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ANSWERS TO REVIEW QUESTIONS

1. The term insurance can be defined in both financial and legal terms. How do
these definitions differ?
The financial definition focuses on an arrangement that redistributes the cost of
unexpected losses. That is, the collection of a small premium payment from all exposed
and distributed to the smaller number of insureds suffering loss. The legal definition
focuses on a contractual arrangement whereby one party agrees to compensate another
party for specific losses. The financial definition provides for the funding of the losses
whereas the legal definition provides for the parameters to the agreement the legally
enforceable contract that spells out the legal rights, duties and obligations of all the
parties to the contract.
2. Describe the difference between direct and indirect losses. Give examples of each.
Direct losses are the immediate first result of an insured peril. Specifically, this is the
actual physical loss or destruction of property. Indirect losses are a result of a direct loss.
If there are losses arising out of the loss of use of an object, it is an indirect loss. An
example would be the destruction of an assembly robot in a car factory. The immediate
loss or destruction of the robot would be the direct loss. The resulting production line
shutdown, idled workers, loss of sales, or increased cost of continuing operations at the
same level of production is the indirect loss.
3. What is the difference between a hazard and a peril? Give examples of each.
A peril is the cause of a loss, whereas a hazard increases the frequency or severity of
losses. A fire is a peril. Improper storage of gasoline is a hazard. Poison is a peril. Bad
directions on a poison container are a hazard. Theft is a peril. An insufficient number of
bank guards create a hazard.
4. Why is it the chance of loss, and not the loss itself, that creates the need for
insurance?
The mere fact that we know houses burn down or losses occur does not create the need
for insurance. If losses were a certainty or we knew that they would occur and when, we
could financially prepare for the loss. However, the problem is that we do not know when
or if losses will occur which introduces much uncertainty. This uncertainty can be shifted
to an insurance company for a price. This transfer then produces certainty for the insured.
The mere existence of a possible loss has not changed, but the uncertainty about the
financial results has been replaced with certainty (by the contract).
5. What are the two definitions of risk discussed in this chapter? Are they really
different from one another?
The two definitions are: 1) the variability in possible outcomes of an event based on
chance; and, 2) uncertainty associated with an exposure to loss. These two definitions are
similar but they put emphasis on different aspects of the word "risk." The first definition
focuses attention on the accuracy of predictability. It is a useful definition since there are
many statistical tools used to measure risk. The second definition focuses attention on the
problems caused by exposure to loss, as distinguished from the problems of loss itself.
Anxiety and loss prevention expenses are costs of the risk (uncertainty) rather than cost
of the losses. We have risk (uncertainty) only before a loss occurs. This risk (uncertainty)
can be transferred to an insurer (a loss cannot be transferred) before a loss occurs.
Because the insurer can accurately predict losses based on the law of large numbers,
insurance reduces risk (uncertainty).

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6. How does insurance redistribute the costs of losses?

By use of the insurance mechanism, the total cost of the gross loss amount is borne by all
those insured. Each insured pays a portion of the loss. This loss ordinarily would be
borne by the unfortunate victim without the sharing mechanism. Thus, the operation of an
insurance system transfers the financial loss from the few unfortunate victims who have
losses, to all who have purchased insurance (including the unfortunate victims).
7. What is the difference between insurable losses and depreciation expense?
To be an "insurable loss" (from the insurers point of view) there must be an unplanned,
undesired reduction in value. Additionally, it should be of economic importance (from the
viewpoint of the insured). Loss of time, loss of memory, loss of a chess game and so
forth, are examples of losses that generally are not considered "losses" since they have
little, if any, measurable and generally recognizable economic value. Depreciation and
depletion expenses, since they are planned, are not considered insurable losses.
Depreciation and depletion expenses are totally expected and planned for. There is no
uncertainty about the expense.
8. How does moral hazard differ from the morale hazard? Give some examples of
each.
Moral hazard means that there exists intentional dishonesty and the insured tries to
defraud the insurer by deliberately causing losses or by exaggerating claims. Morale
hazard means the insured has an attitude of indifference to loss since he has purchased
insurance. A shop owner who hires an arsonist to burn down his store to collect the
insurance proceeds is an example of a moral hazard. A driver who counts on her
insurance to pay for damages caused by others rather than practicing