CHAPTER 2

INSURANCE AND RISK

“Insurance: An ingenious modern game of chance in which

the player is permitted to enjoy the comfortable conviction
that he is beating the man who keeps the table.”
Ambrose Bierce

Learning Objectives

After studying this chapter, you should be able to

◆ Explain the basic characteristics of insurance.

◆ Explain the law of large numbers.

◆ Describe the characteristics of an ideally insurable risk from the viewpoint of a

private insurer.

◆ Identify the major insurable and uninsurable risks in our society.

◆ Describe the major types of insurance.

◆ Explain the social benefits and social costs of insurance.

19
 M ichael and Ashley graduated from a southern university, married, and moved
to Miami, Florida. Like many married couples, they wanted to save money for
a down payment on a house. Shortly after they rented an apartment, a burglar broke
into the premises and stole a wide screen television, laptop computer, camera, jewelry,
and cash stashed in a dresser drawer. The loss exceeded $15,000. The couple had no
insurance. As a result, their goal of accumulating a down payment received a serious
setback. The couple made the common mistake of paying inadequate attention to risk
and insurance in their financial plans.
In Chapter 1, we identified major risks that can cause financial insecurity. For
most people, private insurance is the most important technique for managing risk.
Consequently, you should understand how insurance works. In this chapter, we
examine the basic characteristics of insurance, characteristics of an ideally insurable
risk, major types of insurance, and the social benefits and costs of insurance.

DEFINITION OF INSURANCE BASIC CHARACTERISTICS

There is no single definition of insurance. Insurance OF INSURANCE
can be defined from the viewpoint of several disci- Based on the preceding definition, an insurance plan
plines, including law, economics, history, actuarial or arrangement typically includes the following char-
science, risk theory, and sociology. But each possible acteristics:
definition will not be examined at this point. Instead,
we will examine the common elements that are typi- ■ Pooling of losses
cally present in any insurance plan. However, before ■ Payment of fortuitous losses
proceeding, a working definition of insurance—one ■ Risk transfer
that captures the essential characteristics of a true ■ Indemnification
insurance plan—must be established.
After careful study, the Commission on
Insurance Terminology of the American Risk and
Pooling of Losses
Insurance Association has defined insurance as fol- Pooling or the sharing of losses is the heart of insur-
lows.1 Insurance is the pooling of fortuitous losses ance. Pooling is the spreading of losses incurred by
by transfer of such risks to insurers, who agree to the few over the entire group, so that in the process,
indemnify insureds for such losses, to provide other average loss is substituted for actual loss. In addition,
pecuniary benefits on their occurrence, or to render pooling involves the grouping of a large number of
services connected with the risk . Although this exposure units so that the law of large numbers can
lengthy definition may not be acceptable to all insur- operate to provide a substantially accurate prediction
ance scholars, it is useful for analyzing the common of future losses. Ideally, there should be a large num-
elements of a true insurance plan. ber of similar, but not necessarily identical, exposure
20
 BASIC CHARACTERISTICS OF INSURANCE 21

units that are subject to the same perils. Thus, owner must pay $50,000. The expected loss for each
pooling implies (1) the sharing of losses by the entire owner remains $5000 as shown below:
group and (2) prediction of future losses with some
accuracy based on the law of large numbers. Expected loss = .81 * $0 + .09 * $25,000
The primary purpose of pooling, or the shar- + .90 * $25,000 + .01 * $50,000
ing of losses, is to reduce the variation in possible = $5,000
outcomes as measured by the standard deviation or
Note that while the expected loss remains the
some other measure of dispersion, which reduces
same, the probability of the extreme values, $0 and
risk. For example, assume that two business own-
$50,000, have declined. The reduced probability of
ers each own an identical storage building valued at
the extreme values is reflected in a lower standard
$50,000. Assume there is a 10 percent chance in any
deviation (SD) as shown below:
year that each building will be destroyed by a peril,
and that a loss to either building is an independent .81(0 - $5000)2 + .09($25,000 - $5000)2
event. The expected annual loss for each owner is SD = + .09($25,000 - $5000)2
$5000 as shown below:
H + .01($50,000 - $5000)2
SD = $10,607
Expected loss = .90 * $0 + .10 * $50,000
= $5000 Thus, as additional individuals are added to the
pooling arrangement, the standard deviation
continues to decline while the expected value of the
A common measure of risk is the standard deviation,
loss remains unchanged. For example, with a pool
which is the square root of the variance. The stand-
of 100 insureds, the standard deviation is $1500;
ard deviation (SD) for the expected value of the loss
with a pool of 1000 insureds, the standard devia-
is $15,000, as shown below:
tion is $474; and with a pool of 10,000, the standard
deviation is $150.
In addition, by pooling or combining the loss
SD = 2.90(0 - $5000)2 + .10($50,000 - $5000)2
experience of a large number of exposure units, an
= $15000 insurer may be able to predict future losses with
greater accuracy. From the viewpoint of the insurer,
Suppose instead of bearing the risk of loss individu- if future losses can be predicted, objective risk is
ally, the two owners decide to pool (combine) their reduced. Thus, another characteristic often found in
loss exposures, and each agrees to pay an equal share many lines of insurance is risk reduction based on the
of any loss that might occur. Under this scenario, law of large numbers.
there are four possible outcomes: The law of large numbers states that the greater
the number of exposures, the more closely will the
actual results approach the probable results that are
Possible Outcomes Probability expected from an infinite number of exposures.2 For
Neither building is destroyed .90 * .90 = .81 example, if you flip a balanced coin into the air, the
a priori probability of getting a head is 0.5. If you
First building destroyed, .10 * .90 = .09
flip the coin only 10 times, you may get a head eight
second building no loss
times. Although the observed probability of getting
First building no loss, second .90 * .10 = .09 a head is 0.8, the true probability is still 0.5. If the
building destroyed coin were flipped 1 million times, however, the actual
Both buildings are destroyed .10 * .10 = .01 number of heads would be approximately 500,000.
Thus, as the number of random tosses increases, the
If neither building is destroyed, the loss for each actual results approach the expected results.
owner is $0. If one building is destroyed, each owner A practical illustration of the law of large num-
pays $25,000. If both buildings are destroyed, each bers is the National Safety Council’s prediction of
22 CHAPTER 2 / INSURANCE AND RISK

the number of motor vehicle deaths during a typical insurer, who typically is in a stronger financial position
holiday weekend. Because millions of vehicles are on to pay the loss than the insured. From the viewpoint of
the road, the National Safety Council has been able to the individual, pure risks that are typically transferred
predict with some accuracy the number of motorists to insurers include the risk of premature death, exces-
who will die during a typical Fourth of July weekend. sive longevity, poor health, disability, destruction and
For example, assume that 500 to 700 motorists are theft of property, and personal liability lawsuits.
expected to die during a typical July 4th weekend.
Although individual motorists cannot be identified,
Indemnification
the actual number of deaths for the group of motorists
as a whole can be predicted with some accuracy. A final characteristic of insurance is indemnification
However, for most insurance lines, actuaries for losses. Indemnification means that the insured is
generally do not know the true probability and sever- restored to his or her approximate financial position
ity of loss. Therefore, estimates of both the average prior to the occurrence of the loss. Thus, if your home
frequency and the average severity of loss must be burns in a fire, a homeowners policy will indemnify
based on previous loss experience. If there are a large you or restore you to your previous position. If you are
number of exposure units, the actual loss experience sued because of the negligent operation of an automo-
of the past may be a good approximation of future bile, your auto liability insurance policy will pay those
losses. As we noted earlier, as the number of expo- sums that you are legally obligated to pay. Similarly, if
sure units increases, the relative variation of actual you become seriously disabled, a disability-income insur-
loss from expected loss will decline. Thus, actuar- ance policy will restore at least part of the lost wages.
ies can predict future losses with a greater degree
of accuracy. This concept is important because an
insurer must charge a premium that will be adequate CHARACTERISTICS OF AN
for paying all losses and expenses during the policy
period. The lower the degree of objective risk,
IDEALLY INSURABLE RISK
the more confidence an insurer has that the actual Private insurers generally insure only pure risks.
premium charged will be sufficient to pay all claims However, some pure risks are not privately insurable.
and expenses and provide a margin for profit. From the viewpoint of a private insurer, an insurable
A more rigorous statement of pooling and the risk ideally should have certain characteristics. There
law of large numbers can be found in the appendix at are ideally six characteristics of an insurable risk:
the end of this chapter.
■ There must be a large number of exposure units.
■ The loss must be accidental and unintentional.
Payment of Fortuitous Losses ■ The loss must be determinable and measurable.
■ The loss should not be catastrophic.
A second characteristic of private insurance is the
■ The chance of loss must be calculable.
payment of fortuitous losses. A fortuitous loss is one
■ The premium must be economically feasible.
that is unforeseen and unexpected by the insured and
occurs as a result of chance. In other words, the loss
must be accidental. The law of large numbers is based
Large Number of Exposure Units
on the assumption that losses are accidental and occur
randomly. For example, a person may slip on an icy The first requirement of an insurable risk is a large
sidewalk and break a leg. The loss would be fortuitous. number of exposure units. Ideally, there should be a
large group of roughly similar, but not necessarily iden-
tical, exposure units that are subject to the same peril or
Risk Transfer
group of perils. For example, a large number of frame
Risk transfer is another essential element of insurance. dwellings in a city can be grouped together for purposes
With the exception of self-insurance, a true insurance of providing property insurance on the dwellings.
plan always involves risk transfer. Risk transfer means The purpose of this first requirement is to ena-
that a pure risk is transferred from the insured to the ble the insurer to predict loss based on the law of
 CHARACTERISTICS OF AN IDEALLY INSURABLE RISK 23

