Chapter 2

Explain the major characteristics of typical insurance plan ?

Pooling of losses: Pooling involves spreading losses incurred by the few over the
entire group

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.

Payment of fortuitous losses A fortuitous loss is one that is 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

Why is the pooling technique essential to insurance ?

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.

Explain the major requirement of an insurable risk ?

Large number of exposure units to predict average loss based on the law of large
numbers

Accidental and unintentional loss to assure random occurrence of events

Determinable and measurable loss to determine how much should be paid

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 geographic area, or using financial instruments, such as catastrophe bonds
 Calculable chance of loss to establish a premium that is sufficient to pay all claims
and expenses and yields a profit during the policy period

Economically feasible premium so people can afford to purchase the policy For
insurance to be an attractive purchase, the premiums paid must be substantially less
than the face value, or amount, of the policy

What is the law of large numbers? Why is the law of large numbers important to
private insurers?
is a mathematical principle which states that as the sample size increases, the
deviation between actual results and expected results declines. This principle is
important to private insurers because insurers can reduce objective risk by increasing
the number of loss exposures insured.

Chapter 3

Define risk management . how does risk management differ from insurance
management?

Risk Management can be defined as an executive decisions concerning the

management of pure risks. Risk Management is a process that identifies loss
exposures faced by an organization and selects the most appropriate techniques for
treating such exposures

Explain the objectives of a risk management program both before and after a
loss?

Pre-loss objectives:

Prepare for potential losses in the most economical way

Reduce anxiety

Meet any legal obligations

Post-loss objectives:

Survival of the firm Continue operating Stability of earnings Continued

growth of the firm Minimize the effects that a loss will have on other persons and
on society

Plain the four basic functions of a risk management ?or Risk Management
Process?

Identify potential losses

Measure and analyze the loss exposures

Select the appropriate combination of techniques for treating/handling the loss

exposures Implement and monitor the risk management program (Administering
program)

How can the risk manager identify potential losses ? how does the risk manager
evaluate and analyze each potential?

Risk Managers have several sources of information to identify loss exposures:

Risk analysis questionnaires and checklists Physical inspection Flowcharts
Financial statements Historical loss data Industry trends and market changes can
create new loss exposures. e.g., exposure to acts of terrorism

Measure and Analyze Loss Exposures

Estimate for each type of loss exposure:

Loss frequency refers to the probable number of losses that may occur during some
time period
 Loss severity refers to the probable size of the losses that may occur

Rank exposures by importance

Loss severity is more important than loss frequency:

The maximum possible loss is the worst loss that could happen to the firm during
its lifetime The probable maximum loss is the worst loss that is likely to happen

What conditions must be fulfilled before retention is used in a risk management

program?

Retention means that the firm retains part or all of the losses that can result from a
given loss

Retention is effectively used when:

No other method of treatment is available

The worst possible loss is not serious

Losses are highly predictable

The retention level is the dollar amount of losses that the firm will retain

A risk manager has several methods for paying retained losses:

Current net income: losses are treated as current expenses

Unfunded reserve: losses are deducted from a bookkeeping account Funded

reserve: losses are deducted from a liquid fund Credit line: funds are borrowed to
pay losses as they occur

Self-insurance, or self-funding is a special form of planned retention by which part

or all of a given loss exposure is retained by the firm
Compare between insurance and noninsurance ?

Non-insurance Transfers

A non-insurance transfer is a method other than insurance by which a pure risk and
its potential financial consequences are transferred to another party

Examples include: contracts, leases, holdharmless agreements

Advantages

Can transfer some losses that are not insurable

Less expensive

Can transfer loss to someone who is in a better position to control losses

Disadvantages

Contract language may be ambiguous, so transfer may fail

If the other party fails to pay, firm is still responsible for the loss

Insurers may not give credit for Chapter 3: Risk Management transfers

Insurance

Insurance is appropriate for low-probability, high-severity loss exposures The risk

manager selects the coverages needed, and policy provisions

The risk manager negotiates the terms of the insurance contract

A manuscript policy is a policy specially tailored for the firm

The parties must agree on the contract provisions

Advantages Firm is indemnified for losses; can continue to operate Uncertainty is

reduced Firm may receive valuable risk management services Premiums are
income-tax deductible
Disadvantages Premiums may be costly Negotiation of contracts takes time and
effort The risk manager may become lax in exercising loss control

Chapter 5

Explain the principle of indemnity and its importance to insurance operation ?

The insurer agrees to pay no more than the actual amount of the loss

Purpose:

To prevent the insured from profiting from a loss

To reduce moral hazard

Principle of Indemnity supported by

1. In property insurance, indemnification is based on the actual cash value

(ACV) of the property at the time of loss
2. Principle of Insurable Interest The insured must be in a position to lose
financially if a covered loss occurs

Purposes: To prevent gambling To reduce moral hazard

To measure the amount of the insureds loss
An insurable interest can be supported by: Ownership of property
Potential legal liability Serving as a secured creditor Contractual rights
3. Principle of Subrogation Substitution of the insurer in place of the insured
for the purpose of claiming indemnity from a third party for a loss covered by
insurance.
Discuss the insurable interest doctorine and the time insurable interest must
exist ?

insurable interest exist when

Property insurance: at the time of the loss

Life insurance: only at inception of the policy

The question of insurable interest does not arise when you purchase life insurance
on your own life

Insurable interest in another persons life can be shown by close family ties,
marriage, or a pecuniary (financial) interest

What are main reasons for subrogation in insurance contracts?

Purpose:

To prevent the insured from collecting twice for the same loss

To hold the negligent person responsible for the loss

To hold down insurance rates

The insurer is entitled only to the amount it has paid under the policy

The insured cannot impair the insurers subrogation rights

Subrogation does not apply to life insurance contracts

The insurer cannot subrogate against its own insured

What are main reasons for subrogation in insurance contracts?

Principle of Utmost Good Faith A higher degree of honesty is imposed on both parties
to an insurance contract than is imposed on parties to other contracts

Supported by three legal doctrines:

 Representations: are statements made by the applicant for insurance, A contract is
voidable if the representation is material, false, and relied on by the insurer

Concealment : A concealment is intentional failure of the applicant for insurance

to reveal a material fact to the insurer

To deny a claim based on concealment, a nonmarine insurer must prove:

The concealed fact was known by the insured to be material

The insured intended to defraud the insurer

Warranty: is a statement that becomes part of the insurance contract and is

guaranteed by the maker to be true in all respects

Statements made by applicants are considered representations, not warranties