Chapter 2

Insurance and Risk

What do you think people would do
for fraudulent insurance claims?

Take out a paper and write it down.

Let’s see what people would do to
cheat insurance companies!
2-2
Child worth more dead than alive
Little Ashley McLellan’s lungs filled with freezing water in the
family’s backyard swimming pool near Seattle. Her final, futile
gasps for air must’ve terrified her.

But Ashley’s stepfather Joel Zellmer wasn’t concerned. The three-

year-old’s life meant little; her death meant more. Zellmar
drowned Ashley for a $200,000 life-insurance payout. He’d been
married to Ashley’s mother Stacey Ferguson for only a few months
when the toddler died in December 2003. Fire fighters found her
wet, unconscious body flopped on the living-room floor. Zellmer
claimed he discovered her floating in the pool. She probably went
outside to the deck for some cake left there and somehow slid into
the water, he told investigators.

It was nearly the perfect crime; no witnesses saw Zellmer drown

her. But astute prosecutors still wove a convincing murder case
that earned him 50 years in prison.

http://www.insurancefraud.org/
2-3
• Arsonist stokes flames of greed
Debra Morris dashed back into the flaming house, trying to
rescue her cat. But the second-floor tenant never made it back
out. Morris perished in the voracious smoke and flames that
devoured the structure.

The building’s owner Jeffrey Alnutt had set the place afire,
hoping to steal a $277,000 insurance payday to bail himself
out of crushing debt and failed business ventures in the
Johnstown, N.Y. area. Someone set the fire as revenge
because he was a drug informant for local police, Alnutt
contended.

But the court didn’t buy his story. The case against Alnutt was
largely circumstantial, but was convincingly pieced together by
investigators and prosecutors.

2-4
Sinister seniors.
Two elderly women befriended a pair of homeless
men in Los Angeles, then took out $3 million in life
policies naming themselves as beneficiaries. Some
of the men’s signatures were forged.

Helen Golay and Olga Rutterschmidt then had cars

run down Paul Vados and Kenneth McDavid in dark
alleys at night. McDavid was so packed with
booze, painkillers and sleeping pills that he was
virtually immobile when the car ran over his prone
body. Both women received life without parole.

2-5
• Skin deep scheme. Michigan skin doc Robert
Stokes inflated claims while exposing patients
potentially to HIV and hepatitis by reusing
sutures, scalpels and syringes without proper
cleaning. Stokes also removed facial lesions
but billed insurers at least $1 million for more
invasive procedures. He also falsely diagnosed
these patients with an infectious skin disease.
Stokes received 10 years in federal prison.

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What have you learned after reading
these four cases?

2-7
Agenda
• Definition and Basic Characteristics of
Insurance
• Characteristics of An Ideally Insurable Risk
• Adverse Selection and Insurance
• Insurance vs. Gambling
• Insurance vs. Hedging
• Types of Insurance
• Benefits and Costs of Insurance to Society
Outcome
Understand the terms above and their
applications in an insurance contract
Understand the basics of different types of
insurance contracts 2-8
Definition of Insurance

• Insurance is 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

How Does Insurance Work

https://www.youtube.com/watch?v=qjXgpJpSlCc

2-9
Basic Characteristics of Insurance
• Pooling of losses
– Spreading losses incurred by the few over the entire
group
– Risk reduction based on the Law of Large Numbers
• Example:
– Two business owners own identical buildings valued at
$50,000
– There is a 10 percent chance each building will be
destroyed by a peril in any year; loss to either building is
an independent event
– Expected value and standard deviation of the loss for
each owner is:
Expected loss  0.90 * $0  0.10 * $50,000  $5,000
Standard deviation  0.900  $5,000  0.10$50,000  $5,000
2 2

 $15,000
Would you charge $5000 premium for fire insurance if
you were insurer? 2-10
 Basic Characteristics of Insurance
• Example, continued:
– If the owners instead pool (combine) their loss exposures, and
each agrees to pay an equal share of any loss that might
occur:

– What will be the expected loss and standard deviation? SAME?

Expected loss  0.81* $0  0.09 * $25,000  0.09 * $25,000  0.01* $50,000
 $5,000
Standard deviation  0.810  $5,000   (2)(0.09)$25,000  $5,000   0.01($50,000  $5,000) 2
2 2

 $10,607

– As additional individuals are added to the pooling arrangement,

the standard deviation continues to decline while the expected
value of the loss remains unchanged
Charging $7500 may be OK if 200 contracts 2-11
Basic Characteristics of Insurance

• Payment of fortuitous losses

– Insurance pays for losses that are unforeseen,
unexpected, and occur as a result of chance
• Risk transfer
– A pure risk is transferred from the insured to
the insurer, who typically is in a stronger
financial position
• Indemnification
– The insured is restored to his or her
approximate financial position prior to the
occurrence of the loss

Can I get compensation from say three insurance contracts for the same loss?

