3. Insurance and Risk Bus 200 Introduction to Risk Management and Insurance Fall 2008 Prof. Jin Park
Overview • Insurance • Adverse Selection and Underwriting • Insurable Risk • Types of Insurance • Costs/Benefits of Insurance to Society
Insurance • The pooling of fortuitous losses by transfer of such risks to insurers, who agree to indemnify insureds for such losses, to provide other pecuniary benefits on their occurrence, or to render services connected with the risk.
Characteristics of Insurance • Loss Sharing (pooling of looses) • Law of large numbers • Payment of Fortuitous Losses • Moral hazard • Risk Transfer • Indemnification • No profit from a loss
Loss sharing (pooling) • Pooling arrangement changes the probability distribution of accident costs faced by each participant. • Assume 1,000 individuals each have homes worth $200,000 • On average, 1 home burns down a year (1 out of 1,000) • Without insurance: Max. possible loss per any individual = $200,000 • Suppose all agree to share the loss equally average loss = $200,000 / 1,000 = $200 • Trading between “$200 sure loss” and “chance of losing $100,000”
What if… JP’s Palace, Bloomington, IL • The Governor’s Mansion, Austin TX What if they are put into the same pool and share the losses equally?
Adverse Selection • The tendency of persons with a higher-than-average chance of loss to seek insurance at standard (average) rate, which, if not controlled by underwriting, results in higher-than-expected loss levels. • To mitigate the adverse selection • Detailed application • Medical examination • On-Site investigation • Suicide clause • Preexisting conditions provision
Underwriting • The process of selecting risks (insurance applicants) and classifying them according to their degrees of insurability so that the appropriate rates may be assigned. • Discrimination is acceptable. • Underwriting Decisions • Accept the application • Accept the application subject to certain restrictions or modifications • Reject the application
Life/Health Insurance Type of policies Face amount Insured’s age, gender Tobacco use Residence Health status Family diagnosis Driving records … and more Property/Casualty Type of policies Limit of insurance Nature of business Location Past claim history Total revenue Type of property Construction type Credit history … and more Discrimination via Underwriting
Ideal Characteristics of an Insurable Risk • Large number of similar exposure units • Accidental and unintentional loss • No catastrophic loss • Determinable and measurable loss • Calculable chance of loss • Economically feasible premium
Types of Insurance • Personal, Group, or Commercial • Personal Auto, Homeowner’s, Personal Health • Group Life, Group Health • Product Liability, WC, MMP • Life/Health or Property/Casualty • Whole Life, Annuity, HMO, PPO • Auto, Home, Aviation, Environmental Liability
Types of Insurance • Private or Government • Personal Auto, Homeowner’s, Group Life, Group Health • Social Security, Medicare, Flood, Crop, FDIC, PBGC, WC
Benefits/Costs of Insurance to Society • Benefits • Indemnification • Less Worry & Fear • Source of investment funds • Loss Prevention • Enhancement of Credit • Costs • Cost of Doing Business • Fraudulent claims • Inflated claims