Lecture Three ： Insurance and Its Functions. Learning objectives Defining insurance and explain the basic characteristics of insurance Explain the law.

Lecture Three ：

Insurance and Its Functions

Learning objectives

Defining insurance and explain the basic characteristics of insurance Explain the law of large numbersDescribe the requirements of an insurable riskDescribe the major types of insurance Explain the functions of insurance

Main Contents

Definition of insurance

Basic characteristics of insurance

Insurable risk

Adverse selection and insurance

Insurance and gambling

Types of insurance

Insurance functions

Insurance – what is it?

Definition of insurance

There is no single definition of insurance.

Insurance can be defined from the viewpoint of several disciplines, including law, economics, history, actuarial science, risk theory, and sociology.

Definition of insurance

Different definitions given by scholars

from both abroad and home

Financial definition

Insurance is a financial arrangement that redistributes the costs of unexpected losses. Insurance involves the transfer of potential losses to an insurance pool, the pool combines all the potential losses and then transfers the cost of the predicted losses back to those exposed. Thus, insurance involves the transfer of loss exposures to an insurance pool, and redistribution of losses among the members of the pool---by Mark S. Dorfman

Financial Definition (Page 16 of textbook)

Insurance is 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.

Legal definition

Insurance is a contractual arrangement whereby one party agrees to compensation another party for losses. We call the party agreeing to pay for the losses the insurer, call the party whose loss causes the insurer to make a claims payment the insured. We call the payment the insurer receives a premium, call the insurance contract a policy. Call the insured’s possibility of loss the insured’s exposure to loss.

我国《保险法》（ 2002 年 10 月 28 ）第二条：本法所称保险，是指投保人根据合同约定，向保险人支付保险费，保险人对于合同约定的可能发生的事故因其发生所造成的财产损失承担赔偿保险金责任，或者当被保险人死亡，伤残、疾病或者达到合同约定的年龄、期限时承担给付保险金责任的商业保险行为。

Basic characteristics of insurance

An insurance plan or arrangement typically has certain characteristics. They include the following:

Pooling of losses Payment of fortuitous losses Risk transfer Indemnification

Pooling of losses

Pooling or sharing losses is the heart of insurance.

Pooling is the spreading of losses incurred by the few over the entire group, so that in the process, average loss is substituted for actual loss.

Pooling of losses

Pooling implies: the grouping of a large number of

exposure units, so that the law of large numbers can operate to provide a substantially accurate prediction of future losses.

The sharing of losses by the entire group

Pooling of losses

The Law of Large numbers it states that the greater the number of exposure, the more closely will the actual results that are expected from an infinite number of exposures.

The insurer can predict future losses with a greater degree of accuracy as the number of exposures increases. (explains it by examples)

For most insurance lines, estimates of both average frequency and the average severity of loss must be based on previous loss experiences

The insurer must charge a premium that will be adequate for paying all losses and expenses during the policy period.

Payment of fortuitous losses

A fortuitous loss is one that is unforeseen and unexpected and occurs as a result of chance. That’s the loss must be accidental.

Insurance policies do not cover intentional losses.

Risk transfer

Risk transfer means that a pure risk is transferred from the insured to the insurer, who typically is in a stronger financial position to pay the loss than the insured.

Risk transfer

Pure risk that typically transferred to insurers includes: Premature death Poor health DisabilityDestruction and theft of property Liability lawsuits

Indemnification

Indemnification means that the insured is restored to his or her approximate financial position prior to the occurrence of the loss

Insurable Risk

—what kinds of risks are insurable for a private insurer?

six requirements of Insurable risk

Insurers normally insure only pure risks. However, not all pure risks are insurable.

From the viewpoint of the insurer, there are ideally six requirements of an insurable risk:

six requirements of Insurable risk

1. There must be a larger number of exposure units;

2. The loss must be accidental and unintentional;3. The loss must be determinable and

measurable;4. The loss should not be catastrophic; 5. The chance of loss must be calculable;6. The premium must be economically feasible.

large number of exposure units

There should be a large group of roughly similar, but not necessarily identical, exposure units that are subject to the same peril or group of perils. (examples)

The purpose is to enable the insurer to predict loss based on the law of large numbers.The loss costs can be spread over all insureds.

Accidental and Unintentional Loss

the loss should be accidental and unintentional

the loss should be fortuitous and outside the insured’s control

If an individual deliberately causes a loss, he or she should not be indemnified for the loss

Determinable and measurable loss

The loss should be both determinable and measurable.

It means the loss should be definite as to cause, time, place, and amount.

The purpose is to enable an insurer to determine if the loss is covered under the policy, and how much should be paid.

No catastrophic loss

The loss should not be catastrophic It means that a large proportion of exposure

units should not incur losses at the same time

Otherwise, the insurance pooling would break down and become unworkable.

