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PowerPoint Slidesfor Professors

Spring 2010 Version

This file as well as all other PowerPoint files for the book, “Risk Management and Insurance: Perspectives in a Global Economy” authored by Skipper and Kwon and published by Blackwell (2007), has been created solely for classes where the book is used as a text. Use or reproduction of the file for any other purposes, known or to be known, is prohibited without prior written permission by the authors.

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W. Jean Kwon, Ph.D., CPCUSchool of Risk Management, St. John’s University101 Murray StreetNew York, NY 10007, USA

Phone: +1 (212) 277-5196E-mail: [email protected]

Risk Management and Insurance: Perspectives in a Global Economy 19. The Economic Foundations of Insurance

There are two sections (Insurance Legal Principles; Insurance Contract Structure).

Both are derived from Appendix Chapter 2.

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Study points
Study Points Economy

  • Expected utility and the demand for insurance

  • Insurance supply: characteristics of ideal insurable exposures

Recall the cases
Recall the Cases Economy

  • John and Mary

    • Risk-averse utility function

  • XYZ Insurance

    • Expected value theory

    • Premium at cost

How premium is calculated
How Premium Is Calculated? Economy

  • Cost  expected loss

  • Loadings for

    • Internal expenses (e.g., underwriting and marketing)

    • External fees (e.g., premium taxes and license fees)

  • Profits

Moral hazard
Moral Hazard Economy

  • The propensity of individuals to alter their behavior when risk is transferred to a third party, such as being less careful in:

    • Maintaining health condition

    • Driving

    • House maintenance

  • Fraud as an extreme case

Insurance demand in markets with moral hazard
Insurance Demand in Markets with Moral Hazard Economy

Discussion in page 482

  • Ex-ante moral hazard

    • Insurance fraud

  • Ex-post moral hazard

  • Insurer responses to moral hazard

    • Controlling the marginal benefit of being careful or the marginal cost of being careless

    • Loss sharing through deductible and coinsurance

      • Insight 19.2

    • Rewarding insureds who undertake loss preventing activities

      • Retrospective or experience rating

Moral hazard and insurance demand andrew
Moral Hazard and Insurance Demand EconomyAndrew

  • Andrew, risk-averse salesperson

    • Has €12,000 in cash and a car worth €4,000

    • Probability of accident depending on his driving behavior

      • If not careful, p = 0.5

      • If careful, p = 0.2 but incurs additional expense of €1,000

    • Has a square root function for his wealth utility

Moral hazard and insurance demand ecu insurance
Moral Hazard and Insurance Demand EconomyEcu Insurance

  • Ecu Insurance Company

    • Full insurance at the actuarially fair premium

    • Should it consider Andrew is a safe or risky driver?

      • If a safe driver: premium = 0.2 x €4,000 = €800

      • Otherwise: premium = 0.5 x €4,000 = €2,000

Insurer responses to moral hazard
Insurer Responses to Moral Hazard Economy

  • Controlling the marginal benefit of being careful or the marginal cost of being careless

  • Loss sharing through deductible and coinsurance

    • Insight 19.2

  • Rewarding insureds who undertake loss preventing activities

    • Retrospective or experience rating

Deductible and coinsurance insight 19 2

Stop loss Economy





Insured’s Share

Insurer’s Share

Deductible and Coinsurance (Insight 19.2)

Deductible and coinsurance another look
Deductible and Coinsurance Economy(Another Look)


Amount Financed

Amount Retained


Stop Loss



Coverage Limit

Insurance demand in markets with adverse selection
Insurance Demand in Markets with Adverse Selection Economy

Discussion in page 485-486

  • The effect of adverse selection on insurance markets

  • Insurer responses

    • Eliciting more information about applicants and insureds

    • Designing insurance contracts that encourage insureds with differing risk types to self-select into the most appropriate risk class

      • Table 19.1

Adverse selection and insurance demand individual rating
Adverse Selection and Insurance Demand EconomyIndividual Rating

