Copyright © 2017 Pearson Education, Inc. All rights reserved. Chapter 2 Insurance and Risk Teaching Note Three areas should be emphasized in teaching this chapter. First, the nature of insurance should be discussed. Second, the requirements of an insurable risk should also be stressed. Mention that the requirements of an insurable risk are ideal requirements and are seldom met completely in the real world. Finally, show how insurance differs from both gambling and speculation. The remaining material is descriptive and fairly easy to gras p. It is not necessary to discuss in detail the various fields of insurance , other than to point out that the different fields of insurance are covered in future chapters. Likewise, the social benefits of insurance are quickly grasped by students and may n ot require a large amount of class time. However, it is worthwhile to spend some time on the less obvious costs of insurance, such as moral and attitudinal (morale) hazard. Point out that moral hazard has increased enormously in recent years, especially in the submission of fraudulent claims. Outline I. Meaning of Insurance A. Definition of Insurance B. Basic Characteristics of Insurance 1. Pooling of losses 2. Payment of fortuitous losses 3. Risk transfer 4. Indemnification II. Requirements of an Ideal ly 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 Requirements 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 selecti on Solutions Manual for Principles of Risk Management and Insurance 13th Edition by Rejda IBSN 9780134082578
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Full all chapters instant download please go to Solutions Manual, Test Bank site: downloadlink.org Chapter 2 Insurance and Risk 9 Copyright © 2017 Pearson Education, Inc. All rights reserved. III. Insurance and Gambling Compared A. Insurance eliminates a pure risk, while gambling creates a new speculative risk. B. Insurance is socially productive, while gambling is socially unproductive. IV. Insurance and Hedging Compared A. Insurance tran sfers 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. V. 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 fo r loss 2. Less worry and fear 3. Source of investment funds 4. Loss prevention 5. Enhancement of credit 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, the re is no pooling of losses. c. This guarantee is not insurance. Although the risk of a defective home is transferred to the builder, the re is no pooling of losses, which is the essence of insurance. Any losses would fall directly on the builde r. 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 pres ent 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 substit uted for actual loss. Third, fire losses generally are fortuitous. Finally, the homeowner would be indemnified for any loss. 10 Rejda /McNamara • Principles of Risk Management and Insurance , Thirteenth Edition Copyright © 2017 Pearson Education, Inc. All rights reserved. Answers to Review Questions 1. Insurance plans have four distinct characteristics: (a) Pooling. Losses incurred by the few are s pread 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 importan t, 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. 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 an d 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 sp eculative 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 of 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. Chapter 2 Insurance and Risk 11 Copyright © 2017 Pearson Education, Inc. All rights reserved. 8. Insurance differs from hedging. An insurance transaction usually involves the transfer of risks that ar e 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 pri ce of commodities. A second difference is that moral hazard and adverse selection are more severe proble ms 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. 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 statu te. (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 insu reds 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 requireme nt is met, since most homes do not burn at the same tim e. (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.