large numbers. Loss data can be compiled over time, Meanwhile, the other accountant would still continue
and losses for the group as a whole can be predicted to receive disability-income benefits according to the
with some accuracy. The loss costs can then be spread terms of the policy. In short, it is difficult to determine
over all insureds in the underwriting class. when a person is actually disabled. However, all losses
ideally should be both determinable and measurable.
The basic purpose of this requirement is to enable
Accidental and Unintentional Loss
an insurer to determine if the loss is covered under the
A second requirement is that the loss should be policy, and if it is covered, how much should be paid.
accidental and unintentional; ideally, the loss should For example, assume that Shannon has an expensive
be unforeseen and unexpected by the insured and fur coat that is insured under a homeowners policy. It
outside of the insured’s control. Thus, if an individ- makes a great deal of difference to the insurer if a thief
ual deliberately causes a loss, he or she should not be breaks into her home and steals the coat, or the coat is
indemnified for the loss. missing because her husband stored it in a dry-cleaning
The loss should be accidental because the law establishment but forgot to tell her. The loss is covered
of large numbers is based on the random occurrence in the first example but not in the second.
of events. A deliberately caused loss is not a random
event because the insured knows when the loss will
No Catastrophic Loss
occur. Thus, prediction of future experience may be
highly inaccurate if a large number of intentional or The fourth requirement is that ideally the loss should
nonrandom losses occur. not be catastrophic. This means that a large propor-
tion of exposure units should not incur losses at the
same time. As we stated earlier, pooling is the essence
Determinable and Measurable Loss
of insurance. If most or all of the exposure units
A third requirement is that the loss should be both in a certain class simultaneously incur a loss, then
determinable and measurable. This means the loss the pooling technique breaks down and becomes
should be definite as to cause, time, place, and unworkable. Premiums must be increased to prohibi-
amount. Life insurance in most cases meets this tive levels, and the insurance technique is no longer
requirement easily. The cause and time of death can a viable arrangement by which losses of the few are
be readily determined in most cases, and if the per- spread over the entire group.
son is insured, the face amount of the life insurance Insurers ideally wish to avoid all catastrophic
policy is the amount paid. losses. In reality, however, that is impossible, because
Some losses, however, are difficult to determine catastrophic losses periodically result from floods,
and measure. For example, under a disability-income hurricanes, tornadoes, earthquakes, forest fires, and
policy, the insurer promises to pay a monthly benefit other natural disasters. Catastrophic losses can also
to the disabled person if the definition of disability result from acts of terrorism.
stated in the policy is satisfied. Some dishonest claim- Several approaches are available for meeting the
ants may deliberately fake sickness or injury to collect problem of a catastrophic loss. First, reinsurance can
from the insurer. Even if the claim is legitimate, the be used by which insurance companies are indemni-
insurer must still determine whether the insured sat- fied by reinsurers for catastrophic losses. Reinsurance
isfies the definition of disability stated in the policy. is an arrangement by which the primary insurer that
Sickness and disability are highly subjective, and the initially writes the insurance transfers to another insurer
same event can affect two persons quite differently. (called the reinsurer) part or all of the potential losses
For example, two accountants who are insured under associated with such insurance. The reinsurer is then
separate disability-income contracts may be injured in responsible for the payment of its share of the loss.
an auto accident, and both may be classified as totally Reinsurance is discussed in greater detail in Chapter 6.
disabled. One accountant, however, may be stronger Second, insurers can avoid the concentration of
willed and more determined to return to work. If that risk by dispersing their coverage over a large geo-
accountant undergoes rehabilitation and returns to graphical area. The concentration of loss exposures
work, the disability-income benefits will terminate. in a geographical area exposed to frequent floods,
24 CHAPTER 2 / INSURANCE AND RISK

earthquakes, hurricanes, or other natural disasters most market risks, financial risks, production risks,
can result in periodic catastrophic losses. If the loss and political risks are difficult to insure by private
exposures are geographically dispersed, the possibil- insurers.4 These risks are speculative, and the ideal
ity of a catastrophic loss is reduced. characteristics of an insurable risk discussed earlier
Finally, financial instruments are now available are more difficult to meet. In addition, the potential
for dealing with catastrophic losses. These instru- of each risk to produce a catastrophe loss is great;
ments include catastrophe bonds, which are designed this is especially true for political risks, such as the
to help fund catastrophic losses. Catastrophe bonds risk of war. Finally, calculation of a proper premium
are discussed in Chapters 4 and 6. may be difficult because the chance of loss cannot
be accurately estimated. For example, insurance that
protects a retailer against loss because of a change in
Calculable Chance of Loss
consumer tastes, such as a style change, generally is
A fifth requirement is that the chance of loss should not available. Accurate loss data are not available.
be calculable. The insurer must be able to calculate Thus, it would be difficult to calculate an accurate
both the average frequency and the average severity premium. The premium charged may or may not be
of future losses with some accuracy. This requirement adequate to pay all losses and expenses. Since pri-
is necessary so that a proper premium can be charged vate insurers are in business to make a profit, certain
that is sufficient to pay all claims and expenses and risks are difficult to insure because of the possibility
yields a profit during the policy period. of substantial losses.
Certain losses, however, are difficult to insure
because the chance of loss cannot be accurately
estimated, and the potential for a catastrophic loss TWO APPLICATIONS: THE RISKS
is present. For example, floods, wars, and cyclical OF FIRE AND UNEMPLOYMENT
unemployment occur on an irregular basis, and pre-
diction of the average frequency and severity of losses You will understand more clearly the requirements of
is difficult. Thus, without government assistance, an insurable risk if you can apply these requirements
these losses are difficult for private carriers to insure. to a specific risk. For example, consider the risk of
fire to a private dwelling. This risk can be privately
insured because the requirements of an insurable risk
Economically Feasible Premium
are generally fulfilled (see Exhibit 2.1).
A final requirement is that the premium should be Consider next the risk of unemployment. How
economically feasible. The insured must be able to well does the risk of unemployment meet the ideal
afford the premium. In addition, for the insurance to requirements of an insurable risk? As is evident in
be an attractive purchase, the premiums paid must be Exhibit 2.2, the risk of unemployment does not
substantially less than the face value, or amount, of completely meet the requirements.
the policy. First, predicting unemployment is difficult because
To have an economically feasible premium, the of the different types of unemployment and labor.
chance of loss must be relatively low. One view is that There are professional, highly skilled, semiskilled,
if the chance of loss exceeds 40 percent, the cost of the unskilled, blue-collar, and white-collar workers.
policy will exceed the amount that the insurer must Moreover, unemployment rates vary significantly by
pay under the contract.3 For example, an insurer could occupation, age, gender, education, marital status,
issue a $1000 life insurance policy on a man age 99, city, state, and a host of other factors, including
but the pure premium would be close to that amount, government programs and economic policies that fre-
and an additional amount for expenses would also quently change. In addition, the outsourcing of jobs
have to be added. The total premium would exceed to foreign countries by major corporations is another
the face amount of insurance. major problem in the United States, which makes the
Based on the preceding requirements, most risk of unemployment more difficult to measure and
personal risks, property risks, and liability risks can insure privately. Also, the duration of unemployment
be privately insured because the ideal characteristics varies widely among the different groups. Because a
of an insurable risk generally can be met. In contrast, large number of workers can become unemployed
 TWO APPLICATIONS: THE RISKS OF FIRE AND UNEMPLOYMENT 25

Exhibit 2.1
Risk of Fire as an Insurable Risk

Requirements Does the risk of fire satisfy the requirements?

