Risk and Loss

Question 1

Accidents, severe weather events, theft, and countless other peril can result in:

Answer 1

Serious financial losses for property and business owners.

Question 2

Through insurance:

Answer 2

An individual or group can transfer to an insurance company (“insurer”) the risk of financial loss from a destructive event.

Question 3

The fundamental purpose for insurance is to:

Answer 3

-Indemnify policyholders against covered losses, that is, to restore them to the same financial position they were in before the loss.

-This is achieved when the insurer pays a claim for a covered loss as defined in the policyowner’s insurance policy.

Question 4

Basic Risk and Loss Factors:

Answer 4

There are many different types of insurance, but all are based on the concepts of:

-risk
-loss
-exposure
-peril
-hazard

Question 5

Risk:

Answer 5

-Means the “chance of loss.”

-The uncertainty of loss is the basic reason for insurance’s existence.

-Insurance companies may also use the term “risk” to refer to the insured person, property, or activity.

Question 6

Loss:

Answer 6

-A loss is an unwelcomed and unplanned reduction in economic value.

-The role of insurance is to indemnify the insured for the financial value of an insured loss.

Question 7

A loss can be either direct or indirect:

Answer 7

-A direct loss is the immediate result of an event caused by a covered peril.

-An indirect damage loss is a more remote ramification than a direct loss, but is still a result of loss from a covered peril.

Question 8

Ex:
Direct vs. indirect loss

Answer 8

-If a home is severely damaged by fire, the damage to the building is considered a direct loss.

-Because the home is temporarily uninhabitable the home owner will incur additional living expenses, over and above the home owner’s normal expenses, until the house has been repaired. These additional living expenses are an indirect loss that follows the direct loss of the home.

Question 9

Exposure:

Answer 9

Is the state of being subject to a possible loss.

Question 10

Ex:
Exposure

Answer 10

A motorist is exposed to the risk of being involved in an auto accident that could result in damage to the car, serious injury, lawsuits, or even death.

Question 11

Insurers measure exposure by:

Answer 11

-Assigning exposure units to the person, property, or event for which insurance is being sought. Exposure units are influenced by the insured item’s market value and risk factors facing it.

-In general, the more exposure units assigned to an insured item, the greater its premium.

Question 12

Key Point:
Exposure

Answer 12

The term “exposure” also refers to the total extent of risk an insurer faces with an insured. For example, an insurance company that sells workers compensation insurance faces increased exposure as an insured business’s workforce increases.

Question 13

Peril:

Answer 13

A peril is the destructive event that insurance guards against.

Question 14

Ex:
Peril

Answer 14

-fire
-explosion
-windstorm
-flood
-theft
-collision

Question 15

An insurance policy provides financial protection against losses caused by

Answer 15

-Specified perils.

• Because the insurance policy “covers” them, these are commonly called covered perils.

Question 16

Hazard:

Answer 16

-Is a condition that increases the likely occurrence of a peril or the likely severity of a loss.

-Insurers recognize three types of hazards: moral, morale, and physical.

Question 17

Moral hazards:

Answer 17

-A condition that increases the likely occurrence of a peril or the likely severity of a loss.

-Insurers recognize three types of hazards: moral, morale, and physical.

Question 18

Morale hazards:

Answer 18

-Are also individual tendencies, but they arise from a state of mind, attitude, or indifference to loss.

-Not locking one’s car or driving recklessly are examples of morale hazards.

Question 19

Physical hazards:

Answer 19

-Are physical conditions that increase the chance of loss.

-For instance, dangerous conditions or activities are physical hazards that increase the chance of injury or death.

-Diseases are physical hazards because they increase chance of death.

Question 20

Ex:
Physical hazards

Answer 20

-insufficient light in a high-crime commercial area

-iotholes along a busy highway

-slippery floors

-unsanitary conditions

-congested traffic

-unguarded premises

Question 21

Legal hazards:

Answer 21

-Which are legal or regulatory environment characteristics that affect an insurer’s ability to provide insurance at a premium that fairly reflects its loss exposures.

Question 22

homeowner who leaves his house doors unlocked while away in the belief that his homeowners insurance will cover his losses if thieves break in and steal his possessions is an example of what type of hazard?

Answer 22

Failure to take reasonable measures to reduce the chance of a loss because the loss is covered by insurance demonstrates a morale hazard.

Question 23

Risk management techniques:

Answer 23

Methods for treating risk.

Question 24

People are exposed to risks every day. How they deal with them is called risk management techniques, a process that uses any combination of five risk management techniques:

Answer 24

-avoiding the risk

-controlling (reducing) the risk

-sharing the risk

-retaining the risk

-transferring the risk

Question 25

Risk Avoidance:

Answer 25

-Though not always practical, one way to manage a risk is simply to avoid it.

