specified or Named Perils

Answer 36

individually listed perils that the insurance contract covers. If a loss is caused by a peril that is not listed within the insurance policy, then the loss is not covered.

For example, a life insurance policy may specifically name coverage for only accidental death. A health insurance policy may explicitly only cover cancer or heart attack. A property and casualty policy may explicitly cover only loss caused by fire, windstorm, and hail. Again, a named perils policy spells out the perils that are covered under the policy. By doing so, a named-peril policy can define covered losses narrowly.

Question 37

Loss (Direct)

Answer 37

results when a person or property is damaged, destroyed, or killed by a peril, without any intervening cause. The peril is the proximate cause of the direct loss.

Question 38

Loss (Indirect)

Answer 38

Also known as “Consequential Loss” because the loss is a consequence of or results from a direct loss.

For example, if John is involved in an accident and dies at the scene, his accidental death policy will probably pay the policy’s death claim as his death was a direct result of the accident. If John suffers a broken leg and is taken to the hospital, his health insurance policy will probably cover the injuries sustained as they were a direct result of the accident. If John were to die of a heart attack while receiving treatment for the broken leg, his accidental death policy will probably NOT pay the policy’s death claim as the death was a direct result of a heart attack. The fact that the heart attack may have been a consequence of the accident is irrelevant if the policy only covers direct loss from an accident.

Question 39

Loss (Accident)

Answer 39

unforeseen, unexpected, unintended, and sudden event, which occurs at a specific time and specific place. Additionally, an accident can have witnesses able to describe the actual event

Every accident is an occurrence, but not every occurrence is an accident.

For example, if Sally needs a knee replacement from being involved in a car accident, there are likely witnesses that saw the accident and, in theory, could provide the exact time and location of the accident that caused the injury. If sally needs a knee replacement from years of intense physical activity, there are no witnesses that could provide the specific time and location of the occurrence that resulted in the need for Sally’s knee replacement.

Question 40

Loss (Occurrence)

Answer 40

any event that causes a loss. Occurrences include both accidents and refer to injuries or losses caused by repeated or continuous exposure to conditions over time.

Every accident is an occurrence but every occurrence is not an accident.

For example, if Sally needs a knee replacement from being involved in a car accident, there are likely witnesses that saw the accident and, in theory, could provide the exact time and location of the accident that caused the injury. If sally needs a knee replacement from years of intense physical activity, there are no witnesses that could provide thespecific time and locationof the occurrence that resulted in the need for Sally’s knee replacement.

Question 41

3 types of hazards

Answer 41

1. Physical
   physical or tangible conditions existing in a manner that makes a loss more likely to occur. Physical hazards can be seen, touched, tasted, smelled, or tripped over, thus causing loss.
2. Moral
   make the loss more likely to occur due to the dishonest character of the insured, who may be more disposed to either engage in criminal activity or cause a loss because of their negative habits. The chance of loss is higher because of who the insured is. It is due to the individual character of the insured. A moral hazard, properly defined, occurs when the insured is much more intentioned and conscious of participating in wrongdoing that is more likely to lead to a loss.
3. Morale
   created based as a result of the personal or subjective thought process of the insured. It can arise from a state of mind related to the indifference of an insured to whatever loss may occur. The insured unintentionally creates a loss situation on an unconscious level. They just do not care about loss prevention since the property is insured.

Question 42

Speculative Risk

Answer 42

is a risk that presents the chance for both loss and gain. Speculative risks are not insurable.

For example, investing in the stock market and gambling are a speculative risk as an individual has the possibility of losing all their money or gaining money.

Question 43

Elements of Insurable Risk

Answer 43

Must involve a chance of loss that is accidental, measurable, and definable. General elements of insurable risk include:

The loss must be due to chance (accident) – it is outside the insured’s control; for example, getting a cold.

The loss must be definite and measurable – can document time, place, amount, and when payable for example, the accident was at 2 pm on Friday and caused $2,000 in damage.

The loss must be predictable – can estimate the average frequency and severity; for example, 18% of accidents involve distracted driving.

The loss cannot be catastrophic – must be reasonable; a one trillion-dollar life insurance policy is not reasonable.

The loss exposure to be insured must be substantial – law of large numbers to help insurance companies predict loss.

The loss must be randomly selected – avoid adverse selection.

Question 44

3 Classes of Risk

Answer 44

1. Standard
2. Substandard
3. Preferred

Question 45

Standard Risk

Answer 45

1 of 3 assigned risk classes.
Standard risks are considered to have an average potential for loss. Standard risks are typically insured with a predetermined standard premium.

Question 46

Substandard Risk

Answer 46

2nd of 3 assigned risk classes.
Considered to be a poor risk for the insurance company and have a higher potential for loss. Substandard risks may be insured with an increased premium, a lower benefit, or could be declined altogether.

Question 47

Preferred Risk

Answer 47

3rd of 3 risk classes.
considered to be great for the insurance company and have a lower potential for loss. Preferred risks may be offered a lower premium for the transfer of their risk.

Question 48

Risk Management

Answer 48

The process of analyzing exposures that create risk and designing programs to handle them. 4 steps.

