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RISK MANAGEMENT FOR ENTERPRISES AND INDIVIDUALS Chapter 6 The Insurance Solution and Institutions
1 - 2 © 2010 Flat World Knowledge, Inc. 6 - 2 © 2010 Flat World Knowledge, Inc. Learning Objectives In this section you will learn: The law of large numbers as the essence of insurance. How insurance is defined. Why so many risks cannot be insured by private insurance companies. The definition of insurable risks by private insurers. Why catastrophes such as floods are not insurable risks by private insurers. The types of insurance. The types of insurance company corporate structures. Governmental insurance organizations.
1 - 3 © 2010 Flat World Knowledge, Inc. 6 - 3 © 2010 Flat World Knowledge, Inc. Nature of Insurance Insurance: A social device in which a group of individuals transfer risk to another party such that the third party combines or pools all the risk exposures together. Insureds: Individuals who transfer risk to a third- party. Insurer: The third party that accepts the risks transferred by insureds. Law of large numbers: As a sample of observations is increased in size, the relative variation about the mean declines.
1 - 4 © 2010 Flat World Knowledge, Inc. 6 - 4 © 2010 Flat World Knowledge, Inc. Nature of Insurance Risk Transfer The insurer assumes risk by promising to pay whatever loss may occur as long as it fits the description given in the policy and is not larger than the amount of insurance sold. The insurance contract stipulates what types of losses will be paid by the insurer. Most insurance contracts are expressed in terms of money, although some compensate insureds by providing a service.
1 - 5 © 2010 Flat World Knowledge, Inc. 6 - 5 © 2010 Flat World Knowledge, Inc. Nature of Insurance The amount of risk that is transferred is usually the key to determining whether a certain accounting transaction is considered insurance or not. Finite risk programs are financial methods that can be construed as financing risk assumptions.
1 - 6 © 2010 Flat World Knowledge, Inc. 6 - 6 © 2010 Flat World Knowledge, Inc. Nature of Insurance Risk Pooling (Loss Sharing) Loss sharing is accomplished through premiums collected by the insurer from all insureds. Pooling can be done by any group who wishes to share in each other’s losses. It allows a more accurate prediction of future losses because there are more risk exposures. In order for the law of large numbers to work, the pooled exposures must have approximately the same probability of loss.
1 - 7 © 2010 Flat World Knowledge, Inc. 6 - 7 © 2010 Flat World Knowledge, Inc. Nature of Insurance Insurers need to discriminate, or classify exposures according to expected loss; the rates reflect each insured’s expected loss. The phenomenon of selecting an insurer that charges lower rates for a specific risk exposure is known as adverse selection. Some insurance policy provisions are designed to reduce adverse selection.
1 - 8 © 2010 Flat World Knowledge, Inc. 6 - 8 © 2010 Flat World Knowledge, Inc. Ideal Requisites for Insurability A risk perfectly suited for insurance would meet the following requirements: The number of similar exposure units is large. A major requirement for insurability is mass. The loss exposures to be insured and those observed for calculating the probability distributions must have similarities. The losses that occur are accidental. Losses are definite in time, place, and amount; the requirement of definiteness is essential to accumulate data for future predictions.
1 - 9 © 2010 Flat World Knowledge, Inc. 6 - 9 © 2010 Flat World Knowledge, Inc. Ideal Requisites for Insurability Small possibility of catastrophe. Catastrophic loss is loss that could imperil the insurer’s solvency; may occur in two circumstances. All or many units of the group are exposed to the same loss-causing event; exposure units are susceptible to dependent loss when loss to one exposure unit affects the probability of loss to another. A single large value may be exposed to loss. The cost of coverage is economically feasible. For insurance to be economically feasible for an insured, the size of the possible loss must be significant to the insured, and the cost of insurance must be small compared to the potential loss.
1 - 10 © 2010 Flat World Knowledge, Inc. 6 - 10 © 2010 Flat World Knowledge, Inc. Table 6.1- Examples of Insurable and Uninsurable Risks
1 - 11 © 2010 Flat World Knowledge, Inc. 6 - 11 © 2010 Flat World Knowledge, Inc. Types of Insurance and Insurers Personal, Group, or Commercial Insurance Personal insurance: Insurance that is purchased by individuals and families for their risk needs; such insurance includes life, health, disability, auto, homeowner, and long-term care. Group insurance: Insurance provided by the employer for the benefit of employees. Commercial insurance: Property/casualty insurance for businesses and other organizations.
1 - 12 © 2010 Flat World Knowledge, Inc. 6 - 12 © 2010 Flat World Knowledge, Inc. Types of Insurance and Insurers Life/Health or Property/Casualty Insurance Life/health insurance: Insurance that covers exposures to the perils of death, medical expenses, disability, and old age. Property/casualty insurance: Insurance that covers property exposures such as direct and indirect losses of property caused by perils such as fire, windstorm, and theft.
1 - 13 © 2010 Flat World Knowledge, Inc. 6 - 13 © 2010 Flat World Knowledge, Inc. Types of Insurance and Insurers Private or Government Insurance Voluntary or Involuntary Insurance Insurers’ Corporate Structure Stock Insurers: Insurers created for the purpose of making a profit and maximizing the value of the organization for the benefit of the owners. Mutual Insurers: Insurers owned and controlled, in theory if not in practice, by their policyowners. Profits are shared with owners as policyowners’ dividends.
1 - 14 © 2010 Flat World Knowledge, Inc. 6 - 14 © 2010 Flat World Knowledge, Inc. Types of Insurance and Insurers Captives, Risk Retention Groups, and Alternative Markets Captive insurance company A company that provides insurance coverage to its parent company and other affiliated organizations. The captive is controlled by its policyholder-parent; forming a captive insurer is an expensive undertaking. Risk retention group: A group that provides risk management and retention to a few players in the same industry who are too small to act on their own.
1 - 15 © 2010 Flat World Knowledge, Inc. 6 - 15 © 2010 Flat World Knowledge, Inc. Types of Insurance and Insurers Alternative markets are the markets of all self- insurance programs. Governmental risk pools: Pools formed for governmental entities to provide group self-insurance coverage.
1 - 16 © 2010 Flat World Knowledge, Inc. 6 - 16 © 2010 Flat World Knowledge, Inc. Types of Insurance and Insurers Banks and Insurance Government Insuring Organizations State Insuring Organizations Administer unemployment compensation insurance programs. Insure worker’s compensation benefits. Provide temporary nonoccupational disability insurance, title insurance, or medical malpractice insurance. Assure the availability of property insurance, and indirect loss insurance in some states, to property owners of coastal areas exposed to hurricanes and other windstorms.
1 - 17 © 2010 Flat World Knowledge, Inc. 6 - 17 © 2010 Flat World Knowledge, Inc. Types of Insurance and Insurers Federal Insuring Organizations The Social Security Administration The Federal Deposit Insurance Corporation The Securities Investor Protection Corporation The Federal Crop Insurance Corporation The Federal Crime Insurance Program Fair Access to Insurance Requirements (FAIR) plans The National Flood Insurance Program The Veterans Administration The Pension Benefit Guaranty Corp The Overseas Private Investment Corporation (OPIC)
1 - 18 © 2010 Flat World Knowledge, Inc. 6 - 18 © 2010 Flat World Knowledge, Inc. Summary The essence of insurance is risk transfer and risk pooling. A risk perfectly suited for insurance must meet specific requirements. Many types of insurance policies are available to families and organizations that do not wish to retain their own risks.
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