Definition and Characteristics of Insurance

1. Definition and Characteristics of Insurance BUS 200 Introduction to Risk Management and Insurance Jin Park

2. Definition of Insurance • A social device in which a group of individuals (called “insureds”) transfer risk to another party (called an “insurer”) in order to combine loss experience, which permits statistical prediction of losses and provides for payment of losses from funds contributed (premiums) by all members who transferred risk.

3. Definition of Insurance • The pooling of fortuitous losses by transfer of such risks to insurers, who agree to indemnify insureds for such losses, to provide other pecuniary benefits on their occurrence, or to render services connected with the risk.

4. Definition of Insurance • A formal social device for reducing risk by transferring the risks of several individual entities to an insurer. The insurer agrees, for a consideration, to assume, to a specified extent, the losses suffered by the insured.

5. Definition of Insurance • A system under which individuals, businesses, and other organizations or entities, in exchange for payment of a sum of money (a premium), are guaranteed compensation for losses resulting from certain perils under specified conditions.

6. Characteristics of Insurance • Risk Transfer • Loss Sharing • Insurance is about spreading the financial responsibilities. • Discrimination via underwriting

7. Characteristics of Insurance • Risk Transfer • An insurer, a professional risk-bearer, assumes the financial aspects of risks transferred to it by insureds. • In return, the insurer receives a premium. • Insurer is typically in a stronger financial condition to pay the loss.

8. Characteristics of Insurance • Loss sharing (pooling) • Loss sharing is accomplished through premiums; therefore, group losses are shared by the group’s members. This is the essence of pooling. • Pooling arrangement changes the probability distribution of accident costs facing each person.

9. Characteristics of Insurance • Loss sharing (pooling) • Assume 1,000 individuals each have homes worth $100,000 • On average, 1 home burns down per year • Without insurance: max loss = $100,000 • Suppose all agree to share the loss  average loss = 100,000 / 1,000 = $100 • Trading between “$100 sure loss” and “chance of losing $100,000”

10. Characteristics of Insurance No pooling between two persons Person A Person B Expected Loss = $500 Std. Dev. = $1,000 Expected Loss = $500 Std. Dev. = $1,000

11. Characteristics of Insurance Two-person pooling arrangement Each individual’s expected loss amount = $500 Std. Dev. = $707 compare this with $1,000

12. Characteristics of Insurance Three-person pooling arrangement Each individual’s expected loss amount = $500 Std. Dev. = $577.35 compare with $1,000 or $707

13. Discrimination via underwriting • Underwriting • The process of selecting risks (insurance applicants) and classifying them according to their degrees of insurability so that the appropriate rates may be assigned. The process also includes rejection of those risks that do not qualify. • Note: insurance profits may come from both underwriting and investment.

14. Life/Health Insurance Type of policies Face amount Insured’s age, gender Tobacco use Residence Health status Family diagnosis Driving records … and more Property/Liability Type of policies Limit of insurance Nature of business Location Past claim history Total revenue Type of property Construction type Credit history … and more Discrimination via underwriting

15. Discrimination via underwriting • Underwriting Decisions • Accept the application • Accept the application subject to certain restrictions or modifications • Reject the application

16. Discrimination via underwriting Young person Expected Claim ($) = 0 x (.95) + (10,000) x (.95) = $ 500 • Old person Expected Claim ($) = 0 x (.90) + (10,000) x (.10) = $ 1,000

17. Discrimination via underwriting If they are put into the same pool and share the losses, then total expected claim for the pool = $0x(.855) + $10,000x(.095) + $10,000x(.045) + $20,000x(.005) = $1,500. Thus, the share for each participant in the pool is $750.

18. Discrimination via underwriting • If you were the young person, paying $750, what would you do? ???___________ • If you were the old person, paying $750, what would you do? ???___________ • Then, what will happen to the insurer that sets the pure premium at $750? ???___________

19. Discrimination via underwriting • Adverse Selection • The phenomenon of selecting an insurer that charges lower rates for a specific risk exposures. • The tendency of persons with a higher-than-average chance of loss to seek insurance at standard (average) rate, which if not controlled by underwriting, results in higher-than-expected loss levels. • To mitigate the adverse selection • Detailed application • Medical examination • On-Site investigation • Suicide clause • Preexisting conditions provision