2-12
Characteristics of an Ideally
(Requirements of) Insurable Risk

1.Large number of exposure units

– to predict average loss
2.Accidental and unintentional loss
– to control moral hazard
– to assure randomness
• otherwise, inaccurate prediction of future losses

3.Determinable and measurable loss

– to facilitate loss adjustment
• insurer must be able to determine if the loss is
covered and if so, how much should be paid.

Loss of a finger?
2-13
Requirements of an Insurable Risk

4.No catastrophic loss

– to allow the pooling technique to work
– exposures to catastrophic loss can be
managed by:
• dispersing coverage over a large geographic
area
• using reinsurance
• catastrophe bonds

5.Calculable chance of loss

– to establish an adequate premium

2-14
Requirements of an Insurable Risk

6.Economically feasible premium

– so people can afford to buy
• Will you pay $8,000 car insurance for your used
car worth $10,000?
– Premium must be substantially less than the face
value of the policy
• Pay $500,000 for a $1,000,000 life insurance?

• Based on these requirements:

– Most personal, property and liability risks can be
insured
– Market risks, financial risks, production risks and
political risks are difficult to insure
• Why say insuring financial risk is difficult?
2-15
Does the risk of fire satisfy the above
requirement for insurable risk?

2-16
In class exercise :
Risk of Fire as an Insurable Risk

Let’s do it on ureply
2-17
Exhibit 2.2 Risk of Unemployment as an
Insurable Risk

Large number of exposure units?

Accidental/unintentional loss?

Determinable and measure loss?

No catastrophic loss?

Calculable chance of loss?

Economically feasible premium?

2-18
Exhibit 2.2 Risk of Unemployment as an
Insurable Risk

But the U.S. has insurance for unemployment! Why?

2-19
Adverse Selection and Insurance
• Q: What kind of people would be more likely to
buy insurance?
• Adverse selection is the tendency of persons with
a higher-than-average chance of loss to seek
insurance at standard rates
• If not controlled, adverse selection result in
higher-than-expected loss levels
• Adverse selection can be controlled by:
– careful underwriting (selection and classification of
applicants for insurance)
– policy provisions (e.g., suicide clause in life insurance)

2-20
Insurance vs. Gambling

• Are they the same?

2-21
 Insurance vs. Gambling

Insurance Gambling

• Insurance is a technique • Gambling creates a new

for handing an already speculative risk
existing pure risk

• Gambling is not socially

• Insurance is socially productive
productive:
– The winner’s gain comes
– both parties have a at the expense of the
common interest in the loser
prevention of a loss

2-22
 Insurance vs. Hedging
Insurance Hedging

• Risk is transferred by a • Risk is transferred by a

contract contract
• Insurance involves the • Hedging involves risks
transfer of insurable that are typically
risks uninsurable
• Insurance can reduce • Hedging does not result
the objective risk of an in reduced risk
insurer through the Law – Why?
of Large Numbers
e.g. hedging rising oil with oil futures
Or buying corn futures/forward for corn producers.

How billionaire Ray Dalio helped launch McDonald’s Chicken McNugget

(what would you suggest for those with finance background)
2-23
https://www.cnbc.com/2018/05/03/how-ray-dalio-helped-launch-mcdonalds-chicken-mcnugget.html
Types of Insurance

• Private Insurance
– Life and Health
– Property and Liability
• Government Insurance
– Social Insurance
– Other Government Insurance

2-24
Private Insurance
NYC disability insurance
fraud may total $400 million - CBS News
• Life and Health
– Life insurance pays death benefits to beneficiaries when the
insured dies
– Health insurance covers medical expenses because of sickness
or injury
– Disability plans pay income benefits
• Property and Liability (also called property and casualty)
– Property insurance indemnifies property owners against the
loss or damage of real or personal property
– Liability insurance covers the insured’s legal liability arising
out of property damage or bodily injury to others
– Casualty insurance refers to insurance that covers whatever is
not covered by fire, marine, and life insurance, e.g. against
loss of property, damage or other liabilities. e.g. auto, theft
workers' compensation, etc.
• Include liability coverage 2-25
Private Insurance (Property and
Liability )
• Private insurance coverages can be grouped into two
major categories
– Personal lines
• coverages that insure the real estate and personal property of
individuals and families or provide protection against legal
liability, e.g. auto insurance (covering physical damage of the
auto, theft, etc.) , medical expense coverage, homeowner
insurance, personal umbrella liability insurance (extra insurance
that provides protection beyond existing limits and coverages of
other policies e.g. covering catastrophic lawsuit, ), boatowners
insurance (covering both the boats and the families, can be very
comprehensive covering medical, physical damage, liability, etc.)
…… you can find this in your textbook
– Commercial lines
• coverages for business firms, nonprofit organizations, and
government agencies

