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Chapter 2 INSURABLE LOSS EXPOSURES. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. INSURABLE LOSS EXPOSURES Which losses.

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Presentation on theme: "Chapter 2 INSURABLE LOSS EXPOSURES. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. INSURABLE LOSS EXPOSURES Which losses."— Presentation transcript:

1 Chapter 2 INSURABLE LOSS EXPOSURES

2 McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. INSURABLE LOSS EXPOSURES Which losses are insurable? - Gambling and stock market losses, - Coverage for losses due to pollution is unavailable. - Limited amounts of Insurance against Floods, earthquakes, draughts can be purchased. (Speculative Risk vs. Pure Risk) - Private insurance do not offer coverage for unemployment - Long-term care insurance for older people is currently evolving coverage. Problem: The private insurance must develop coverage constrained by the standard of ideally insurable exposures.

3 McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Gambling and Speculative Risk Gambling and Insurance are opposites. Gambling creates risk where nonexisted. Insurance reduce risk through pooling and operation of law of large numbers. “There is no chance like either you win and get the money or lose and get the insurance”

4 McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. The insurances are prepared and sold to those that have legal interest. The insureds should not be indifferent to losses. (This may cause rises in the premiums as a result of losses rising) Insured events should represent a loss to them personally. This doctrine is known as insurable interest. Speculative losses can not be insured as this would make the owners in a position of being indifferent to operating results

5 McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. IDEALLY INSURABLE LOSS EXPOSURES 1. A large group of similar items exposed to the same peril. -An insurance pool needs to have substantial number of individual units to obtain predictive accuracy (statistical benefit of law of large numbers) - The items in the insurance pool, or the exposure units, need to be similar to enable a fair premium calculation. (Barns of farmers, brick homes and wooden homes) - The perils faced by the exposures in the insurance pool should be the identical perils for the same reasons requiring the exposure to be similar to one another. ( house by a gas station faces additional peril for fire)

6 2. Losses Must Be Accidental or Beyond the Insured’s Control: - Nonaccidential, or expected, reductions of economic value such as depreciation or wear and tear are not insurable. -An insurance system will not pay for an insured’s deliberately caused losses. 3. Definite losses capable of causing economic hardship. - Losses must be definate: member’s loss must be verifiable ( insurance for fire not for mental illness) - measurable: losses insured against should be measurable: - the loss of a loved pet, - loss of race horses or valuable livestock represent an insurable exposure as damaged sustained can be measured in economic terms. - severity: Potential damage should cause economic hardship. For inexpensive items, insurance are not preferred to be purchased. Insurance can be purchased only when losses are large and uncertain. “ Large-Loss Principle”

7 McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. 4. Extremely low probability of a catastrophic loss to the insurance pool. - A loss extraordinary large relative to the amounts of property in an insurance pool. If it was insured, it will cause the insolvency of even well-run insurers. - Catastrophic losses from natural disasters have two general characteristics: 1. Limited in geographic impact: 2. Not accurately predictable - Tornados occur regularly ( in USA), predictable with a reasonable accuracy - Earthquakes and volcanic eruptions do not occur regularly

8 McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. When Only the People Most Exposed to Loss Want Coverage By use of law of large numbers, the pool is able to predict losses accurately and charge a premium appropriate to the risk. Attitude toward risk is to pay relatively small premium to uncertain losses. (High premiums will make people prefer to quit having insurance) In case of highly costly losses government either guarantees or subsidizes to insurers against excessive losses to keep premiums attractive and prevent the exodus of the better situated risk

9 McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. RISK CLASSIFICATION - Applicants for insurance have been put in classes according to the probability of loss - Risk Class: - Automobile Ins: Urban, Male, under 24 and no accidents on his driving record. - Life Insurance: Female, 45 yrs old, average height and weight. - Pools should be formed by the insureds that carry same /similar characteristics. (Prob of Loss X $ value exposed to loss) + expenses

10 McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. RISK CLASSIFICATION (Cont.) SUBSIDIZATION occurs if each insured does not pay the mathematically fare price for insurance. - if the insured is paying more than the mathematically fair price, the insured provides the subsidy. - If the insured is paying less than the fair price, the insured receives a subsidy. (ex: life and automobile ins) ADVERSE SELECTION occurs when one party to a transaction has more relevant information than another party to the transaction, the party with the superior information can take advantage of the situation. e.g. Purchasing a fire insurance after being threatened by an arsonist.

