Insurance

Section 4

Prepared by

Eman Abdelrahim Shehata

Assistant lecture at Statistics, Mathematics and Insurance Department
Faculty of Commerce, Assiut University
 Section 4
Chapter (3)
Insurance

Definition of Insurance:
Insurance is The pooling of fortuitous losses by
transfer of such risks to insurers, who agree to
indemnify insureds for such losses, to provide
other pecuniary benefits on their occurrence, or
to render services connected with the risk.
 Basic Characteristics of Insurance
1- Pooling of losses.
2- Spreading losses incurred by the few over the entire
group.
3- Risk reduction based on the Law of Large Numbers.
Law of large numbers :which in effect states that as the
number of exposure units increases when predicting
the risk, proportionally the actual results are
increasingly likely to become close to expected
proportion
According to the law of large numbers, what
happens as the number of exposure units
increases?

(A) Actual results will increasingly differ from

probable results.
(B) Actual results will more closely approach
probable results.
(C) Non-diversifiable risk will decrease.
(D) Objective risk will increase.
4- Payment of fortuitous losses: Insurance pays for
losses that are unforeseen, unexpected, and occur
as a result of chance.

(4) Characteristics of a fortuitous loss include

which of the following:
I. The loss is certain to occur.
II. The loss occurs as a result of chance.
(a) I only
(b) II only
(c) Both I and II
(d) Neither I nor II
5- Risk transfer
A pure risk is transferred from the insured to
the insurer, who typically is in a stronger
financial position.
6- Indemnification
The insured is restored to his or her approximate
financial position prior to the occurrence of the
loss.
All of the following are characteristics of insurance EXEPT
(A) Risk avoidance
(B) pooling of losses
(C) Payment of fortuitous losses
(D) indemnification

Which of the following is implied by the pooling of loss

(A) Sharing of losses by an entire group
(B) Inability to predict losses with any degree of accuracy
(C) Substitution of actual loss for average loss
(D) Increase of objective risk
A group of farmers agreed that if any farmer suffered a property
loss, the loss would be spread over the entire group. In this way,
each farmer is responsible for the average loss of the group
rather than the actual loss that the farmer sustained, which
characteristic of insurance is embodied in this agreement:

(A) Risk avoidance

(B) pooling of losses
(C) Fortuitous losses
(D) Indemnification
 Requirements of an Insurable Risk
1- A large number of homogeneous exposure units
Large number of exposure units to predict average loss.
The existence of a large number of homogeneous
exposure units allows insurers to benefit from the so-
called “law of large numbers,” which in effect states that
as the number of exposure units increases, proportionally
the actual results are increasingly likely to become close
to expected proportions.

The vast majority of insurance policies are provided for

individual members of very large classes. Automobile
insurance, for example, covered about 175 million
automobiles in the United States in 2004
Why is a large number of exposure units generally
required before a pure risk is insurable
(A) It prevents the insurer from losing money
(B) It eliminates intentional losses
(C) It minimize moral hazard
(D)It enables the insurer to predict losses more
accurately
2- Definite Loss
The event that gives rise to the loss that is subject to
the insured, at least in principle, take place at a known
time, in a known place, and from a known cause.

the time, place and cause of a loss should be clear

enough that a reasonable person, with sufficient
information, could objectively verify all three elements
Which of the following is implied by the
requirement that a loss should be determinable and
measurable to be insurable:

I. The loss must be definite as to place.

II. The loss must be definite as to amount.

(a) I only
(b) II only
(c) Both I and II
(d) Neither I nor II
3- Accidental Loss
- Loss should be accidental and unintentional.
- The loss should be ‘pure,’ in the sense that it results from an
event is only the opportunity for cost.
- Events that contain speculative elements, are not considered
insurable (uninsurable).

The requirement that losses should be accidental and unintentional

in order to be insurable results in which of the following?
I. Decrease in moral hazard.
II. More accurate prediction of future losses.

