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Chapter 1

Chapter 1. Fundamentals and Terminology. Introduction Definitions and terms. Introduction Definitions and terms. Insurance Defined Two main elements 1) Financial intermediation 2) Contractual relationship Loss (definition of) Types of losses Direct Loss Indirect Loss Chance of Loss

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Chapter 1

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  1. Chapter 1 Fundamentals and Terminology

  2. IntroductionDefinitions and terms

  3. IntroductionDefinitions and terms • Insurance Defined • Two main elements 1) Financial intermediation 2) Contractual relationship • Loss (definition of) • Types of losses • Direct Loss • Indirect Loss • Chance of Loss • Number expected / Total exposed = Fraction

  4. Peril - The cause of a loss or contingency that causes a loss • “Named peril” or Specified peril contracts • ”Open-peril" contracts • burden of proof is different • Hazard • Something that increases the probability of loss or increases the severity when a loss occurs (or both) • physical, moral, morale

  5. Proximate cause of the loss • Also known as the Doctrine of proximate cause • First insured peril in an unbroken chain of events leading to the loss - all is paid.

  6. Risk - many definitions - the term is used in a variety of ways 1) To describe that there is a possibility of loss 2) To identify the probability of loss 3) To identify the cause of loss - peril 4) To identify conditions that increase frequency of severity of loss - hazard 5) To identify the property or person exposed 6) To identify the potential $ amount of loss 7) To describe the variation in potential losses – the ability to predict

  7. Objective Risk - relative variation from expected • Degree of risk – the ability to predict • Not the same thing as probability of loss • Law of large numbers and its impact • Coefficient of variation = /x = % of variation expected relative to the mean • OBJECTIVE RISK V. THE PROBABILITY OF LOSS

  8. Objective Risk vs. The Probability of Loss

  9. Objective Risk vs. The Probability of Loss

  10. Objective Risk vs. The Number of Exposures

  11. Risk – other types • Pure Risk - exposure that can result in a loss or no change (two possible outcomes) • Speculative Risk - exposure that can result in a loss, no change, or gain (three possible outcomes) • Subjective Risk - individual’s mental attitude concerning loss • Operational Risk – a term used by the banking industry synonymous with pure risk

  12. Risk Management • Logical process used by firms and individuals to deal with exposures to loss. • Involves pre-loss planning concerning the use of post-loss resources to minimize overall costs. • Continuous process that identifies exposures and decides how to deal efficiently with them. • Post-loss activities puts the plans into action.

  13. Mathematical Basis for insurance - Example • Houses in pool 10,000 • Avg. value of each $ 80,000 • Total property value $ 800 million • Predicted losses = 1.5% of value $12 million • Predicted Loss per house $ 1,200 • Rate per $100 of value $ 1.50

  14. Mathematical Basis for insurance - Example continued • Insurance Premium • Cost of losses $ 1.50 • Admin. costs .45 • Reserves for unexpected losses .10 • Investment earnings (0.07) • Rate per $100 value $ 1.98

  15. Insurance works well when: • Many individuals purchase • Paying relatively small premium amounts • Few people collect • Keeps rates affordable • Losses can be large

  16. Costs to Society • The costs of operating the insurance mechanism • Commissions • Overhead of the company • Exaggerated claims • Intentional losses (moral) • General indifference about the way we treat our property, etc. (morale) • Does not include losses that would have occurred anyway – not a cost of operating the system

  17. Insurance Benefits to Society • Stability of families • Aids planning ability to businesses • Facilitates credit transactions • Anti-monopoly device • Reduces credit costs • Increases capital efficiency

  18. The Problem of ArsonAn Illustration of Loss Costs • What is Arson? • What is Arson-for-Profit? • What are the costs? • Who really pays for Arson? • Should insurance companies be substituted for the role of public law enforcement authorities?

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