Insurance

RISK

Risk
Risk is the uncertainty concerning the occurrence of a loss. Insurance industry often uses the term risk to refer to identify the property or life being insured.
That driver is a poor risk That building is an unacceptable risk

Peril and Hazard

Peril is the cause of loss- if a house burns, fire is the peril. A hazard is a condition that creates or increases the chance of loss Physical hazard- physical condition that increases the chance of loss- icy roads increase the chance of auto accident Moral hazard- dishonesty or character defects in an individual that increases the frequency or severity of lossfaking an accident to claim from an insurer Morale hazard- carelessness or indifference to a loss because of the existence of insurance Legal hazard- characteristics of the legal system or regulatory environment that increase the frequency or severity of losses

Pure Risk and Speculative Risk

Pure risk is a situation in which there are only the possibilities of loss or no loss Speculative risk is a situation in which either profit or loss is possible Insurers typically insure only pure risk Law of large numbers can be applied more easily to pure risk than to speculative risk Society may benefit from a speculative risk even though a loss occurs, but is harmed if a pure risk is present and a loss occurs

Types of Pure Risk

Personal Risks- risks that directly affect the individual. Possibility of loss or reduction of earned income, extra expenses or the depletion of financial assets a) Risk of premature death- death of a family head with unfulfilled financial obligations b) Risk of insufficient income during retirement c) Risk of poor health- payment of medical bills and loss of earned income d) Risk of unemployment- unemployment can result from business cycle downswings, technological and structural changes in the economy, seasonal factors, imperfections in the labor market

Types of Pure Risk contd..

Property Risks- risks of having property damaged or lost.
Direct loss- financial loss that results from the physical damage, destruction or theft of the property Indirect or consequential loss- a financial loss that results indirectly from the occurrence of a direct physical damage or theft loss

Types of Pure Risk contd..

Liability risks- Under the legal system, you can be held legally liable if you do something that results in bodily injury or property damage to someone else. A court of law may order to pay substantial damage to the person injured
No maximum upper limit with respect to the amount of loss. A Lien can be placed on income and financial assets to satisfy a legal judgment Legal defence costs can be enormous

Methods of Handling Risk

Avoidance- Avoid risk by not carrying out the activity Loss control- Consists of certain activities that reduce the frequency and severity of losses

Retention- Retain all or part of a given risk

Loss Prevention- reducing probability of loss-safe driving, strict security measures, Loss Reduction- reducing severity of losses- seat belts, use of fire resistant materials Active retention- consciously aware but deliberately retain risk Passive retention- unknowingly retained risks

Non-insurance transfers- service contracts, hedging price risks using derivatives Insurance

INSURANCE AND RISK

Insurance
Insurance is the pooling of money by a company from a group of people or organizations, to pay for the fortuitous losses that any of them may suffer. The money that the people pay to the insurance company is called the premium, and for this premium, the company promises to indemnify any of its customers for covered losses.

Insurance
Insurance is defined as the equitable transfer of the risk of a loss, from one entity to another, in exchange for payment.
an insurer is a company selling the insurance; an insured, or policyholder, is the person or entity buying the insurance policy; the insurance rate is a factor used to determine the amount to be charged for a certain amount of insurance coverage, called the premium.

Basic characteristics of Insurance

1. Pooling of losses: Insurance spreads few losses over the whole group so the average loss is substituted for actual loss. 2. Compensation of Fortuitous Losses: Fortuitous loss is that type of loss which is unforeseen and unexpectedly occurs as a result of chance. 3. Risk transfer: Insurance helps to transfer risk from the insured to insurer. 4. Indemnification: The insured is restored to his her appropriate financial position prior to the occurrence of the loss.

Pooling of losses
Pooling is the sharing of losses incurred by the few over the entire group, so that in the process, average loss is substituted for actual loss. Pooling involves the grouping of a large number of exposure units so that the law of large numbers can operate to provide a substantially accurate prediction of future losses.
Sharing of losses by the entire group Prediction of future losses with some accuracy based on the law of large numbers

Pooling of losses contd..

The law of large number states that the greater the number of exposures, the more closely will the actual result 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 and unexpected and occurs as a result of chance.
The loss must be accidental

The law of large numbers is based on the assumption that losses are accidental and occur randomly.

