Chapter2. Nature of Insurance, Risk, Perils and Hazards

Keywords

THE NATURE OF INSURANCE

Risk Pooling

Risk Pooling, also known as loss sharing, spreads risk by sharing the possibility of loss over a large number of people. It transfers risk from an individual to a group.

Law of Large Numbers

The law of large numbers states that larger groups provide an increased degree of accuracy in loss predictions, based on past experience. The higher the exposure, the more likely the event can be predicted.

RISK

Risk is defined as the potential for loss.

Peril (风险) is something that can cause a financial loss, such as an earthquake or tornado. Perils can also be referred to as the accident itself.

Loss is the unintentional decrease in the value of an asset due to a peril.

Homogeneous exposure units are similar objects of insurance that are exposed to the same group of perils.

Types of Risk

  • Speculative risk is a risk that presents the chance for both loss and gain. Gambling is an example. Speculative risks are not insurable.
  • Pure risks are the only insurable risks and present a potential for loss only with no possibility of gain, such as injury, illness, and death.

Treatment of Risk – how people deal with risk

► Avoidance – Don’t do anything - the elimination of a hazard is an example of risk avoidance

► Reduction – Minimizing the severity of a potential loss – smoke alarms, stop smoking

► Retention – Self insure - Used when losses are highly predictable and the worst possible loss is not serious. (风险是长期存在的, 并且有很大概率发生, 而损失通常不大)

► Transfer – Buying insurance is the best way to transfer risk. Incorporation is also a risk transfer

► Sharing- Each party assumes a portion of the risk receiving benefits under the system

Elements of Insurable Risk

► Loss must be due to chance (accident) – Outside the insured’s control

► Loss must be definite and measurable – Time, place, amount, and when payable

► Loss must be predictable – Estimate the average frequency and severity

► Loss cannot be catastrophic – Must be reasonable, 1 trillion dollar policy is not reasonable

► Loss exposure to be insured must be large – Insurance company must be able to predict loss

► Loss must be randomly selected – Adverse selection

Risk Management

The process of analyzing exposures that create risk and designing programs to handle them is called risk management.

Principle of Indemnity (赔款)

The principle of indemnity involves making an insured whole by restoring them to the same condition as before a loss.

Adverse(不利) Selection

Insurers must minimize adverse selection, which is defined as the tendency for poorer than average risks to seek out insurance. For example, a person who takes 12 prescriptions is a poor risk. If an insurer cannot compensate poor risks with better than average risks, then its loss experience will increase and its ability to pay claims may be compromised.

Reinsurance

One way insurers deal with catastrophic loss is through reinsurance, which is defined as spreading risk from one insurer to one or more other insurers. Many insurers are able to minimize exposure to loss by reinsuring risks.

HAZARDS

Hazard

A condition or situation that creates or increases a chance of loss is called a hazard.

Hazard Examples: Icy roads, driving while intoxicated, improperly stored toxic waste.

Types of Hazards

  • Physical – Poor health, overweight, blind.
  • Moral – Dishonesty, drugs, alcohol abuse.
  • Morale – Careless attitude – reckless driving, jumping off a cliff, stealing, racing motorcycles, carefree, careless lifestyle

Quiz

  • Question 1: Insurance companies determine risk exposure by which of the following?

    • Insurable interest
    • Insurance exchanges
    • Law of large numbers and risk pooling <- `` All forms of insurance determine exposure through risk pooling and the law of large numbers.``
    • Population table data

  • Question 2: Which of these are considered to be events or conditions that increase the chances of an insured’s loss?

    • Risks
    • Hazards <- Hazards are events or conditions that increase the likelihood of an insured's loss.
    • Indemnity
    • Perils

  • Question 3: People with higher loss exposure have the tendency to purchase insurance more often than those at average risk. This is called

    • risk retention
    • preexisting conditions
    • law of large numbers
    • adverse selection <- Adverse selection is the tendency of persons with higher loss exposure to purchase insurance more often than those at average risk.

  • Question 4: An example of risk sharing would be

    • Adding more security to a high-risk building
    • Choosing not to invest in the stock market
    • Doctors pooling their money to cover malpractice exposures (不当经营) <- Doctors pooling their money to cover malpractice exposures is an example of risk sharing.
    • Buying an insurance policy to cover potential liabilities

  • Question 5: Which of these techniques will remove the risk of losing money in the stock market by never purchasing stocks?

    • Risk reduction
    • Risk transference
    • Risk avoidance <- Risk avoidance could eliminate the risk of losing money in the stock market by never investing in stocks.
    • Risk retention