FINN 372

Actuarial Sciences &

Insurance
Fall Semester, 2024
 Instructor Introduction
 FSA (1982) & FPSA
 7 years Canada
 Proprietor of Nauman Associates since
1985
 Ambassador to Pakistan for SOA for 5
years
 PSOA Council approx. 20 years
 PSOA President – 5 years
 Course Background
 Disconnect of Insurance Industry and
Universities
 Balance between business exposure and
technicality
 Students finding job opportunities
 Increase of demand in actuarial sciences
and insurance sectors
 Curriculum of Course
 Insurance 40% (basics, Life Insurance
products, Takaful & financial
statements)
 Actuarial 50% (basics catch up,
evaluation of Science
assurance & annuities,
premium calculation & reserves
 Code of 10% (Codes & Case Study)
Conduct
 Emphasis on life insurance
 Thrust of Course
 Emphasis on concepts
 Lesser emphasis on theory
 No proofs
 No complex extensions
 Mathematical none the same (will take
mathematical turn after a few lectures)
 Stress on learning
 Testing Criteria
 CP – All lectures - 5%
 Project (tentatively - 15%
between lectures 11 & 18)
 Quizzes (3 out of 4) - 30%
 Midterm - 20%
 Final - 30%
Total = 100%
 Attendance Rules
 Uniform policy by SDSB
 (4 excused absences, 1 percentage point
deduction for each absence between 5-7
and 8 or above is an automatic “D”)
 Be Punctual & Regular
 Tests
 Quizzes every alternate week
 1st Quiz in lecture 5 (tentatively)
 Mid in lecture 14
 Cheat sheets allowed (after first quiz)
 Combination of MCQ’s, True/False &
Subjective
 Samples upload on LMS before quizzes,
mid and final
 Increasing weightage of subjective
portion with time.
 Rules for lectures
 Punctuality
 No cell phones
 No lap tops
 Name tags
 Questions any time
 Presentations upload (in combination
with coursepack)
 Instructor Availability
 4 TA’s Ramsha, Talha, Zartasha and
Maria)
 Instructor generally available
 Prior appointment/contact
Broad Objectives / Target
Outcomes
 Learning (particularly from each other)
 Enhance critical thinking
 Relate theoretical knowledge (particularly
Maths) to everyday life
 Keep things simple
 Basics of Insurance
Concepts
 Chapters 1 & 2 of Coursepack
 What is risk?
 Chance of an adverse event having negative
financial impact
 Uncertainty/unpredictability/random/chance
based
 Amount of Risk is the extent of variation in
possible outcomes of an event based on
chance (lesser confidence in prediction)
 Greater the variation around average (or
expected chance & severity of loss), greater
the risk
 Risk is the uncertainty associated with chance
based financial loss
 Examples of Sources of risk
Natural : flood, drought, earthquake
Health : illness, epidemic, pandemic
Life-cycle : Dying early, living too long
Social : crime, war
Economic : unemployment, financial
crisis, inflation, political
instability, poor governance
Political : riot, coup, war
Environment : air quality,
unexpected weather
patterns, nuclear disaster
Cyber : Disruption, IT dependence
 Consequences of risk
 Risks have various consequences which could
affect the person and an entity members
 Thus, risk management is important
 E.g. possible consequences of accidents include
financial losses, temporary or permanent
disability, death
 Loss from insurance perspective is chance
based (random) reduction in economic value of
an asset (person or object)
 Losses that are bound to happen are generally
considered uninsurable
 Different from depreciation, routine expenses
(bound to happen)
 HOW DO WE HANDLE RISK
1. Avoidance or reduction : Choosing not to (or
carefully) participate in an activity because of
the risk involved e.g. not getting a driver’s
license, driving carefully;
2. Retention : Meeting as regular expense or
saving money in case of future losses, e.g.
putting money regularly in a savings account in
case of a car accident;
3. Transfer : Passing the risk on to an insurance
company, e.g. paying a monthly fee for an
insurance policy and expecting the insurance
company to protect your assets.
 Can be a combination of 1-3
 Can vary significantly between individual
Typical Risk Management Strategies
(assuming average risk appetite)

Chance of Loss
Low High
Amount of Low Retain & meet loss Retain and set
Loss when happens money aside
High Insure Avoid / Reduce

Note : Risk Management strategy will vary

greatly from person to person depending on
his risk attitude and appetite.
 What is Insurance?
Insurance is a legal contract that transfers
adverse financial consequences risk from a
policyholder to an insurance provider, in
exchange for a consideration (premium)
OR
Insurance is financial arrangement which
redistributes cost of unexpected losses
 How Insurance Works
Premiums

Insurance Company

Claims

Insurance works through “pooling “

Relatively small individual outgo
against significant loss
 Pooling in Insurance
 Difficult to forecast loss and its amount
for 1 individual or asset
 Confidence in forecast increases as

similar risks are combined (pooled)