1. Large number of Yes. Numerous exposure units are present.
exposure units
2. Accidental and Yes. With the exception of arson, most fire losses are accidental and
unintentional loss unintentional.
3. Determinable and Yes. If there is disagreement over the amount paid, a property
measurable loss insurance policy has provisions for resolving disputes.
4. No catastrophic loss Yes. Although catastrophic fires have occurred, all exposure units
normally do not burn at the same time.
5. Calculable chance of loss Yes. Chance of fire can be calculated, and the average severity of a
fire loss can be estimated in advance.
6. Economically feasible Yes. Premium rate per $100 of fire insurance is relatively low.
premium

Exhibit 2.2
Risk of Unemployment as an Insurable Risk

Requirements Does the risk of unemployment satisfy the requirements?

1. Large number of Not completely. Although there are a large number of employees,
exposure units predicting unemployment is often difficult because of the different
types of unemployment and different types of labor.
2. Accidental and Not always. Some unemployment is due to individuals who
unintentional loss voluntarily quit their jobs.
3. Determinable and Not completely. The level of unemployment can be determined, but
measurable loss the measurement of loss may be difficult. Most unemployment is
involuntary because of layoffs or because workers have completed
temporary jobs. However, some unemployment is voluntary; workers
voluntarily change jobs because of higher wages, a change in careers,
family obligations, relocation to another state, or other reasons.
4. No catastrophic loss No. A severe national recession or depressed local business condi-
tions in a town or city could result in a catastrophic loss.
5. Calculable chance of loss Not completely. The different types of unemployment in specific
occupations can make it difficult for actuaries to estimate the chance
of loss accurately.
6. Economically feasible Not completely. Adverse selection, moral hazard, policy design, and
premium the potential for a catastrophic loss could make the insurance too
expensive to purchase. Some plans, however, will pay unemployment
benefits in certain cases where the unemployment is involuntary, and
the loss payments are relatively small, such as waiver of life insur-
ance premiums for six months, or payment of credit card minimum
payments for a limited period.

at the same time, a potential catastrophic loss is also of widespread unemployment is difficult to insure
present. And because certain types of unemployment by private insurers. However, unemployment can be
occur irregularly, it may be difficult to calculate the insured by social insurance programs. Social insurance
chance of loss accurately. For these reasons, the risk programs are discussed later in the chapter.
26 CHAPTER 2 / INSURANCE AND RISK

ADVERSE SELECTION AND risk, while insurance is a technique for handling

INSURANCE an already existing pure risk. Thus, if you bet $500
on a horse race, a new speculative risk is created,
When insurance is sold, insurers must deal with the but if you pay $500 to an insurer for a homeown-
problem of adverse selection. Adverse selection is the ers policy that includes coverage for a fire, the risk
tendency of persons with a higher-than-average chance of fire is already present. No new risk is created by
of loss to seek insurance at standard (average) rates, the transaction.
which if not controlled by underwriting, results in The second difference is that gambling can be
higher-than-expected loss levels. For example, adverse socially unproductive, because the winner’s gain
selection can result from high-risk drivers who seek comes at the expense of the loser. In contrast, insur-
auto insurance at standard rates, from persons with ance is always socially productive, because neither the
serious health problems who seek life or health insur- insurer nor the insured is placed in a position where
ance at standard rates, and from business firms that the gain of the winner comes at the expense of the
have been repeatedly robbed or burglarized and seek loser. Both the insurer and the insured have a com-
crime insurance at standard rates. If the applicants for mon interest in the prevention of a loss. Both parties
insurance with a higher-than-average chance of loss win if the loss does not occur. Moreover, frequent
succeed in obtaining the coverage at standard rates, we gambling transactions generally never restore the
say that the insurer is “adversely selected against.” If losers to their former financial position. In contrast,
not controlled by underwriting, adverse selection can insurance contracts restore the insureds financially in
result in higher-than-expected loss levels. whole or in part if a loss occurs.
Adverse selection can be controlled by care-
ful underwriting. Underwriting refers to the process
of selecting and classifying applicants for insurance. INSURANCE AND HEDGING
Applicants who meet the underwriting standards are
insured at standard or preferred rates. If the underwrit-
COMPARED
ing standards are not met, the insurance is denied, or an In Chapter 1, we discussed the concept of hedging, by
extra premium must be paid, or the coverage offered which risk can be transferred to a speculator through
may be more limited. Insurers frequently sell insurance the purchase of a futures contract. An insurance
to applicants who have a higher-than-average chance contract, however, is not the same thing as hedging.
of loss, but such applicants must pay higher premiums. Although both techniques are similar in that risk is
The problem of adverse selection arises when appli- transferred by a contract, and no new risk is created,
cants with a higher-than-average chance of loss succeed there are some important differences between them.
in obtaining the coverage at standard or average rates. First, an insurance transaction typically involves the
Policy provisions are also used to control adverse transfer of pure risks because the characteristics of
selection. Examples are the suicide clause in life an insurable risk generally can be met. However,
insurance and the preexisting conditions clause in hedging is a technique for handling speculative risks
individual medical expense policies prior to enact- that may be uninsurable, such as protection against
ment of the Affordable Care Act, also known as a decline in the price of agricultural products and
“Obamacare.” These policy provisions are discussed raw materials.
in greater detail later in the text when specific insur- A second difference between insurance and hedging
ance contracts are analyzed. is that insurance can reduce the objective risk of an
insurer by application of the law of large numbers. As
the number of exposure units increases, the insurer’s
INSURANCE AND GAMBLING prediction of future losses improves because the relative
variation of actual loss from expected loss will decline.
COMPARED Thus, many insurance transactions reduce objective
Insurance is often erroneously confused with gam- risk. In contrast, hedging typically involves only risk
bling. There are two important differences between transfer, not risk reduction. The risk of adverse price
them. First, gambling creates a new speculative fluctuations is transferred to speculators who believe
 TYPES OF INSURANCE 27

they can make a profit because of superior knowl- Property and Liability Insurance In 2010, there
edge of market conditions. The risk is transferred, not were 2689 property and liability insurers in the
reduced, and prediction of loss generally is not based United States. 6 Property insurance indemnifies
on the law of large numbers. property owners against the loss or damage of real
or personal property caused by various perils, such
as fire, lightning, windstorm, or tornado. Liability
TYPES OF INSURANCE insurance covers the insured’s legal liability arising
out of property damage or bodily injury to others;
Insurance can be classified as either private or gov- legal defense costs are also paid.
ernment insurance. Private insurance includes life Property and liability insurance is also called
and health insurance and property and liability insur- property and casualty insurance. In practice,
ance. Government insurance includes social insurance nonlife insurers typically use the term property and
programs and other government insurance plans. casualty insurance (rather than property and liability
insurance) to describe the various coverages and
Private Insurance operating results. Casualty insurance is a broad field
of insurance that covers whatever is not covered
Life Insurance At the end of 2010, 917 life insurers by fire, marine, and life insurance; casualty lines
were doing business in the United States, down from include auto, liability, burglary and theft, workers
a peak of 2343 in 1988. The decline is due to merg- compensation, and health insurance.
ers and consolidations to reduce operating costs and Exhibit 2.3 identifies the major property and
general overhead and to increase efficiency.5 casualty coverages sold today. Although there is
Life insurance pays death benefits to designated some overlap, the various coverages can be grouped
beneficiaries when the insured dies. The benefits into two major categories—personal lines and com-
pay for funeral expenses, uninsured medical bills, mercial lines.
estate taxes, and other expenses. The death pro-
ceeds can also provide periodic income payments 1. Personal Lines. Personal lines refer to coverages
to the deceased’s beneficiary. Life insurers also sell that insure the real estate and personal property
annuities, individual retirement account (IRA) plans, of individuals and families or provide them with
401(k) plans, and individual and group retirement protection against legal liability. Major personal
plans. Some life insurers also sell (1) individual and lines include the following:
group health insurance plans that cover medical ■ Private passenger auto insurance protects the
expenses because of sickness or injury; (2) disabil- insured against legal liability arising out of
ity income plans that replace income lost during a auto accidents that cause property damage or
period of disability; and (3) long-term care policies bodily injury to others. Auto insurance also
that cover care in nursing facilities. includes physical damage insurance on a cov-
ered auto for damage or loss resulting from
Health Insurance Although many life insurers a collision, theft, or other perils. Medical
described above also sell some type of individual or expense coverage and uninsured motorist cov-
group health insurance plan, the health insurance erage are also available.
industry overall is highly specialized and controlled ■ Homeowners insurance is a package policy
by a relatively small number of insurers. About that provides property insurance and per-
35 health insurers write most individual and group sonal liability insurance in one policy. There
health insurance plans sold today. These companies are a number of homeowners policies avail-
include Blue Cross Blue Shield Association, AETNA, able that cover the dwelling, other structures,
UnitedHealth Group, and WellPoint. Medical and personal property against loss or damage
expense plans pay for hospital and surgical expenses, from numerous perils, including fire, light-
physician fees, prescription drugs, and a wide variety ning, windstorm, or tornado. The policies also
of additional medical costs. Health insurance plans include theft coverage and personal liability
are covered in greater detail in Chapters 15–16. insurance. A homeowners policy is an example
28 CHAPTER 2 / INSURANCE AND RISK