Risk transfer
Risk transfer means that 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 financial position prior to the occurrence of the loss.

Insurable risk
Because insurance companies are businesses that want to make a profit, there are only certain risksknown as insurable risksthat private insurers are willing to cover. Almost all risks insured by insurance companies are pure risks, which are risks where there is no possibility of profit. However, not all pure risks are insurable.

Requirements of an insurable risk

A risk is only insurable if there are a large number of exposure units and if potential loss

is fortuitous must have element of uncertainty has a determinable and measurable value- e.g. life insurance is not catastrophic (affecting a large number of exposure units at the same time), i.e., AIDS, otherwise principle of pooling is not working can be calculated in magnitude & frequency, so that premium can be determined quantum of loss far bigger than premium; premium is economically feasible is not against law/public interest, i.e., insure against software copyright violation

TYPES OF INSURANCE
Life and Health Insurance Property and Liability Insurance

Benefits of Insurance to Society

Indemnification for loss- individuals and families can maintain their financial security Reduction of worry and fear- true both before and after a loss has occurred Source of investment funds- important source of funds for capital investments Loss prevention- Insurance companies are involved in numerous loss prevention programs Enhancement of credit- Insurance enhances a persons credit- property insurance makes an individual a better credit risk

Costs of Insurance to Society

Cost of doing business- Insurance consumes scarce economic resources Fraudulent claims Payment of fraudulent claims results in higher premiums to all insured. Inflated claims- Premiums must be increased to pay the additional losses.

FUNDAMENTAL LEGAL PRINCIPLES

Principle of Indemnity
Principle of indemnity states that the insurer agrees to pay no more than the actual amount of the loss.
The insured should not profit from a loss

Purpose
Prevent the insured from profiting from a loss Reduce moral hazard

Principle of Insurable Interest

The principle of insurable interest states that the insured must be in a position to lose financially if a covered loss occurs Purpose
To prevent gambling To reduce moral hazard To measure the amount of insureds loss in property insurance

Principle of Subrogation
Subrogation means substitution of the insurer in place of the insured for the purpose of claiming indemnity from a third person for the loss covered by insurance
Insurer is entitled to recover from a negligent third party any loss payments made to the insured.

Principle of Utmost Good Faith

A higher degree of honesty is imposed on both parties of an insurance contract than is imposed on parties to other contracts. Principle of Utmost Good Faith is supported by three important legal doctrinesrepresentations, concealment and warranty.

Principle of Utmost Good Faith Representations

Representations are statements made by the applicant for insurance. The insurance contract is voidable at the insurers option if the representation is material, false and relied on by the insurer.
Material means that if the insurer knew the true facts, the policy would not have been issued, or it would have been issued on different terms; false means that the statement is not true or misleading; reliance means that the insurer relies on the misrepresentation in issuing the policy at a specified premium

Principle of Utmost Good Faith Concealment

A concealment is intentional failure of the applicant for insurance to reveal a material fact to the insurer.
Concealment is the same as non-disclosure.

Principle of Utmost Good Faith Warranty

A warranty is a statement that becomes part of the insurance contract and is guaranteed by the maker to be true in all respects.
In exchange for a reduced premium, a store owner may warrant that an approved burglary alarm system will be operational at all times

INSURANCE COMPANY OPERATIONS

Rate Making
Rate making refers to the pricing of insurance. Insurance pricing differs considerably from pricing of other products. When other products are sold, the company generally knows in advance what its costs of producing the products are. Person who determines rates and premiums is known as actuary.

Underwriting
Underwriting refers to the process of selecting, classifying and pricing applicants for insurance.

Production
Production refers to the sales and marketing activities of insurers. Agents who sell insurance are frequently referred to as producers.

Claim Settlement
Verification of a covered loss Fair and prompt payment of claims Personal assistance to the insured

Reinsurance
Reinsurance is an arrangement by which the primary insurer that initially writes the insurance transfers to another insurer (called the reinsurer) part or all of the potential losses associated with such insurance. Primary insurer ceding company; accepting insurer- reinsurer; amount of insurance retained by the ceding company for its own account net retention Reinsurer may reinsure part or all of the risk with another insurer- retrocession; retrocessionaire

Investments
Premiums are paid in advance- they can be invested until needed to pay claims and expenses