Chapter 2

Insurance Mechanism

2-2

What do you think people would do for fraudulent insurance claims?

Take out a piece of paper and write it down. Let’s see what people would do to cheat insurance companies!

2-3

Agenda

• Definition and Basic Characteristics of Insurance

• Characteristics of An Ideally Insurable Risk• Adverse Selection and Insurance• Insurance vs. Gambling • Insurance vs. Hedging• Types of Insurance• Benefits and Costs of Insurance to Society

Outcome Understand the terms above and their

applications in an insurance contractUnderstand the basics of different types of

insurance contracts

2-4

Definition of Insurance

• Insurance is the pooling of ______ 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

https://www.youtube.com/watch?v=M1yzSOxxAjk

2-5

Basic Characteristics of Insurance

• Pooling of losses– Spreading losses incurred by the few over the entire group– Risk reduction based on the Law of Large Numbers

• Example:– Two business owners own identical buildings valued at $50,000– There is a 10 percent chance each building will be destroyed by

a peril in any year; loss to either building is an independent event

– Expected value and standard deviation of the loss for each owner is:

000,5$___________________ lossExpected

000,15$

000,5$000,50$10.0000,5$090.0 22

deviationStandard

2-6

Basic Characteristics of Insurance

• Example, continued:– If the owners instead pool (combine) their loss exposures, and

each agrees to pay an equal share of any loss that might occur:– What will be the expected loss?– How about the standard deviation?

– As additional individuals are added to the pooling arrangement, the standard deviation continues to decline while the expected value of the loss remains unchanged

2-7

Basic Characteristics of Insurance

• Payment of fortuitous losses– Insurance pays for losses that are unforeseen, unexpected, and

occur as a result of chance• Risk transfer

– A pure risk is transferred from the insured to the insurer, who typically is in a stronger financial position

• Indemnification– The insured is restored to his or her approximate financial

position prior to the occurrence of the loss

2-8

Characteristics of an Ideally Insurable Risk

1.Large number of exposure units– to predict ________

2.Accidental and unintentional loss– to control __________– to assure _________

3.Determinable and measurable loss– to facilitate loss adjustment

• insurer must be able to determine if the loss is covered and if so, how much should be paid.

Loss of a finger?

2-9

Requirements of an Insurable Risk

4.No catastrophic loss– to allow the pooling technique to work– exposures to catastrophic loss can be

managed by:• dispersing coverage over a large geographic

area• using reinsurance•

5.Calculable chance of loss– to establish an ______________

2-10

Requirements of an Insurable Risk

6.Economically feasible premium– so people can afford to buy– Premium must be substantially less than the face

value of the policy

• Based on these requirements:– Most personal, property and liability risks can be

insured– Market risks, financial risks, production risks and

political risks are difficult to insure

2-11

Does the risk of fire satisfy the above requirement for insurable risk?

2-12

In class exercise :Risk of Fire as an Insurable Risk

Take out a piece of paper and answer the questions

2-13

Exhibit 2.2 Risk of Unemployment as an Insurable Risk

Large number of exposure units?

Accidental/unintentional loss?

Determinable and measure loss?

No catastrophic loss?

Calculable chance of loss?

Economically feasible premium?

2-14

Adverse Selection and Insurance

• Adverse selection is the tendency of persons with a higher-than-average chance of loss to seek insurance at standard rates

• If not controlled, adverse selection result in higher-than-expected loss levels

• Adverse selection can be controlled by:– careful underwriting – policy provisions

2-15

Insurance vs. Gambling

• Are they the same?

2-16

Insurance vs. Gambling

Insurance

• Insurance is a technique for handing an already existing pure risk

• Insurance is socially productive:– both parties have a

common interest in the prevention of a loss

Gambling

2-17

Insurance vs. Hedging

Insurance

• Risk is transferred by a contract

• Insurance involves the transfer of insurable risks

• Insurance can reduce the objective risk of an insurer through the Law of Large Numbers

Hedging

• Risk is transferred by a contract

• Hedging involves risks that are typically uninsurable– Remember the

requirement for insurable risks?

• Hedging does not result in reduced risk– Why?

2-18

Types of Insurance

• Private Insurance– Life and Health– Property and Liability

• Government Insurance– Social Insurance– Other Government Insurance

2-19

Private Insurance

• Life and Health– Life insurance pays _____ benefits to beneficiaries when

the insured dies– Health insurance covers _____ expenses because of

sickness or injury– Disability plans pay ______ benefits

• Property and Liability– 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 is not covered by fire, marine, and life insurance

2-20

Private Insurance (Property and Liability )

• Private insurance coverages can be grouped into two major categories– Personal lines

• coverages that insure the real estate and personal property of individuals and families or provide protection against legal liability

– Commercial lines• coverages for business firms, nonprofit organizations,

and government agencies

2-21

Exhibit 2.3 Property and Casualty Insurance Coverages

2-22

Try to find more details yourselves

2-23

2-24

Government Insurance

• Social Insurance Programs– Financed entirely or in 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– Examples:

• Social Security, Unemployment, Workers Comp

• Other Government Insurance Programs– Found at both the federal and state level– Examples:

