In this chapter, the learning objectives are: Definition and basic characteristics of insurance, characteristics of an ideally insurable risk, adverse selection and insurance, insurance vs. Gambling, insurance vs. Hedging, types of insurance, benefits and costs of insurance to society. | Insurance and Risk Lecture No. 3 1 Objectives Definition and Basic Characteristics of Insurance Characteristics of An Ideally Insurable Risk Adverse Selection and Insurance Insurance vs. Gambling Insurance vs. Hedging Types of Insurance Benefits and Costs of Insurance to Society 2 Definition of Insurance Insurance is the pooling of fortuitous losses by transfer of such risks to insurers, who agree to indemnify insureds for such losses, to provide other pecuniary benefits on their occurrence, or to render services connected with the risk 3 Basic Characteristics of Insurance Pooling of losses Spreading losses incurred by the few over the entire group Risk reduction based on the Law of Large Numbers Example: Two business owners own identical buildings valued at $50,000 There is a 10 percent chance each building will be destroyed by a peril in any year; loss to either building is an independent event Expected value and standard deviation of the loss for each owner is: 4 Transparency . | Insurance and Risk Lecture No. 3 1 Objectives Definition and Basic Characteristics of Insurance Characteristics of An Ideally Insurable Risk Adverse Selection and Insurance Insurance vs. Gambling Insurance vs. Hedging Types of Insurance Benefits and Costs of Insurance to Society 2 Definition of Insurance Insurance is the pooling of fortuitous losses by transfer of such risks to insurers, who agree to indemnify insureds for such losses, to provide other pecuniary benefits on their occurrence, or to render services connected with the risk 3 Basic Characteristics of Insurance Pooling of losses Spreading losses incurred by the few over the entire group Risk reduction based on the Law of Large Numbers Example: Two business owners own identical buildings valued at $50,000 There is a 10 percent chance each building will be destroyed by a peril in any year; loss to either building is an independent event Expected value and standard deviation of the loss for each owner is: 4 Transparency Master Basic Characteristics of Insurance Example, continued: If the owners instead pool (combine) their loss exposures, and each agrees to pay an equal share of any loss that might occur: As additional individuals are added to the pooling arrangement, the standard deviation continues to decline while the expected value of the loss remains unchanged Basic Characteristics of Insurance Payment of fortuitous losses Insurance pays for losses that are unforeseen, unexpected, and occur as a result of chance Risk transfer A pure risk is transferred from the insured to the insurer, who typically is in a stronger financial position Indemnification The insured is restored to his or her approximate financial position prior to the occurrence of the loss Characteristics of an Ideally Insurable Risk Large number of exposure units to predict average loss Accidental and unintentional loss to control moral hazard to assure randomness Determinable and measurable loss to facilitate loss adjustment insurer