11 McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. PRINCIPLES OF RISK CLASSIFICATION -Insurers use risk classification to minimize subsidization and adverse selection. (age/gender/place of residency) Rate Classification Factors on four points: Separation and Class Homogeneity Male, 20 should be in a different pool from a male, 40 Reliability information about the factor should be easily obtained and should not be subject to manipulation by the insured, otherwise independent verification from applicants such as health certificate, etc. Incentive Value Reward good insureds (lower premium for those with below-average loss potential) Social Acceptability Most difficult underwriting criterion to handle! Definition of “social acceptability” What do we do when mathematically fair insurance exchange conflicts with a socially desired outcome?

12 McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Important Social Issues 1. AIDS: The cost of aids is very high. Subsidization issue inevitably occurs. It can be the cause of collapse of insurance systems but there are arguments. Debate on the case of AIDS: a) Accepting the claims due to AIDS, subsidizing some insured and spread the cost of AIDS throughout the country. b) The unfairness of the propose underwriting results. High price for society to pay to solve this problem.

13 McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Important Social Issues (Cont.) Automobile Insurance: - More accidents occur in the urban areas than in the rural areas. - Medical and repair and medical costs are also higher in the city. - City residents transfer more exposure to loss to the insurance pool. -Young males are responsible for more accident as well as unmarried drivers compared to married ones. - Thus, insurance premiums for young, unmarried, inner city, male drivers are more expensive. - The basis of conflict between the goals of separation and homogeneity, social acceptability and the incentive value. (Penalizing ppl. falling into that particular group although driving carefully. High premiums also discourage people to get insurance which is hardly socially acceptable Pension Benefits: The issue of whether and Individual’s gender is a legal risk classification. Women live longer than men (as a group), counterargument is that only 15% of them. So is it fair to penalize all women for the longevity of this minority of women? If men and women each receive identical monthly pension checks based on equal pension contributions. The group of women will receive more money than the man. How about if man and the woman dies on the same month receiving same # of pensions after retirement? Man will have received more pension benefits than woman, if the benefits were based on gender

14 McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. BRANCHES OF INSURANCE Various categories where insurance transactions traditionally have been made: GOVERNMENT SOCIAL SECURITY UNEMPLOYMENT

15 McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. PRIVATE LIFENONLIFE Life Annuity Medical Expense And Disability Fire Marine Bonding Casualty Automobile Liability Crime Worker’s Compensation

16 McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. BRANCHES OF INSURANCE (Cont.) Fire Insurance: Generally covers stationary property. Perils as windstorm, riot and vandalism Business Income: Indirect losses related with fire and other perils Marine Insurance: Covers Mobile property, ocean marine covers ships and their cargos. Inland Marine Ins: Covers property moving on planes, trains and trucks. Bonding: A special type where one party (surety) guarantees the performance (surety bond) or the honesty (fidelity bond) of a second party to a third party. If second party is poor and dishonest than loss to the third party must be paid by the surety. Life Insurance: It is based on the human life contingencies. If the covered peril is death, the contract is called life insurance. If the peril is survival, the contract is called annuity. The annuity guaranties that the insured will not have to survive without money. If the covered peril is sickness or disability, the coverage is called medical expense insurance or disability insurance.

17 McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. New Coverages Weather-related insurance: Payments for crop-hail damage, rained-out concerts, or too much or too little snow. Change-of-law Insurance: Payments are made if new regulations increase construction costs after contracts are signed. Municipal Bond Insurance: This coverage guarantees principle and interest payments on municipal securities. Motion Picture Completion Bonds: Payment made if the film is not completed on time. Death of a star or other unforeseen events cause the insurer to pay. Boiler and Machinery Insurance: Property Ins contracts specifically exclude damage caused by exploding steam boilers. Some insurance companies sell this type of coverage. The insured in addition to the indemnity agreement, have to pay for the regular inspection.


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