Topic 7. Characteristics of an Insurable Risk

1. Topic 7. Characteristics of an Insurable Risk BUS 200 Introduction to Risk Management and Insurance Jin Park

2. Overview • Requirements of An Insurable risk • Large number of similar exposure units • Accidental and unintentional loss • No catastrophic loss • Determinable and measurable loss • Calculable chance of loss • Economically feasible premium • Types of Insurance

3. Insurable Risk 1. Large Number of Similar Exposure Units • Enable the insurer to predict loss based on the law of large numbers • Exposure units = item, person, etc… • If exposure units are dissimilar and the insurer treats them indifferently, there will be “adverse selection” problem. • If “large number” is violated, the insurer will not be confident in their estimations, and thus, high risk charge must be added in the premium.

4. Insurable Risk 2. Accidental and Unintentional Loss • The loss should be fortuitous and outside of the insured’s control. • The law of large number is based on the random occurrence of events. Thus, If non-random (intentional or non-accidental) loss is insured, the prediction on the probability of a loss would be highly inaccurate. • If intentional loss is paid, moral hazard would be substantially increased and premium would rise as a result.

5. Insurable Risk 3. No Catastrophic Loss • No excessive possibility of catastrophe for the group as a whole. • Catastrophic event could imperil the insurer’s solvency. • The pooling (loss sharing) mechanism of insurance breaks down and becomes unworkable if catastrophic loss occurs. • In certain cases, insurers are forced to provide coverage for catastrophic losses. • Terrorism coverage

6. Insurable Risk 3. No Catastrophic Loss • Remedy for insuring a catastrophic loss • Reinsurance • Geographical dispersion • CAT Bonds (Catastrophic bonds) • Designed to pay for a catastrophic loss

7. Insurable Risk 4. Determinable and Measurable Loss • A loss must be definite in time, place, and amount. • It enables an insurer to determine if the loss is covered under the policy, and if it is covered, how much should be paid. • Easy to determine and measure • Most property losses • Life insurance cases • Difficult to determine and measure • Disability income benefits • Pain and suffering

8. Insurable Risk 5. Calculable Chance of Loss • The insurer must be able to calculate both the average frequency and severity of future losses with some accuracy. • It is necessary so that a proper insurance premium can be charged. • Difficult to calculate chance of loss • Floods, wars, cyclical unemployment, acts of terrorism, etc…

9. Insurable Risk 6. Economically Feasible Premium • The insured must be able to pay the premium. • The premium paid must be substantially less than the potential loss. • Would you like to buy an insurance policy covering losses to your “BIC® pen”? • To have economically feasible premium, the chance of loss should be relatively low. • A life insurance policy on a man age 99.

10. Insurable Risk

11. Types of Insurance • Personal, Group, or Commercial • Life/Health or Property/Casualty • Private or Government • Voluntary or Involuntary