Principles of Insurance Chapter 2
Principles of Insurance Chapter 2 INS 3103
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This 4 page Class Notes was uploaded by Miranda Houston on Tuesday January 26, 2016. The Class Notes belongs to INS 3103 at Mississippi State University taught by Seth Pounds in Fall 2015. Since its upload, it has received 33 views. For similar materials see Principles of Insurance in Business at Mississippi State University.
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Date Created: 01/26/16
Outline I. Meaning of Insurance: no single definition A. Definition of Insurance: The pooling of fortuitous losses by transfer of such risks to insurers, who agree to indemnify insured’s for such losses, to provide other pecuniary benefits on their occurrence, or to render services connected with the risk B. Basic Characteristics of Insurance 1. Pooling of losses: The heart of insurance. Pooling involves spreading losses incurred by the few over the entire group so that in the process average loss is substituted for actual loss. Risk reduction is based on the Law of Large Numbers. According to the Law of Large Numbers, the greater the number of exposures, the more closely will the actual results approach the probable results that are expected from an infinite number of exposures. Page 20-21 2. Payment of fortuitous losses: A fortuitous loss is one that is unforeseen, unexpected, and occur as a result of chance 3. Risk transfer: A pure risk is transferred from the insured to the insurer, who typically is in a stronger financial positionm 4. Indemnification: The insured is restored to his or her approximate financial position prior to the occurrence of the loss II. Requirements of an Ideally Insurable Risk A. General Requirements 1. Large number of exposure units: to predict average loss based on the Law of Large Numbers 2. Accidental and unintentional loss: to assure random occurrence of events 3. Determinable and measurable loss: to determine how much should be paid 4. No catastrophic loss: to allow the pooling technique to work, exposures to catastrophic loss can be managed by using reinsurance, dispersing coverage over a large geographical area, or using financial instruments, such as catastrophe bonds 5. Calculable chance of loss: insurer must be able to calculate the average frequency and severity of future losses, so that a premium that is sufficient to pay all claims and expenses and yields a profit during the policy period can be established 6. Economically feasible premium: So people can afford to purchase the policy. For Insurance to be an attractive purchase, the premium paid must be substantially less than the face value, or amount, of the policy B. Application of the Requirements: Exhibit 2.1 1. The risk of fire to a private dwelling satisfies the requirements. 2. The risk of unemployment does not completely meet all requirements. C. Adverse Selection and Insurance: The tendency of persons with a higher- than-average chance of loss to seek insurance at standard rates. If no controlled by underwriting, adverse selection results in higher-than-expected loss levels. Can be controlled by: careful underwriting (selection and classification of applicants for insurance), policy provisions (ie suicide clause in life insurance) 1. Nature of adverse selection 2. Consequences of adverse selection III. Insurance and Gambling Compared Insurance: a technique for handling an already existing pure risk. Insurance is always socially productive: both parties have a common interest in the prevention of a loss Gambling: creates a new speculative risk. Gambling is not socially productive: the winner’s gain comes at the expense of the loser A. Insurance eliminates a pure risk, while gambling creates a new speculative risk. B. Insurance is socially productive, while gambling is socially unproductive. IV. Insurance and Hedging Compared Insurance: Risk is transferred by contract, involves the transfer of pure (insurable) risk. Can reduce the objective risk of an insurer: through the law of large numbers Hedging: Risk is transferred by contract, involves risks that are typically uninsurable. Does not result in reduced risk A. Insurance transfers a pure risk, while hedging involves the transfer of a speculative risk. B. Insurance reduces objective risk, while hedging does not. V. Types of Insurance A. Private Insurance: Exhibit 2.3 Personal Lines: coverage that insure the real estate and personal property of individuals and families or provide protection against legal liability Commercial Lines: coverage for business firms, nonprofit organizations, and government agencies 1. Life insurance: pays death benefits to beneficiaries when the insured dies 2. Health insurance: covers medical expenses because of sickness or injury Disability Plans: pay income benefits 3. Property and liability insurance Property Insurance: Indemnifies property owners against the loss or damage of real or personal property Liability Insurance: Covers the insured’s legal liability arising out of property damage or bodily injury to others Casualty Insurance: Refers to insurance that covers whatever fire, marine, and life insurance do not cover B. Government Insurance 1. Social insurance: financed entirely or in a large part by contributions from employers and/or employees. Benefits are heavily weighted in favor of low-income groups. Eligibility and benefits are prescribed by statute. Ex: social security, unemployment, workers comp 2. Other government insurance programs: found at both the federal and state level. Ex: federal flood insurance, state health insurance pools VI. Social Benefits and Costs of Insurance A. Benefits of Insurance to Society 1. Indemnification for loss (Stability): less likely to apply for public assistance or welfare benefits, business can remain open 2. Reduction of worries and fear: takes away the worry of inevitable or probable risk. Ex: house burning, death of a family dependent 3. Source of investment funds: insurance companies make money and they put that back into the market, creates more money to borrow for business 4. Loss prevention: insurers employ loss prevention specialists 5. Enhancement of credit: property insurance protects lender and borrower B. Costs of Insurance to Society 1. Cost of doing business: and expense loading is the amount needed to pay all expenses, including commissions, general administrative expenses, state premium taxes, acquisition expenses, and an allowance for contingencies and profit 2. Fraudulent claims: 3. Inflated claims: seeking more money than the claim is worth What is the result to the insurance company? They must charge higher premiums to cover additional losses
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