  • Two Japanese

    • Risk averse and each with initial wealth of ¥125,000

    • Will suffer a ¥100,000 loss if cancer develops

    • One is “low risk” (p = 0.25) and the other is “high risk” (p = 0.75)

    • Insurance at actuarially fair premium

Adverse selection and insurance demand pooled rating
Adverse Selection and Insurance Demand EconomyPooled Rating

  • If the insurer pools both risks

    • Fair pooled premium [(¥75,000 + ¥25,000) ÷ 2] = ¥50,000

A solution
A Solution Economy

  • Eliciting more information about applicants and insureds

  • Designing insurance contracts that encourage insureds with differing risk types to self-select into the most appropriate risk class

Insurer s tool underwriting
Insurer’s Tool – Underwriting Economy

  • Case

    • A city with one health insurer, Monopoly Insurance

    • All citizens must purchase health insurance.

    • There are 1,000 good risk citizens and 1,000 bad risk citizens.

  • Will the insurer classify them into high and low risk classes and charge different premiums?

    • No. Instead, it can treat all risks equal and charge the same premium.

    • No medical exam would be required.

Insurer s tool underwriting1
Insurer’s Tool – Underwriting Economy

  • Suppose

    • A good risk costs the insurer $1000 a year.

    • A bad risk costs the insurer $5,000 a year.

  • The pooled premium is then:

Insurer s tool underwriting2
Insurer’s Tool – Underwriting Economy

Medical Exam Required

Those Who Pass Gets the Coverage for $2,000 of yearly premium.

Those Who Fail Gets the Coverage for $4,000 of yearly premium.

  • Suppose now

    • Competition Insurance enters the market.

    • It has the risk information of the city.

    • It wants to generate profits with minimum effort. Possible?

  • The result

    • Monopoly Insurance goes out of business.

Substitutes for insurance
Substitutes for Insurance Economy

  • Substitutes

    • Higher insurance prices tend to decrease the amount of market insurance purchased by risk-averse individuals and increase the amount of loss reduction “bought.”

  • Complements

    • Loss prevention and market insurance are complements, not substitutes.

      • An investment in loss prevention may actually raise the amount of risk that a risk-averse person faces and therefore raises the demand for market insurance.

Why corporations purchase insurance1
Why Corporations Purchase Insurance Economy

Discussion continues from Chapter 2

  • Already covered are:

    • Managerial self-interest

    • Corporate taxation

    • Cost of financial distress

    • Capital market imperfections

  • Other reasons include:

    • Insurers may offer real service efficiencies.

    • Regulated industries have a higher demand for insurance.

    • The purchase of some types of insurance is required by government.

Ideal insurable exposures not necessarily practical in some aspects
“Ideal” Insurable Exposures Economy– Not Necessarily Practical in Some Aspects

Ideal insurable exposures
“Ideal” Insurable Exposures Economy

  • Presence of numerous independent and identically distributed (IID) units

  • Unintentional losses

  • Easily determinable losses as to time, amount, and type

  • Economically feasible premium

Numerous iid exposure units
Numerous IID Exposure Units Economy

  • Each exposure unit (e.g., liability risk) in an insurance pool should be IID.

  • Two random variables (e.g., exposures units) are independent if the occurrence of an event affecting one of the variables has no affect on the other variable.

    • The independence property is important because it affects how well insurers can diversify the systematic risk of their insurance pools.

  • Random variables are identically distributed if the probability distributions of two random variables prescribe the same probability to each potential occurrence.

Numerous iid exposure units1
Numerous IID Exposure Units Economy

  • The law of large numbers

    • Variance and standard deviation as measures of dispersion

  • Effects of pooling IID exposures units – A fire insurer would be interested in the following four statistics:

    • The total amount of losses expected to be paid during the year;

    • The standard deviation of the total loss distribution (to understand the riskiness inherent in providing this insurance)

    • The average loss (to determine the premium to be charged);

    • The standard deviation of the average loss distribution (to determine the risk each exposure unit contributes to the risk class)

Probability of ruin figure 19 3
Probability of Ruin Economy(Figure 19.3)

Accidental losses
Accidental Losses Economy

  • Losses should be accidental or unintentional

    • We made this point earlier in the context of moral hazard

    • From a societal viewpoint, it clearly is not good public policy to allow policyholders to collect insurance proceeds for internationally causing losses.