Exhibit 2.3 flood zones. Flood losses are excluded under

Property and Casualty Insurance Coverages standard homeowners and renters policies.
1. Personal lines
Flood insurance is typically sold by partici-
pating property and casualty insurers.
■ Private passenger auto insurance
2. Commercial Lines. Commercial lines refer to
■ Homeowners insurance
property and casualty coverages for business
■ Personal umbrella liability insurance
firms, nonprofit organizations, and government
■ Earthquake insurance
agencies. Major commercial lines include the
■ Flood insurance following:
2. Commercial lines ■ Fire insurance covers losses caused by fire and
■ Fire and allied lines insurance lightning; it is usually sold as part of a pack-
■ Commercial multiple-peril insurance age policy, such as a commercial multiple-peril
■ General liability insurance policy. Allied lines refer to coverages that are
■ Products liability insurance usually purchased with fire insurance, such as
■ Workers compensation insurance
coverage for windstorm, hail, and vandalism.
■ Commercial auto insurance
Indirect losses can also be covered, including
the loss of business income, rents, and extra
■ Accident and health insurance
expenses.
■ Inland marine and ocean marine insurance
■ Commercial multiple-peril insurance is a pack-
■ Professional liability insurance
age policy, which can be written to include
■ Directors and officers liability insurance
property insurance, general liability insurance,
■ Boiler and machinery insurance (also known as business income insurance, equipment break-
mechanical breakdown, equipment breakdown, or down insurance, and crime insurance.
systems breakdown coverage)
■ General liability insurance covers the legal
■ Fidelity bonds and surety bonds
liability of business firms and other organi-
■ Crime insurance zations that arise out of property damage
■ Other coverages or bodily injury to others. Legal liability
can arise out of the ownership of business
property, sale or distribution of products,
of a multiple-line policy, which refers to state and manufacturing or contracting opera-
legislation that allows insurers to write prop- tions. However, general liability insurance
erty and casualty lines in one policy. does not include products liability insurance,
■ Personal umbrella liability insurance provides which is a separate line.
protection against a catastrophic lawsuit or ■ Products liability insurance covers the legal

judgment. Coverage applies on an excess basis liability of manufacturers, wholesalers, and

after any underlying insurance coverages are retailers to persons who are injured or incur
exhausted. Policy limits typically range from property damage from defective products.
$1 million to $10 million. ■ Workers compensation insurance covers

■ Earthquake insurance covers damage that can workers for a job-related accident or disease.
result from the shaking and cracking of build- The insurance pays for medical bills, disabil-
ings and damage to personal property in an ity income benefits, rehabilitation benefits,
earthquake. Homeowners policies and busi- and death benefits to the dependents of an
ness insurance policies do not cover damage employee whose death is job-related.
from earthquake. However, coverage can be ■ Commercial auto insurance covers the legal

obtained by an endorsement to the policy or liability of business firms arising out of the
by a separate policy. ownership or operation of business vehicles.
■ Federal flood insurance is a federal pro- It also includes physical damage insurance on
gram that provides coverage for flood covered business vehicles for damage or loss
losses to homeowners and business firms in resulting from a collision, theft, or other perils.
 TYPES OF INSURANCE 29

■ Accident and health insurance is also sold by ■ Other coverages include aircraft insurance, which
some property and casualty insurers. This line provides physical damage insurance on covered
is similar to the health insurance coverages aircraft and liability coverage for legal liabil-
sold by life and health insurers. ity arising out of the ownership or operation of
■ Inland marine insurance covers goods being aircraft. Credit insurance covers manufacturers
shipped on land, which include imports, exports, and wholesalers against loss because an account
domestic shipments, and instrumentalities of receivable is uncollectible. Financial guaranty
transportation (for example, bridges, tunnels, insurance guarantees the payment of principal
and pipelines). Inland marine insurance also and interest on debt instruments issued by the
covers personal property such as fine art, jew- insured. Private mortgage insurance (PMI) guar-
elry, and furs. antees the mortgage lender for a loss up to certain
■ Ocean marine insurance covers ocean-going limits for a property foreclosure if the borrower
vessels and their cargo from loss or damage defaults on the mortgage.
because of perils of the sea; contracts are also
written to cover the legal liability of shippers
and owners. Government Insurance
■ Professional liability insurance provides Numerous government insurance programs are in
protection against malpractice lawsuits or operation at the present time. Government insurance
lawsuits that result from a substantial error can be divided into social insurance programs and
or omission. Professional liability insurance other government insurance programs.
covers the professional acts or omissions of
physicians, surgeons, attorneys, accountants,
Social Insurance Social insurance programs are
and other professionals. For example, medical
government insurance programs with certain charac-
malpractice insurance covers physicians and
teristics that distinguish them from other government
other health-care providers for liability claims
insurance plans. These programs are financed entirely
arising out of harm or injury to patients.
or in large part by mandatory contributions from
■ Directors and officers (D&O) liability insur-
employers, employees, or both, and not primarily by
ance provides financial protection for the
the general revenues of government. The contributions
directors and officers and the corporation if
are usually earmarked for special trust funds; the ben-
the directors and officers are sued for misman-
efits, in turn, are paid from these funds. In addition, the
agement of the company’s affairs.
right to receive benefits is ordinarily derived from or
■ Boiler and machinery insurance (also known as
linked to the recipient’s past contributions or coverage
mechanical breakdown, equipment breakdown,
under the program; the benefits and contributions gen-
or systems breakdown coverage) is a highly
erally vary among the beneficiaries according to their
specialized line that covers losses due to the
prior earnings, but the benefits are heavily weighted
accidental breakdown of covered equipment.
in favor of low-income groups. Moreover, most social
Such equipment includes steam boilers, air
insurance programs are compulsory. Covered workers
conditioning and refrigeration equipment, and
and employers are required by law to pay contribu-
electrical generating equipment.
tions and participate in the programs. Finally, eligibility
■ Fidelity bonds cover loss caused by the dishonest
requirements and benefit rights are usually prescribed
or fraudulent acts of employees, such as embez-
exactly by statute, leaving little room for administrative
zlement and the theft of money. Surety bonds
discretion in the award of benefits.7
provide for monetary compensation in the case
Major social insurance programs in the United
of failure by bonded persons to perform certain
States include the following:
acts, such as failure of a contractor to construct
a building on time. ■ Old-Age, Survivors, and Disability Insurance
■ Crime insurance covers the loss of money, (Social Security)
securities, and other property because of bur- ■ Medicare
glary, robbery, theft, and other crime perils. ■ Unemployment insurance
30 CHAPTER 2 / INSURANCE AND RISK