Question 49

Risk Management, 4 steps of

Answer 49

Risk management may be accomplished by (1) detecting the potential loss exposure; (2) selecting a method or tool to reduce risk; (3) executing a course of action; and (4) reviewing the measures taken periodically. The risk may be reduced or managed by purchasing an insurance contract.

Question 50

TREATMENT OF RISK / METHODS OF HANDLING RISK

Answer 50

8 basic risk strategies:

1. Avoidance
2. Reduction
3. Retention
4. Transfer
5. Sharing
6. Pooling
7. Reinsurance
8. Prevention

Question 51

Risk avoidance
(1 of 8 risk strategies)

Answer 51

Risk can be avoided by eliminating a hazard.

For example, if you do not go skydiving (eliminate the hazard of skydiving), you have no risk of dying in a skydiving accident.

Question 52

Risk Reduction

2nd of 8 risk strategies

Answer 52

Risk can be reduced by minimizing the severity of a potential loss.

For example, installing smoke alarms reduces the risk of a total loss from a house fire. Quitting smoking is an additional example of risk reduction.

Question 53

Risk retention

3rd of 8 risk strategies

Answer 53

Risk can be retained through self-insurance. Self-insurance is typically used when losses are highly predictable, and the worst possible loss is not severe.

For example, a person retains the risk of needing to replace a toaster by not purchasing the 2-year extended warranty on a new toaster that only cost $50.

Question 54

Risk transfer

4th of 8 risk strategies

Answer 54

Risk can be transferred or passed from one party to another, typically through the use of an insurance contract.

Buying insurance is the best way to transfer risk. Additional examples include incorporation and hold-harmless clauses.

Question 55

Risk sharing

5th of 8 risk strategies

Answer 55

Risk can be shared by multiple parties. Each party assumes a portion of the risk receiving benefits under the system.

Insureds share in the risk of medical expenses through copayment and deductible cost-sharing programs.

Question 56

Risk Pooling

6th of 8 risk strategies

Answer 56

Risk Pooling, also known as loss sharing, spreads risk by sharing the possibility of loss over a large number of people. It transfers risk from an individual to a group. Insurance companies function through the concept of pooling of all their insured’s risk.

Question 57

Reinsurance

7th of 8 risk strategies

Answer 57

One-way insurers deal with preventing a catastrophic loss is through reinsurance, which is defined as the spreading of risk from one insurer to one or more other insurers. Many insurers are able to minimize exposure to substantial loss by reinsuring risks.

Question 58

Prevention

8th of 8 risk strategies

Answer 58

Another risk management tool available is loss prevention. Loss prevention involves taking actions to eliminate damage or loss. It is a method used to identify and analyze risk and to control losses.

For example, constructing a building using masonry materials rather than wood, removing flammable materials from a premises or de-icing the wings of an aircraft prior to takeoff illustrate loss prevention.

Question 59

Chapter Summary

Answer 59

CHAPTER SUMMARY
► Chapter Summary

Key points to remember from this chapter include:

Accident, health, property, and casualty insurance contracts are all contracts of indemnity.
The Law of Large Numbers is a principle of actuarial science that states that the higher the number of risks insured in the same risk pool; the more predictable losses become.
A peril is something that can cause a financial loss.
Specified or Named Perils individually list perils that they cover.
Special or Open Peril insurance policies do not name the perils they cover but instead begin by saying they cover all direct causes of loss.
A loss is an unintentional decrease in the value of an asset due to a peril.
Direct loss results when a person or property is damaged, destroyed, or killed by a peril, without any intervening cause.
An indirect loss is also known as Consequential Loss.
An Occurrence is any event that causes a loss.
A hazard is a condition or situation that creates or increases a chance of loss.
Types of hazards:
Physical Hazard
Moral Hazard
Morale Hazard
Physical hazards are physical or tangible conditions existing in a manner that makes a loss more likely to occur.
Moral hazards make the loss more likely to occur due to the dishonest or villainous character of the insured.
Morale hazard is created based as a result of the personal or subjective thought process of the insured.
Risk is defined as the potential for loss.
There are two types of risks:
Speculative Risk
Pure Risk
Standard risks are considered to have an average potential for loss.
Substandard risks are considered to be a poor risk for the insurance company and have a higher potential for loss.
Risk Pooling, also known as loss sharing, spreads risk by sharing the possibility of loss over a large number of people.
Insurers must minimize adverse selection, which is defined as the tendency for poorer than average risks to seek out insurance.
Sound and competent underwriting may reduce the chance of adverse selection.
The process of analyzing exposures that create risk and designing programs to handle them is called risk management.
Treatment of risk includes implementing the following strategies:
Risk Avoidance
Risk Reduction
Risk Retention
Risk Transfer
Risk Sharing
Risk can be avoided by eliminating a hazard.
Risk can be reduced by minimizing the severity of a potential loss.
Risk can be retained through self-insurance.
Risk can be transferred or passed from one party to another through an insurance contract.
Risk can be shared by multiple parties.
Reinsurance is the spreading of risk from one insurer to one or more other insurers.
Loss prevention involves taking actions to eliminate damage or loss.