Insurance and Risk
RMI 3500
Intro. to Risk Management
& Insurance
Robert Klein
Revised 12-23-09
Topic Objectives
• Explain the concept of
insurance.
• Identify the basic
characteristics of
insurance.
• Outline and apply the
requirements of an
insurable risk.
Insurance Defined
• Insurance is the pooling of fortuitous
losses by transfer of risks to insurers.
• Insureds pay relatively small, certain
premiums in return for protection
against a potential loss they cannot
afford.
• Reinsurance is the transfer of risk
from one insurer to another.
Insurance Pictured
Risk Transfer/Diversification
Insureds
Insurer
Reinsurers
Pooling & Objective Risk
Objective
Risk
Insurance Has Long History
• In 3000 BC merchants in Sumer and Babylonia pooled
their money to protect themselves from losses from
thieves and pirates.
• Greeks and Romans established benevolent societies;
dues used to pay burial expenses of members who
died.
• Marine, life, disability, and fire insurance developed in
Europe beginning in 15th century.
• Ben Franklin formed the
Philadelphia Contributorship
for the Insurance from Losses
by Fire in 1730.
• Presbyterian Ministers’ Fund of
Philadelphia offered life
insurance to members in 1759.
Basic Characteristics of
Insurance
• Pooling of Losses • Risk Transfer
sharing of losses by • Indemnification
group - insured is restored
using large to his/her prior
numbers to reduce position, i.e., no
objective risk financial gain
• Payment of
fortuitous losses
uncertain and
occurs as result of
chance
…Not!
Questions
• Is it feasible to insure your car for
deterioration through normal use?
• Does it make sense for 2 people to
create an insurance pool for auto
accidents?
• Is risk pooling only possible using
insurance companies?
More Questions
• Do risks have to be identical to be
pooled?
• If I have an arrangement to borrow
money to cover a loss, is that
insurance?
• Is it feasible for me to buy an
insurance policy that pays me twice
the market value of my car if I have
an accident?
Requirements of Insurable Risk
• Large number of exposure units
- to predict average loss
- to reduce objective risk
• Accidental and unintentional loss
- to control moral hazard
- to assure randomness
• Determinable and measurable loss
- to facilitate loss adjustment
More Requirements
• No catastrophic loss • Economically
- to allow pooling feasible premium
- independent losses - something people
- use of diversification can afford to buy
- risk of loss and
• Calculable chance of
premium must be
loss substantially less
- to determine accurate than potential loss
premium
More Questions
• The river is starting to
rise next to my house -
should I be able to buy
flood insurance?
• Would you sell fire
insurance to an
arsonist?
• Would you sell fire
insurance that paid
twice the market value
of the house if it burned
down?
More Questions!
• Could we sell insurance to cover
therapy for alien abduction?
• Is insurance for large meteor
collisions feasible?
• Can you calculate an insurance
premium for an event that has never
occurred?
• Is physical damage insurance
economically feasible for a $500 car?
Expected Loss
• The expected loss for any individual
or group is equal to the probability
that a loss will occur multiplied times
the amount of the loss.
• If p = .2 and L = $1,000,
then EL = .2 x $1,000 = $200
Expected Loss Distribution
(P) x Loss= EL
Expected Loss Distribution
.5 $0 $0
0.6
.25 $100 $25
.1 $200 $20 0.5
.05 $300 $15
.05 $400 $20 0.4
.025 $500 $12.5 Probability
0.3
.025 $600 $15
1.0 $108 0.2
0.1
0
0 100 200 300 400 500 600
Loss
Expected Loss = pi(xi)
What is Adverse Selection?
• All else equal, high-risk people will find it
more attractive to buy insurance than low-
risk people.
• If premiums are based on the average
expected loss for all individuals, high-risk
people will be more likely to purchase
insurance than low-risk people.
• Adverse selection can cause a risk pool to
collapse as low-risk people leave and the
average loss and premium escalates.
How to Avoid Adverse Selection
• Insurers use underwriting selection
and risk-based pricing to charge each
insured the appropriate premium.
• Underwriting is a process
by which insurers match
insureds with an
appropriate premium,
through selection and risk
classification.
Types of Insurance
• Private Insurance
Life and Health Insurance
Property and Liability Insurance
auto, home, commercial
• Government Insurance
Social Insurance
Social Security, Work Comp, Unemployment
Other Government Insurance
flood, crop, crime
Social Benefits & Costs of
Insurance
• Benefits • Costs
- indemnification - transaction costs
- less anxiety - fraud
- savings - moral hazard
- loss prevention - inflated claims
- credit
enhancement