Transferring Losses

The concept of risk is why insurance exists. An insured may have absolutely no medical expenses in a good year, but if he/she is hit by a bus, they could easily be over $500,000. We cannot eliminate risk from life, even at extraordinary expense.

The only way to eliminate auto-related injuries is to eliminate automobiles. Thus, the effective response to risk combines two elements: efforts to lessen the risk, and the purchase of insurance against the risk that remains.

In exchange for a premium, the insurer will pay a claim should a specified contingency, such as death or medical bills, arise. The insurer is able to offer such protection against financial loss by pooling the risks from a large group of similarly situated individuals (exposure units). With a large pool, the laws of probability assure that only a small fraction of the insured population will die or be hospitalized in a year. If, for example, each of 100,000 individuals independently faces a .5% risk in a year, on average 500 will have losses. If each of the 100,000 people paid a premium of $1,000, the insurance company would collect a total of $100 million, enough to pay $200,000 to anyone who had a loss (assuming 500 people had a loss).

Insurance works through the statistical concept of the Law of Large Numbers. This law assures that when a large number of people face a low-probability event, the proportion experiencing the event will be lower than the mathematical proportion. For instance, with a pool of 100,000 people who each face a .5% risk, the Law of Large Numbers dictates that 500 people or more will have losses during the same period only 1 time in 1,000.

Insurance is a business. But it is only a business for those companies who are able to maintain their financial strength while paying out claims. While insurance helps you manage risk by protecting against things that would significantly impact your financial future if they occurred, the Law of Large Numbers helps insurance companies by making predictable, with reasonable accuracy, the claims it will pay from year to year.

When you flip a coin, the probability that the coin will land on heads is 50% and the probability it will land on tails is 50%. However, let’s say we flipped a coin 10 times, and it lands on heads 9 of those times. Does this mean the calculated probability was wrong?

No. In a small sample such as 10 coin tosses, the actual results may vary considerably from predicted results. However, if we flipped the coin 10 million times (a large number of times) the calculated probability of 50% heads and 50% tails would be extremely accurate.

Although the ability to predict future losses with some degree of accuracy is critical to the concept of insurance, certain types of perils are unpredictable. Such perils, when they cause losses, do not establish a pattern of predictability that can be used for future predictions of anticipated loss. In a hurricane, airplane crash, or epidemic, many may suffer at the same time. Insurance companies spread such risks not only across individuals but also across good years and bad, building up reserves in the good years to deal with heavier claims in bad ones. For further protection they also diversify across lines, selling health insurance as well as homeowners’ insurance, for example.

Another basic rule governing insurance states that before an individual can benefit from insurance, he/she must face the possibility of economic loss in the event of a claim against the life or property being insured. This requirement is known as insurable interest.

Insurers will recognize 3 situations that constitute insurable interest:

1. An individual always has an insurable interest in his/her own life. Therefore, anyone (who is legally capable of doing so) may apply for an insurance policy on themselves.

2. Insurable interest exists on the life of an immediate family member or marital partner (close kinship). Insurable interest also exists if there is a financial relationship (business partner, key person, or debtor).

3. Insurable interest need only exist at time of application with life insurance. Once the policy has been issued the insurer must pay the death benefit at time of claim even if the insurable interest no longer exists.

Certain risks may not be transferred through insurance; insurable risks have certain characteristics that make the rate of loss fairly predictable, allowing insurers to adequately prepare for the losses that do occur. For a risk to be acceptable to a conventional insurance company, it must meet the following criteria:

1) Loss must be uncertain

The purpose of insurance is to offset the financial loss of a covered event. Not knowing what is going to happen to the individual exposure unit creates the need for insurance. If a future loss is certain, it is not insurable.

With life insurance, the uncertainty rests not with whether an individual will die, but rather with when that individual will die and what financial obligations will be left behind when death does occur.

2) Large number of exposure units

Insurance companies cannot predict who will die when, but by using data about a large number of people, they can predict with reasonable accuracy how many people in a given population are likely to die during a certain period of time (the larger the group, the more accurately the insurance company will be able to predict losses of the group). And thus, the Law of Large Numbers aids insurance companies in determining appropriate premium charges to ensure they can maintain financial strength while paying out claims.

3) Loss must pose an economic hardship

If the potential loss does not justify the outlay of premium and the underwriting expenses to the insurance company, the risk is not insurable.

4) Loss must be ascertainable

With life insurance, monetary value is placed on the insured’s ability to earn an income or on the needs of his/her survivors. With health insurance, economic loss is measured by lost wages or by actual medical expenses incurred.

Perils and Hazards

Perils and hazards are related to the concept of risk. A peril is the specific cause of a loss and is the event being insured against. With life insurance, the peril being insured against is death. A hazard is a condition or factor that promotes the peril. Hang gliding, for example, is a hazard that promotes the peril of death.

When a person applies for life or health insurance, the insurer looks at the hazards that the applicant may encounter and how they relate to the peril being insured against. There are 3 types of hazards that insurers are concerned about:

• Physical
• Moral
• Morale

Physical hazards include factors such as a person’s weight, medical history, and occupation. A moral hazard is a dishonest applicant, one who lies about his/her medical history, occupation, or hobbies. Morale hazards are more subjective and include such things as road rage, and the tendency to drink alcohol to excess or use drugs, which can promote the risk of health problems or premature death.

Lesson Summary

Insurance operates by pooling funds from many individuals facing similar risks to cover financial losses upon specific events through contractual agreements. Key concepts in insurance are:

• The Law of Large Numbers forms the statistical basis for insurance operations by enabling companies to predict claims with reasonable accuracy by pooling risks across a large group.

• Insurable interest is needed for a person to benefit from insurance, with requirements including having a financial stake in the insured event.

• Perils are the causes of losses while hazards are factors promoting these losses, with insurers considering physical, moral, and morale hazards in assessing risks.

While insurance is essential for managing risks, insurance companies rely on statistical principles and pooling of risks to maintain financial viability while ensuring that covered individuals can recover from unforeseen events without incurring significant economic losses.

Chapter Vocabulary