Chapter 2

Insurance and Risk

 Teaching Note
Risk was defined in Chapter 1. This chapter opens with a definition of insurance. You may want to stress
the essential elements included in the definition: pooling, fortuitous loss, transfer, and indemnification.
Pooling naturally leads to a discussion of the law of large numbers, which you can discuss in relation to
objective risk, which was covered in Chapter 1. Of course certain perils are difficult to insure privately.
Comparing a readily insurable peril (fire, for example) with a peril that’s difficult to insure (flood, for
example) while citing the discussing the characteristics of an ideally insurable risk is effective.

Adverse selection is often misunderstood by students. It’s not “high risk people buying insurance”—that
happens all the time. If they are identified and properly rated, there’s no adverse selection. Adverse
selection occurs when higher-than-average risks attempt to purchase insurance at the average cost.
Undetected, the insurer’s losses will be higher than expected. Insurers use underwriting and contractual
provisions to address this problem.

You may want to spend some time comparing gambling and insurance, again citing concepts from Chapter
1. Gambling creates a new speculative risk, while insurance addresses a pure risk that is already present.
Gambling does have a similarity to insurance in one respect, application of the law of large numbers. Most
casino gambling is done through repetitive small wagers rather than a few large wagers. The casino’s
actual results should approach its expected results through the application of the law of large numbers.

The chapter closes with an overview of the types of insurance and the costs and benefits of insurance to
society. The benefits of insurance should be discussed, including the enhancement of credit. Try to borrow
money to purchase a house without having physical damage insurance on the home, which serves as
collateral for the loan. You may want to include some examples from the “Hall of Shame” when you
discuss fraudulent claims, a cost of insurance to society. You may want to note that the benefits of
insurance to society far outweigh the costs.

 Outline
I. Definition of Insurance

II. Basic Characteristics of Insurance

A. Pooling of losses
B. Payment of fortuitous losses
C. Risk transfer
D. Indemnification

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III. Characteristics of an Ideally Insurable Risk

A. General Requirements
1. Large number of exposure units
2. Accidental and unintentional loss
3. Determinable and measurable loss
4. No catastrophic loss
5. Calculable chance of loss
6. Economically feasible premium
B. Application of the Characteristics
1. The risk of fire to a private dwelling satisfies the requirements.
2. The risk of unemployment does not completely meet all requirements.
C. Adverse Selection and Insurance
1. Nature of adverse selection
2. Consequences of adverse selection

IV. Insurance and Gambling Compared

A. Insurance addresses an existing pure risk, while gambling creates a new speculative risk.
B. Insurance is socially productive, while gambling is socially unproductive.

V. Insurance and Hedging Compared

A. Insurance transfers a pure risk, while hedging involves the transfer of a speculative risk.
B. Moral hazard and adverse selection are more severe problems for insurers than for speculators
who buy or sell futures contracts.

VI. Types of Insurance

A. Private Insurance
1. Life insurance
2. Health insurance
3. Property and liability insurance
B. Government Insurance
1. Social insurance
2. Other government insurance programs

VI. Social Benefits and Costs of Insurance

A. Benefits of Insurance to Society
1. Indemnification for loss
2. Reduction of worry and fear
3. Source of investment funds
4. Loss prevention
5. Enhancement of credit

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10 Rejda/McNamara • Principles of Risk Management and Insurance, Fourteenth Edition

B. Costs of Insurance to Society

1. Cost of doing business
2. Fraudulent claims
3. Inflated claims

 Answers to Case Application

a. This is not insurance. Although the risk of a defective television set is transferred to the manufacturer,
there is no pooling of losses.

b. This is not insurance. Although the risk of defective tires for the first 50,000 miles is transferred to
the manufacturer, there is no pooling of losses.

c. This guarantee is not insurance. Although the risk of a defective home is transferred to the builder, there
is no pooling of losses, which is the essence of insurance. Any losses would fall directly on the builder.

d. This is not insurance. The risk of default has been transferred to the cosigner. If the debtor defaults,
the cosigner must make the payments. The loss would fall directly on the cosigner, and there is no
pooling of losses.

e. The elements of insurance are present here. First, risk transfer is present; the homeowner transfers the
risk of fire to the group. Second, pooling of losses is also present. Pooling is the essence of insurance.
Fire losses would be pooled over the entire group, and average loss is substituted for actual loss.
Third, fire losses generally are fortuitous. Finally, the homeowner would be indemnified for any loss.

