Chapter 2
Insurance
and Risk
Agenda
• Definition and Basic Characteristics of
Insurance
• Characteristics 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
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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
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• Insurance is a system where many people (or businesses) contribute money into a
common pool to protect themselves against unexpected losses. They pay money
(called premiums) to an insurance company, which agrees to cover certain risks. If
something bad happens—like an accident, fire, or illness—the insurance company
helps pay for the loss, either by giving money or providing a service. This way, no one
person has to bear the full cost alone.
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Basic Characteristics of Insurance
• Pooling of losses
– Pooling involves spreading losses incurred by the
few over the entire group
– Risk reduction is based on the Law of Large
Numbers
– According to the Law of Large Numbers, the
greater the number of exposures, the more
closely will the actual results approach the
probable results that are expected from an
infinite number of exposures.
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• Pooling of losses means that a large group of people or businesses share the risk of
loss. Everyone contributes a small amount (premium) to a common fund. When a few
people in the group experience a loss (like an accident or damage), they are
compensated using this shared money.
How it Works:
• Not everyone will face a loss at the same time.
• The losses of a few are covered by the contributions of many.
• This makes it easier for individuals to handle unexpected financial burdens.
• Risk Reduction & the Law of Large Numbers:
• The Law of Large Numbers states that when more people are insured, the insurance
company can predict losses more accurately.
• This is because, with a large group, patterns become clearer, and the overall risk
becomes more stable.
• The bigger the group, the more predictable and fair the system becomes.
• Essentially, insurance works better when more people participate because it spreads
risk more evenly and reduces uncertainty.
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Basic Characteristics of Insurance
• Example of Pooling:
– Two business owners own identical buildings
valued at $50,000
– There is a 10 percent chance each building will
be destroyed by a peril in any year
– Loss to either building is an independent event
– Expected value and standard deviation of the
loss for each owner is:
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Basic Characteristics of Insurance
• Example, continued:
– If the owners instead pool (combine) their loss
exposures, and each agrees to pay an equal
share of any loss that might occur:
– As additional individuals are added to the pool,
the standard deviation continues to decline while
the expected value of the loss remains
unchanged
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Basic Characteristics of Insurance
• Payment of fortuitous losses
– A fortuitous loss is one that is unforeseen,
unexpected, and occur as a result of chance
• Risk transfer
– A pure risk is transferred from the insured to the
insurer, who typically is in a stronger financial
position
• Indemnification
– The insured is restored to his or her approximate
financial position prior to the occurrence of the
loss
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• 1. Payment of Fortuitous Losses
• A fortuitous loss is a loss that happens suddenly and by chance—it is not planned or
expected. Examples include:
•
• A car accident
• A house fire
• A sudden illness
• Insurance helps cover these unexpected losses, so you don’t have to bear the full
financial burden alone.
•
• 2. Risk Transfer
• When you buy insurance, you transfer your financial risk to the insurance company.
This means:
•
• If something bad happens, the insurer, who has more money and resources, will help
cover the cost.
• For example, if your house burns down, the insurance company pays to rebuild it
instead of you having to pay for everything yourself.
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• 3. Indemnification
• Indemnification means the insurance company helps you return to your previous
financial position before the loss happened. It doesn’t make you richer or poorer—just
brings you back to where you were.
•
• For example:
•
• If your insured car gets damaged in an accident, the insurance company pays for
repairs to restore it.
• If a business suffers damage from a fire, insurance helps it recover without financial
ruin.
• In short, insurance protects you from unexpected losses, shifts financial risk to a
stronger company, and helps you recover after a loss.
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Characteristics of an Ideally
Insurable Risk
• Large number of exposure units
– to predict average loss based on the law
of large numbers
• Accidental and unintentional loss
– to assure random occurrence of events
• Determinable and measurable loss
– to determine how much should be paid
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• 1. Large Number of Exposure Units
• Insurance works best when there are many similar things (or people) being insured.
• For example, if an insurance company covers millions of cars, it can predict how many
accidents will happen each year using past data.
• The more people insured, the more accurate the predictions, making insurance fair
and stable.
• 2. Accidental and Unintentional Loss
• Insurance only covers losses that happen by accident or unexpectedly.
• This ensures that people don’t cause damage on purpose just to get money from
insurance.
• Example: A sudden fire in a house is covered, but if someone sets their house on fire
deliberately, it won’t be covered.
• 3. Determinable and Measurable Loss
• The insurance company must be able to determine what happened and measure how
much money is needed to fix the loss.