■ Workers compensation not have the distinguishing characteristics of social

■ Compulsory temporary disability insurance insurance programs. Important federal insurance
■ Railroad Retirement Act programs include the following:
■ Railroad Unemployment Insurance Act
■ The Federal Employees Retirement System
Old-Age, Survivors, and Disability Insurance, (FERS) provides retirement, survivor, and
commonly known as Social Security, is a massive disability benefits to federal employees hired
public income-maintenance program that provides after 1983.
retirement, survivor, and disability benefits to eligi- ■ The Civil Service Retirement System provides
ble individuals and families. retirement, survivor, and disability benefits to
Medicare is part of the total Social Security pro- federal employees hired before 1984.
gram and covers the medical expenses of most people ■ The Federal Deposit Insurance Corporation
age 65 and older and certain disabled people younger (FDIC) provides insurance on checking and
than age 65. savings accounts in commercial banks, credit
Unemployment insurance programs provide unions, and savings and loan association.
weekly cash benefits to eligible workers who experi- ■ The Pension Benefit Guaranty Corporation
ence short-term involuntary unemployment. Regular (PBGC) is a federal corporation that guaran-
state unemployment benefits are typically paid up to tees (up to certain limits) the pension benefits of
26 weeks after certain eligibility requirements are met. workers if a private defined-benefit pension plan
In recent years, temporary emergency unemployment is terminated.
programs have also been enacted to provide additional ■ The National Flood Insurance Program (NFIP)
weeks of benefits to beneficiaries who have exhausted makes property insurance available (up to cer-
their regular benefits during severe business recessions. tain limits) to homeowners and business firms
In addition, extended benefits also may be available to who reside in flood zones.
unemployed workers in states with high unemployment ■ Other federal programs include various life
who exhaust their regular benefits. Unemployment insurance programs to veterans, federal crop
insurance is discussed in Chapter 18. insurance, war risk insurance, and numerous
As stated earlier, workers compensation insurance additional programs.
covers workers against a job-related accident or dis-
A wide variety of insurance programs also exist
ease. Although workers compensation is a casualty line
at the state level. They include the following:
sold by private insurers, it is also an important form of
social insurance. The social insurance aspects of work- ■ As stated earlier, state workers compensation
ers compensation are discussed in Chapter 18. programs provide medical, disability, rehabilita-
In addition, compulsory temporary disability tion, and survivor benefits if workers are injured
insurance, which exists in five states, Puerto Rico, or die as a result of a job-related accident or
and the railroad industry, provides for the partial disease.
replacement of wages that may be lost because of a ■ State children’s health insurance programs
temporary nonoccupational disability.8 (SCHIP) are joint state-federal programs that
The Railroad Retirement Act provides retirement provide low-cost health insurance to low-income
benefits, survivor benefits, and disability income ben- children and families.
efits to railroad workers who meet certain eligibility ■ The majority of states have high-risk pools that
requirements. make health insurance available to persons who
Finally, the Railroad Unemployment Insurance are uninsurable or substandard in health.
Act provides unemployment and sickness benefits to ■ Residual market plans (also called shared or
railroad employees. involuntary market plans) exist in a number
of states, which provide insurance to high-risk
Other Government Insurance Programs Other policyholders in certain states who may have
government insurance programs exist at both the difficulty in obtaining basic insurance in the
federal and state level. However, these programs do standard market. These plans include (1) FAIR
 BENEFITS OF INSURANCE TO SOCIETY 31

(Fair Access to Insurance) Plans, which pro- Reduction of Worry and Fear
vide basic property insurance to high-risk
A second benefit of insurance is that worry and fear
policyholders; (2) Beach and Windstorm Plans
are reduced. This is true both before and after a loss.
that provide windstorm and hurricane coverage
For example, if family heads have adequate amounts
to property owners along the Atlantic and Gulf
of life insurance, they are less likely to worry about
Coast seaboard; (3) Citizens Property Insurance
the financial security of their dependents in the event
Company (CPIC) that makes available cover-
of premature death; persons insured for long-term
age to property owners in Florida for wind-
disability do not have to worry about the loss of
storm, hurricanes, and certain other perils; and
earnings if a serious illness or accident occurs; and
(4) Citizens Property Insurance Corporation that
property owners who are insured enjoy greater peace
provides insurance to policyholders in Louisiana.
of mind because they know they are covered if a loss
■ Other state programs include the California
occurs. Worry and fear are also reduced after a loss
Earthquake Authority, Florida Hurricane
occurs, because the insureds know that they have
Catastrophe Fund, Maryland Automobile
insurance that will pay for the loss.
Insurance Fund, and the State Life Insurance
Fund in Wisconsin.
Source of Investment Funds
The insurance industry is an important source of funds
for capital investment and accumulation. Premiums
BENEFITS OF INSURANCE are collected in advance of the loss, and funds not
TO SOCIETY needed to pay immediate losses and expenses can
The major social and economic benefits of insurance be loaned to business firms. These funds typically
include the following: are invested in shopping centers, hospitals, facto-
ries, housing developments, and new machinery and
■ Indemnification for loss equipment. The investments increase society’s stock
■ Reduction of worry and fear of capital goods, and promote economic growth
■ Source of investment funds and full employment. Insurers also invest in social
■ Loss prevention investments, such as housing, nursing homes, and
■ Enhancement of credit economic development projects. In addition, because
the total supply of loanable funds is increased by the
advance payment of insurance premiums, the cost of
Indemnification for Loss capital to business firms that borrow is lower than it
Indemnification permits individuals and families to be would be in the absence of insurance.
restored to their former financial position after a loss
occurs. As a result, they can maintain their financial Loss Prevention
security. Because insureds are restored either in part or
Insurance companies are actively involved in numer-
in whole after a loss occurs, they are less likely to apply
ous loss-prevention programs and also employ a
for public assistance or welfare benefits, or to seek finan-
wide variety of loss-prevention personnel, includ-
cial assistance from relatives and friends.
ing safety engineers and specialists in fire preven-
Indemnification to business firms also permits
tion, occupational safety and health, and products
firms to remain in business and employees to keep
liability. Some important loss-prevention activities
their jobs. Suppliers continue to receive orders, and
that property and casualty insurers strongly sup-
customers receive the goods and services they desire.
port include the following:
The community also benefits because its tax base is
not eroded. In short, the indemnification function ■ Highway safety and reduction of auto accidents
contributes greatly to family and business stability and deaths
and therefore is one of the most important social and ■ Fire prevention
economic benefits of insurance. ■ Reduction of work-related injuries and disease
32 CHAPTER 2 / INSURANCE AND RISK

■ Prevention of auto thefts cover the expenses incurred by insurance companies

■ Prevention and detection of arson losses in their daily operations. An expense loading is
■ Prevention of defective products that could injure the amount needed to pay all expenses, including
the user commissions, general administrative expenses,
■ Prevention of boiler explosions state premium taxes, acquisition expenses, and an
■ Educational programs on loss prevention allowance for contingencies and profit. In 2010,
property and casualty insurers incurred underwrit-
The loss-prevention activities reduce both
ing costs of about 28 percent for each underwriting
direct and indirect, or consequential, losses. Society
dollar for sales and administration, taxes, licenses
benefits, because both types of losses are reduced.
and fees. In 2010, life insurers incurred costs of
17 percent of expenditures for operating expenses,
Enhancement of Credit taxes, and investment expenses.9 As a result, total
costs to society are increased. For example, assume
A final benefit is that insurance enhances a person’s
that a small country with no property insurance has
credit. Insurance makes a borrower a better credit risk
an average of $100 million of fire losses each year.
because it guarantees the value of the borrower’s col-
Also assume that property insurance later becomes
lateral or gives greater assurance that the loan will be
available, and the expense loading is 30 percent of
repaid. For example, when a house is purchased, the
losses. Thus, total costs to this country are increased
lending institution normally requires property insur-
to $130 million.
ance on the house before the mortgage loan is granted.
However, these additional costs can be justified
The property insurance protects the lender’s finan-
for several reasons. First, from the insured’s view-
cial interest if the property is damaged or destroyed.
point, uncertainty concerning the payment of a cov-
Similarly, a business firm seeking a temporary loan
ered loss is reduced because of insurance. Second, the
for Christmas or seasonal business may be required
costs of doing business are not necessarily wasteful,
to insure its inventories before the loan is made. If a
because insurers engage in a wide variety of loss-
new car is purchased and financed by a bank or other
prevention activities. Finally, the insurance industry
lending institution, physical damage insurance on the
provides jobs to millions of workers in the United
car may be required before the loan is made. Thus,
States. However, because economic resources are
insurance can enhance a person’s credit.
used up in providing insurance to society, a real
economic cost is incurred.

COSTS OF INSURANCE
Fraudulent Claims
TO SOCIETY
A second cost of insurance comes from the submis-
Although the insurance industry provides enormous
sion of fraudulent claims. Examples of fraudulent
social and economic benefits to society, the social
claims include the following:
costs of insurance must also be recognized. The
major social costs of insurance include the following: ■ Auto accidents are faked or staged to collect
benefits.
■ Cost of doing business
■ Dishonest claimants fake slip-and-fall accidents.
■ Fraudulent claims
■ Phony burglaries, thefts, or acts of vandalism are
■ Inflated claims
reported to insurers.
■ False health insurance claims are submitted to
Cost of Doing Business collect benefits.
■ Dishonest policyholders take out life insur-
One important cost is the cost of doing business.
ance policies on unsuspecting insureds and later
Insurers consume scarce economic resources—land,
arrange to have them killed.
labor, capital, and business enterprise—in providing
insurance to society. In financial terms, an expense The payment of such fraudulent claims results
loading must be added to the pure premium to in higher premiums to all insureds. The existence of
 COSTS OF INSURANCE TO SOCIETY 33

insurance also prompts some insureds to deliberately ■ Insureds inflate the amount of damage in auto
cause a loss to profit from insurance. These social collision claims so that the insurance payments
costs fall directly on society. will cover the collision deductible.
Some types of insurance fraud are especially out- ■ Disabled persons often malinger to collect disability-
rageous. The Coalition Against Insurance Fraud has income benefits for a longer duration.
established a “hall of shame” for insurance scams ■ Insureds exaggerate the amount and value of
that are strikingly shocking, brazen, and outrageous property stolen from a home or business.
(see Insight 2.1).
Inflated claims must be recognized as an impor-
tant social cost of insurance. Premiums must be
Inflated Claims increased to pay the additional losses. As a result,
disposable income and the consumption of other
Another cost of insurance relates to the submission of
goods and services are reduced.
inflated or “padded” claims. Although the loss is not
intentionally caused by the insured, the dollar amount
of the claim may exceed the actual financial loss. Cost to Society of Fraudulent and Inflated Claims
Examples of inflated claims include the following:
According to the Insurance Information Institute,
■ Attorneys for plaintiffs sue for high-liability industry estimates of fraud are about 10 percent
judgments that exceed the true economic loss of of the property and casualty incurred losses and
the victim. loss adjustment expenses each year. Based on this