 Answers to Review Questions

1. Insurance plans have four distinct characteristics:
(a) Pooling. Losses incurred by the few are spread over the entire group so that in the process,
average loss is substituted for actual loss.
(b) Fortuitous loss. Insurance plans provide for the payment of fortuitous losses. A fortuitous loss is
one that is unforeseen and unexpected, and occurs as a result of chance.
(c) Risk transfer. In private insurance, a pure risk is transferred from the insured to the insurer, which
is typically in a better financial position to pay the loss than the insured.
(d) Indemnification. Compensation is given to the victim of a loss, in whole or in part, by payment,
repair, or replacement.

2. The law of large numbers states that the greater the number of exposures, the more closely the actual
results will approach the probable results expected from an infinite number of exposures. As the
number of exposures increases, the relative variation of actual loss from expected loss will decline.
Thus, the insurer can predict future losses with a greater degree of accuracy as the number of
exposures increases. This is important, since an actuary must charge a premium that is adequate for
paying all losses and expenses during the policy period. The lower the degree of objective risk, the
more confidence an insurer has that the actual premium charged will be sufficient to pay all claims
and expenses and leave a margin for profit.

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 Chapter 2 Insurance and Risk 11

3. There are several requirements of an ideally insurable risk:

(a) There must be a large number of exposure units.
(b) The loss must be accidental and unintentional.
(c) The loss must be determinable and measurable.
(d) The loss should not be catastrophic.
(e) The chance of loss must be calculable.
(f) The premium must be economically feasible.

4. Insurers can deal with the problem of a catastrophe loss by (1) reinsurance, (2) avoiding the
concentration of risk by dispersing coverage over a large geographical area, and (3) use of certain
financial instruments in the capital markets, such as catastrophe bonds.

5. These risks are generally uninsurable for several reasons. First, many of these risks are speculative
risks, which are difficult to insure privately. Second, the potential for a catastrophic loss is great;
this is particularly true for political risks, such as the risk of war. Finally, calculation of the correct
premium may be difficult because the chance of loss cannot be accurately estimated.

6. (a) Adverse selection is the tendency for persons with a higher-than-average chance of loss to seek
insurance at standard (average) rates, which, if not controlled by underwriting, results in higher-
than-expected loss levels.
(b) Adverse selection can be controlled by careful underwriting, by charging higher premiums to
substandard applicants for insurance, and by certain policy provisions.

7. Insurance differs from gambling in two ways. First, gambling creates a new speculative risk that did
not exist before, while insurance is a technique for handling an already existing pure risk. Second,
gambling is socially unproductive, since the winner’s gain comes at the expense of the loser.
Insurance is always socially productive, since both the insured and insurer win if the loss does not
occur.
8. Insurance differs from hedging. An insurance transaction usually involves the transfer of risks that are
insurable, since the requirements of an insurable risk can generally be met. Hedging is a technique for
handling risks that are typically uninsurable, such as protection against a substantial decline in the price
of commodities. A second difference is that moral hazard and adverse selection are more severe
problems for insurers than for speculators who buy or sell futures contracts.

9. (a) The major fields of private insurance are life insurance, health insurance, and property and
liability insurance (also called property and casualty insurance).
(b) Property and casualty coverages can be divided into personal lines and commercial lines.
Personal lines include private passenger auto insurance, homeowners insurance, personal
umbrella liability insurance, earthquake insurance, and flood insurance.
Commercial lines include fire and allied lines insurance, commercial multiple peril insurance, general
liability insurance, products liability insurance, workers compensation insurance, commercial auto
insurance, accident and health insurance, inland marine and ocean marine insurance, professional
liability insurance, directors and officers liability insurance, boiler and machinery insurance (also
known as equipment breakdown insurance), fidelity and surety bonds, and crime insurance.

