Can someone recommend me a resource that can show a sample of how underwriters or actuaries work to finally come up with the rates to be paid by insureds? I want to see how practically that can be! An example here would be very helpful to me. Thanks.
An Introduction to Insurance
Ideal Requisites for Insurability - Part 2
Case Study 03- Who Should Insure against Megacatastrophes?
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 03- Who Should Insure against Megacatastrophes?”
The case study describes the difficulties that insurance companies can face following the occurrence of megacatastrophes.
For insurance to be economically feasible for an insured, the size of the possible loss must be significant to the insured, and the cost of insurance must be small compared to the potential loss.
Otherwise, the purchase of insurance is not practical. If the possible loss is not significant to those exposed, insurance is inappropriate. Cost-benefit analysis is needed for the insurers to determine if the rates can be feasible to insureds.
For catastrophic coverage, the insurer may determine through capital budgeting methods and cash flow analysis that it cannot provide low enough costs to make the coverage feasible for insureds.
Economic Feasibility (Continued)
Retention (bearing the financial loss by oneself) of many risks is almost automatic because the loss would not be a burden.
If all the people who own automobiles were wealthy, it is doubtful that much automobile collision insurance would be written because such losses would not be significant to the wealthy owners. Insurance is feasible only when the possible loss is large enough to be of concern to the person who may bear the burden.
The possible loss must also be relatively large compared to the size of the premium. If the losses the insurer pays plus the cost of insurer operations are such that the premium must be very large in relation to the potential loss, insurance is not economically feasible.
From the viewpoint of the insured, when the expected loss premium is high relative to the maximum possible loss, internal budgeting for the risk is preferable to insurance.
Economic Feasibility (Continued)
The use of deductibles (a form of retention) to eliminate insurance reimbursement for frequent small losses helps make automobile collision premiums economically feasible. The deductible eliminates claims for small losses.
Insurance is best suited for risks involving large potential losses with low probabilities.
Large losses are key because insureds cannot pay them, and low probabilities for large losses make premiums relatively small compared with the possible losses. In other situations, insurance may not be economically feasible for the person or business facing risk.
Small automobile collision losses have such high probability and the cost of settling them is so great that the premium for covering them would be very large compared to the size of actual losses.
For example, if a policy with a $200 deductible costs $85 more than one with a $500 deductible, you may consider $85 too large a premium for $300 of lower deductible.
Summary of Insurable Risks
Table 6.1 provides an analysis of the insurability characteristics of a few common perils and risks. The first column lists the requirements for insurability that we have just discussed.
Note that the risk of flooding is not considered insurable because of its potential for catastrophe: many exposures can suffer losses in the same location. Thus, flooding is covered by the federal government, not by private insurers.
Hurricanes, though similar to floods, are covered by private insurers, who obtain reinsurance to limit their exposure. After a catastrophe like Hurricane Andrew, however, many reinsurers became financially strapped or insolvent.
Summary of Insurable Risks (Continued)
The second example in Table 6.1 is fire.
Fire is an insurable risk because it meets all the required elements. Even this peril can be catastrophic, however, if fires cannot be controlled and a large geographical area is damaged, such as the large fires in Colorado and Arizona in 2002.
Disability is another type of peril that is considered insurable in most cases. The last example is the risk of terrorism. As noted above, it is no longer considered an insurable risk due to the catastrophic element associated with this peril since the September 11, 2001, attack.
In this section you studied that a risk perfectly suited for insurance meets the following requirements:
The number of similar exposure units is large.
The losses that occur are accidental.
A catastrophe cannot occur.
Losses are definite.
The probability distribution of losses can be determined.
The cost of coverage is economically feasible.
Explain whether the following risks and perils are insurable by private insurers:
a. A hailstorm that destroys your roof
b. The life of an eighty-year-old man
c. A flood
e. Biological warfare
f. Dirty bombs
 Governmental insurance programs make greater deviations from the ideal requisites for insurability. They are able to accept greater risks because they often make their insurance compulsory and have it subsidized from tax revenues, while private insurers operate only when a profit potential exists. The nature of government insurance programs will be outlined later in this chapter.
 Jeff D. Opdyke and Christopher Oster, “Hit With Big Losses, Insurers Put Squeeze on Homeowner Policies,” Wall Street Journal, May 14, 2002.
 Insurance is regulated by the states, a topic that will be covered in more detail in Chapter 7 "Insurance Operations".
END of UNIT
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