• Federal flood insurance, state health insurance pools

2-25

Social Benefits of Insurance

• Indemnification for Loss– Contributes to family and business stability

• Reduction of Worry and Fear– Insureds are less worried about losses

• Source of Investment Funds– Premiums may be invested, promoting economic growth

• Loss Prevention– Insurers support loss-prevention activities that reduce direct and

indirect losses

• Enhancement of Credit– Insured individuals are better credit risks than individuals

without insurance

2-26

Social Costs of Insurance

• Cost of Doing Business– Insurers consume resources in providing insurance to

society– An 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

• Sales & administrative expenses (property and casualty) account for 26% of each underwriting dollars

• Operating expenses for life insurance: 12%• The U.S. spends more than $2 trillion on healthcare annually. At

least 3 percent of that spending — or $68 billion — is lost to fraud each year. (National Health Care Anti-Fraud Association, 2008)

• Cost of Fraudulent and Inflated Claims– Payment of fraudulent or inflated claims results in higher

premiums to all insureds, thus reducing disposable income and consumption of other goods and services

2-27

Social Costs of Insurance (similar figures can be found in the Text)

• Cost of Fraudulent and Inflated Claims– Payment of fraudulent or inflated claims results in higher

premiums to all insureds, thus reducing disposable income and consumption of other goods and services

• Cost estimated to be greater than $80 billion annually• Suspected fraud of bodily injury up from 9% to 11% (2002 to 2007)• Of which 20% (2007) involve buildup up from 18%, 2002

– Buildup: Excessive treatment, unnecessary treatment or diagnosis leading to inflation

• about 45 million (20%) US adult believe it is acceptable to defraud insurers under certain conditions

• Three percent of slip-and-fall injuries are fraudulent. (National Floor Safety Institute)

• Bogus injury claims and related costs such as litigation amount to nearly $2 billion a year. (ibid)

2-28

“Minor fraud”?

• Will you claim for insurance for work-related injury which is actually a sport injury?

• You have property insurance, an expensive mirror (HKD2000) is broken due to your carelessness, will you claim for the insurance saying the mirror is broken with unknown cause?

• Would you stay home after your have recovered from illness to continue collecting compensation?

2-29

Case application

• Based on the definition of insurance mentioned, indicates which of the following is considered insurance.– a. A TV set is guaranteed by the manufacturer against

defects for 90 days.– b. A new set of radial tires is guaranteed by the

manufacturer against road defects for 50,000 miles. – c. A builder of new homes gives a 10-year guarantee

against structural defects in the home.– d. A cosigner of a note agrees to pay the loan balance if

the original debtor defaults on the payments. – e. A large group of homeowners agrees to pay for losses

to homes that burn during the year because of fire.

2-30

Appendix (Reference)

• Basic Statistics and the Law of Large Numbers

2-31

Probability and Statistics

• The probability of an event is the long-run relative frequency of the event, given an infinite number of trials with no changes in the underlying conditions.

• Events and probabilities can be summarized through a probability distribution

– Distributions may be discrete or continuous

• A probability distribution is characterized by:– A mean, or measure of central tendency– A variance, or measure of dispersion

2-32

Probability and Statistics

• The mean or expected value is:

iiPXEVor

Amount of Loss (Xi)

Probability of Loss (Pi)

XiPi

$ 0 X 0.30 = $ 0

$360 X 0.50 = $180

$600 X 0.20 = $120

= $300 iiPX

2-33

Probability and Statistics

• The variance of a probability distribution is:

• For the previous loss distribution,

• The standard deviation = • Higher standard deviations, relative to the mean, are

associated with greater uncertainty of loss; therefore, the risk is greater

22 EVXP ii

800,46

800,1800,1000,27

)300600(20.0

)300360(50.0)3000(30.02

222

33.2162

2-34

Law of Large Numbers

• The law of large numbers is the mathematical foundation of insurance.

• Average losses for a random sample of n exposure units will follow a normal distribution because of the Central Limit Theorem.– Regardless of the population distribution, the distribution

of sample means will approach the normal distribution as the sample size increases.

– The standard error of the sampling distribution can be reduced by simply increasing the sample size

2-35

Exhibit A2.1 Sampling Distribution Versus Sample Size

2-36

Exhibit A2.2 Standard Error of the Sampling Distribution Versus Sample Size

2-37

Law of Large Numbers

• When an insurer increases the size of the sample of insureds:– Underwriting risk _______, because more

insured units could suffer a loss. – But, underwriting risk does not increase

proportionately. It increases by the square root of the increase in the sample size.

– There is “safety in numbers” for insurers!

2-38

Question 1• Compare the risks of

– Fire with– Warin terms of how well they meet the requirements

of an ideally insurable risk

No model answers given

2-39

Question 1.1

• As a private insurer, you are considering insuring buildings of a flooding zone, which of the requirements of insurable risk are not met?

2-40

Question 2

• Explain the following benefits of insurance to the society– Indemnification for loss– Enhancement of credit– Source of funds for capital investment and

accumulation

• What are the major costs of insurance to society

2-41

Question 2

• Explain the following benefits of insurance to the society– Indemnification for loss– Enhancement of credit– Source of funds for capital investment and

accumulation

• What are the major costs of insurance to society