INSIGHT 2.1
Insurance Fraud Hall of Shame—Shocking Examples of Insurance Fraud
The Coalition Against Insurance Fraud compiles annually • Torching his home and children die. Timothy Nicholls
a list of insurance fraud cases that are especially shock- torched his home to get insurance money to pay his
ing, brazen, and outrageous. The following is a summary of mounting debt to a motorcycle gang that supplied him
several shocking cases: with methamphetamines. Three children died of smoke
inhalation. Nichols received life in prison.
• Sinister seniors. Two elderly women befriended two • Playing with fire backfires. Victor and Olga Barriere
homeless men in Los Angeles and took out $3 million wanted to burn their rickety home for the insurance.
of life insurance on the men, naming themselves as The couple was stuck with a $315,000 mortgage and a
beneficiaries. Helen Golay and Olga Rutterschmidt then decaying home that nobody wanted to buy. They hired
had cars run down and kill the two men. Both women handyman Thomas Trucious to torch the place for an
received life without parole. insurance payoff. The plan backfired. The handyman was
• Killing street people for life insurance. Richard James a rank amateur who blew up the house in a searing fire-
is a Guyanese-American life insurance agent who con- ball, fatally engulfing himself in flames and endangering
spired to take out fraudulent life insurance policies on homes in the neighborhood.
Guyanese street people in the New York City area. He • Nursing home hellholes. Robert Wachter ran three nurs-
had them killed for the payouts. Four street people were ing homes in Missouri. Residents were denied water,
killed in a scheme that netted more than $1 million. food, and sanitation. He billed Medicare and Medicaid
James and a crony are headed to prison for life. for many of the same services. Some residents died of
• Crooked cop shoots himself. A passerby found Los neglect. Wachter received 18 months in federal prison
Angeles District police officer Jeff Stenroos lying on the and fines of $750,000.
ground near his open door. He claimed he was shot by
a car-burglary suspect with a ponytail and black leather
jacket. But the shooting was a hoax. Stenroos shot him-
Source: Adaptation of selected cases from Hall of Shame’s No-Class of 2011
self in his bulletproof vest and then filed a fraudulent Dishonored; Amazing Disgrace: 2008 Shamers Dishonored;, and Newsroom, Top
workers compensation claim. Swindlers of 2007, Coalition Against Insurance Fraud, at [Link].
34 CHAPTER 2 / INSURANCE AND RISK

estimate, property and casualty insurance fraud Most Americans think insurance fraud is
exceeded $30 billion each year over the five-year committed only by career criminals and large crime
period from 2006 to 2010. In addition, according rings, such as auto-theft rings, chop shops, and
to the Federal Bureau of Investigation (FBI), health- dishonest doctors and lawyers. This restricted view
care fraud is an estimated 3 to 10 percent of total of insurance fraud is incorrect. Many Americans
health-care spending. This includes both private and who otherwise think they are basically honest often
public fraud. According to the Centers for Medicare engage in a variety of actions that clearly fall within
and Medicaid Services estimated health-care fraud the category of insurance fraud (see Insight 2.2).
amounted to between $77 billion and $259 billion Although fraudulent and inflated claims must be
in 2010.10 recognized as a social cost of insurance, the economic
Some people commit insurance fraud because benefits of insurance generally outweigh these costs.
they are greedy, need large amounts of cash for Insurance reduces worry and fear; the indemnification
various purposes, and view insurers as easy targets. function contributes greatly to social and economic
Others want to reduce their out-of-pocket costs stability; financial security of individuals and firms is
when a loss occurs, such as covering their deductible, preserved; and from the perspective of insurers, objec-
or want to “get back” at insurers who may be per- tive risk in the economy is reduced. The social costs of
ceived as unfair. The end result is higher insurance insurance can be viewed as the sacrifice that society
premiums for all policyholders. must make to obtain these benefits.

INSIGHT 2.2
Don’t Think Insurance Fraud Is Committed Only by Hardened Crooks
So, you think insurance fraud is committed only by hardened They may not even think this is real insurance fraud.
crooks and large crime rings? “Heck, it’s only a few dollars,” or “Nobody’s really being
Actually, many normally honest people also commit hurt,” or “I’ve paid my premiums for years, and now it’s
fraud. Maybe even your church-going uncle . . . that helpful my turn.”
neighbor across the street . . . a friendly store owner downtown. Well guess again. Try this quiz. If you check “yes” for any
People sometimes “just fudge a bit” or tell “little white question, you may have committed insurance fraud.
lies” when they apply for insurance or make a claim.

Yes or No Have you ever knowingly:

❑ ❑ said you drive fewer miles to work than you really do, when applying for auto coverage?
❑ ❑ said you never use your car for work though you actually do, when applying for auto coverage?
❑ ❑ said you park your car in a garage when you actually park it on the street, when applying for auto coverage?
❑ ❑ said you live in a different location than you really do, when applying for auto coverage?
❑ ❑ let a body shop pad your car repair bill to recoup your deductible when making an auto claim?
❑ ❑ inflated the value of possessions stolen from your home or car when making a claim?
❑ ❑ inflated the value of jewelry or other goods you lost when making a claim?
❑ ❑ asked a repairman to pad a bill for damage to your home so you could recoup your deductible?
❑ ❑ said your business has fewer employees than it really does, when you applied for workers compensation
coverage?
❑ ❑ said your employees have safer jobs than they really do, when you applied for workers compensation coverage?
❑ ❑ fudged your medical history so you seem healthier on your life insurance application?
❑ ❑ said you don’t smoke even though you really do, when applying for life insurance coverage?
❑ ❑ said an injury you received at home or while playing sports was work-related so you could collect workers
compensation coverage?
❑ ❑ stayed home even though you’re healed, so you could keep collecting workers compensation?

Source: Reprinted with permission of the Coalition Against Insurance Fraud, [Link].
 SUMMARY 35

Case Application
There are numerous definitions of insurance. Based on c. A builder of new homes gives a 10-year guarantee
the definition of insurance stated in the text, indicate against structural defects in the home.
whether each of the following guarantees is considered d. A cosigner of a note agrees to pay the loan balance
insurance. if the original debtor defaults on the payments.
a. A new television is guaranteed by the manufacturer e. A large group of homeowners agrees to pay for
against defects for 90 days. losses to homes that are damaged or destroyed by
b. A new set of radial tires is guaranteed by the manu- fire during the year.
facturer against road defects for 50,000 miles.

SUMMARY ■ Adverse selection is the tendency of persons with a

higher-than-average chance of loss to seek insurance at
■ There is no single definition of insurance. However, a average rates, which, if not controlled by underwriting,
typical insurance plan contains four elements: results in higher-than-expected loss levels.
Pooling of losses ■ Insurance is not the same as gambling. Gambling creates
Payment of fortuitous losses a new speculative risk, whereas insurance deals with
Risk transfer an existing pure risk. Also, gambling may be socially
Indemnification unproductive, because the winner’s gain comes at the
expense of the loser. Insurance is socially productive
Pooling means that the losses of the few are spread over because both the insured and insurer benefit if the loss
the group, and average loss is substituted for actual does not occur.
loss. Fortuitous losses are unforeseen and unexpected
and occur as a result of chance. Risk transfer involves ■ Insurance is not the same as hedging. Insurance involves
the transfer of a pure risk to an insurer. Indemnification the transfer of a pure risk, whereas hedging involves
means that the victim of a loss is restored in whole or in the transfer of a speculative risk. Also, insurance may
part by payment, repair, or replacement by the insurer. reduce objective risk because of the law of large num-
bers. Hedging typically involves only risk transfer and
■ The law of large numbers states that the greater the not risk reduction.
number of exposures, the more likely the actual results
■ Insurance can be classified into private and govern-
will approach the expected results. The law of large
ment insurance. Private insurance consists of life and
numbers permits an insurer to estimate future losses
health insurance and property and liability insurance.
with some accuracy.
Government insurance consists of social insurance and
■ From the viewpoint of a private insurer, an insurable other government insurance programs.
risk ideally should have certain characteristics.
■ The major benefits of insurance to society are as follows:
There must be a large number of exposure units.
Indemnification for loss
The loss must be accidental and unintentional.
Reduction of worry and fear
The loss must be determinable and measurable.
Source of investment funds
The loss should not be catastrophic.
Loss prevention
The chance of loss must be calculable.
Enhancement of credit
The premium must be economically feasible.
■ Insurance imposes certain costs on society, which
■ Most personal risks, property risks, and liability risks
include the following:
can be privately insured, because the requirements of an
insurable risk generally can be met. However, most mar- Cost of doing business
ket risks, financial risks, production risks, and political Fraudulent claims
risks generally are difficult to insure privately. Inflated claims
36 CHAPTER 2 / INSURANCE AND RISK