2-26
Exhibit 2.3 Property and Casualty Insurance
Coverages

e.g. situation that may need umberlla liability insurance:

serious auto accident where you are at fault, or harm caused
to others by your dog when u are walking the dog

2-27
Fire and allied lines
-allied lines: purchased along with fire insurance like storm,
hail, vandalism or even loss of business income, extra expenses, etc.

Multiple-peril insurance: a package of policy including property, general

liability, business income loss, equipment failure or even criminal insurance.

General liability insurance covers the legal liability of business (e.g. property
damage or bodily injury, sales of products or contract operation). Like the
powerdrill manufacturer example I mentioned before

Worker compensation insurance: job-related accidents or diseases covering

medical bills, disability benefits, death benefit, etc.

Inland marine insurance covers goods being shipped on land (in transit
over land) and personal property like jewelry, antique painting, etc. stored at
the policy holder location. 2-28
Ocean marine insurance covers ocean-going vessel and the cargo
or legal liability of shippers and owners, Stranded Taiwan container ship
blocks Suez Canal
Professional liability insurance covers e.g. malpractice of
lawyers and medical person
Directors and officers liability insurance: provides financial
support if they are sued for mismanagement.

Fidelity bonds for loss caused by the dishonest or fraudulent

acts of employees
e.g. banks and financial institutions

Surety bonds cover loss caused by the failure of

bonded person, e.g. contractor

2-29
Government Insurance

• Social Insurance Programs

– Financed entirely or in large part by contributions from
employers and/or employees
– Benefits are heavily weighted in favor of low-income
groups
– Eligibility and benefits are prescribed by statute
– Examples:
• Social Security, Unemployment, Workers Compensation
• Other Government Insurance Programs
– Found at both the federal and state level
– Examples:
• Federal flood insurance, state health insurance pools

2-30
Social Benefits of Insurance
• Indemnification for Loss
– Contributes to family and business stability
• Reduction of Worry and Fear
– Insureds are less worried about losses
– Workers killed in construction site. The wife….
• Source of Investment Funds
– Premiums may be invested, promoting economic growth
• Loss Prevention
– Insurers support loss-prevention activities that reduce
direct and indirect losses
• Enhancement of Credit
– Insured individuals are better credit risks than individuals
without insurance

You can also say that it is a kind of social responsibility of

2-31
insurance companies or their roles in the society
Social Costs of Insurance
• Cost of Doing Business
– Insurers consume resources in providing insurance to
society
– An expense loading is the amount needed to pay all
expenses, including commissions, general administrative
expenses, state premium taxes, acquisition expenses,
and an allowance for contingencies and profit
• Sales & administrative expenses (property and casualty)
account for 26% of each underwriting dollars
• Operating expenses for life insurance: 12%
• The U.S. spends more than $2 trillion on healthcare
annually. At least 3 percent of that spending — or $68 billion
— is lost to fraud each year. (National Health Care Anti-
Fraud Association, 2008)
– Justified by:
• millions of jobs created
• Uncertainty of payment reduced
• Insurer engaged in loss prevention activities
Every $2 million invested in fighting health-care fraud returns $17.3 million in recoveries,
court-ordered judgments, plus bogus claims that weren’t paid and other anti-fraud savings. 2-32
(National Health Care Anti-Fraud Association, 2008)
Social Costs of Insurance
(similar figures can be found in the Text)
• Cost of Fraudulent and Inflated Claims
– Payment of fraudulent or inflated claims results in higher
premiums to all insureds, thus reducing disposable income
and consumption of other goods and services
• Cost estimated to be greater than $80 billion annually
• Suspected fraud of bodily injury up from 9% to 11%
(2002 to 2007)
• Of which 20% (2007) involve buildup up from 18%,
2002
– Buildup: Excessive treatment, unnecessary
treatment or diagnosis leading to inflation
• about 45 million (20%) US adult believe it is acceptable to
defraud insurers under certain conditions
• Three percent of slip-and-fall injuries are fraudulent.
(National Floor Safety Institute)
• Bogus injury claims and related costs such as litigation
amount to nearly $2 billion a year. (ibid)
2-33
 “Minor fraud”?

