3. Insurance and Risk
Bus 200Introduction to Risk Management and Insurance
Fall 2008Prof. Jin Park
Overview
Insurance Adverse Selection and
Underwriting Insurable Risk Types of Insurance Costs/Benefits of Insurance to
Society
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.
Characteristics of Insurance
Loss Sharing (pooling of looses) Law of large numbers
Payment of Fortuitous Losses Moral hazard
Risk Transfer Indemnification
No profit from a loss
Loss sharing (pooling) Pooling arrangement changes the probability
distribution of accident costs faced by each participant.
Assume 1,000 individuals each have homes worth $200,000
On average, 1 home burns down a year (1 out of 1,000)
Without insurance: Max. possible loss per any individual = $200,000
Suppose all agree to share the loss equally average loss = $200,000 / 1,000 = $200
Trading between “$200 sure loss” and “chance of losing $100,000”
What if… JP’s Palace, Bloomington, IL
What if they are put into the same pool and share the losses equally?
The Governor’s Mansion, Austin TX
Adverse Selection 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.
To mitigate the adverse selection Detailed application Medical examination On-Site investigation Suicide clause Preexisting conditions provision
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. Discrimination is acceptable.
Underwriting Decisions Accept the application Accept the application subject to certain
restrictions or modifications Reject the application
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/Casualty Type of policies Limit of insurance Nature of business Location Past claim history Total revenue Type of property Construction type Credit history … and more
Ideal Characteristics of an Insurable Risk
Large number of similar exposure units
Accidental and unintentional loss No catastrophic loss Determinable and measurable loss Calculable chance of loss Economically feasible premium
Types of Insurance Personal, Group, or Commercial
Personal Auto, Homeowner’s, Personal Health
Group Life, Group Health Product Liability, WC, MMP
Life/Health or Property/Casualty Whole Life, Annuity, HMO, PPO Auto, Home, Aviation, Environmental
Liability
Types of Insurance
Private or Government Personal Auto, Homeowner’s, Group
Life, Group Health Social Security, Medicare, Flood, Crop,
FDIC, PBGC, WC
Benefits/Costs of Insurance to Society Benefits
Indemnification Less Worry & Fear Source of investment funds Loss Prevention Enhancement of Credit
Costs Cost of Doing Business Fraudulent claims Inflated claims