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12 Rejda/McNamara • Principles of Risk Management and Insurance, Fourteenth Edition

10. (a) Social insurance programs are government insurance programs with certain characteristics. The
programs are enacted into law to deal with social and economic problems. The programs
generally are compulsory and financed by contributions from covered employers and employees;
benefits are paid from specifically earmarked funds; benefits are skewed or weighted in favor of
lower income groups; benefit amounts generally are related to the covered individual’s earnings;
and eligibility requirements and benefit rights are prescribed by statute.
(b) Major social insurance programs are the following:
• Old-age, survivors, and disability insurance (Social Security)
• Medicare
• Unemployment insurance
• Workers compensation
• Compulsory temporary disability insurance
• Railroad Retirement Act

 Answers to Application Questions

1. (i) Risk of fire
(a) Large number of exposure units. This is generally met, since there are millions of homes
that are insured.
(b) Accidental and unintentional loss. This requirement is generally met, since most insureds do
not deliberately start a fire.
(c) Determinable and measurable loss. A fire loss can be determined and measured. In case of
disagreement, a property insurance policy has a provision for resolving disputes.
(d) No catastrophic loss. This requirement is met, since most homes do not burn at the same time.
(e) Calculable chance of loss. Insurers can estimate within ranges the probability of a fire loss.
(f) Economically feasible premium. For most insureds, this requirement is fulfilled.
(ii) Risk of war
(a) Large number of exposure units. This requirement is not fulfilled. Based on the law of large
numbers, it is difficult to estimate accurately the number of wars that will occur.
(b) Accidental and unintentional loss. This requirement is not met. Most wars are not
accidental, and losses are intentional.
(c) Determinable and measurable loss. Although a war loss can be determined, the
measurement of loss would be difficult.
(d) No catastrophic loss. This requirement is not fulfilled, since large numbers of exposure
units would simultaneously incur losses.
(e) Calculable chance of loss. This requirement cannot be easily met.
(f) Economically feasible premium. Because of the catastrophic potential of war, the premiums
would not be economically feasible.

2. (a) (1) Indemnification means that insureds are restored to their former financial position after a
loss occurs, either partly or wholly. As a result, individuals and families can maintain their
economic security and are less likely to apply for public assistance or welfare, or seek
financial assistance from relatives and friends.

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 Chapter 2 Insurance and Risk 13

(2) Insurance makes a borrower a better credit risk because it guarantees the value of the
borrower’s collateral, or gives greater assurance that the loan will be repaid. For example,
life insurance can be used to pay off a bank loan if the creditor dies prematurely, and so
makes the creditor a better credit risk. Property insurance secures the collateral for a loan. If
money is borrowed for the purchase of a home, the lender commonly requires property
insurance on the home in case the home is damaged or destroyed.
(3) Premiums are collected in advance, and funds not needed to pay immediate losses and
expenses can be invested in financial securities issued by business firms and government
units. These funds typically are invested in capital goods, such as housing developments,
shopping centers, new plants, machinery and equipment, and local government projects,
such as water treatment plants. Since the stock of capital goods is increased, economic
growth and full employment are promoted. In addition, since the supply of loanable funds is
increased, the cost of capital to business firms is lower than it would be in the absence of
insurance.
(b) The major social and economic costs of insurance are the following:
• Cost of doing business
• Fraudulent claims
• Inflated claims

3. (a) Ideal requirements of a privately insurable risk:

• Large number of exposure units
• Accidental and unintentional loss
• Determinable and measurable loss
• No catastrophic losses
• Calculable chance of loss
• Economically feasible premium
(b) The requirement of not having a catastrophic loss is not met because large numbers of exposure
units in a flood zone would be incurring losses at the same time. Also, the requirement of an
economically feasible premium generally is not met. Without a government backup, premiums
for flood insurance in major flood zones generally would be unaffordable for many insureds.

4. (a) Life insurance can provide the needed funds for a college education.
(b) Auto liability insurance will protect the parents if Danielle negligently injures someone while
driving a family car.
(c) An individual or group disability income policy will provide periodic income payments if Jacob
becomes totally disabled.
(d) A homeowners policy will provide the desired protection. Windstorm and hurricanes are covered
perils.
(e) A commercial general liability insurance policy will cover Nathan if a customer is injured in his
store.

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