KEY CONCEPTS AND TERMS APPLICATION QUESTIONS

Adverse selection (26) Ocean marine insurance (29) 1. Compare the risks of (i) fire with (ii) war in terms of
Casualty insurance (27) Personal lines (27) how well they meet the requirements of an ideally
Commercial lines (28) Pooling (20) insurable risk.
Expense loading (32) Property insurance (27)
2. a. Private insurers provide social and economic ben-
Fidelity bonds (29) Reinsurance (23)
efits to society. Explain the following benefits of
Fortuitous loss (22) Requirements of an
insurance to society.
Indemnification (22) insurable risk (24)
Inland marine insurance (29) Risk transfer (22) (1) Indemnification for loss
Insurance (20) Social insurance (29) (2) Enhancement of credit
Law of large numbers (21) Surety bonds (29) (3) Source of funds for capital investment and
Liability insurance (27) Underwriting (26) accumulation
Life insurance (27) b. Explain the major costs of insurance to society.

3. Buildings in flood zones are difficult to insure by pri-

REVIEW QUESTIONS vate insurers because the ideal requirements of an
1. Explain each of the following characteristics of a insurable risk are difficult to meet.
typical insurance plan. a. Identify the ideal requirements of an insurable risk.
a. Pooling of losses
b. Which of the requirements of an insurable risk are
b. Payment of fortuitous losses
not met by the flood peril?
c. Risk transfer
d. Indemnification 4. Private insurance provides numerous coverages that
can be used to meet specific loss situations. For
2. Explain the law of large numbers.
each of the following situations, identify a private
3. Pure risks ideally should have certain characteristics insurance coverage that would provide the desired
to be insurable by private insurers. List the six protection.
characteristics of an ideally insurable risk.
a. Emily, age 28, is a single parent with two
4. Identify the approaches that insurers can use to deal dependent children. She wants to make certain
with the problem of catastrophic loss exposures. that funds are available for her children’s educa-
5. Why are most market risks, financial risks, production tion if she dies before her youngest child finishes
risks, and political risks considered difficult to insure college.
by private insurers? b. Danielle, age 16, recently obtained her driver’s
6. a. What is the meaning of adverse selection? license. Her parents want to make certain they are
b. Identify some methods that insurers use to control protected if Danielle negligently injures another
for adverse selection. motorist while driving a family car.
7. What are the two major differences between insurance c. Jacob, age 30, is married with two dependents. He
and gambling? wants his income to continue if he becomes totally
disabled and unable to work.
8. What are the two major differences between insurance
and hedging? d. Tyler, age 35, recently purchased a house for
$200,000 that is located in an area where torna-
9. a. Identify the major fields of private insurance.
does frequently occur. He wants to make certain
b. Identify several property and casualty insurance that funds are available if the house is damaged or
coverages. destroyed by a tornado.
10. a. Explain the basic characteristics of social insurance e. Nathan, age 40, owns an upscale furniture store.
programs. Nathan wants to be protected if a customer is
b. Identify the major social insurance programs in the injured while shopping in the store and sues him
United States. for the bodily injury.
 NOTES 37

INTERNET RESOURCES the general public. IRC is devoted solely to research and
communication of its research findings. Visit the site at
■ The American Insurance Association (AIA) is an impor-
[Link]/
tant trade and service organization that represents
approximately 300 insurers. The site lists available ■ InsWeb operates an online insurance marketplace that
publications, position papers on important issues enables consumers to get quotes for numerous insur-
in property and casualty insurance, press releases, ance products, including auto, homeowners, and renters
insurance-related links, and names of state insurance insurance, term insurance, and individual health insur-
commissioners. Visit the site at ance. Overall, it is an excellent source of information
[Link]/aiapub/ for consumers. Visit the site at
[Link]
■ The Coalition Against Insurance Fraud is an alliance of
consumer, law enforcement, and insurance industry
■ The International Risk Management Institute (IRMI) seeks
groups that attempt to reduce insurance fraud through
public education and action. Numerous examples of to be the premier authority in providing expert advice
fraudulent claims are listed. Visit this interesting site at and practical strategies on risk management and insur-
ance. IRMI has a large online library with information
[Link]/
on numerous risk management and insurance topics.
■ The Insurance Information Institute (III) has an excellent Visit the site at
site for obtaining information on property and casualty [Link]
insurance. III provides timely consumer information on
auto, homeowners, and business insurance, submission ■ The National Association of Mutual Insurance Companies
of claims and rebuilding after catastrophes, and ways is a trade association that represents mutual insurance
to save money. The site contains background material companies involved in property and casualty insurance.
and information for the news media, including televi- Visit the site at
sion, newspapers, and radio. Visit this important site at [Link]
[Link]

■ [Link] provides timely information on auto insur-

ance, homeowners insurance, life and health insurance, SELECTED REFERENCES
disability insurance, and other types of insurance. Rate The Financial Services Fact Book 2012, New York:
quotes can be obtained online for major lines of insur- Insurance Information Institute, 2012.
ance. The site provides valuable information to consum-
The Insurance Fact Book 2012, New York: Insurance
ers on most types of insurance. Visit the site at
Information Institute, 2012.
[Link]
Life Insurers Fact Book 2011, Washington, DC: American
■ The Insurance Journal is a definitive online source of Council of Life Insurers, 2011.
timely information on the property/casualty industry. Risk Management and Insurance, 2nd ed., Compiled from
A free online newsletter is available that provides publications by Charles M. Nyce and George E. Rejda,
breaking news on important developments in property Boston, MA: Pearson Custom Publishing, 2008.
and casualty insurance. Visit the site at
[Link]
NOTES
■ The Insurance Research Council (IRC) is a division of the
Institutes. IRC is an independent, nonprofit research 1. Bulletin of the Commission on Insurance Terminology
organization supported by leading property and casu- of the American Risk and Insurance Association,
alty insurance companies and associations. IRC pro- (October 1965).
vides timely and reliable information based on extensive 2. Robert I. Mehr and Sandra G. Gustavson, Life
data collection and analyses and examines important Insurance: Theory and Practice, 4th ed. (Plano, TX:
public policy issues that affect insurers, customers, and Business Publications, 1987), p. 31.
38 CHAPTER 2 / INSURANCE AND RISK

3. Robert I. Mehr, Fundamentals of Insurance, 2nd ed. 6. The Insurance Fact Book 2012, New York: Insurance
(Homewood, IL: Richard D. Irwin, 1986), p. 43. Information Institute, p. v.
4. Market risks include the risks of adverse price 7. George E. Rejda, Social Insurance and Economic
changes in raw materials, general price level Security, 7th ed. (Armonk, New York M.E. Sharpe,
changes (inflation), changes in consumer tastes, new Inc., 2012), pp. 15-17.
technology, and increased competition from com- 8. The five states are California, Hawaii, New Jersey,
petitors. Financial risks include the risks of adverse New York, and Rhode Island.
price changes in the price of securities, adverse
changes in interest rates, and the inability to bor- 9. The Insurance Fact Book 2012, New York: Insurance
row on favorable terms. Production risks include Information Institute, p. 38; Life Insurers Fact Book
shortages of raw materials, depletion of natural 2011, Table 5.1.
resources, and technical problems in production. 10. Insurance Information Institute, “Insurance Fraud,”
Political risks include the risks of war, acts of ter- March 2012. This article is periodically updated.
rorism, government uprisings, adverse government
regulations, and the nationalization of foreign
plants by a hostile government. Students may take a self-administered test on
5. American Council of Life Insurers, Life Insurers Fact this chapter at
Book 2011, Washington, D.C., 2011, Table 1.7. [Link]/rejda
Available at [Link]
 APPENDIX

