Chapter 2

Question 1

Define Insurance

Answer 1

Insurance is the pooling of fortuitous losses by transfer of such risks to insurers, who agree to indemnify insureds for such losses.

Question 2

What are the basic characteristics of insurance?

Answer 2

1. Pooling of losses
2. Payment of fortuitous losses
3. Risk transfer
4. Indemnification

Question 3

What does the law of large numbers state?

Answer 3

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.

Question 4

What is a fortuitous loss?

Answer 4

One that is unforeseen, unexpected, and occur as a result of chance

Question 5

What occurs during risk transfer?

Answer 5

A pure risk is transferred from the insured to the insurer, who typically is in a stronger financial position

Question 6

What does indemnification mean?

Answer 6

The insured is restored to his or her approximate financial position prior to the occurrence of the loss

Question 7

What are the characteristics of an ideally insurable risk?

Answer 7

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

Question 8

Why would an insurance company want to have a large number of exposure units?

Answer 8

To predict average loss based on the law of large numbers

Question 9

Why would an insurance company want to insure accidental and unintentional loss?

Answer 9

To assure random occurrence of events

Question 10

Why would an insurance company want determinable and measurable loss?

Answer 10

To determine how much should be paid

Question 11

Why would an insurance company want to avoid catastrophic loss?

Answer 11

T allow the pooling technique to work

Question 12

How can exposure to catastrophic loss be managed?

Answer 12

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

Question 13

Why would an insurance company want calculable chance of loss?

Answer 13

To establish a premium that is sufficient to pay all claims and expenses and yields a profit during the policy period

Question 14

Why would an insurance company want economically feasible premiums?

Answer 14

• 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

Question 15

Based on the characteristics of ideally insurable risk:

Answer 15

• Most personal, property and liability risks can be insured
• Market risks, financial risks, production risks and political risks are difficult to insure

Question 16

What is adverse selection?

Answer 16

The tendency of persons with a higher-than-average chance of loss to seek insurance at standard rates (ex. a high risk driver)

Question 17

If not controlled by underwriting adverse selection:

Answer 17

Results in higher-than-expected loss levels

Question 18

Adverse selection can be controlled by:

Answer 18

-Careful underwriting (selection & classification of applicants for insurance) if standards are not met, insurance is denied
- Policy provisions (e.g., suicide clause in life insurance)

Question 19

Compare Gambling and Insurance

Answer 19

Insurance
- Handles an already existing pure risk
- Is always socially productive: both parties have a common interest in the prevention of a loss
Gambling
- Creates a new speculative risk
- Is not socially productive: The winner’s gain comes at the expense of the loser

Question 20

Compare Insurance and Hedging

Answer 20

Insurance
- Risk is transferred by a contract
- Involves the transfer of pure (insurable) risks
- Moral hazard and adverse selection are more severe problems for insurers
Hedging
- Risk is transferred by a contract
- Involves risks that are typically uninsurable
- Fewer problems of moral hazard and adverse selection for entities who buy or sell futures contracts

Question 21

Insurance can be classified as either:

Answer 21

Private or government insurance

Question 22

Private insurance includes:

Answer 22

Life and health insurance as well as property and liability insurance

Question 23

Government Insurance includes:

Answer 23

Social insurance programs and other government insurance plans

Question 24

Life Insurance:

Answer 24

Pays death benefits to beneficiaries when the insured dies

Question 25

Health insurance:

Answer 25

covers medical expenses because of sickness or injury

Question 26

Property insurance:

Answer 26

indemnifies property owners against the loss or damage of real or personal property

Question 27

Liability insurance:

Answer 27

Covers the insured’s legal liability arising out of property damage or bodily injury to others

Question 28

Casualty Insurance:

Answer 28

Refers to insurance that covers whatever is not covered by fire, marine, and life insurance

Question 29

Private insurance coverages can be grouped into two major categories:

Answer 29

• Personal lines
• Private lines

Question 30

Private lines of insurance:

Answer 30

Coverages that insure the real estate and personal property of individuals and families or provide protection against legal liability

Question 31

Commercial lines of insurance:

Answer 31

Coverages for business firms, nonprofit organizations, and government agencies

Question 32

Characteristics of social insurance programs include:

Answer 32

• 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

Question 33

What benefits does insurance provide for society?

Answer 33

1. Indemnification for Loss
2. Reduction of Worry and Fear
3. Source of Investment Funds
4. Loss Prevention
5. Enhancement of Credit

Question 34

The major social costs of insurance are:

Answer 34

• Cost of during business
• Fraudulent claims
• Inflated claims

Question 35

What is expense loading in reference to the cost of doing business and insurance’s burden on society?

Answer 35

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