• Example: If a car is damaged in an accident, the insurer can check the repair costs
and pay accordingly.
• This makes sure payments are fair and based on actual losses.
• In short, insurance works well when there are many insured items, losses happen
randomly, and the cost of damage can be calculated.
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Characteristics of an Ideally
Insurable Risk
• No catastrophic loss
– to allow the pooling technique to work
– exposures to catastrophic loss can be managed
by using reinsurance, dispersing coverage over a
large geographic area, or using financial
instruments, such as catastrophe bonds
• Calculable chance of loss
– to establish a premium that is sufficient to pay all
claims and expenses and yields a profit during
the policy period
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• 1. No Catastrophic Loss
• Insurance works by spreading risk among many people. But if a huge disaster (like a
massive earthquake or war) affects everyone at once, the system can collapse.
• To prevent this, insurance companies:
• Buy reinsurance (insurance for insurance companies) to share big risks.
• Spread coverage over different locations (so one event doesn’t affect everyone).
• Use financial tools like catastrophe bonds to prepare for extreme events.
• 2. Calculable Chance of Loss
• Insurance companies must estimate how often losses will happen and how much they
will cost.
• This helps them set the right premium (the amount you pay for insurance).
• If they charge too little, they might not have enough money to pay claims. If they
charge too much, people won’t buy insurance.
• Example: A life insurance company uses data on age, health, and lifestyle to predict
how long people will live and set fair prices.
• In short, insurance companies manage big risks carefully and use data to set fair
prices that cover claims while staying profitable.
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Characteristics of an Ideally
Insurable Risk
• Economically feasible premium
– so people can afford to purchase the policy
– For insurance to be an attractive purchase, the
premiums paid must be substantially less than
the face value, or amount, 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
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1. Economically Feasible Premium
● Insurance needs to be affordable so people can actually buy it.
● If the premium (the price you pay for insurance) is too high, people won’t see the benefit of
buying it.
● For example, if life insurance costs $10,000 per year but only pays $50,000 at death, it wouldn’t
be worth it.
2. Why Some Risks Are Easy to Insure
● Personal risks (like health and life insurance), property risks (like home and car
insurance), and liability risks (like business insurance) can be insured because:
○ The chance of loss is predictable.
○ Losses happen randomly and don’t affect everyone at once.
○ The cost of a loss can be measured.
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3. Why Some Risks Are Hard to Insure
Certain risks are difficult or almost impossible to insure because they are too unpredictable or
widespread:
● Market risks (like stock market crashes)
● Financial risks (like business losses from inflation)
● Production risks (like sudden changes in raw material prices)
● Political risks (like government policy changes or war)
These risks are hard to insure because they:
● Don’t happen by chance—they are influenced by human decisions.
● Can cause huge losses to many people at the same time.
● Are difficult to measure in terms of financial impact.
In short, insurance works best when risks are random, measurable, and affordable, but it struggles with
unpredictable risks that affect too many people at once.
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Exhibit 2.1 Risk of Fire as an Insurable Risk
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Exhibit 2.2 Risk of Unemployment as an
Insurable Risk
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Adverse Selection and Insurance
• Adverse selection is the tendency of
persons with a higher-than-average chance
of loss to seek insurance at standard rates
• If not controlled by underwriting, adverse
selection results in higher-than-expected
loss levels
• Adverse selection can be controlled by:
– careful underwriting (selection and classification
of applicants for insurance)
– policy provisions (e.g., suicide clause in life
insurance)
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What is Adverse Selection?
● Adverse selection happens when people who are more likely to experience a loss try to buy
insurance at normal rates.
● Example: A person with a serious illness applies for health insurance without telling the insurer. If
the company doesn’t know about the illness, they may charge the same premium as for a healthy
person, leading to unexpectedly high claims.
Why is it a Problem?
● If too many high-risk people buy insurance without the company knowing, the company will lose
money because they will have to pay more claims than expected.
● This could make insurance more expensive for everyone, or even cause the company to fail.
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How is it Controlled?
1. Careful Underwriting – Insurance companies carefully review applications to assess risk. They may:
○ Ask for medical exams before approving health or life insurance.
○ Check driving records before giving car insurance.
2. Policy Provisions – Insurance companies add special rules to prevent misuse.
○ Example: In life insurance, the suicide clause says that if someone dies by suicide within a short period
(e.g., 2 years), the insurer won’t pay the full benefit.
○ This stops people from buying a big policy right before an intentional loss.
