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Summary Chapter 5: Insurance Principles
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CHAPTER 5: INSURANCE PRINCIPLESWHAT IS INSURANCE?
The combination of risk pooling and risk transfer is the basis of
insurance
A contract binding a party to indemnify another against a specified loss
in return for premiums paid
Contract:
- Insurance is conducted by means of a legal contract
- Specifies the rights and obligations of each party
- Insurer: promise to pay a specified benefit if an event occurs
- Insured: promise to pay regular premiums
- Contract: the policy
- Insured: policyholder
Indemnify:
o Means to put back in original position
o Insurance policies aim to pay enough to get the policyholder back to
the position they would be in if the insured event had not happened
Specified Loss:
Insurance policy will specify exactly which risks are and are not
covered by the policy.
I/P cover a set of related losses
Premiums paid:
Insurance policies usually require a regular premium to be paid to
the insurer monthly in advance
The premium is calculated based on the expected value of all the
events that are specified in the policy, plus allowance for the
insurer’s costs and profits
Insurance is basically a system for exchanging small, predictable,
regular premiums for large, unpredictable losses
WHY USE INSURANCE?
, RISK
AVERSIO
N
SOCIAL RISK
BENIFITS POOLING
WHY
USE
SMOOTHI INSURA
ECONOMI
NG OF NCE? ES OF
CASHFLO
SCALE
WS
PROTECTI
BETTER ON FROM
USE OF UNACCEP
CAPITAL TABLE
RISKS
RISK AVERSION:
Describes a general preference for certainty over uncertainty
Likely to prefer guaranteed outcome, and this is consistent with risk
averse behavior.
Prefer the uncertain outcome you show risk-seeking behavior
RISK POOLING:
insurers take full advantage of the law of large numbers; the number
of policyholders is so large that insurers can expect a stable and
relatively predictable claim pattern
the aggregate outgoing claims cash flows paid by the insurer do not
fluctuate wildly over time, reducing the risk for the insurer.
For policyholders, the large size of the risk pool they are joining is also
a positive—they can have fewer doubts about the financial security of
their insurer.
ECONOMIES OF SCALE:
The ability of larger institutions to be more cost effective than small
institutions
Expertise allow the institution to keep the average costs down to a
level only achievable by operating on a large scale.
Example:
Say that an insurer with fewer than 5 000 policyholders needs 1
actuary. An insurer with 5 001–20 000 policyholders needs 2 actuaries,
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