• Will you claim for insurance for work-related

injury which is actually a sport injury?
• You have property insurance, an expensive
mirror (HKD2000) is broken due to your
carelessness, will you claim for the insurance
saying the mirror is broken with unknown
cause?
• Would you stay home after your have
recovered from illness (say Covid 19) to
continue collecting compensation?

2-34
Case application
• Based on the definition of insurance mentioned,
indicates which of the following is considered
insurance.
– a. A TV set is guaranteed by the manufacturer against
defects for a year.
• Warranty guarantee the performance (defects somewhat expected)
• Insurance cover unexpected loss in general
– b. A new set of radial tires is guaranteed by the
manufacturer against road defects for 50,000 miles.
– c. A builder of new homes gives a 10-year guarantee
against structural defects in the home.
– d. A cosigner of a note agrees to pay the loan balance if
the original debtor defaults on the payments.
• Don’t do that
– e. A large group of homeowners agrees to pay for losses
to homes that burn during the year because of fire.
2-35
Appendix (reference only)

• Basic Statistics and the Law of Large

Numbers

2-36
Probability and Statistics

• The probability of an event is the long-run relative

frequency of the event, given an infinite number
of trials with no changes in the underlying
conditions.
• Events and probabilities can be summarized
through a probability distribution

• A probability distribution is characterized by:

– A mean, or measure of central tendency
– A variance, or measure of dispersion

2-37
Probability and Statistics

• The mean or expected value is:

 or EV   X i Pi

Amount of Probability XiPi

Loss (Xi) of Loss (Pi)
$ 0 X 0.30 = $ 0
$360 X 0.50 = $180
$600 X 0.20 = $120
X P i i
= $300

2-38
Probability and Statistics

• The variance of a probability distribution is:

 2   Pi  X i  EV 2
• For the previous loss distribution,
 2  0.30(0  300) 2  0.50(360  300) 2
0.20(600  300) 2
 27,000  1,800  1,800
 46,800

• The standard deviation =     216.33

2

• Higher standard deviations, relative to the mean, are

associated with greater uncertainty of loss; therefore, the risk
is greater

2-39
Law of Large Numbers

• The law of large numbers is the mathematical

foundation of insurance.
• Average losses for a random sample of n exposure
units will follow a normal distribution because of
the Central Limit Theorem.
– Regardless of the population distribution, the distribution
of sample means will approach the normal distribution as
the sample size increases.
– The standard error of the sampling distribution can be
reduced by simply increasing the sample size

2-40
Exhibit A2.1 Sampling Distribution
Versus Sample Size

2-41
Exhibit A2.2 Standard Error of the Sampling
Distribution Versus Sample Size

2-42
Law of Large Numbers

• When an insurer increases the size of the

sample of insureds:
– Underwriting risk increases, because more
insured units could suffer a loss.
– But, underwriting risk does not increase
proportionately. It increases by the square root
of the increase in the sample size.
– There is “safety in numbers” for insurers!

2-43
Questions to recap the concepts
learned

2-44
Question 1
• Compare the risks of
– Fire with
– War
in terms of how well they meet the requirements
of an ideally insurable risk
So what are the 6 requirements?
• Large number of exposure units.
• Accidental and unintentional loss.
• Determinable and measurable loss.
• No catastrophic loss.
• Calculable chance of loss.
• Economically feasible premium.
No model answers given 2-45
Question 1.1

• As a private insurer, you are considering

insuring buildings of a flooding zone, which
of the requirements of insurable risk are
not met?

2-46
Question 2

• Explain the following benefits of insurance

to the society
– Indemnification for loss
– Enhancement of credit
– Source of funds for capital investment and
accumulation
• What are the major costs of insurance to
society

2-47
Question 3
• You want to buy a flat. You pay 30 percent of the cost of the
flat as a down payment and borrow the other 70 percent
from a bank. The flat will serve as collateral for the loan. The
lender (bank) requires you to purchase property insurance
on the home so that the collateral supporting the loan will be
protected. This scenario illustrates which benefit of
insurance to society?

• Enhancement of credit

2-48
Question 4

• What does adverse selection mean?

• What are the methods insurer can use to
control for adverse selection?

2-49
Question 5

• Of insurance plan,
– What is pooling of losses?
– What is payment of fortuitous losses?
– Risk transfer?
– Indemnification?

2-50
Question 6

• How can insurers deal with catastrophic

loss of exposures?

2-51