Principles of Risk and Insurance - Introduction to the Principles of Risk and Insurance

We are exposed to many situations that many cause a loss (perils). The primary purpose of insurance is to provide economic protection against losses that may be incurred due to a chance of an event happening such as death, illness, or accident. This type of protection is provide through an insurance policy, which is simply a device used by companies to accumulate funds to have enough reserves to meet these uncertain losses.

Risk can be defined as uncertainty regarding loss:

  • the inability to work and earn an income due to disability is a risk
  • the destruction of a home due to hurricane is a risk the loss of family income due to death is a risk
  • the potential for an automobile accident is a risk
  • the chance of someone slipping on your icy driveway is a risk

A peril is the cause of a possible loss (the event that is insured against)
examples: illness, theft, hurricane, collision, fire, liability, etc...

Practice Question:
Conditions that increase either the severity or frequency of loss are referred to as:
A. Perils
B. Hazards
C. Risks
D. Adverse Selection

Answer: B
Perils are the cause of a loss (theft, disaster, etc...). Hazards are events or action that will increase the potential for a loss to occur.

A hazard is a condition that may create or increase the chance of loss arising from a given peril. There are three basis types of hazards to remember.
The Three Basis Types of Hazards:
1) Physical Hazards
They are physical characteristics pertaining to the individual or property that increase the chance of loss. Examples include: building a house in a flood zone, past medical history or high blood pressure.
2) Moral Hazards
These are actions that people initiate to increase risk and the chance of loss (Dishonesty/ Willingness to generate or prevent loss). Examples include: overstating the amount of vehicle damage to your insurance company; or drug additions/alcoholism related events that lead to loss.
3) Morale Hazards
Individual tendencies that arise from attitude or state of mind causing indifference to loss (Carelessness). Examples include: a robbery occurs because you failed to lock doors; or automobile catches on fire because you neglected to add oil.

Practice Question:
Which of the following hazards would be considered "Moral Hazards"?
I. Drinking and Driving
II. Reporting excess damage from a hurricane storm to collect additional benefit
III. Stealing your friends automobile, to help them file a theft claim
IV. Failing to lock your home windows resulted in the theft of a TV

A. I and II only
B. II and III only
C. I, II, and III
D. I, II, III, and IV

Answer: C
I, II, and III are considered moral hazards because they all involve some type of prior knowledge or deception for the loss. Failure to lock home windows or doors which results in theft would be considered a morale hazard because it is an innocent/unplanned act of negligence.

Law of Large Numbers
Simply stated, the law of large numbers demonstrates that the larger and more homogeneous the group to be insured, the more certain the mortality or morbidity predictions.

What does this mean?
To control risk, insurance companies will spread out their risk to minimize their exposure to loss. In addition to this they will rely on the principle that the larger the number of individual risks that are combined into a group, the more certainty there is as to the amount of loss incurred in any given period. This allows insurers the ability to predict an approximate number of claims within a certain group during a certain period.

For example:
Using statistics it may show that out of a study of 50,000 insured male drivers age 45 years or older, 500 will get into an automobile accident in their first year of coverage. It will not be possible to predict which drivers this will be, but the number of estimated accidents will prove to be quite useful. However, if you look at a small group of 500 drivers in the same class, it is not statistically feasible to predict if any in the group will have an accident in the first year. Because insurers cover thousands and thousands of lives, it is possible to predict when and to what extent accidents will occur and, consequently, when claims will arise. All forms of insurance including auto, health, disability, life, etc... rely on risk pooling and the law of large numbers.

Adverse Selection
The insurance industry can also face problems of signaling and screening. People who buy insurance often have a better idea of the risks they face than do the sellers of insurance. People who know that they face large risks are more likely to buy insurance than people who face small risks.

Adverse Selection is the likelihood that parties with the greatest probability of loss are the ones that will most desire the insurance coverage.

Insurance companies try to minimize the problem that only the people with big risks will buy their product, which is the problem of adverse selection, by trying to measure risk and to adjust premium prices they charge for this risk. In turn, auto insurance companies will charge higher premiums for drivers that have drunk driving convictions or numerous speeding tickets and life insurers will decline or charge more to insured's that have a checkered medical history such as heart attacks or high blood pressure.

Insurable Risks
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