Chapter 2

Insurance Mechanism

2-2
What do you think people would do
for fraudulent insurance claims?
Take out a piece of paper and write it
down. Lets see what people would
do to cheat insurance companies!
2-3
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

2-4
Definition of Insurance
Insurance is the pooling of ______
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
https://www.youtube.com/watch?v=M1yzSOxxAjk
2-5
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:






000 , 5 $ _________ __________ loss Expected

000 , 15 $
000 , 5 $ 000 , 50 $ 10 . 0 000 , 5 $ 0 90 . 0
2 2

deviation Standard
2-6
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?
How about the standard deviation?





As additional individuals are added to the pooling arrangement,
the standard deviation continues to decline while the expected
value of the loss remains unchanged

2-7
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

2-8
Characteristics of an Ideally
Insurable Risk
1.Large number of exposure units
to predict ________
2.Accidental and unintentional loss
to control __________
to assure _________
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?
2-9
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


5.Calculable chance of loss
to establish an ______________

2-10
Requirements of an Insurable Risk
6.Economically feasible premium
so people can afford to buy
Premium must be substantially less than the face
value of the policy

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

2-11
Does the risk of fire satisfy the above
requirement for insurable risk?
2-12
In class exercise :
Risk of Fire as an Insurable Risk
Take out a piece of paper and answer the questions
2-13
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?
2-14
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, adverse selection result in
higher-than-expected loss levels
Adverse selection can be controlled by:
careful underwriting
policy provisions

2-15
Insurance vs. Gambling
Are they the same?
2-16
Insurance vs. Gambling
Insurance

Insurance is a technique
for handing an already
existing pure risk

Insurance is socially
productive:
both parties have a
common interest in the
prevention of a loss
Gambling

2-17
Insurance vs. Hedging
Insurance

Risk is transferred by a
contract

Insurance involves the
transfer of insurable risks




Insurance can reduce the
objective risk of an insurer
through the Law of Large
Numbers

Hedging

Risk is transferred by a
contract

Hedging involves risks
that are typically
uninsurable
Remember the
requirement for insurable
risks?

Hedging does not result in
reduced risk
Why?
2-18
Types of Insurance
Private Insurance
Life and Health
Property and Liability
Government Insurance
Social Insurance
Other Government Insurance

2-19
Private Insurance
Life and Health
Life insurance pays _____ benefits to beneficiaries when
the insured dies
Health insurance covers _____ expenses because of
sickness or injury
Disability plans pay ______ benefits
Property and Liability
Property insurance indemnifies property owners against
the loss or damage of real or personal property
Liability insurance covers the insureds 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
2-20
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
Commercial lines
coverages for business firms, nonprofit organizations,
and government agencies

2-21
Exhibit 2.3 Property and Casualty Insurance
Coverages
2-22
Try to find more details yourselves
2-23
2-24
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 Comp
Other Government Insurance Programs
Found at both the federal and state level
Examples:
Federal flood insurance, state health insurance pools
2-25
Social Benefits of Insurance
Indemnification for Loss
Contributes to family and business stability
Reduction of Worry and Fear
Insureds are less worried about losses
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

2-26
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)

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
2-27
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)


2-28

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 to continue collecting
compensation?
2-29
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 90 days.
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.
e. A large group of homeowners agrees to pay for losses
to homes that burn during the year because of fire.

2-30
Appendix (Reference)

Basic Statistics and the Law of Large
Numbers
2-31
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
Distributions may be discrete or continuous
A probability distribution is characterized by:
A mean, or measure of central tendency
A variance, or measure of dispersion
2-32
Probability and Statistics
The mean or expected value is:

i i
P X EV or
Amount of
Loss (X
i
)
Probability
of Loss (P
i
)
X
i
P
i

$ 0 X 0.30 = $ 0
$360 X 0.50 = $180
$600 X 0.20 = $120
= $300
i i
P X
2-33
Probability and Statistics
The variance of a probability distribution is:

For the previous loss distribution,




The standard deviation =
Higher standard deviations, relative to the mean, are
associated with greater uncertainty of loss; therefore, the risk
is greater

2
2
EV X P
i i

800 , 46
800 , 1 800 , 1 000 , 27
) 300 600 ( 20 . 0
) 300 360 ( 50 . 0 ) 300 0 ( 30 . 0
2
2 2 2

33 . 216
2

2-34
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
2-35
Exhibit A2.1 Sampling Distribution
Versus Sample Size
2-36
Exhibit A2.2 Standard Error of the Sampling
Distribution Versus Sample Size
2-37
Law of Large Numbers
When an insurer increases the size of the
sample of insureds:
Underwriting risk _______, 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!

2-38
Question 1
Compare the risks of
Fire with
War
in terms of how well they meet the requirements
of an ideally insurable risk
No model answers given
2-39
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?
2-40
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
2-41
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