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