  • Some losses occur naturally over time.

    • It is usually less expensive to budget for possible repair or replacement of the property than to purchase insurance.

Determinable losses
Determinable Losses Economy

  • The details of the insured loss – time, place, and amount – must be verified and the payment amount agreed upon by the insured and the insurer.

  • The costs of verifying loss details should be relatively low for insurance to be offered at an economically feasible premium.

Economically feasible premiums
Economically Feasible Premiums Economy

  • On the one hand, rational risk-averse individuals will pay a maximum premium equal to the expected value of the loss plus the risk premium. On the other, the owners of private insurance companies require that insurance rates be enough to give them a competitive return on their investments.

  • Factors affecting this range

    • Competition in the market

    • Threats of new entrances

    • Price

    • Threat of alternative products and substitutes

    • The bargaining power of consumers

    • The degrees of risk attitudes of consumers

Legal aspects a short visit appendix chapter a2
Legal Aspects: A Short Visit EconomyAppendix Chapter A2

Legal principles
Legal Principles Economy

  • Indemnity

  • Insurable interest

  • Utmost good faith

Indemnity Economy

  • In nonlife insurance

    • Actual cash value (ACV)

    • Replacement cost

    • Valued policy

    • Other insurance provision

      • Primary and excess insurance Figure A2-1

    • Subrogation

Another example of primary and excess

Excess Economy


Another Example of Primary and Excess

Personal Umbrella Liability Insurance

(Liability Coverage)



(Liability Coverage)


Personal Automobile

(Liability Coverage)


Indemnity Economy

  • In life insurance

    • No application of “other insurance” provision

      • When applied, it could be in relation to the total earnings power of the insured life and the sum of life insurance in the aggregate of all outstanding policies

    • Thus, life insurance policies are “valued policies.”

  • In health insurance

    • ‘Coordination of benefits”

Insurable interest
Insurable Interest Economy

  • The principle:

    • An insured must have a financial interest in the loss event that is the subject of the insurance contract for the policy.

  • Application in

    • Nonlife insurance

      • Bailment

    • Life insurance

      • Insurable interest for domestic partners  Insight A2-2

      • Viatical Settlements (and Death Bonds)  Insight A2-3

Bailment – Temporary change in possession of property but with no change in ownership

Utmost good faith
Utmost Good Faith Economy

  • A higher degree of honesty on the parties to an insurance contract than what is expected from parties to other [legal] contracts

  • Information asymmetry problem inherent with insurance contracts

Good faith

Utmost Good faith

http://www.lawyersrealestate.com.au/blogger/2006_04_01_archive.asp; http://www.freerepublic.com/focus/f-news/1780026/posts

Utmost good faith applications
Utmost Good Faith – Applications Economy


  • Misrepresentation

    • Material response incorrectly made by an applicant in procuring insurance

  • Concealment

    • Intentional failure to disclose material information

  • Warranty

    • Statement of fact or promise that must be true for the insurer to be liable under the insurance contract

When "material" misrepresentation Economy

or concealment is found...,

The contract becomes


Cancelled Contract?

Void Contract?

Insurance contract a short visit appendix chapter a2
Insurance Contract: A Short Visit EconomyAppendix Chapter A2

Characteristics Economy

  • Aleatory contract

    • The values exchanged by the contracting parties may not seem equal.

  • Unilateral contract

    • Only one party (the insurer) has a legal duty to act.

  • Conditional contract

    • The insurer is obligated to honor its promises only if the insured has complied with certain conditions specified in the policy.

