Principles of Insurance Chapter 2
Principles of Insurance Chapter 2 INS 3103
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This 3 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 229 views. For similar materials see Principles of Insurance in Business at Mississippi State University.
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Date Created: 01/26/16
Chapter 2 I. Meaning of Insurance: There is no single definition a. Insurance: The pooling of fortuitous losses by transfer of such risks to insurers who agree to ademnify 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 Risk i. 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 ii. Payment of Fortuitous Losses: A fortuitous loss is one that is unforeseen, unexpected, and occur as a result of chance iii. Risk Transfer: A pure risk is transferred from the insured to the insurer, who typically is in a stronger financial position iv. 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 i. Large number of exposure units: to predict average loss based on the Law of Large Numbers ii. Accidental and Unintentional Loss: to assure random occurrence of events iii. 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 catastrophic bonds iv. 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 v. 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 in book c. Adverse Selection and Insurance: the tendency of persons with a higher thanaverage chance of loss to seek insurance at standard rates. If not controlled by underwriting, adverse selection results in higherthan expected loss levels. Can be controlled by: careful underwriting (selection and classification of applicants for insurance), policy provisions (ie suicide clause in life insurance) i. Nature of Adverse Selection ii. Consequence of Adverse Selection III. Insurance and Gambling a. 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 b. Gambling: creates a new speculative risk. Gambling is not socially productive: the winner’s gain comes at the expense of the loser IV. Insurance and Hedging a. Insurance: risk is transferred by contract, involves the transfer of put (insurable) risk. Can reduce the objective risk of an insurer, through the Law of Large Numbers b. Hedging: Risk is transferred by contract, involves risks that are typically uninsurable. Does not result in reduced risk V. Types of Insurance a. Private Insurance: Exhibit 2.3 i. Personal Lines: coverage that insure the real estate and personal property of individuals and families, or provide protection against legal liability ii. Commercial Lines: coverage for business firms, nonprofit organizations, and government agencies iii. Life Insurance: pays death benefits to beneficiaries when the insured dies iv. Health Insurance: covers medical expenses because of sickness or injury v. Disability Plans: pay income benefits vi. Property Insurance: indemnifies property owners against the loss or damage of real or personal property vii. Liability Insurance: covers the insured’s legal liability arising out of property damage of bodily injury to others viii. Casualty Insurance: refers to insurance that covers whatever fire, marine, and life insurance do not cover b. Government Insurance i. Social Insurance: financed entirely or in a large part by contributing from employers and/or employees. Benefits are heavily weighted in favor or lowincome groups. Eligibility and benefits are prescribed by statute. Ex: social security, unemployment, workers comp ii. 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 i. Indemnification for Loss (Stability): less likely to apply fro public assistance or welfare benefits, business can remain open ii. Reduction of Worry and Fear: takes away the worry of inevitable or probable risk. Ex: house burning, death of a family dependent iii. Source of Investment Funds: insurance companies make money and they put that back into the market, creates more money to borrow for business iv. Loss Prevention: insurers employ loss prevention specialists v. Enhancement of Credit: property insurance protects lender and borrower b. Cost of Insurance to Society i. 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 ii. Fraudulent Claims iii. Inflated Claims: seeking more money than the claim is worth iv. What is the result to the insurance company? They must charge higher premiums to cover additional losses
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