(A) I only (B) II only

(C) Both I and II (D) Neither I nor II

2- Accidental loss means that the event should be fortuitous ( )

(True or False)
4- Large Loss
insurer must be able to determine if the loss is covered
and if so, how much should be paid. The size of The loss
must be meaningful from the perspective of the insured.

Insurance premiums need to cover both the expected

cost of losses, plus the cost of issuing and administering
the policy, adjusting losses, and supplying the capital
needed to reasonably assure that the insurer will be able
to pay claims. For small losses these latter costs may be
several times the size of the expected cost of losses.
There is little point in paying such costs unless the
protection offered has real value to a buyer.
5- Affordable Premium
If the likelihood of an insured event is so high, or
the cost of the event so large, that the resulting
premium is large relative to the amount of
protection offered, it is not likely that anyone
will buy insurance
6- Calculable Loss
There are two elements that must be estimable:
the probability of
the attendant cost
loss
Calculable chance of loss to establish an adequate
premium, and economically feasible premium so
people can afford to buy, premium must be
substantially less than the face value of the policy.
Based on these requirements:
- Most personal, property and liability risks can be
insured.
- Market risks, financial risks, production risks and
political risks are difficult to insure
Reason why Market risks, financial risks and production
risks are often uninsurable include which of the following

I. The potential to produce a catastrophic loss great

II. The chance of loss cannot be accurately estimated

(A) I only (B) II only

(C) Both I and II (D) Neither I nor II

Which of the following statements about financial risk is

(are) true?
I. Enterprise risk does not include financial risk.
II. II. financial risk is easily addressed through the
purchase of insurance.
(A) I only (B) II only
(c) Both I and II (D) Neither I nor II
7- Limited risk of catastrophically large losses.
No catastrophic loss to allow the pooling technique to
work, the exposures to catastrophic loss can be
managed by, the dispersing coverage over a large
geographic area by:
- using reinsurance, and
- Catastrophe bonds.
Methods by which insurers may minimize or avoid
catastrophic losses include which of the following
I. The use of reinsurance
II. Concentrating coverage written in one geographic
region

(A) I only (B) II only

(C) Both I and II (D) Neither I nor II
From the viewpoint of the insurer, all of the
following are characteristics of an ideally insurable
risk EXCEPT.
(a) The loss must be accidental.
(b) The loss should be catastrophic.
(c) The premium must be economically feasible.
(d) There must be a large number of exposure
units.
 Adverse Selection, Insurance and
Gambling
- Adverse selection is :
The tendency of persons with a higher-than-average
chance of loss to seek insurance at standard rates.
Adverse selection can be controlled by:
- careful underwriting (selection and classification
of applicants for insurance),
- policy provisions (e.g., suicide clause in life
insurance).
- Insurance is a technique for handing an
already existing pure risk. Insurance is socially
productive. Both parties have a common
interest in the prevention of a loss.

- Gambling creates a new speculative risk.

Gambling is not socially productive. The
winner’s gain comes at the expense of the loser
Which of the following is a result of adverse selection
(A) the insurer's financial results will be substantially
improved
(B) persons most likely to have losses are also most likely to
seek insurance at standard rates
(C) it is unnecessary for the insurance company to use
underwriting
(D) Insurance can be written only by the federal government

The tendency for unhealthy people to seek life or

health insurance at standard rate an example of
(A) Moral hazard
(B) Fundamental risk
(C) Morale hazard
(D) Adverse selection
Which of the following statements regarding
insurance and gambling is (are) true:
I. Insurance is used to handle existing pure risks,
while gambling creates a new speculative risk.
II. Insurance usually involves risk avoidance,
while gambling typically involves only risk
reduction.

(A) I only (B) II only

(C) Both I and II (D) Neither I nor II
 Insurance vs. Hedging
-Insurance:
Insurance involves the transfer of insurable risks.
Insurance can reduce the objective risk of an insurer
through the Law of Large Numbers.

- Hedging:
In hedging risk is transferred by a contract. Hedging
involves risks that are typically uninsurable. Hedging
does not result in reduced risk