Example :
 Difficult to predict loss in 1 year for 1 car;

but prediction becomes better as number

increases e.g. 10, 100, 1,000, 10,000 etc.
 Law of large numbers

 Insurance Companies pool similar risks

and have higher degree of confidence

about losses in the pool
 Pooling in Insurance
 Charge average loss premium to each
individual and pay claims where loss
actually incurs
 Insurance Companies redistribute losses
over greater pool
 Pure vs Speculative Risks
 Pure risk only results in loss
 Speculative risk has both up and down
side (investments)
 Extreme of speculative risk is gambling
 Traditionally only “pure risk insurable”
 Ideal Conditions for Pure Risks to be
Insurable
 Loss should be
 Definite
 Measurable (amount & timing)
 Relatively low chance of happening
 Sufficient severity to cause financial hardship to
insured
 Outside the control of insured
 Part of large group of similar risks
 Does not give rise to significant irresponsible or
indifferent behavior
 Preferably not catastrophic in nature (war) for the
insurance industry.
 Perils & Hazards
 Peril is defined as cause of loss (death, sickness, fire,
earthquake, accident etc.)
 Hazard is a condition or situation which increases
chance OR severity of loss/peril
 Hazards can be divided between physical, moral and
morale hazard categories
 Physical hazard is a physical phenomenon that
increases chance or severity of loss (poorly
maintained road, traffic lights malfunction etc.)
 Moral/Morale hazard result from dishonesty or
inappropriate behaviour of the insured
 Moral hazard is conscious effort to increase
chance OR severity of peril (fraudulent claim,
lying, dishonesty)
 Morale hazard is unconscious effort for the
same (state of mind, indifference etc. –better
 Differences between hazards
 Physical Hazard – generally beyond control of
insured and not as a result of
insurance
 Morale Hazard – non-deliberate attitude as a
result of
insurance
 Moral Hazard – deliberate or conscious act as a
result of
insurance
 Boundaries can get blurred between morale and
moral hazard
 Direct vs Indirect Losses
 Direct losses are immediate or first result of
insured peril
 Indirect losses are consequential or secondary
result of insured peril
 Example if a person is hospitalized

 Medical expenses are a direct loss

 Any loss of income due to injury/sickness is an
indirect loss

 Indirect losses may or may not be covered by

insurance depending upon the type of insurance
policy purchased.
 Insurable Interest & Indemnification
Principle
 A person (say A) has insurable interest in a
person or object (say B) when damage / loss to B
results in financial loss to A
 Dependents of a breadwinner
 Owner of assets (etc.)

 Indemnification principle
 Put back in same financial position
 No profit from damage/loss
 Insurance system operates to at most indemnify
losses (no profit results from insurance)
 Essential requirement
 Insurable Interest & Indemnification
Principle
 If insurable interest does not exist,
indemnification principle will not apply
 Absence gives rise to moral/morale hazard
 Some pure risks are considered non-insurable or
non-desirable
Which of following risks would generally
be considered insurable
1. Damage to car in an accident (relatively large)
2. Major routine repair of car
3. Business loss generally
4. Business Loss of Profit due to fire
5. Major event cancellation loss
– under what conditions
6. Life insurance with payment of proceeds to
- Dependent
- Non-dependent
7. Loss from investment in stock market investment
Which of following risks would generally
be considered insurable

8. Ransom Insurance
9. Claims from pandemic (Covid 19)
 Subsidization & Risk Classification
 Premiums should be fair for insurance system to
be sustainable
 If insured is paying more than mathematical fair
price, insured is subsidizing
 If insured is paying less than mathematical fair
share, insured is being subsidized

* Overall, lot of subjectivity in subsidization due to varying

perceptions and cultural values (subsidy to a certain extent
is inherent in insurance)
 Subsidization & Risk Classification
 In case of heavy subsidies, individuals
subsidizing will have tendency to leave
 Increases overall premium
 Gets into price spiral
 Important to come up with a proper, fair and
socially acceptable risk classification system
 Separate pools of broadly similar risks
 Factors affecting Risk Classification
 Material difference in risk from next class
 Relatively same expected value of loss
(similar risks)
 Preferably large number in each risk
bracket
 Reliability
 Incentive Value
 Practical and legal considerations (Gender,
race, ability to pay etc.)
 Market Impact
(Fairness has relative meaning - what about
being penalized for factors insured’s
 Adverse / Anti Selection
 Form of moral hazard at time of purchase of
policy
 The insured person conceals information that
places him in a high risk bracket
 Can be viewed as incorrect risk classification
 More claims than expected/charged
 Thus, average risk of the insured group
increases and premium rises
 Ultimately, low-risk people quit and high-risk
people are left in the group
 Makes insurance unfeasible (Cost spiral)
Checks against moral/morale hazard (and
its impact)
Ways to minimize moral and morale hazards :
 Have rigorous underwriting (upfront checking

of risks) procedures
 Implement co-payments and deductibles

(morale hazard also)

 Exclude predictable events (such as planned

surgeries for health insurance) from the

benefit package
 Greater scrutiny at claims stage (moral

hazard only)
 Establish mandatory insurance, so that high

risk and low risk people are members of the

risk pool to reduce financial impact
 Example of Typical
Risk Classification for life insurance
 Age
 Gender
 Medical history (including family history)
 Smoking
 Occupation (?)
Changing Methods of Underwriting (Risk
Classification)
 Change to risk “makers” rather than risk
“markers”
 Lifestyle (diet, exercise, smoking)
 Body mass index (BMI)

 Use of technology
 Dynamic underwriting (wearables)
 Regular premium discounts or hikes
 Use of cell phones (smoking status, anxiety)
Main Types of Insurance in Pakistan
 Life
 Health
 Motor
 Marine
 Fire
Benefits and Costs to society of Insurance
System
A. Benefits
 Stability in family (protects income & assets)
 Stability for businesses (protects income &
assets)
 Encourages positive risk taking in economy
 Enhances risk management culture
 More efficient resource allocation
 Lower firm’s cost of capital (reduces uncertainty)
 Anti-monopoly
 Supports credit in economy
 Contribution to society's welfare and social
security system
 Long-term savings and investments
Benefits and Costs to society of Insurance
System
B. Costs (Incremental outgoes due to
Insurance)
 Increase in cost due to moral hazard
 Increase cost due to morale hazard
 Frivolous litigation due to claims
 Intermediation cost (generally quite high
particularly in developing countries)?