Slides 4

Question 1

List and define the basic characteristics of insurance

Answer 1

Basic characteristics of insurance are

1. Pooling of losses. This is the heart of it as in includes sharing losses and changing the probability distribution of accident costs faced by each participant.
2. Payment of fortuitous losses : This is the payment of losses that are as a result of chance and not intentional.
3. Risk transfer - the tranfer of pure risk from an individual to an insurer who is in a stronger financial position to pay for the loss.
4. Indemnification: Putting one in position they were in before the loss occurred

Question 2

What is
i) Adverse selection
ii) The law of large numbers

How to prevent or mitigate adverse selection

Answer 2

Adverse selection is the tendency of persons with higher than average chance of loss going in for insurance at standard costs, which may in the long run lead to higher than expected loss levels.

ii) The law of results states that the greater the number of exposures, the more closely the actual results will be to the probable expected results.

How to prevent adverse selection
i) Suicide clause
ii) Detailed application
iii) On -site investigation
iv) Medical examination
v) Provision of preexisting conditions

Question 3

What are the ideal characteristics of an insurable risk?

Answer 3

1. There must be a large number of exposure units. This is to enable the insurer use the law of large numbers to predict losses more accurately.
2. The premium or cost should be economically feasible. i.e. insured parties should be able to pay.
3. Loss must be accidental and unintentional
4. Chance of loss must be calculable . i.e. average frequency and severity
5. Losses should be determinable and measurable. ie should be definite as to cause, time, place and amount.
6. No catastrophic losses. ie. no significant /multiple number of losses should occur at the same time . can still happen in events of flood or natural disasters

Question 4

How to deal with catastrophic losses

Answer 4

1. Reinsurance- arrangement where the insurer transfers part or all potential losses to another insurer (reinsurer)
2. Insurers can avoid large concentration of risk by dispersing their coverage over a larger geographical area.

Question 5

Differentiate between insurance and gambling

Answer 5

1. Gambling creates a new speculative risk( chance of win or loss) whereas insurance deals with the transfer of pure risk from a party to an insurer.
2. Gambling is socially unproductive as winners win at the expense of losers whereas with insurance, neither the insurer or insured is affected by another’s win or loss.

Question 6

Differentiate between insurance and hedging

Answer 6

1. Insurance involves the transfer of pure risk whereas Hedging involves the transfer of speculative risk.
2. Hedging is a technique for handling risks that are mostly not insurable such as
   protection against the decline in price of products, raw materials, foreign exchange etc.