Chapter 4: Insurance and Risk

Tuan Minh Nguyen

Learning Objectives

• Explain the basic characteristics of insurance.

• Explain the law of large numbers.
• Describe the characteristics of an ideally insurable risk from the viewpoint
of a private insurer.
• Identify the major insurable and uninsurable risks in our society.
• Describe the major types of insurance.
• Explain the social benefits and social costs of insurance.
1. 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.
2. Basic Characteristics of Insurance

• An insurance plan or arrangement typically includes the following

characteristics:
• Payment of fortuitous losses
• Risk transfer
• Indemnification
• Pooling of losses
2. Basic Characteristics of Insurance

• Payment of fortuitous losses

• A fortuitous loss is one that is 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
2. Basic Characteristics of Insurance

• Pooling involves spreading losses incurred by the few over the entire
group, so that in the process, average loss is substituted for actual loss.
• Pooling implies
• The sharing of losses by the entire group
• The prediction of future losses with some accuracy based on the law of large
numbers
2. Basic Characteristics of Insurance

• The primary purpose of pooling, or the sharing of losses, is to reduce the

variation in possible outcomes as measured by the standard deviation or
some other measure of dispersion, which reduces risk.
2. Basic Characteristics of Insurance

• Example of pooling:
• 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.
• Calculate expected value and standard deviation for each owner with pooling and
without pooling.
• Expected return formula: E(X) = Σ[X * P(X)]
• Standard deviation formula: σ = √Σ[(X - E(X))2 * P(X)]
2. Basic Characteristics of Insurance

• Risk reduction is based on the Law of Large Numbers

• According to the Law of Large Numbers, the greater the number of
exposures, the more closely will the actual results approach the probable
results that are expected from an infinite number of exposures.
2. Characteristics of an Ideally Insurable Risk

• Large number of exposure units

• to predict average loss based on the law of large numbers
• Accidental and unintentional loss
• to assure random occurrence of events
• Determinable and measurable loss
• to determine how much should be paid
2. Characteristics of an Ideally Insurable Risk

• No catastrophic loss
• To allow the pooling technique to work
• Exposures to catastrophic loss can be managed by using reinsurance, dispersing
coverage over a large geographic area, or using financial instruments, such as
catastrophe bonds
2. Characteristics of an Ideally Insurable Risk

• Calculable chance of loss

• to establish a premium that is sufficient to pay all claims and expenses and yields a
profit during the policy period
• Economically feasible premium
• So people can afford to purchase the policy
• For insurance to be an attractive purchase, the premiums paid must be substantially
less than the face value, or amount, of the policy
3. Adverse Selection and 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 by underwriting, adverse selection results 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)
4. Insurance and Gambling

• Insurance
• Handles an already existing pure risk
• Is always socially productive:
• Both parties have a common interest in the prevention of a loss
• Gambling
• Creates a new speculative risk
• Is not socially productive
• The winner’s gain comes at the expense of the loser
5. Insurance and Hedging

• Insurance
• Risk is transferred by a contract
• Involves the transfer of pure (insurable) risks
• Moral hazard and adverse selection are more severe problems for insurers
• Hedging
• Risk is transferred by a contract
• Involves risks that are typically uninsurable
• Fewer problems of moral hazard and adverse selection for entities who buy or sell futures
contracts
6. Types of Insurance

• Insurance can be classified as either private or government insurance

• Private insurance includes life and health insurance as well as property and liability
insurance
• Government insurance includes social insurance programs and other government
insurance plans
6. Types of Insurance

• Life and Health

• Life insurance pays death benefits to beneficiaries when the insured dies
• Health insurance covers medical expenses because of sickness or injury
6. Types of Insurance

• Property and Liability

• 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
6. Types of Insurance

• 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
• Commercial lines: coverages for business firms, nonprofit organizations, and
government agencies
6. Types of 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
• Other Government Insurance Programs
• Found at both the federal and state level
7. Benefits of Insurance to Society

• Indemnification for Loss

• Reduction of Worry and Fear
• Source of Investment Funds
• Loss Prevention
• Enhancement of Credit
8. Costs of Insurance to Society

• The major social costs of insurance include:

