Ch. 2 Test Bank - Insurance

Chapter 2
1) All of the following are characteristics of insurance EXCEPT

A) risk avoidance.
B) pooling of losses.
C) payment of fortuitous losses.
D) indemnification.
Answer: A
2) Which of the following is implied by the pooling of losses?

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
Answer: A
3) 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) No diversifiable risk will decrease.
D) Objective risk will increase.
Answer: B
4) According to the law of large numbers, what should happen as an insurer increases the
number of units insured?
A) The amount the insurer expects to pay in claims should decrease.
B) Underwriting expenses should decrease.
C) Actual results will more closely approach expected results.
D) The insurer's profitability should become more variable.
Answer: C
5) 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
Answer: B
6) 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.
Answer: B
7) From the standpoint of the insurer, all of the following are characteristics of an ideally
insurable risk EXCEPT
A) The loss must be unintentional.
B) The chance of loss must be calculable.
C) The loss must be indeterminable.
D) The loss must be measurable.
Answer: C
8) 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 minimizes moral hazard.
D) It enables the insurer to predict losses more accurately.
Answer: D
9) 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
Answer: C
10) 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
Answer: C .
11) 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
Answer: A
12) Which of the following types of risks best meets the requirements for being insurable
by private insurers?
A) market risks
B) property risks
C) financial risks
D) political risks
Answer: B
15) 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.
Answer: B
16) The tendency for unhealthy people to seek life or health insurance at standard rates is
an example of
A) moral hazard.
B) fundamental risk.
C) attitudinal hazard.
D) adverse selection.
Answer: D
23) All of the following are benefits to society that result from insurance EXCEPT
A) less worry and fear.
B) elimination of moral hazard.
C) indemnification for loss.
D) loss prevention.
Answer: B
25) All of the following are social costs associated with insurance EXCEPT
A) insurance company operating expenses.
B) fraudulent claims.
C) inflated claims.
D) increased cost of capital.
Answer: D
26) 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) pooling of losses
B) fortuitous losses
C) risk avoidance
D) indemnification
Answer: A
27) XYZ Insurance Company writes coverage for most perils which can damage
property. XYZ, however, does not write flood insurance on property located in flood
plains. Which requirement of an ideally insurable risk might be violated if XYZ wrote
flood insurance on property located in flood plains?
A) There must be a large number of similar exposure units.
B) The loss should not be catastrophic.
C) The chance of loss must be calculable.
D) The losses must be determinable and measurable.
Answer: B
28) ABC Appliance offers a warranty requiring an annual fee. The warranty may be
purchased at the time of sale or at any time within the first year after the appliance was
purchased. The warranty fee after the date of purchase is twice the time-of-purchase fee.
When asked why the fee was higher after the date of purchase, ABC's president said,
"Buying a warranty is voluntary. We've noted that those who buy the warranty after the
purchase date have a greater need for service." Charging the same rate or a lower rate
after the date of purchase would expose ABC to what problem that also impacts private
insurers?
A) excessive premiums
B) reduced claims
C) bad investments
D) adverse selection
Answer: D
31) One branch of government insurance programs has a number of distinguishing

characteristics. These programs are compulsory, they are financed by mandatory
contributions rather than general tax revenues, and benefits are weighted in favor of low-
income groups. These government insurance programs are called
A) welfare programs.
B) social insurance programs.
C) casualty insurance programs.
D) private insurance programs.
Answer: B
32) Gina would like to buy a house. She will pay 10 percent of the cost of the house as a
down payment and borrow the other 90 percent from a mortgage lender. The home will
serve as collateral for the loan. The lender requires Gina to purchase property insurance
on the home so that the collateral supporting the loan will be protected. This scenario
illustrates which of the following benefits of insurance to society?
A) enhancement of credit
B) reduction of fear and worry
C) source of investment funds
D) incentives for loss prevention
Answer: A
33) ABC Insurance Company calculated the amount that it expected to pay in claims
under each policy sold. Rather than selling the insurance for the amount it expected to pay
in claims, ABC added an allowance to cover the cost of doing business, including
commissions, taxes, and acquisition expenses. This allowance is called a(n)
A) policyowner dividend.
B) premium.
C) expense loading.
D) rate credit.
Answer: C
34) JKL Insurance Company estimates that 14 out of every 100 homeowners it insures
will file a claim each year. Last year, JKL insured 200 homeowners. According to the law
of large numbers, what should happen if JKL insures 2,000 homeowners this year?
A) The total number of claims filed by JKL policyowners should decrease.
B) The total dollar value of claims will decrease.
C) The average size of loss will decline in value.
D) The actual results will more closely approach the expected results.
Answer: D
35) Apex Insurance Company wrote a large number of property insurance policies in an
area where earthquake losses could occur. When the president of Apex was asked if she
feared that a severe earthquake might put the company out of business, she responded,
"Not a chance. We transferred most of that risk to other insurance companies." An
arrangement by which an insurer that initially writes insurance transfers to another insurer
part or all of the potential losses associated with such insurance is called
A) hedging.
B) speculating.
C) reinsurance.
D) loss avoidance.
Answer: C
.
38) Ashley opened an all-you-can-eat buffet restaurant. The cost per-person was based
upon what Ashley believed an average restaurant patron would consume. The restaurant
began to lose money. Ashley concluded that her patrons had "above average" appetites,
and were attracted to her restaurant because they could eat as much as they wanted while
being charged an average price. A similar phenomenon exists in insurance markets. This
problem is called
A) moral hazard.
B) adverse selection.
C) attitudinal hazard.
D) fundamental risk.
Answer: B
39) Which of the following statements is (are) true concerning private insurance?
I. Social insurance programs are private insurance programs.
II. Both individuals and businesses purchase private insurance.
A) I only
B) II only
C) both I and II
D) neither I nor II
Answer: B
40) Adverse selection occurs
A) when an insurance company loses money on its investments.
B) when individuals intentionally bring about a loss in order to collect from an insurer.
C) when catastrophic losses occur as a result of a natural disaster.
D) when applicants with a higher-than-average chance of loss seek insurance at standard
rates.
Answer: D

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What is the law of large numbers and how does it apply to insurance?

What characteristics define an ideally insurable risk?

Chapter 2

1) All of the following are characteristics of insurance EXCEPT

2) Which of the following is implied by the pooling of losses?

15) Which of the following is a result of adverse selection?

31) One branch of government insurance programs has a number of distinguishing

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