Cpcu 500 Ch.6

Front 1

Pooling

Back 1

Insurance reduces risk through pooling. Pooling combines loss exposures and financial resources within a group. Losses shared by members of the group. Insurance is similar in concept but is slightly different.

Pooling functions best when loss exposures are uncorrelated. Exposures don't have to be independent of each other but you want to make sure they aren't fully correlated. Pooling can work as long as exposures are not perfectly positively correlated (loss exposures do not necessarily have to be independent to benefit from pooling).

Front 2

Pooling pt.2

Back 2

Insurer benefit from pooling when they insure a large number of loss exposures. As pool increases in total the standard deviation and expected losses of the pool increases. As pool increases, standard deviation per member actually decreases.

A social benefit of pooling is that it helps to reduce risk in society.

Front 3

Pooling e.x.

Back 3

If two individuals have a 67% probability of not suffering a homeowners loss, assuming the losses are independent of one another, there is a .45 probability of neither individual suffering a loss if they enter into a pooling arrangement.

The probability that neither will have a loss can be found by multiplying the two probabilities together: .67 x .67 = .45

Front 4

Pooling vs. insurance

Back 4

Pooling enables losses to be shares among those in the pool, while insurance transfers risk from the pool. Insurance contract transfers risk from insured to insurer. If premium is inadequate to pay benefits, insurer cannot collect additional premiums so the insurer is bearing the risk in that situation.

Front 5

Pooling vs. insurance pt.2

Back 5

Insurers have stronger financial resources compared to a pool polling has everyone sharing in the loss together which isn't as financially strong as an insurance arrangement b/c insurer is able to provide a stronger guarantee in the event of further losses. Resources come from initial capital from investors and retained earnings.

Front 6

Benefits of insurance

Back 6

Pays for covered losses (indemnify insured for covered losses) - primary role of insurance. Principle of indemnity.

Managing cash flow uncertainty. Reduces uncertainty created by many loss exposures. Provides financial compensation to insured.

Satisfying legal requirements (insurance is often used to meet statutory or contractual requirements arising from business relationships) - both statutory (state) requirements and contractual requirements e.x. workers compensation. Additionally there are contractual agreements that can be satisfied e.x. contractor must show proof of liability insurance before a construction contract is granted.

Front 7

Benefits of insurance pt.2

Back 7

Insurance helps promoting risk control activity - insured has incentive to undertake cost-effective risk control measures (business implements security system to lower their premiums).

Enabling efficient use of resources - no need to set aside large emergency fund. Allows insured to use their money more efficiently.

Providing credit support - insurance can provide evidence of financial resources. Reduces lender's uncertainty. Homeowner must show proof of insurance before receiving home equity loan.

Front 8

Benefits of insurance pt.3

Back 8

Insurance can provide source of investment funds. Insureds not required to create large reserves to pay for losses therefore insured doesn't need liquid assets with low returns, they can invest in higher appreciating assets. Insurer invests premiums until losses paid. Insurance can provide investment finds for insured and insurer so both parties can have an investment fund.

Reducing social burdens. Insurance helps reduce the burden of uncompensated accident victims to society. Helps society as a whole.

Benefits of insurance match risk financing goals b/c insurance satisfies 3 of the 5 risk financing goals: pays for losses, manage cash flow variability, and satisfies legal requirements.

Front 9

Insurable loss exposures

Back 9

An ideally insurable loss exposure has the following six characteristics: pure risk, fortuitous loss, measurable and definite, large number of exposure units, independent and not catastrophic and affordable premiums.

Something that doesn't fit the six characteristics could still be insurable, just not ideally insurable.

Front 10

Pure risk

Back 10

An ideally insurable loss exposure involves pure risk, not speculative risk. Chance of loss or no loss.

If speculative risk was insured, insurer would have to charge an excessive premium so no one would buy it. Premium would eliminate and expected profits of the insured.

Front 11

Fortuitous loss

Back 11

An ideally insurable loss exposure involves a fortuitous loss, which is accidental/unexpected. Fortuitous from one point of view - vandalism, theft. Fortuitous from both points of view (insurance comp. and insured) - fire, weather, storm.

Insurance is suitable when there is reasonable uncertainty about probability or timing of a loss, without the threat of moral or morale hazard (if there's some expectation, it's not fortuitous). Fires started by riot or civil commotion are considered fortuitous. Only intentional fires started by the insured are not considered fortuitous. Fire losses tend to be low frequency therefore they are economically feasible to insure.

Front 12

Definite and measurable

Back 12

An ideally insurable loss exposure involves a loss that is definite and measurable. Definite in time, cause, and location. Some losses aren't definite and measurable e.x. an inspector comes to your house and there's a gas leak, there's no way of knowing when it started or.

Liability policies written on an occurrence basis require the insurer to be able to determine that the event occurred during the policy period.

Front 13

Large number of exposure units

Back 13

An ideally insurable loss exposure involves a large number of similar exposure units (home insurance). Insurance spreads risk among a large number of similar exposure units within same period.

Law of large numbers requires that past events occur under the same conditions in the future.