BASIC STATISTICS AND THE

LAW OF LARGE NUMBERS

T he application of probability and statistics is

crucial in the insurance industry. Insurance actu-
aries constantly face a tradeoff when determining
determined without experimentation. For example, if
a “fair” coin is flipped in the air, the probability the
coin will come up “heads” is 50 percent, and the prob-
the premium to charge for coverage: the premium ability it will come up “tails” is also 50 percent. Other
must be high enough to cover expected losses and probabilities, such as the probability of dying during a
expenses, but low enough to remain competitive specified year or the probability of being involved in
with premiums charged by other insurers. Actuaries an auto accident, can be estimated from past loss data.
apply statistical analysis to determine expected loss A convenient way of summarizing events and
levels and expected deviations from these loss levels. probabilities is through a probability distribution.
Through the application of the law of large numbers, A probability distribution lists events that could
insurers reduce their risk of adverse outcomes. occur and the corresponding probability of each
In this appendix, we review some statistical con- event’s occurrence. Probability distributions may
cepts that are important to insurers, including prob- be discrete, meaning that only distinct outcomes are
ability, central tendency, and dispersion. Next, we possible, or continuous, meaning that any outcome
examine the law of large numbers and how insurance over a range of outcomes could occur.1
companies apply it to reduce risk. Probability distributions are characterized by
two important measures: central tendency and dis-
persion. Although there are several measures of cen-
PROBABILITY AND STATISTICS tral tendency, the measure most often employed is the
mean (μ) or expected value (EV) of the distribution.2
To determine expected losses, insurance actuaries The mean or expected value is found by multiplying
apply probability and statistical analysis to given loss each outcome by the probability of occurrence, and
situations. The probability of an event is simply the then summing the resulting products:
long-run relative frequency of the event, given an infi-
nite number of trials with no changes in the underly-
ing conditions. The probability of some events can be m or EV = g X iPi

39
40 CHAPTER 2 / INSURANCE AND RISK

For example, assume that an actuary estimates the central tendency and dispersion measures are in
the following probabilities of various losses for a the same units. The square root of the variance is the
certain risk: standard deviation. The variance and standard devia-
tion of the first distribution are as follows:
Amount Probability
s2 = .3010 - 3002 2 + .501360 - 3002 2
of Loss (Xi) of Loss (Pi) XiPi
+ .201600 - 3002 2
$ 0 * .30 = $ 0
= 27,000 + 1,800 + 18,000
$360 * .50 = $180
= 46,800
$600 * .20 = $120
s = 246,800 = 216.33
πXiPi = $300

Thus, we could say that the mean or expected loss For the second distribution, the variance and sta-
given the probability distribution is $300. ndard deviation are:
Although the mean value indicates central ten-
dency, it does not tell us anything about the riskiness s2 = .401225 - 3002 2 + .601350 - 3002 2
or dispersion of the distribution. Consider a second = 2,250 + 1,500
probability-of-loss distribution: = 3,750
s = 23,750 = 61.24
Amount of Probability of
Loss (Xi) Loss (Pi) XiPi
Thus, while the means of the two distributions are
$225 * .40 = $ 90 the same, the standard deviations are significantly
$350 * .60 = $210 different. Higher standard deviations, relative to
the mean, are associated with greater uncertainty
πXiPi = $300
of loss; therefore, risk is higher. Lower standard
deviations, relative to the mean, are associated with
This distribution also has a mean loss value of $300.
less uncertainty of loss; therefore, risk is lower.
However, the first distribution is riskier because
The two probability distributions used in the dis-
the range of possible outcomes is from $0 to $600.
cussion of central tendency and dispersion are “odd”
With the second distribution, the range of possible
in that only three and two possible outcomes, respec-
outcomes is only $125 ($350 – $225), so we are
tively, could occur. In addition, specific probabilities
more certain about the outcome with the second
corresponding to the loss levels are assigned. In prac-
distribution.
tice, estimating the frequency and severity of loss is
Two standard measures of dispersion are
difficult. Insurers can employ both actual loss data
employed to characterize the variability or dispersion
and theoretical loss distributions in estimating losses.3
about the mean value. These measures are the variance
(s2) and the standard deviation (s). The variance of
a probability distribution is the sum of the squared
differences between the possible outcomes and the LAW OF LARGE NUMBERS
expected value, weighted by the probability of the Even if the characteristics of the population were
outcomes: known with certainty, insurers do not insure pop-
ulations. Rather, they select a sample from the
s2 = a Pi 1X i - EV 2 2 population and insure the sample. Obviously, the
relationship between population parameters and
So the variance is the average squared devia- the characteristics of the sample (mean and stand-
tion between the possible outcomes and the mean. ard deviation) is important for insurers, since actual
Because the variance is in “squared units,” it is neces- experience may vary significantly from the popula-
sary to take the square root of the variance so that tion parameters. The characteristics of the sampling
 LAW OF LARGE NUMBERS 41

distribution help to illustrate the law of large The second important implication of the Central
numbers, the mathematical foundation of insurance. Limit Theorem for insurers is that the standard error of
It can be shown that the average losses for a ran- the sample mean distribution declines as the sample size
dom sample of n exposure units will follow a normal increases. Recall that the standard error is defined as
distribution because of the Central Limit Theorem,
which states: sx = sx > 2n

If you draw random samples of n observations from In other words, the standard error of the sample mean
any population with mean μx and standard deviation loss distribution is equal to the standard deviation of
sx, and n is sufficiently large, the distribution of sample the population divided by the square root of the sam-
means will be approximately normal, with the mean
ple size. Because the population standard deviation
of the distribution equal to the mean of the population
mx = mx , and the standard error of the sample mean
is independent of the sample size, the standard error
sx equal to the standard deviation of the population of the sampling distribution, sx can be reduced by
(sx) divided by the square root of n (sx = sx > 2n) simply increasing the sample size.
This approximation becomes increasingly accurate as This result has important implications for insurers.
the sample size, n, increases. For example, assume that an insurer would like to
select a sample to insure from a population where the
The Central Limit Theorem has two important mean loss is $500 and the standard deviation is $350.
implications for insurers. First, it is clear that the As the insurer increases the number of units insured
sample distribution of means does not depend on (n), the standard error of the sampling distribution sx
the population distribution, provided n is sufficiently will decline. The standard error for various sample sizes
large. In other words, regardless of the population is summarized below:
distribution (bimodal, unimodal, symmetric, skewed
right, skewed left, and so on), the distribution of n sx
sample means will approach the normal distribution
as the sample size increases. This result is shown in 10 110.68
Exhibit A2.1. 100 35.00
The normal distribution is a symmetric, bell- 1,000 11.07
shaped curve. It is defined by the mean and standard
10,000 3.50
deviation of the distribution. About 68 percent of the
distribution lies within one standard deviation of the 100,000 1.11
mean, and about 95 percent of the distribution lies
within two standard deviations of the mean. The nor- Thus, as the sample size increases, the difference
mal curve has many statistical applications (hypothe- between actual results and expected results decreases.
sis testing, confidence intervals, and so on) and is easy Indeed, sx approaches zero as n gets very large. This
to use. result is shown graphically in Exhibit A2.2.

Exhibit A2.1
Sampling Distribution Versus Sample Size Exhibit A2.2
Standard Error of the Sampling Distribution Versus
f(x) Sample Size
sx
n  10,000

n  1000

sx  sx n

x
E(X )
n
42 CHAPTER 2 / INSURANCE AND RISK

Obviously, when an insurer increases the size reduce their objective risk. There truly is “safety in
of the sample insured, underwriting risk (maximum numbers” for insurers.
insured losses) increases because more insured units
could suffer a loss. The underwriting risk for an
insurer is equal to the number of units insured mul- NOTES
tiplied by the standard error of the average loss
1. The number of runs scored in a baseball game is a dis-
distribution, sx. Recalling that sx is equal to sx > 2n, crete measure as partial runs cannot be scored. Speed
we can rewrite the expression for underwriting risk as: and temperature are continuous measures as all values
over the range of values can occur.
n * sx = n * sx > 2n = 2n * sx 2. Other measures of central tendency are the median,
which is the middle observation in a probability dis-
tribution, and the mode, which is the observation that
Thus, while underwriting risk increases with occurs most often.
an increase in the sample size, it does not increase 3. Introductory statistics texts discuss several popular
proportionately. theoretical distributions, such as the binomial and
Insurance companies are in the loss business— Poisson distributions, that can be used to estimate
they expect some losses will occur. It is the deviation losses. Another popular distribution, the normal
between actual losses and expected losses that is the distribution, is discussed next under the “Law of
major concern. By insuring large samples, insurers Large Numbers.”