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An Introduction to Insurance
The Nature of Insurance
In this section you will learn the following:
The law of large numbers as the essence of insurance
How insurance is defined
A brief survey of insurance literature reveals differences of opinion among authors concerning how the term insurance should be defined. Regardless, however, the literature agrees that insurance has to contain both of the following elements: risk pooling and risk transfer.
We regard insurance as a social device in which a group of individuals transfer risk to another party in such a way that the third party combines or pools all the risk exposures together.
Pooling the exposures together permits more accurate statistical prediction of future losses. Individuals who transfer risk to a third-party are known as insureds. The third party that accepts the risks transferred by insureds is known as the insurer.
Risk Pooling & Transfer
Risk pooling creates a large sample of risk exposures and, as the sample gets larger, the possibility of missing future loss predictions gets lower. This is the law of large numbers, discussed in the unit.
The combination of risk pooling and risk transfer (from the owner of the risk to a third, unrelated party) physically reduces the risk, both in number and in the anxiety it causes.
Case Study 01- The Law of Large Numbers
Please download the PDF containing the case studies for this module. This is available from the module resources section for this module.
The first case study we will examine is “Case Study 01- The Law of Large Numbers”.
The Law of Large Numbers is central to understanding how insurance works. The case study describes why it is necessary for insurance companies to possess a large number of exposures.
How Insurance Works
Click through the following steps to study how insurance works.
Risk is transferred from an individual or entity (insured) to a third party (insurer).
The third party (insurer) pools all the risk exposures together to compute potential future losses with some level of accuracy. The insurer uses various forecasting techniques, depending on the distribution of losses.
The pooling of the risk leads to an overall reduction of risk in society because insurers’ accuracy of prediction improves as the number of exposures increases.
Insurers pool similar risk exposures together to compute their own risk of missing the prediction.
Insurers discriminate via underwriting-the process of evaluating a risk and classifying it with similar risks. Both the transfer of risk to a third party and the pooling lead to reduced risk in society as a whole and a sense of reduced anxiety.
Insurance is created by an insurer that, as a professional risk-bearer, assumes the financial aspect of risks transferred to it by insureds.
In return for accepting this variability in outcomes (our definition of risk), the insurer receives a premium.
Through the premium, the policyholder has paid a certain expense in order to transfer the risk of a possible large loss. The insurance contract stipulates what types of losses will be paid by the insurer.
The insurer assumes risk by promising to pay whatever loss may occur as long as it fits the description given in the policy and is not larger than the amount of insurance sold. The loss may be zero, or it may be many thousands of dollars.
Most insurance contracts are expressed in terms of money, although some compensate insureds by providing a service.
Whether the insurer fulfills its obligations with money or with services, the burden it assumes is financial. The insurer does not guarantee that the event insured against will not happen. Moreover, it cannot replace sentimental value or bear the psychological cost of a loss.
Not all aspects of loss can be measured in terms of money; therefore, such risks cannot be transferred to an insurer.
Because these noneconomic risks create uncertainty, it is apparent that insurance cannot completely eliminate uncertainty. Yet insurance performs a great service by reducing the financial uncertainty created by risk.
A life insurance contract obligates the insurer to pay a specified sum of money upon the death of the person whose life is insured.
A liability insurance policy requires the insurer not only to pay money on behalf of the insured to a third party but also to provide legal and investigative services needed when the event insured against occurs.
The terms of some health insurance policies are fulfilled by providing medical and hospital services (e.g., a semiprivate room and board, plus other hospital services) if the insured is ill or injured.
A home may be worth only $80,000 for insurance purposes, but it may have many times that value to the owner in terms of sentiment.
The death of a loved one can cause almost unbearable mental suffering that is in no way relieved by receiving a sum of money from the insurer.
Insurance or Not?
In the real world, a clear definition of what is considered an insurance product does not always exist. The amount of risk that is transferred is usually the key to determining whether a certain accounting transaction is considered insurance or not. A case in point is the product called finite risk.
Premiums paid by the corporation to finance potential losses (losses as opposed to risks) are placed in an experience fund, which is held by the insurer. Over time, the insured pays for his or her own losses through a systematic payment plan, and the funds are invested for the client.
This arrangement raises the question, Is risk transferred, or is it only an accounting transaction taking place? The issue is whether finite risk should be called insurance without the elements of insurance.
It was used by insurers and reinsurers and became the center of a controversy that led to the resignation of Hank Greenberg, the former chairperson and chief executive officer (CEO) of American International Group (AIG) in 2006.
Finite risk programs are financial methods that can be construed as financing risk assumptions. They began as arrangements between insurers and reinsurers, but they can also be arrangements between any business and an insurer.
Risk Pooling (Loss Sharing)
In general, the bulk of the premium required by the insurer to assume risk is used to compensate those who incur covered losses.
Pooling can be done by any group who wishes to share in each other’s losses. The pooling allows a more accurate prediction of future losses because there are more risk exposures.
Being part of pooling is not necessarily an insurance arrangement by itself. As such, it is not part of the transfer of risk to a third party.
In a pooling arrangement, members of the group pay each other a share of the loss. Even those with no losses at all pay premiums to be part of the pooling arrangement and enjoy the benefits of such an arrangement.
Loss sharing is accomplished through premiums collected by the insurer from all insureds-from those who may not suffer any loss to those who have large losses. In this regard, the losses are shared by all the risk exposures who are part of the pool.