Front 14

Not catastrophe/affordable

Back 14

Exposure units must be independent and not catastrophic to the insurer. E.x. of catastrophic to insurer is windstorm and flood. Multi-million dollar property can be catastrophic to small insurer.

Insurer must charge affordable premium (most important). Possibly the most important characteristics of insurance. Small losses, or high probability losses, are generally uninsurable.

Front 15

Property loss exposures

Back 15

For most property loss exposures, the main underwriting criteria focus is on the threat of loss by fire. Most property losses are definite and measurable. Location is most important factor in determining if there are a large number of exposure units. Timing of fire losses in commercial property only become critical if the loss occurs near the policy expiration date.

With windstorm, adverse selection is present (people who need the insurance are the only ones purchasing the insurance, big problem for insurer). Property owners in windstorm-prone areas are more likely to demand insurance.

Front 16

Liability loss exposures

Back 16

Frequency and severity of liability loss exposures varies widely. Depends on organization's operations and existing legal environment.

Types of liability loss exposures: premises and operations (accident occurring on premises (customer falls) usually considered fortuitous b/c they usually arise from accidents) all premises and operations liability loss exposures exhibit all of the characteristics of an ideally insurable loss therefore they aren't catastrophic, or off premises but due to ongoing operations (employee is delivering product and gets in accident injuring another person). Products (injury caused by defective product).

Premiums for commercial premises liability loss exposures are always economically feasible b/c they are related to fire.

Front 17

Liability loss exposures pt.2

Back 17

Products liability loss exposures: losses may be difficult to measure in monetary terms. Liability loss could be catastrophic if the product is widely distributed and many claims result from a loss (a product contamination of food would be a loss exposure that would pose a serious financial hardship if a loss occurred therefor it would be catastrophic). Premiums may not be feasible for inherently dangerous products. All product liability losses are considered fortuitous however they may not be definite and measurable.

Front 18

Net income loss exposures

Back 18

Net income loss exposures represent potential losses of net income due to property losses or liability losses (if building is destroyed, that could effect net income). Coverage for net income losses associated with property losses continuous until property has been restored. Net income losses associated with liability losses may not be definite, and are catastrophic.

Front 19

Personnel loss exposure

Back 19

Frequency and severity of personal loss exposures varies widely. Value of key employee is difficult to measure. Potential loss of key employees does not usually involve large numbers of similar exposure units.

Personnel loss exposures include death and retirement. Loss exposures associated with death are few at organizations unless a disaster strikes.

Front 20

Personal loss expsures

Back 20

Personal loss exposures include: property (individual homes are easier to group together than commercial property exposures because individual homes serve the same purpose, resulting in large number of exposure units therefore personal meets all six characteristics). Liability (includes premises and autos (meet all characteristics of ideally insurable)). Net income (losses caused by economy are not considered pure risks). Life, health, and retirement instead of personnel with commercial.

Front 21

Life, health and retirement

Back 21

Losses are subject to moral and morale hazards. Cause of loss many not be fortuitous (suicide).

These losses are typically managed through life and health insurance, as well as government programs. These causes of loss all have a large number of similar exposure units. Life and health policies don't always have economically feasible premiums. Retirement insurance is not available.

Front 22

Reasons for government insurance

Back 22

Insurance for certain exposures can be obtained through gov't insurance programs. Legislators often find it easier to establish gov't insurance plans than to analyze bids from private insurers and supervise/regulate these plans.

Reasons for gov't insurance: fills needs unmet by private insurers. Compels people to buy certain insurance (when insurance is compulsory, it is unnecessary to spend money on marketing) so it obtains greater efficiency due to no marketing or other admin costs. Achieve collateral social purpose, can help prevent economic disruption if certain events happen.

Front 23

Government partipation

Back 23

Ways gov't participates in insurance: gov't can be exclusive insurer (in some states the gov't is the only workers comp option) - gov't can collect premiums, provide coverage and pay claims (can also provide reinsurance by providing 100% reinsurance or by reinsuring part of the risk). Gov't can partner with private insurers - partnerships with insurers usually develop when insurers can no longer provide adequate coverage. Gov't can be a competitor to private insurers - state gov'ts provide workers compensation insurance in competition with private insurers.

Front 24

Federal government programs

Back 24

Federal gov't programs include: National Flood Insurance Program - enforces building codes and reduces new construction in flood zones. Terrorism Risk Insurance Program (TRIP) - temporarily meets the unmet needs for a backstop to insured terrorism losses (gov't acts as reinsurer in the case of terrorist acts, this can help prevent economic disruptions). Federal Crop Insurance - gov't subsidizes and re insures private insurers.

Front 25

State government programs

Back 25

State gov't program includes: Fair Access to insurance Requirements (FAIR) plans - provides basic property ins. to consumers otherwise unable to obtain coverage in the private market. Workers compensation. Beach and Windstorm plans - does not replace normal channels of insurance. Beach and windstorm plans are offered by state gov'ts to consumers who cannot obtain coverage in the private market. Residual Auto plans - provide compulsory auto liability coverage to high-risk drivers.

Most consumers obtain workers comp and auto liability insurance through private insurers.