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Basic Characteristics of Insurance
Sarayut Nathaphan
Basic Characteristics of Insurance
Four characteristics of an insurance plan
1. Pooling of losses
2 Payment of fortuitous losses
2.
3. Risk transfer
4. Indemnification
1. Pooling of losses
Pooling is the spreading of losses incurred by the few
over the entire group, so that in the process, average
loss is substituted for actual loss.
• Key mechanism is “law of large number”.
• Future losses are predicted based on law of large
number.
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1. Pooling of losses
Principal of loss pooling
“There should be a large number of similar, but not
necessarily identical, exposure units that are subject to
the same peril”, which can be concluded as
1. The sharing of losses by the entire group.
2. Prediction of future losses with some accuracy
based on the law of large numbers.
1. Pooling of losses
Ex: assume that 1,000 farmers in a village of Sakon
Nakorn agree that if any farmer’s home is damaged or
destroyed by a fire, the other members of the group will
indemnify the actual costs of the unlucky farmer who
has a loss. Further assume that each home is worth
200,000 Baht, and ,on average, one home burns every
year.
1. Pooling of losses
In the absence of insurance, the maximum loss to each
farmer is 200,000 Baht, if the home should burn.
With the pooling of loss, the maximum loss for each
farmer is 200 Baht for the actual loss of 200,000 Baht.
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1. Pooling of losses
In reality, the actuary seldom knows the true probability
and severity of loss. Therefore, estimates of both the
average frequency and the average severity of loss
must be based on previous loss experience (objective
risk). As the number of exposures increases, the
relative variation of actual loss from expected loss will
decline.
Note:
1. Pooling of loss is the spreading of losses
incurred by the few over the entire group so
that in the process average loss is substituted
for actual loss.
2. The primary purpose of pooling, or the
sharing of losses, is to reduce the variation in
possible outcomes as measured by the
standard deviation or some other measure of
dispersion, which reduces risk.
Assume two business owners each own an
identical storage building valued at $50,000.
Assume there is a 10% chance in any year that
each building will be destroyed by a peril, and
that a loss to either building is an independent
event.
If the two owners decide to pool their loss
agreeing to pay an equal share of any loss that
might occur.
Do risk pooling help reduce risk of the two
owners?
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From the last problem, if there is another owner
joins the pool, what is the level of risk?
2. Payment of fortuitous losses
A fortuitous loss is one that is unforeseen and
unexpected and occurs as a result of chance.
Law of large number is based on the assumption that
losses are accidental and occur randomly.
randomly
Insurance policies do not cover intentional losses.
3. Risk Transfer
Risk transfer means that a pure risk is transferred from
the insured to the insurer, who typically is in a stronger
financial position to pay the loss than the insured.
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4. Indemnification
Indemnification means that the insured is restored to his
or her approximate financial position prior to the
occurrence of the loss.
Requirements of an insurable risk
Insurer normally insure only pure risk. Not all pure risks
are insurable. Six requirements of an insurable risks.
1. There must be a large number of exposure units.
2. The loss must be accidental and unintentional.
3. The loss must be determinable and measurable.
4. The loss should not be catastrophic.
5. The chance of loss must be calculable.
6. The premium must be economically feasible.
Large number of exposure units
There should be a large group of similar, not
necessarily identical, exposure units that are
subject to the same peril or groups of perils.
Purpose of this requirement is to let the insurer to
predict loss based on the law of large numbers.
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Accidental and unintentional loss
Loss should be fortuitous and outside the insured’s
control. If an individual deliberately causes a loss, he
or she should not be indemnified for the loss.
Two purposes of this requirement are
1. If intentional losses were paid, moral hazard would
be substantially increased and caused insurance
premium to risk which driven away a large number
of insured.
Accidental and unintentional loss
2. Law of large number requires random occurrence
of events. As intentional loss is controlled by the
insured, prediction of future experience may be
highly inaccurate.
Determinable and measurable loss
Loss should be definite as to cause, time, place, and
amount.
Ex: under a disability income policy, the insurer
promises to pay a monthly benefit to the disabled
person if the definition of disability stated in the policy is
satisfied. Some dishonest claimants may deliberately
fake sickness or injury to collect from the insurer. Even
if the claim is legitimate, the insurer must still determine
whether the insured satisfies the definition of disability.
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Determinable and measurable loss
Purpose of this requirement is to enable an insurer to
determine if the loss is covered under the policy, and if
it is covered, how much should be paid.
No catastrophic loss
This is to ensure that a large proportion of exposure
units should not incur losses at the same time. If not
the pooling of losses principle is violated and premium
willill iincrease prohibitively.
hibiti l
Reinsurance is used by the insurer in order to avoid
the concentration of loss exposures in a geographic
area.
Calculable chance of loss
Both average frequency and the average severity of
future losses with some accuracy.
Purpose of this requirement is to assess the appropriate
p
premium.
Ex. Certain loss is difficult to insure because the chance
of loss cannot be accurately estimated, and the
potential for a catastrophic loss is present, i.e., floods,
wars, cyclical unemployment due to an irregular basis,
etc.
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Economically feasible premium
For the insurance to be attractive purchase, the
premiums paid must be substantially less than the
face value, or amount, of the policy.
The have an economically feasible premium, the
chance of loss must be relatively low.
Thoughts and Practice
Apply six requirements to consider whether risk
of fire and risk of unemployment is(are)
insurable or uninsurable.
Term Paper
Explore history, competitive situations (market
size, number of insurers, product variety), types
of insurance products, and the impact of Asean
Economic Commuity (AEC) on Thai insurance
industry.
Propose potential product(s) for the specific
insurance you are interesting in.
