Revised Chp 3
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Transcript of Revised Chp 3
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1
Nature & Functions of Insurance
In its simplest aspect, insurance has two
fundamental characteristics:
1. Transferof risk from the individual to the group.
2. Sharingof losses on some equitable basis.
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Operation of Insurance Illustrated
1. 1,000 dwellings valued at $100,000 each.
2. Each owner faces risk of a $100,000 loss.
3. Owners agree to share losses that occur.
4. Ifone house burns (total loss) each owner pays
($100 x 1,000 = $100,000).
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3
Insurance Defined: Individual
Perspective
Insurance is an economic device whereby the
individual substitutes a small certain cost (the
premium) for a large uncertain financial loss (the
contingency insured against) which would exist if
it were not for the insurance.
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Probability Theory and Law of
Large Numbers
Probability theory is the body of knowledge
concerned with measuring the likelihood that
something will happen and making predictions
based on this likelihood.
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Determining the Probability of an
Event 1. A prioriestimates determined from the underlying
conditions:
the probability of flipping a head is .5
the probability of drawing the Ace of Spades is 1/52
2. A prioriestimates not significant for us except inillustratingLaw of Large Numbers.
3. The type probability useful for Risk Management isreferred to as a posteriori probability
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Illustration of a Sampling of Losses
Experienced by an Insurance Company
Year Houses that Burn
1 7
2 11
3 10
4 9
5 13
Total 50
Average 10
Sample Size I
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Illustration of Sampling of Losses
Year Houses that Burn
1 16
2 4
3 10
4 12
5 8
Total 50
Average 10
Sample Size II
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Standard Deviation
Year Average ActualLosses Losses Differences
1 10 7 3 9
2 10 11 1 1
3 10 10 0 04 10 9 1 1
5 10 13 3 9
20
Variance = 4, Standard Deviation = 2
Sample Size I Deviation
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Standard Deviation
Year Average ActualLosses Losses Differences
1 10 16 6 36
2 10 4 6 36
3 10 10 0 0
4 10 12 2 4
5 10 8 2 4
80
Variance = 16, Standard Deviation = 4
Sample Size II Deviation
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Dual Application of Law of Large
Numbers
1. To estimate the underlying probability
accurately, insurer must have a large sample of
experience.
2. Once the estimate of probability has been
made, it must be applied to a large number of
exposure units to permit the underlyingprobability to work itself out.
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Elements of an Insurable Risk
1. Large numbers of exposure units
2. Definite and measurable loss
3. The loss must be fortuitous
4. The loss must not be catastrophic
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Additional Attributes of an Insurable Risk
Randomness- It is hoped that the risk will
approximate the general conditions found in
society in general. However, in real lifeAdverse
Selection complicatesthe entire situation
Economic FeasibilityThe cost of the
insurance must not be excessively high in
relation to the cost of the loss
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Classification of Private
Insurance 1. Life Insurance
2. Accident and health Insurance
3. Property and liability insurance
fire
marine
casualty fidelity and surety bonds
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Social Insurance Definition
1. Coverage is compulsory
2. Eligibility derived from contributions:
no requirement to demonstrate need
3. Method of determining benefits prescribed by law
4. Benefits not directly related to contributions
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Social Insurance Programs in the
U.S. 1. Old-Age, Survivors and Disability Insurance
2. Railroad Retirement, Disability and Unemployment
Insurance
3. Unemployment Insurance
4. Medicare
5. State Compulsory Temporary Disability
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Federal Public Guarantee
Programs
1. Federal Deposit Insurance Corporation
2. National Credit Union Administration
3. Securities Investor Protection Corporation
4. Pension Benefit Guarantee Corporation