ASC172 – PRINCIPLES OF RISK

MANAGEMENT AND INSURANCE

Chapter 1 Part B:
Risk and Insurance
Week 2

Nur Haidar Binti Hanafi

Siti Nurasyikin Binti Shamsuddin
 TABLE OF CONTENTS

Learning Objectives
1.4 Definition of Insurance
1.5 Basic characteristics of insurance
1.6 Requirement of an insurable risk
Conclusions
Quiz
References
 LEARNING OBJECTIVES
At the end of this lesson, students
should be able to:
• Define the meaning of insurance
• Describe basic characteristics of
insurance
• Explain requirements of an
insurable risk
 1.4 Definition of Insurance
• Insurance: pooling of fortuitous losses by
transfer of such risks to insurers
• Insurer agree to indemnify insureds for such
losses, to provide other pecuniary benefits
on their occurrence
 1.5 Basic Characteristics of
Insurance
a) Pooling of losses
Spreading losses incurred by the few
over the entire group
Risk reduction is based on the law of
large numbers
Law of large numbersthe greater the
number of exposures, the more closely
will the actual results approach the
probable results that are expected
from an infinite number of exposures
 Cont. Basic Characteristics of
Insurance
• Example of pooling:
• 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
Expected
of theloss
loss0for $0  0.10
.90 *each is: $5,000
* $50,000
owner
Standard deviation  0.900  $5,000   0.10$50,000  $5,000 
2 2

 $15,000
 Cont. 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:
Expected loss  0.81* $0  0.09 * $25,000  0.09 * $25,000  0.01* $50,000
 $5,000

Standard deviation  0.810  $5,000   (2)(0.09)$25,000  $5,000   0.01($50,000  $5,000) 2

2 2

 $10,607

• The standard deviation continues to decline while

the expected value of the loss remains
unchanged, as additional individuals are added to
the pool
Cont. Basic Characteristics of Insurance

b) Payment of fortuitous losses

• A fortuitous loss is one that is
unforeseen, unexpected, and occur as
a result of chance
c) Risk transfer
• A pure risk is transferred from the
insured to the insurer, who typically is
in a stronger financial position
d) Indemnification
• The insured is restored to his or her
approximate financial position prior to
the occurrence of the loss
 Characteristics of an Ideally
Insurable Risk
a) Large number of exposure units
To predict average loss based on the
law of large numbers
Enable insurer to predict the losses if
homogeneous
b) Accidental and unintentional loss
To assure random occurrence of
events
c) Determinable and measurable loss
To determine how much should be
paid
 Characteristics of an Ideally
Insurable Risk
d) No catastrophic loss
To allow the pooling technique to work
Exposures to catastrophic loss can be
managed by using reinsurance, dispersing
coverage over a large geographical area,
or using financial instruments, such as
catastrophe bonds
e) Calculable chance of loss
To establish a premium that is sufficient
to pay all claims and expenses and yields
a profit during the policy period
Characteristics of an Ideally
Insurable Risk
f) Economically feasible premium
So people can afford to purchase the
policy
For insurance to be an attractive
purchase, the premiums paid must be
substantially less than the face value, or
amount, 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
Adverse Selection and Insurance
• Adverse selection: tendency of
persons with a higher-than-average
chance of loss to seek insurance at
standard rates
If not controlled by underwriting,
adverse selection results in higher-
than-expected loss levels
Adverse selection can be controlled by:
Careful underwriting (selection and
classification of applicants for insurance)
Policy provisions
Eg: Suicide clause in life insurance
 Insurance vs. Gambling
Insurance Gambling

• Insurance is a • Gambling creates a

technique for new speculative
handing an already risk
existing pure risk
• Insurance is always • Gambling is not
socially productive: socially productive
Both parties have The winner’s
a common interest gain comes at
in the prevention the expense of
of a loss the loser
 Types of Insurance
Governme
Private
nt
Insurance
Insurance
 Private Insurance
• Life and health
• Life insurance pays death benefits to
beneficiaries when the insured dies
• Health insurance covers medical
expenses because of sickness or injury
• Disability plans pay income benefits
 Cont. Private Insurance
• Property and liability
Property insurance  indemnifies
property owners against the loss or
damage of real or personal property
Liability insurance  covers the
insured’s legal liability arising out of
property damage or bodily injury to
others
Casualty insurance  covers whatever
is not covered by fire, marine, and life
insurance
 Cont. Private Insurance
• Two major categories of Private
insurance coverages:
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
 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
Eg: social security, unemployment,
workers comp
• Other government insurance programs
Found at both the federal and state
level
Eg: federal flood insurance, state
 Benefits of Insurance to society

• Indemnification for loss

• Reduction of worry and fear
• Source of investment funds
• Loss prevention
• Enhancement of credit
 Costs of Insurance to Society

• Cost of doing business

• Fraudulent claims
• Inflated claims
 CONCLUSIONS

Now, students are able to:

• Define what is insurance
• Explain basic characteristics of insurance
• Explain the requirement of an insurable
risk
 QUIZ
1) All of the following are characteristics of an ideally
insurable risk, EXCEPT
A) The chance of loss must be calculable.
B) The loss must be measurable.
C) The loss must be indeterminable.
D) The loss must be unintentional.
Answer: C

2) Why is a large number of exposure units are required

before a pure risk is insurable?
A) It minimizes moral hazard.
B) It prevents the insurer from losing money.
C) It eliminates intentional losses.
D) It enables the insurer to predict losses more
accurately.
Answer: D
 QUIZ
3) All of the following are characteristics of
insurance EXCEPT
A) risk avoidance.
B) indemnification.
C) payment of fortuitous losses.
D) pooling of losses.
Answer: A
4) Which of the following is implied by the pooling
of losses?
A) sharing of losses by an entire group
B) increase of objective risk
C) inability to predict losses with any
degree of accuracy D) substitution of actual
loss for average loss
 QUIZ

3) What happens as the number of

exposure units increases, according to the
law of large numbers?
A) Nondiversifiable risk will decrease.
B) Objective risk will increase.
C) Actual results will increasingly
differ from probable results.
D) Actual results will more closely
approach probable results.
Answer: D
REFERENCE
• Redja, G.E. (2008). Principles of Risk Management
and Insurance, tenth edition, Addison-Aesley
• Redja, G.E. (2014). Principles of Risk Management
and Insurance, twelfth edition, Pearson Education
Limited