-For example, those who do not own a car avoid the risk of having a car being stolen or damaged.

Question 26

Risk Control:

Answer 26

-If risk cannot be avoided, it may be controllable through risk prevention or risk reduction measures.

Question 27

Risk prevention measures:

Answer 27

-Reduce the likelihood that a loss will occur.

-For example, shoveling snow off a sidewalk makes it less likely a visitor will slip and fall.

Question 28

Risk reduction measures:

Answer 28

-Reduce the severity of any loss that does occur.

-Having fire extinguishers does not keep fires from starting, but when available and used, they often limit fire damage.

Question 29

Risk Sharing:

Answer 29

-Sharing the burden of a loss with others is one of the oldest ways to manage risk.

-Under a risk-sharing arrangement, groups share the financial burden of a loss suffered by any member of the group.

Question 30

Ex:
Risk sharing

Answer 30

-Pooling is a modern example of risk sharing.

-Groups of cities or other municipalities may organize a formal arrangement by which they share one another’s losses of a common nature (e.g., flooding) through pooled resources.

Question 31

Risk Retention:

Answer 31

-Sometimes called the “do nothing” option.

Simply accepting a risk and dealing with a loss using personal funds.

-If the potential financial loss is small, risk retention makes sense.

-However, if the potential loss is great, risk retention may lead to financial disaster.

Question 32

With insurance policies, deductibles are:

Answer 32

-A risk retention device. Deductibles shift small losses to the policyowner, leaving the insurance to cover more serious losses.

Question 33

Risk retention is involved when a business:

Answer 33

Sets up a formal self-insurance program, which puts aside funds to pay for any losses that occur.

Question 34

Risk Transfer:

Answer 34

-Modern insurance.

-In exchange for paying a premium, an individual or business can transfer the risk of loss to an insurance company through an insurance policy.

-Should a covered loss occur, the insurer will compensate the insured for the value of the loss up to policy limits.

Question 35

Key point:
Risk Transfer:

Answer 35

Risk transfer—transferring the risk of loss to a third party—is the basis for most insurance today.

Question 36

Not all pure risks are insurable. Before an insurance company will issue a policy:

Answer 36

-It must first determine whether the application represents an insurable risk.

Question 37

To be insurable, a risk must conform to the following standards and requirements:

Answer 37

A covered loss must be definite as to time, cause, and location. It must be clear that a covered loss has occurred
.
-The value of the item to be insured must be measurable. Without this, it would not be possible to determine premium rates and claim amounts.

-The insured event must be accidental or outside the insured’s control. Only losses that occur due to chance are insurable.

-In general, losses are not covered if due to catastrophic events such as a war or massive earthquake impacting many policyowners at once.
The risk must be part of a large group of similar risks that the insurance company can use to predict future losses.

-Only pure risks (e.g., the risk of a house burning) are insurable; speculative risks are not.

Question 38

Key points:
Insurable Risk

Answer 38

Risk transfer—transferring the risk of loss to a third party—is the basis for most insurance today.

Question 39

When an insurance company receives an application for coverage:

Answer 39

-It begins a process known as underwriting.

-Underwriting determines whether a particular risk can be insured and at what rate.

-An important function of the underwriting process is to protect the insurer against adverse selection.

Question 40

Adverse selection:

Answer 40

-Means to “select against.”

-It is the tendency of those at greater-than-average risk of loss to seek insurance.

-In other words, people who are at the greatest risk of loss are also the ones most likely to do whatever is necessary to buy insurance to cover that loss.

-For example, a person with a bad driving record is especially likely to recognize the need for auto insurance.

Question 41

Insurance is largely based on:

Answer 41

Insurance is largely based on statistics, probabilities, and averages that are wrapped up in the law of large numbers.

Question 42

Law of Large Numbers:

Answer 42

Mathematical concept says that what is not predictable in a single instance becomes predictable the greater the number of similar instances are being observed.

Question 43

The law of large numbers makes it possible for insurance company actuaries (i.e., insurance mathematicians) to predict:

Answer 43

-losses among a group of similar risks, as long as there are a sufficiently large number of risks to observe.

-This explains the requirement that, to be insurable, the risk must be part of a large group of similar risks that the insurance company can use to predict future losses.

Question 44

Ex:
Law of Large Numbers

Answer 44

-Regardless of past statistics, an actuary cannot reasonably predict if any of ten houses will burn down in the next year because there are too few to base predictions on.

-But, in a group of 10,000 houses an actuary can reasonably predict that a certain number will burn down in the next year.

-While the law of large numbers helps actuaries predict the number of losses that might occur in a given population over a period of time, it does not predict which homes will suffer the loss.

-It is that uncertainty that makes insurance so important.