Chapter Two
Insurance and Risk
Agenda
• Definition of Insurnace
• Basic Characterisicts of Insurance
• Characteristiccs of an Ideally Insurable Risk
• Adverse Selection and Insurance
• Insurance and Gambling Compared
• Insurance and Hedging Compared
• Types of Insurance
• Benefits and Costs of Insurance to Society
Basic Charactristics of Insurance
• Pooling of losses
• Payment of fortuitous losses
• Risk transfer
• Indemnification
If you flip a coin into the air, a priori
probability of getting a head is 0.5.
If you flip the coin only 10 times,
you may get a head eight times.
Although the observe probability
of getting a head is 0.8, the true
probability is still 0.5.
If the coin were flipped 1 million
times, however, the actual number
of heads would be app 500,000.
Thus, as the number of random
tosses increases, the actual results
approach the expected results.
• Example, Continued:
• Suppose the two owners decide to pool (combine) their loss
exposures, and each agrees to pay an equal share of any loss that
might occur.
• Under this scenario, there are four possible outcomes:
Possible outcomes Probability Loss payments
Neither building is destroyed .90 * .90 = .81 $0
1st building destroyed, 2nd building no .10 * .90 = .09 $25,000
loss
1st building no loss, 2nd building .90 * .10 = .09 $25,000
destroyed
Both building are destroyed .10 * .10 = .01 $50,000
Possible outcomes Probability Loss payments
Neither building is destroyed .90 * .90 = .81 $0
1st building destroyed, 2nd building no .10 * .90 = .09 $25,000
loss
1st building no loss, 2nd building .90 * .10 = .09 $25,000
destroyed
Both building are destroyed .10 * .10 = .01 $50,000
• Thus, as additional individuals are added to the pooling arrangement,
the standard deviation continues to decline while the expected value
of the loss remains unchanged.
• For example, with a pool of 100 insureds, the standard deviation is
$1500; with a pool of 1000 insureds, the standard deviation is $475;
and with a pool of 10,000, the standard deviation is $150.
• By pooling or combining the loss experience of a large number of
exposure units, an insurer may be able to predict future losses with
greater accuracy. From the viewpoint of the insurer, if future losses
can be predicted, objective risk is reduced. Thus, another
characteristic often found in many lines of insurance is risk reduction
based on the law of large numbers.
Six Characteristics of an
Ideally Insurable Risk
• Commercial insurers
generally insure only pure
risks.
• However, some pure risks
are not privately insurable.
Form the viewpoint of a
private insurer, an
insurable risk ideally
should have certain
characteristics.
Six Characteristics of an
Ideally Insurable Risk