This is the essence of pooling.
Risk Pooling (Loss Sharing) - Continued
For this purpose, actuaries, charged with determining appropriate rates (prices) for coverage, estimate the frequency and severity of losses and the loss distribution These estimates are made for a series of categories of insureds, with each category intended to group insureds who are similar with regard to their likelihood.
An underwriter then has the job of determining which category is appropriate for each insured. Actuaries combine the information to derive expected losses. Estimates generally are based on empirical (in this case, observed) data or theoretical relationships, making them objective estimates.
When the actuary must rely on judgment rather than facts, the estimates are termed subjective. In most cases, both objective and subjective estimates are used in setting rates.
A life insurer may estimate that 250 of the 100,000 risk exposures of forty-year-old insureds it covers will die in the next year.
If each insured carries a $1,000 policy, the insurer will pay out $250,000 in claims (250 ×$1,000). To cover these claims, the insurer requires a premium of $2.50 from each insured ($250,000/100,000), which is the average or expected cost per policyholder.
An additional charge to cover expenses, profit, and the risk of actual losses exceeding expected losses would be included in the actual premium. A reduction of the premium would result from the insurer sharing its investment earnings with insureds.
Discrimination: The Essence of Pooling
In order for the law of large numbers to work, the pooled exposures must have approximately the same probability of loss. In other words, the exposures need to be homogeneous (similar). Insurers, therefore, need to discriminate, or classify exposures according to expected loss.
If the two groups of dissimilar risk exposures were charged the same rate, problems would arise. As previously stated, rates reflect average loss costs. Thus, a company charging the same rate to both twenty- year-old insureds and sixty-year-old insureds would charge the average of their expected losses. The pooling will be across ages, not by ages.
For this reason, twenty-year-old insureds with relatively low rates of mortality are charged lower rates for life insurance than are sixty-year-old insureds, holding factors other than age constant.
The rates reflect each insured’s expected loss.
Case Study 02- Fitting into a Lower Risk-Exposure Pooling Group
Please download the PDF containing the case studies for this module. This is available from the module resources section for this module.
The next case study we will examine is “Case Study 02- Fitting into a Lower Risk-Exposure Pooling Group”.
The case study describes the importance of exposure pooling in the insurance industry.
This phenomenon of selecting an insurer that charges lower rates for a specific risk exposure is known as adverse selection because the insureds know they represent higher risk, but they want to enjoy lower rates.
Often, the insurer simply does not have enough information to be able to distinguish completely among insureds, except in cases of life insurance for younger versus older insureds. Furthermore, the insurer wants to aggregate in order to use the law of large numbers. Thus, some tension exists between limiting adverse selection and employing the law of large numbers.
Adverse selection, then, can result in greater losses than expected. Insurers try to prevent this problem by learning enough about applicants for insurance to identify such people so they can either be rejected or put in the appropriate rating class of similar insureds with similar loss probability. Many insurers, for example, require medical examinations for applicants for life insurance.
Adverse selection occurs when insurance is purchased more often by people and/or organizations with higher-than-average expected losses than by people and/or organizations with average or lower- than-average expected losses.
That is, insurance is of greater use to insureds whose losses are expected to be high (insureds “select” in a way that is “adverse” to the insurer). On this basis alone, no problem exists because insurers could simply charge higher premiums to insureds with higher expected losses.
Adverse Selection (Continued)
Some insurance policy provisions are designed to reduce adverse selection.
The suicide clause in life insurance contracts, for example, excludes coverage if a policyholder takes his or her own life within a specified period, generally one or two years.
The preexisting conditions provision in health insurance policies is designed to avoid paying benefits to people who buy insurance because they are aware, or
should be aware, of an ailment that will require medical attention or that will disable them in the near future. 
In this section you studied the following:
The essence of insurance, which is risk transfer and risk pooling
The necessity of discrimination in order to create pools of insureds
The fact that insurance provides risk reduction
1. What is the definition of insurance?
2. What is the law of large numbers? Why do insurers rely on the law of large numbers?
3. Why is it necessary to discriminate in order to pool?
4. Why are finite risk programs not considered insurance?
 The interested student should also explore it further. In the case of AIG, the finite risk arrangements were regarded as noninsurance transactions. In early 2006, AIG agreed to pay
$1.64 billion to settle investigations by the Securities and Exchange Commission and New York State Attorney General Eliot Spitzer, who brought charges against AIG. This recent real-life example exemplifies how the careful treatment of the definition of insurance is so important to the business and its presentation of its financial condition. For more information on finite risk programs, see “Finite Risk Reinsurance,” Insurance Information Institute (III), May 2005, at; Ian McDonald, Theo Francis, and Deborah Solomon, “Rewriting the Books-AIG Admits ‘Improper’ Accounting Broad Range of Problems Could Cut $1.77 Billion Of Insurer’s Net Worth A Widening Criminal Probe,” Wall Street Journal, March 31, 2005, A1; Kara Scannell and Ian McDonald, “AIG Close to Deal to Settle Charges, Pay $1.5 Billion,” Wall Street Journal, February 6, 2006, C1; Steve Tuckey, “AIG Settlement Leaves Out Life Issues,” National Underwriter Online News Service, February 10, 2006. These articles are representative regarding these topics.
 Recent health care reforms (HIPAA 1996) have limited the ability of insurers to reduce adverse selection through the use of preexisting-condition limitations.
END of UNIT
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