Chapter 2

Insurance
and Risk

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Agenda

• Definition and Basic Characteristics of

Insurance
• Characteristics of An Ideally Insurable
Risk
• Adverse Selection and Insurance
• Insurance vs. Gambling
• Insurance vs. Hedging
• Types of Insurance
• Benefits and Costs of Insurance to
Society
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2-2
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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Review of Statisics

• Given the assessment result of

Mathematics Course:
• No Scores Number of Percentage (%)
students
1 90 04 3.6
2 70 83 75.5
3 50 17 15.4
4 40 06 5.5
Sum 110 100

• Expected Value of Scores:

E=90*0.036+70*0.755+50*0.154+40*0.055
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Basic Characteristics of Insurance

• Pooling of losses
– Spreading losses incurred by the few over the entire group
– Risk reduction based on the Law of Large Numbers
• Example:
– 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:

Expected loss  0.90 * $0  0.10 * $50,000  $5,000

Standard deviation  0.900  $5,000  0.10$50,000  $5,000

2 2

 $15,000
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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:

Expected loss  0.81* $0  0.09 * $25,000  0.09 * $25,000  0.01* $50,000

 $5,000
Standard deviation  0.810  $5,000   (2)(0.09)$25,000  $5,000   0.01($50,000  $5,000) 2
2 2

 $10,607
– As additional individuals are added to the pooling arrangement,
the standard deviation continues to decline while the expected
value of the loss remains unchanged

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• destroyed 0.1  0.1*0.1=0.01

• Buidling 2
• no risk 0.9  0.1*0.9 =0.09
• destroyed 0.1

• Building 1
• destroyed 0.1 0.9*0.1 =0.09

• No risk 0.9 Buildling 2

• no risk 0.9 0.9*0.9 = 0.81

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Basic Characteristics of Insurance

• Payment of fortuitous losses

– Insurance pays for losses that are 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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Requirements of an Insurable Risk

• There must be large number of exposure

units
– to predict average loss
• The loss must be accidental and
unintentional
– to control moral hazard
– to assure randomness
• The loss must be determinable and
measurable
– to facilitate loss adjustment
• insurer must be able to determine if the loss is
covered and if so, how much should be paid.
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Requirements of an Insurable Risk

• The loss should not be catastrophic

(cancer, natural siaster …)
– A large proportion of exposure units should not
incur loss at the same time
– to allow the pooling technique to work
– exposures to catastrophic loss can be managed
by:
• dispersing coverage over a large geographic area
• using reinsurance
• catastrophe bonds (buy bond and receive coupon)

• The chance of loss must be calculable

– to establish an adequate premium (pjis bảo hiểm)

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Requirements of an Insurable Risk

• The premium must be economically feasible

(khả thi)
– 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

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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, adverse selection result 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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 Insurance vs. Gambling

Insurance Gambling

• Insurance is a technique • Gambling creates a new

for handing an already speculative risk
existing pure risk

• Gambling is not socially

• Insurance is socially productive
productive:
– The winner’s gain comes
– both parties have a at the expense of the
common interest in the loser
prevention of a loss

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 Insurance vs. Hedging

Insurance Hedging

• Risk is transferred by • Risk is transferred by

a contract a contract
• Insurance involves the • Hedging involves risks
transfer of insurable that are typically
risks uninsurable
• Insurance can reduce • Hedging does not
the objective risk of an result in reduced risk
insurer through the
Law of Large Numbers

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Types of Insurance

• Private Insurance
– Life and Health
– Property and Liability
• Government Insurance
– Social Insurance
– Other Government Insurance

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2-17
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
• 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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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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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

– Contributes to family and business stability
• Reduction of Worry and Fear
– Insureds are less worried about losses
• Source of Investment Funds (whe expire you receive ins và
…)
– Premiums may be invested, promoting economic growth
• Loss Prevention
– Insurers support loss-prevention activities that reduce direct
and indirect losses
• Enhancement of Credit
– Insured individuals are better credit risks than individuals
without insurance

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Social Costs of Insurance

• Cost of Doing Business

– Insurers consume scarce economic resources in providing
insurance to society
– 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
• Cost of Fraudulent (lừa đảo) and Inflated Claims
– Payment of fraudulent or inflated claims results in higher
premiums to all insureds, thus reducing disposable
income and consumption of other goods and services

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Class exercise
• Two business owners own identical buildings. The first
owner’s building is valued at $60,000, the other’s
worth $78,000.
– There is a 8 percent chance each building will be destroyed by a
peril in any year; loss to either building is an independent event
 Calculate the Expected value and standard deviation of the loss
for each owner.

• If the owners instead pool (combine) their loss

exposures, and each agrees to pay an equal share of
any loss that might occur.
 Calculate the Expected value and standard deviation of the loss
for each owner.
 Give your comment on the differences between the two
situations.

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