Insurance and Risk

2nd Session
I. Meaning of Insurance

 A. Definition of Insurance – There is no

single definition of Insurance.

 B. Basic Characteristics of Insurance

There are certain common elements that are
typically present in any Insurance Plan:
I. Meaning of Insurance

B. Basic Characteristics of Insurance:

 Pooling of Losses – Losses incurred by the few are
spread over the entire group, so that in the process,
average loss is substituted for actual loss.
 Payment of Fortuitous Losses – Insurance plans
provide for the pooling of fortuitous losses. A
fortuitous loss is one that is unforeseen and
unexpected and occurs as a result of chance. In
other words, the loss must be accidental!
I. Meaning of Insurance

B. Basic Characteristics of Insurance:

 Risk Transfer – In private Insurance, a Pure Risk is
transferred from the Insured to the Insurer, who
typically is in a stronger financial position to pay the
loss than the Insured.
 Indemnification – Indemnification means that the
insured is restored to his or her approximate position
prior to the occurrence of the loss.
II. Requirements of an Insurable Risk

There are six general requirements:

1. Large number of exposure units – Ideally, there should be

a large group of roughly similar, but not necessarily identical,
exposure units that are subject to the same peril or group of
perils.
2. Accidental and unintentional loss – Ideally, the loss should
be fortuitous and outside the insured’s control. Thus if an
individual deliberately causes a loss, he or she should not be
indemnified for the loss.
3. Determinable and measureable loss – This means the loss
should be definite as to cause, time, place and amount.
II. Requirements of an Insurable Risk

There are six general requirements:

4. No catastrophic loss – This means that a large proportion of

exposure units should not incur losses at the same time.
Pooling is the essence of Insurance.
5. Calculable chance of loss – The Insurer must be able to
calculate both the average frequency and the average severity
of future losses with some degree of accuracy.
6. Economically feasible premium – The insured must be able
to afford to pay the premium. In addition, for the Insurance to
be an attractive purchase, the premiums paid must be
substantially less than the face value, or amount, of the policy.
III. Description of Insurable and
Uninsurable Risks

A. Insurable Risks

 Personal
 Property
 Liability
III. Description of Insurable and
Uninsurable Risks

B. Generally Uninsurable Risks

 Market
 Financial
 Production
 Political
III. Description of Insurable and
Uninsurable Risks

These Risks are generally uninsurable for

several reasons:
1. Many of these risks are speculative risks, which
are very difficult to insure privately.
2. The potential for a catastrophic loss is great; this
is particularly true for political risks, such as the risk
of war.
3. Calculation of the proper premium may be
difficult because the chance of loss cannot be
accurately estimated.
IV. Insurance Distinguished from
Other Transactions

A. How Insurance differs from Gambling

Insurance differs from gambling in two ways:
 Gambling creates a new Speculative Risk that did
not exist before, while Insurance is a technique for
handling an already existing Pure Risk.
 Gambling is socially unproductive, since the
winner’s gain comes at the expense of the loser!
However, Insurance is always socially productive,
since both the insured and the insurer win if the
loss does not occur!
IV. Insurance Distinguished from
Other Transactions

B. How Insurance Differs from Hedging

Insurance differs from Hedging in two ways:
 An Insurance transaction usually involves the transfer of
Risks that are Insurable since the requirements of an
Insurable Risk generally can be met. Hedging is a technique
for handling Risks that are typically uninsurable, such as
protection against a substantial decline in the price of
commodities e.g oil.
 A second difference is that Insurance may reduce Objective
Risk because of the application of the law of large numbers.
In contrast, hedging typically involves only Risk Transfer, not
Risk Reduction!