• Cost of Doing Business
• 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
• Fraudulent Claims
• Inflated Claims
Problems
Methods by which insurers may minimize or avoid catastrophic losses include which of the
following?
I. The use of reinsurance
II. Concentrating coverage written in one geographic region
A) I only
B) II only
C) both I and II
D) neither I nor II
Problems
Gina would like to buy a house. She will pay 10 percent of the cost of the house as a down payment
and borrow the other 90 percent from a mortgage lender. The home will serve as collateral for the
loan. The lender will not make the loan to Gina unless the home is insured. Using insurance to secure
the collateral for a loan illustrates which of the following benefits of insurance to society?
A) enhancement of credit
B) reduction of fear and worry
C) source of investment funds
D) incentives for loss prevention
Problems
From the viewpoint of the insurer, all of the following are characteristics of an ideally insurable risk
EXCEPT
A) The loss must be accidental.
B) The loss should be catastrophic.
C) The premium must be economically feasible.
D) There must be a large number of exposure units.
Problems
Which of the following is a result of adverse selection?
A) The insurer's financial results will be substantially improved.
B) Persons most likely to have losses are also most likely to seek insurance at standard rates.
C) It is unnecessary for the insurance company to use underwriting.
D) Insurance can be written only by the federal government.
Problems
A group of farmers agreed that if any farmer suffered a property loss, the loss would be spread over
the entire group. In this way, each farmer is responsible for the average loss of the group rather than
the actual loss that each farmer sustained. Which characteristic of insurance is embodied in this
agreement?
A) pooling of losses
B) fortuitous losses
C) risk avoidance
D) indemnification
Problems
Risk pooling with 2 people
Each person has 5 percent chance of losing 5,000 dollars if a loss exposure happens.
Assume losses are uncorrelated. How much amount of risk can be reduced with pooling.
Without pooling
Probability of loss = 5% -> loss -5000
Prob of no loss = 1-5%= 95% -> loss =0
Expected loss = 0.05*(-5000)+0.95*0
Std =( (-5000+250)^2*0.05)+(0+250)^2*0.95)^1/2= 1.098
With pooling
Both losing = 0.05*0.05=0.0025 -> each has to pay = -5000
Neither losing 0.95*0.95 -> each has to pay = 0
1st losing 2nd not =0.05 * 0.95 = 0.475 -> each has to pay -2,500
2nd losing, 1st not = 0.95 * 0.05 =0.0475 -> each has to pay -2,500
Expected loss= 0.0025 *(-5000)+ 0.9025*0 + 0.0475*(-2,500)+ 0.0475*(-2.500)= -250
Std = [(-5,000+250)^2 * 0.0025+ (0+250)^2* 0.9025+(-2,500+250)^2*0.0475+(-2,500+250)^2* 0.0475]^1/2= 770
CONCLUSION: the expected loss still the same but the standard deviation reduced from 1,098 to 770 with pooling
• Ex: Insurer A’s coverage requires an annual premium of $90,000 with a $5,000
per-claim deductible. Insurer B’s coverage requires an annual premium of
$35,000 with a $10,000 per-claim deductible. 5 percent is the appropriate
interest (discount) rate. Risk manager predicts the following losses will occur
• Which coverage bid should she select, based on the number of expected
claims and the magnitude of these claims? For simplicity, assume that
premiums are paid at the start of the year, losses and deductibles are paid at
the end of the year, and 5 percent is the appropriate interest (discount) rate.
Ans
Coverage 1
Premium = -90,000 at the start of the year
Expected loss =12*(-5,000) + 6 *(-5,000) + 2*(-5,000) = 100,000 at the end of year
Þ Present value of expected loss = -100,000/ 1.05= 95,238
Total expense = -90,000- 95,238= -185,238
Coverage 2
Premium = - 35,000 at the start of the year
Expected loss = 12*( - 5,000) + 6*( - 10,000) + 2*( -10,000) = -140,000 at the end of the year
Þ Present value of expected loss = -140,000/1,05= -133,333
Total expense = -35,000-133,333= -168,333
=> Choose coverage 2 as an expense is lower
• Ex: Insurer A’s coverage requires an annual premium of $150,000 with a
$35,000 per-claim deductible. Insurer B’s coverage requires an annual
premium of $250,000 with a $15,000 per-claim deductible. The discount
rate is 8 percent.
• Which coverage bid should she select, based on the number of expected
claims and the magnitude of these claims?
Ans

Insurer A
CFO = -150,000
CF1 : 6 *(- 35,000) + 4 *( -20,000)= -140,000
Þ CF0 = -140,000/1,08= -129,630
CF2 = 4*( -10,000) + 2*(-20,000)+ 2*(-35,000)= -150,000 => -150,000/ 1,08^2= - 128,600
Total expense = -150,000 – 129,630 – 128,600 = -408,230
Ínsurer B
CF0 = -250,000
Cf1 = 6*( - 10,000)+ 4 * (-15,000)= -120,000 => CFO= -120,000/1,08= -111,111
CF2= 4 *( -10,000) + 2*( -20,000) + 2* (-15,000)= -100,000 => CF 0