Bottom Line
Adverse selection means high-risk people want more insurance, which can be bad for insurers. To prevent this,
companies carefully check applicants and use special policy rules to keep things fair.
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Insurance vs. Gambling
Insurance Gambling
• Insurance is a • Gambling creates a
technique for new speculative risk
handing an already • Gambling is not
existing pure risk socially productive
• Insurance is always – The winner’s gain
socially productive: comes at the
– both parties have a expense of the loser
common interest in
the prevention of a
loss
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Insurance vs. Hedging
Insurance Hedging
• Risk is transferred • Risk is transferred
by a contract by a contract
• Insurance involves • Hedging involves
the transfer of pure risks that are
(insurable) risks typically uninsurable
• Insurance can • Hedging does not
reduce the objective result in reduced
risk of an insurer risk
– through the Law of
Large Numbers
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Types of Private Insurance
• Life and Health
– Life insurance pays death benefits to
beneficiaries when the insured dies
– Health insurance covers medical expenses
because of sickness or injury
– Disability plans pay income benefits
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1. Life Insurance
● What it does: Pays money to the chosen beneficiaries (family, spouse, or anyone you select) when the
insured person dies.
● Example: If a person has a $100,000 life insurance policy, their family gets $100,000 after their
passing.
● Purpose: Helps loved ones financially after the insured person is gone.
2. Health Insurance
● What it does: Pays for medical expenses due to illness, injury, or hospital visits.
● Example: If someone breaks their leg, health insurance helps cover the doctor’s fees, hospital bills,
and medicines.
● Purpose: Reduces the financial burden of medical costs.
3. Disability Plans
● What it does: Provides income if someone becomes unable to work due to injury or illness.
● Example: If a person can’t work for 6 months due to an accident, a disability plan will pay them a
percentage of their salary.
● Purpose: Helps replace lost income so they can continue to pay for their daily expenses.
In short, life insurance helps after death, health insurance covers medical bills, and disability insurance
provides income if you can’t work.
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Types of Private Insurance
• Property and Liability
– Property insurance indemnifies property owners
against the loss or damage of real or personal
property
– Liability insurance covers the insured’s legal
liability arising out of property damage or bodily
injury to others
– Casualty insurance refers to insurance that
covers whatever is not covered by fire, marine,
and life insurance
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1. Property Insurance
● What it does: Protects homes, buildings, cars, or personal belongings from loss or damage.
● Example: If a fire destroys your house, property insurance helps pay for repairs or rebuilding.
● Purpose: Helps owners recover financially after damage to their property.
2. Liability Insurance
● What it does: Covers legal costs and payments if you accidentally cause injury or damage to
someone else’s property.
● Example:
○ If your dog bites a neighbor, liability insurance helps pay for their medical bills.
○ If you crash into another car, it covers repair costs for the other driver.
● Purpose: Protects you from financial loss due to lawsuits or claims from others.
3. Casualty Insurance
● What it does: Covers other risks that don’t fall under fire, marine, or life insurance.
● Example: Includes car insurance, theft insurance, workers' compensation, etc.
● Purpose: Provides extra coverage for unexpected events beyond basic property or life insurance.
In short:
● Property insurance covers damage to your belongings.
● Liability insurance covers harm you cause to others.
● Casualty insurance includes various other risks like accidents, theft, or legal claims.
●
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Types of Private Insurance
• Private insurance coverages can be grouped
into two major categories
– Personal lines: coverages that insure the real
estate and personal property of individuals and
families or provide protection against legal
liability
– Commercial lines: coverages for business firms,
nonprofit organizations, and government
agencies
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Exhibit 2.3
Property and
Casualty Insurance
Coverages
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Types of Government Insurance
• Social Insurance Programs
– Financed entirely or in large part by
contributions from employers and/or employees
– Benefits are heavily weighted in favor of
low-income groups
– Eligibility and benefits are prescribed by statute
– Examples: Social Security, Unemployment,
Workers Comp
• Other Government Insurance Programs
– Found at both the federal and state level
– Examples:Federal flood insurance, state health
insurance pools
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Social Benefits of Insurance
• Indemnification for Loss
• Reduction of Worry and Fear
• Source of Investment Funds
• Loss Prevention
• Enhancement of Credit
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Social Costs of Insurance
• Cost of Doing Business
– An expense loading is the amount needed to pay
all expenses, including commissions, general
administrative expenses, state premium taxes,
acquisition expenses, and an allowance for
contingencies and profit
• Fraudulent Claims
• Inflated Claims
Higher premiums to cover additional losses
reduce disposable income and consumption
of other goods and services
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