1. Definition and Characteristics of Insurance
BUS 200
Introduction to Risk Management and Insurance
Jin Park

2. Definition of Insurance
A social device in which a group of individuals (called “insureds”) transfer risk to another party (called an “insurer”) in order to combine loss experience, which permits statistical prediction of losses and provides for payment of losses from funds contributed (premiums) by all members who transferred risk.

3. Definition of Insurance
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.

4. Definition of Insurance
A formal social device for reducing risk by transferring the risks of several individual entities to an insurer. The insurer agrees, for a consideration, to assume, to a specified extent, the losses suffered by the insured.

5. Definition of Insurance
A system under which individuals, businesses, and other organizations or entities, in exchange for payment of a sum of money (a premium), are guaranteed compensation for losses resulting from certain perils under specified conditions.

6. Characteristics of Insurance
Risk Transfer
Loss Sharing (pooling)
Discrimination via underwriting

7. Characteristics of Insurance
Risk Transfer
An insurer, a professional risk-bearer, assumes the financial aspects of risks transferred to it by insureds.
In return, the insurer receives a premium.
Insurer is typically in a stronger financial condition to pay the loss.

8. Characteristics of Insurance
Loss sharing (pooling)
Loss sharing is accomplished through premiums; therefore, group losses are shared by the group’s members. This is the essence of pooling.
Pooling arrangement changes the probability distribution of accident costs facing each person.

9. Characteristics of Insurance
Loss sharing (pooling)
Assume 1,000 individuals each have homes worth $100,000
On average, 1 home burns per year
Without Insurance: max loss = $100,000
Suppose all agree to share the loss
 average loss = 100,000 / 1,000 = $100
Trading 100 ‘loss’ for sure for chance of losing 100,000

10. Characteristics of Insurance
No pooling between two persons
Person A Person B
Outcomes
Prob.
$ 0
0.80
$ 2,500
0.20
500
Outcomes
Prob.
$ 0
0.80
$ 2,500
0.20
500
Expected Loss = $500
Std. Dev. = $1,000
Expected Loss = $500
Std. Dev. = $1,000

11. Characteristics of Insurance
Two-person pooling arrangement
Scenarios
Total cost
A Loss
B Loss
Prob.
Neither loss $0
.64
A loss – B no loss
$2,500
$1,250
.16
200
A no loss – B loss
Both losses
$5,000
.04
100
Each individual’s expected loss amount = $500
Std. Dev. = $ compare this with $1,000

12. Characteristics of Insurance
Three-person pooling arrangement
Scenarios
Total cost
Participant’s share
Prob.
No loss $0 $
.512
$ 0
1 loss – 2 no loss
$2,500 $
.384
$320
2 loss – 1 no loss
$1,666.67
.096
$160
Three losses
$7,500
$2,500.00
.008
$ 20
1.00
$500
Each individual’s expected loss amount = $500
Std. Dev. = $ compare with $1,000 or $707

13. Discrimination via underwriting
The process of selecting risks (insurance applicants) and classifying them according to their degrees of insurability so that the appropriate rates may be assigned. The process also includes rejection of those risks that do not qualify.
Note: insurance profits may come from both underwriting and investment.

14. Discrimination via underwriting
Life/Health Insurance
Type of policies
Face amount
Insured’s age, gender
Tobacco use
Residence
Health status
Family diagnosis
Driving records
… and more
Property/Liability
Type of policies
Limit of insurance
Nature of business
Location
Past claim history
Total revenue
Type of property
Construction type
Credit history
… and more

15. Discrimination via underwriting
Underwriting Decisions
Accept the application
Accept the application subject to certain restrictions or modifications
Reject the application

16. Discrimination via underwriting
Young person
Expected Claim ($)
= 0 x (.95) + (10,000) x (.95)
= $ 500
Old person
Expected Claim ($)
= 0 x (.90) + (10,000) x (.10)
= $ 1,000
Outcome
Payment
Prob.
No Claim
$ 0
.95
Claim
$10,000
.05
Outcome
Payment
Prob.
No Claim
$ 0
.90
Claim
$10,000
.10

17. Discrimination via underwriting
If they are put into the same pool and share the losses, then total expected claim for the pool = $0x(.855) + $10,000x(.095) + $10,000x(.045) + $20,000x(.005) = $1,500. Thus, the share for each participant in the pool is $750.
Scenarios
Total cost
Prob.
Neither claims $0
.855
$ 0
Only Young claims
$10,000
.095
$950
Only Old claims
.045
$450
Both claim
$20,000
.005
$100

18. Discrimination via underwriting
If you were the young person, paying $750, what would you do?
???___________
If you were the old person, paying $750, what would you do?
Then, what will happen to the insurer that sets the pure premium at $750?

19. Discrimination via underwriting
Adverse Selection
The phenomenon of selecting an insurer that charges lower rates for a specific risk exposures.
The tendency of persons with a higher-than-average chance of loss to seek insurance at standard (average) rate, which if not controlled by underwriting, results in higher-than-expected loss levels.
To mitigate the adverse selection
Detailed application
Medical examination
On-Site investigation
Suicide clause
Preexisting conditions provision

20. Reading Assignment Insurers back marketer’s contest awards.
Loss sharing ???
WTC Insurance fight
Indemnification ???