Characteristics continued
Characteristics (continued) Economy

  • Personal contract

    • The agreement is between the insurer and the insured person (not the insured property).

      • Hence, property insurance contracts cannot be assigned to another insured person without the insurer’s consent.

  • Contract of adhesion

    • The contract is designed by one party and offered to another party on a "take it or leave it" basis.

  • Reasonable expectations doctrine

    • It considers the objectively reasonable expectations of insureds and beneficiaries regarding the terms of insurance contracts.

The insurance contracting process
The Insurance Contracting Process Economy

  • Offer and acceptance

    • Binding authority

    • Conditional premium receipt

  • Consideration

    • Insurer – promise to pay the stipulated insurance benefits

    • Insured – complete application and initial premium payment

  • Legal competence

    • Age?

  • Legal purpose

Structure of the insurance contract
Structure of the Insurance Contract Economy

  • Declarations

  • Insuring agreements

  • Exclusions

  • Conditions

  • Endorsements (riders)

Declarations page
Declarations (Page) Economy

Insight A2-4Automobile Liability Insurance Limits

  • Policy limits

    • Aggregate limits

    • Sublimits such as:

      • Per person limit

      • Per occurrence limit

  • Loss sharing

    • Deductible

      • Elimination period (e.g., health insurance)

    • Coinsurance

Insuring agreements
Insuring Agreements Economy

  • Describes the nature of the insurer's obligations:

    • Promises to pay certain sums upon the occurrence of enumerated events, for example:

      • Property damage to covered property caused by insured perils

      • Payment for settlements and judgments when the insured is found legally liable for activities covered in the contract

        • Plus a duty to defend the insured against all allegations

      • Life insurer’s promise to pay the beneficiary (or insured) certain amounts upon the death (or survival) of the insured

      • In health insurance, reimbursement of covered medical expenses or the periodic payment of income for covered disabilities

Exclusions Economy

  • A necessary element of the contract for the following reasons

    • Insurable risks should be independent and identically distributed loss events.

    • Problems of moral hazard must be addressed.

    • When applicable, the insurer avoids overlapping coverage and the inefficiency created by such redundancy.

    • Exclusions can serve to limit coverage to make the premium more affordable.

Conditions Economy

  • The insured must meet these conditions to keep the policy valid and to receive applicable benefits.

    • Prompt notification of a loss event

    • Mitigation of the property from further loss

    • Documentation of evidence

    • Cooperation to the insurer and investigation

Conditions termination of contract
Conditions – Termination of Contract Economy

Cancellation differs from voiding (avoiding)a contract or void contract.

  • Cancellation

  • Nonrenewal

Endorsements and riders
Endorsements and Riders Economy

  • Added to the standardized contract to modify the terms and conditions of the policy.

    • Endorsements commonly used in nonlife insurance business

    • Riders commonly in life insurance business

Discussion question 1
Discussion Question 1 Economy

  • Hannah owns a home worth US$50,000, which is subject to the risk of fire. The probability of a fire is 25 percent and the amount of damage due to the fire would be US$40,000. Assume Hannah’s utility function is the square root of wealth. Hannah has been offered full insurance at a cost of US$13,000. Will she buy the insurance? Why or why not?

Discussion question 2
Discussion Question 2 Economy

  • A frequency distribution shows the number of accidents that an insurer can expect from each exposure unit in its insurance pool during the year. Use the information provided below to answer the following questions:

    • Calculate the expected number of accidents a single exposure unit could expect during the next year.

    • Calculate the standard deviation of the number of accidents a single exposure unit could expect during the next year.

    • Calculate the standard deviation of the number of accidents.

Discussion question 3
Discussion Question 3 Economy

  • Consider the following lotteries, x, y and z:

    • Calculate the expected value of each gamble.

    • Assuming a risk-averter’s utility function of wealth is given below. Calculate the expected utility of each gamble for a person who has an initial wealth level of 10. Which gamble does this person prefer? Why?