Principles of Insurance Flashcards
Insurance
Insurance is a financial arrangement that redistributes the costs of unexpected losses.
Insurance involves the transfer of potential losses to a group of individuals exposed to the same risk through what is referred to as an insurance “pool.” Members contribute financial consideration to fund the pool based upon the combined predicted losses divided by the number of members. As covered losses occur, members receive funds from the pool to replace the economic loss sustained.
Legal Definition of Insurance
Insurance is a contractual arrangement whereby one party agrees to compensate another party for losses, in exchange for consideration paid (i.e., the premium).
Exposure to Loss
The insured’s possibility of loss is called his exposure to loss. If the insured purchases an insurance policy, he transfers the exposure to loss to the insurer.
Self Insurance
Self-Insurance means that a firm or other organization may decide to deal with its own risks. They decide to operate much like a commercial insurance company and will engage in the same types of activities as a commercial insurer. When these activities involve the operation of the law of large numbers and predictions regarding future losses, they are commonly referred to as self-insurance.
Advantages of Self Insurance
Avoid expenses of commercial insurance market.
Losses may be less than average experience.
Build up reserves if there is a long time between losses.
Avoid having to support higher risk firms that may be in a commercial pool.
Disadvantages of Self Insurance
No protection from catastrophic loss.
Paying losses rather than premiums may result in greater variation of costs from year to year.
Paying claims with its own staff may create adverse public relations.
Unable to take advantage of expertise and service provided by a commercial insurer.
Loss
The word “loss,” as it is commonly used, means being without something previously possessed such as “loss of memory” and “loss of time.”
When the word is used in insurance, however, it takes on a more limited meaning. It is called insurable loss.
Insurable Loss
Direct losses are the immediate, or first, result of an insured peril.
Example: If a fire destroys a home, the loss of the home is the direct loss.
Indirect losses, also called consequential losses (such as loss of use), are a secondary result of an insured peril.
Example: If a tornado destroys a restaurant, the property damage is the direct loss. The loss of income during the period when the business is being reestablished is the indirect loss.
Chance of Loss
The chance of loss is the probability of loss.
The concept of chance of loss refers to a fraction. The numerator is either the actual or the expected number of losses. The denominator represents the number exposed to loss. The chance of loss in a given case may or may not be known accurately before a loss occurs. If we are referring to the predicted chance of loss, we divide the expected number of losses by the number of exposed units. This fraction is called a priori chance of loss.
If we are looking back in time, we can divide the actual number of losses by the total number of exposures. This fraction is called the actual or ex-post chance of loss.
Perils
A peril is defined as the cause of the loss. For example, fires, tornadoes, heart attacks, and criminal acts constitute perils.
Hazard
Hazards are conditions that increase the probability of loss from a peril, by increasing either the frequency or the severity of potential losses.
Four Categories of Hazards
Physical Hazards:
Moral Hazards
Morale Hazards
Legal Hazards
Physical Hazards
Physical Hazards: Involve physical characteristics such as type of construction, location, occupancy of building, having frayed wires on plugs, steep stairs with no railing, or smoking in bed.
Moral Hazards
Moral Hazards: Involve dishonest tendency such as exaggerating losses in a theft claim or auto insurance fraud (e.g., two cars intentionally bump each other with many passengers claiming injury).
Morale Hazards
Morale Hazards: Involve an increase in losses due to knowledge of insurance coverage such as having a different attitude toward a loss because the loss will be covered by an insurance company (e.g., leaving a car unlocked, ordering unnecessary medical tests, or a jury’s tendency to grant larger amounts of money in situations where an insurer will have to pay).
