Definition and Characteristics of Insurance

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

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.

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.

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.

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.

Characteristics of Insurance   

Risk Transfer Loss Sharing (pooling) Discrimination via underwriting

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.

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.

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

Characteristics of Insurance No pooling between two persons Person A

Person B

Outcomes

Prob.

$0

0.80

0

$ 2,500

0.20

500

Expected Loss = $500 Std. Dev. = $1,000

Outcomes

Prob.

$0

0.80

0

$ 2,500

0.20

500

Expected Loss = $500 Std. Dev. = $1,000

Characteristics of Insurance Two-person pooling arrangement Scenarios

Total cost A Loss

B Loss

Prob.

Neither loss

$0

$0

.64

$0

0

A loss – B no loss $2,500

$1,250 $1,250 .16

200

A no loss – B loss $2,500

$1,250 $1,250 .16

200

Both losses

$2,500 $2,500 .04

100

$5,000

Each individual’s expected loss amount = $500 Std. Dev. = $707 compare this with $1,000

Characteristics of Insurance Three-person pooling arrangement Scenarios

Total cost Participant’s share

Prob.

No loss

$0

$

0

.512

$

1 loss – 2 no loss

$2,500

$ 833.33

.384

$320

2 loss – 1 no loss

$2,500

$1,666.67

.096

$160

Three losses

$7,500

$2,500.00

.008

$ 20

1.00

$500

0

Each individual’s expected loss amount = $500 Std. Dev. = $577.35 compare with $1,000 or $707

Discrimination via underwriting 

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.

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

Discrimination via underwriting 

Underwriting Decisions   

Accept the application Accept the application subject to certain restrictions or modifications Reject the application

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.

Outcome

Payment

Prob.

No Claim

$0

.95

No Claim

$0

.90

Claim

$10,000

.05

Claim

$10,000

.10

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

$

Only Young claims $10,000

.095

$950

Only Old claims

$10,000

.045

$450

Both claim

$20,000

.005

$100

0

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? ???___________

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-thanexpected loss levels. To mitigate the adverse selection     

Detailed application Medical examination On-Site investigation Suicide clause Preexisting conditions provision

Reading Assignment 

Insurers back marketer’s contest awards. 



Loss sharing ???

WTC Insurance fight 

Indemnification ???