Insurance and Risk

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Insurance and Risk

• RMI 3500
• Intro. to Risk Management Insurance
• Robert Klein

Revised 8-29-07
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Topic Objectives

• Explain the concept of insurance.
• Identify the basic characteristics of insurance.
• Outline and apply the requirements of an
  insurable risk.

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Insurance Defined

• Insurance is the pooling of fortuitous losses by
  transfer of risks to insurers.
• Insureds pay relatively small, certain premiums
  in return for protection against a potential loss
  they cannot afford.
• Reinsurance is the transfer of risk from one
  insurer to another.

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Insurance Pictured
Risk Transfer/Diversification
Insureds
Insurer
Reinsurers
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Pooling Objective Risk
Objective Risk
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Insurance Has Long History

• In 3000 BC merchants in Sumer and Babylonia
  pooled their money to protect themselves from
  losses from thieves and pirates.
• Greeks and Romans established benevolent
  societies dues used to pay burial expenses of
  members who died.
• Marine, life, disability, and fire insurance
  developed in Europe beginning in 15th century.

• Ben Franklin formed the Philadelphia
  Contributorship for the Insurance from Losses by
  Fire in 1730.
• Presbyterian Ministers Fund of Philadelphia
  offered life insurance to members in 1759.

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Basic Characteristics of Insurance

• Pooling of Losses
• sharing of losses by group
• using large numbers to reduce objective risk
• Payment of fortuitous losses
• uncertain and occurs as result of chance

• Risk Transfer
• Indemnification
• insured is restored to his/her prior position,
  i.e., no financial gain

Not!
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Questions

• Is it feasible to insure your car for
  deterioration through normal use?
• Does it make sense for 2 people to create an
  insurance pool for auto accidents?
• Is risk pooling only possible using insurance
  companies?

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More Questions

• Do risks have to be identical to be pooled?
• If I have an arrangement to borrow money to cover
  a loss, is that insurance?
• Is it feasible for me to buy an insurance policy
  that pays me twice the market value of my car if
  I have an accident?

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Requirements of Insurable Risk

• Large number of exposure units
• to predict average loss
• to reduce objective risk
• Accidental and unintentional loss
• to control moral hazard
• to assure randomness
• Determinable and measurable loss
• to facilitate loss adjustment

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More Requirements

• No catastrophic loss
• to allow pooling
• independent losses
• use of diversification
• Calculable chance of loss
• to determine accurate premium

• Economically feasible premium
• something people can afford to buy
• risk of loss and premium must be substantially
  less than potential loss

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More Questions

• The river is starting to rise next to my house -
  should I be able to buy flood insurance?
• Would you sell fire insurance to an arsonist?
• Would you sell fire insurance that paid twice the
  market value of the house if it burned down?

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More Questions!

• Could we sell insurance to cover therapy for
  alien abduction?
• Is insurance for large meteor collisions
  feasible?
• Can you calculate an insurance premium for an
  event that has never occurred?
• Is physical damage insurance economically
  feasible for a 500 car?

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Expected Loss

• The expected loss for any individual or group is
  equal to the probability that a loss will occur
  multiplied times the amount of the loss.
• If p .2 and L 1,000,
• then EL .2 x 1,000 200

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Expected Loss Distribution

• (P) x Loss EL
• .5 0 0
• .25 100 25
• .1 200 20
• .05 300 15
• .05 400 20
• .025 500 12.5
• .025 600 15
• 1.0 108

Expected Loss ?pi(xi)
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What is Adverse Selection?

• All else equal, high-risk people will find it
  more attractive to buy insurance than low-risk
  people.
• If premiums are based on the average expected
  loss for all individuals, high-risk people will
  be more likely to purchase insurance than
  low-risk people.
• Adverse selection can cause a risk pool to
  collapse as low-risk people leave and the average
  loss and premium escalates.

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How to Avoid Adverse Selection

• Insurers use underwriting selection and
  risk-based pricing to charge each insured the
  appropriate premium.

• Underwriting is a process by which insurers match
  insureds with an appropriate premium, through
  selection and risk classification.

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Types of Insurance

• Private Insurance
• Life and Health Insurance
• Property and Liability Insurance
• auto, home, commercial
• Government Insurance
• Social Insurance
• Social Security, Work Comp, Unemployment
• Other Government Insurance
• flood, crop, crime

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Social Benefits Costs of Insurance

• Benefits
• indemnification
• less anxiety
• savings
• loss prevention
• credit enhancement

• Costs
• transaction costs
• fraud
• moral hazard
• inflated claims