Calculable chance of loss

The chance of loss should be calculable .The insurers must be able to calculate both the average frequency and the average severity of future losses with some accuracy.

This requirement is necessary so that the premium can be charged and sufficient to pay all claims and expenses and yield profit.

Economically feasible premium

The premium should be economically feasible. The insured must be able to afford to pay the

premium; Low premium is attractive and competitive in

market; To have an economically feasible premium, the

chance of loss must be relatively low.

personal risks, property risks, and liability risks can be privately insured.

most market risks, financial risks, production risks, and political risks are usually uninsurable by private insurers. The reasons are: First, being speculative, and difficulty to insure

privately; Second, a great potential to cause catastrophic

loss; Finally, calculation of premium is difficult.

Risk—insurable or non-insurable?

Adverse selection and insurance

Adverse selection is 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. (Examples) .

There are some ways to control adverse selection:

careful underwriting; (Examples)

policy provisions (Examples ： waiting period, suicide clause)

Insurance Versus Gambling

Insurance is often confused with gambling. Actually they are quite different from the following viewpoints: Gambling creates a new speculative risk, while insurance is a technique for handling an already existing pure risk. (examples) gambling is socially unproductive, while insurance is always socially productive. Gambling is illegal in China.

Ideal Requisites Examples (Page 20-21 of text)

Examples 1: Risk of fire as insurable risk

Examples 2: Risk of unemployment as insurable risk

A. Large Number of Similar Exposure Units

B. Accidental and unintentional loss

C. Determinable and measurable loss

D. No catastrophic loss

E. Calculable chance of losses

F. Economically feasible premium

Types of Insurance

Types of Insurance

Insurance can be classified as various types:

Personal or CommercialLife-Health or Property-LiabilityPrivate or GovernmentVoluntary or Involuntary

Types of Insurance

Insurance can be classified as either private or government insurance

private insurance

Life insurance, health insurance, property insurance and liability insurance

government insurance

Social insurance

Other government insurance

Private insurance

Life and health insurance Property and liability insurance:

Fire and insurance and allied lines. Marine insurance : ocean marine inland marine casualty insurance:

automobile insurance general liability insurance burglary and theft insurance workers compensation insurance glass insurance boiler and machinery insurance nuclear insurance crop-hail insurance health insurance other miscellaneous lines Multiple-line insurance Fidelity and surety bonds

Government insurance

Government insurance can be divided into social insurance programs and other government insurance programs ： social insurance: (in the U.S) Old-age, survivors, and disability insurance( social security) Medicare Unemployment insurance Workers compensation Compulsory temporary disability insurance Railroad Retirement Act Railroad Unemployment Insurance ActOther government insurance programs (in the U.S.)

Social insurance programs in China

Social insurance

Pension system

Urban Employee Health Insurance

New Rural Co-operative Medical System

Unemployment insurance Other social insurance programs

Insurance functions

Insurance functions

Various argues on the functions of insurance:

Unique function: Indemnification for loss

Fundamental functions: spreading risks and

indemnification for loss

Multi-function: besides the fundamental functions, there more other function as pooling funds, deposit, etc.

Insurance functions

Basic functions: dispersing risk indemnifying loss

Derived functions: pooling funds risk-supervising

Insurance functions in national economy

Insurance in micro-economy Help the disaster companies by

compensating loss Emphasize financial budget Emphasize risk management

Insurance in macro-economy Ensure the operation of social production Promote import and export

Benefits of insurance to society

The major social and economic benefits of insurance include the following:

indemnification for loss less worry and fear source of investment funds loss prevention enhancement of credit

Costs of insurance to society

Although the insurance industry provides enormous social and economic benefits to society, the social costs of insurance should also be recognized.

The major social costs of insurance include the following: cost of doing business fraudulent claims inflated claims

Summary

There is no single definition of insurance. However, a typical insurance plan contains four elements: pooling payment of fortuitous losses risk transfer

indemnification There are several ideal requirements of an insurable

risks: There must be a larger number of exposure units; The loss must be accidental and unintentional; The loss must be determinable and measurable;

The loss should not be catastrophic; The chance of loss must be calculable; The premium must be economically feasible

Insurance is not the same as gambling Insurance can be classified into private and

government insurance Insurance plays important functions in national

economy Insurance brings both benefits and costs to society.

But we benefit a lot from it.

Review questions

1. Explain the major characteristics of a typical insurance plan 2. Why is the pooling technique essential to insurance?3. Explain the law of large numbers and show how the law can

be used by an insurance to estimate future losses4. Explain the major requirements of an insurable risk5. Why most market risks, financial risks, production risks, and

political risks considered to be uninsurable by private insurers?

6. ? 7. Identify the major fields of private and government insurance

in China 8. Explain the insurance functions, and how insurance is

beneficial to society and what kind of costs does bring to society?