The concept of risk is the reason insurance exists. You might go an entire year without an auto accident, but a single collision could create $50,000 or more in property damage and liability. Risk is part of life, and even spending large amounts of money can’t eliminate it completely.

To eliminate auto-related injuries entirely, you’d have to eliminate automobiles. Since that isn’t realistic, an effective response to risk usually combines two approaches:

• Reduce the risk when you can.
• Buy insurance for the risk that remains.

In exchange for a premium, the insurer agrees to pay a claim if a specified contingency occurs, such as property damage, theft, or liability. The insurer can offer this protection by pooling the risks of a large group of similarly situated individuals, called exposure units.

With a large pool, the laws of probability make overall losses more predictable. For example, if each of 100,000 individuals independently faces a .5% risk of loss in a year, the expected number of losses is 500. 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 each person who had a loss (assuming 500 people had a loss). In practice, insurers must also account for administrative costs, reserves, and profit margins when setting premiums.

Insurance works through the statistical concept of the Law of Large Numbers. This law states that as the number of exposure units increases, the actual results will more closely approximate the expected results. 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 only works for companies that can stay financially strong while paying claims. Insurance helps you manage risk by protecting you from losses that could seriously affect your financial future. The Law of Large Numbers helps insurers by making it possible to predict, with reasonable accuracy, how many claims they’ll pay from year to year.

Sidenote

Know this...

The larger the number of exposure units in the group, the more accurately the insurance company can predict future losses of the group as a whole. It is NOT possible to predict the probability of loss for each individual exposure unit in the group.

A coin flip is a simple way to see this idea. The probability of heads is 50%, and the probability of tails is 50%. But suppose you flip a coin 10 times and it lands on heads 9 times. Does that mean the probability was wrong?

No. With a small sample (like 10 flips), actual results can vary a lot from what you’d expect. If you flipped the coin 10 million times, the results would be much closer to the calculated probability of 50% heads and 50% tails.

Even though predictability is essential to insurance, some perils are difficult to predict because they can cause many losses at the same time. Hurricanes, airplane crashes, and epidemics can create losses that don’t follow the usual patterns insurers rely on.

To handle these kinds of events, insurers spread risk in several ways:

• Across many individuals
• Across good and bad years (building reserves in good years to pay heavier claims in bad years)
• Through tools such as reinsurance, catastrophe bonds, or government programs like the National Flood Insurance Program (NFIP) and the Terrorism Risk Insurance Act (TRIA)
• By diversifying across lines of insurance (for example, selling both health insurance and homeowners’ insurance)

Another basic rule of insurance is that before someone can benefit from insurance, they must face the possibility of economic loss if a claim occurs against the life or property being insured. This requirement is called insurable interest.

Insurers 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 in 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 the time of claim, even if the insurable interest no longer exists.

Not every risk can be transferred through insurance. Insurable risks have characteristics that make the rate of loss fairly predictable, allowing insurers to 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. Uncertainty about what will happen to an exposure unit creates the need for insurance. If a future loss is certain, it isn’t insurable.

With life insurance, the uncertainty isn’t whether an individual will die, but when the individual will die and what financial obligations will remain when death occurs. With property and casualty insurance, the uncertainty is whether a loss such as fire, theft, or collision will occur.

2) Large number of exposure units

Insurance companies can’t predict who will die when. However, by using data from 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 insurer can predict losses for the group.

This is one way the Law of Large Numbers supports insurance pricing: it helps insurers set premium charges that allow them to remain financially strong while paying claims.

3) Loss must pose an economic hardship

If the potential loss doesn’t justify the premium and the underwriting expenses to the insurance company, the risk isn’t insurable.

4) Loss must be ascertainable

The insurer must be able to measure the loss.

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. With property insurance, the loss is measured by the reduction in property value or the cost to repair or replace the damaged property.

5) Loss must be accidental and unintentional

Intentional acts or predictable events aren’t insurable. Insurance covers unforeseen and unplanned occurrences.

6) Loss must not be catastrophic to the insurer

The loss must not affect a large number of exposure units simultaneously. Catastrophic losses (such as war or widespread natural disasters) are typically excluded or managed through reinsurance.

Perils and Hazards

Perils and hazards are closely related to risk.

• A peril is the specific cause of a loss - the event being insured against.

  • With life insurance, the peril is death.
  • With property insurance, the peril may be fire, theft, or collision.

• A hazard is a condition or factor that increases the chance that a peril will occur.

  • For example, faulty wiring is a hazard that increases the likelihood of a fire.

When someone applies for life or health insurance, the insurer looks at the hazards the applicant may face and how those hazards relate to the peril being insured against. There are 3 types of hazards insurers focus on:

• Physical
• Moral
• Morale

Physical hazards include factors such as a person’s weight, medical history, and occupation. A moral hazard involves dishonesty, such as lying about medical history, occupation, or hobbies, or committing fraud (for example, staging an accident). Morale hazards are more subjective and involve carelessness or indifference because insurance exists - such as leaving doors unlocked because the property is insured.

Lesson Summary

Insurance operates by pooling funds from many individuals facing similar risks to cover financial losses from 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.

Insurance helps manage risk by protecting against significant financial losses. At the same time, insurers rely on pooling and statistical predictability to remain financially viable while paying covered claims.

Chapter Vocabulary

Definitions

Hazard

A circumstance that tends to increase the probability or severity of a loss.

Insurable Interest

A right or relationship in regard to the subject matter of the insured contract such that the insured can suffer a financial loss from damage, loss, or destruction of it.

Insurable Risk

Risks for which it is relatively easy to get insurance and that meet certain criteria. These include being definable, accidental in nature, and part of a group of similar risks large enough to make losses predictable. The insurance company also must be able to come up with a reasonable price for the insurance.

Insurance

An economic device transferring risk from an individual to a company and reducing the uncertainty of risk via pooling.

Law of Large Numbers

The theory of probability on which the business of insurance is based. Simply put, this mathematical premise says that the larger the group of units insured, the more accurate the predictions of loss will be.

Moral Hazard

Personality characteristics that increase the probability of losses, for example, not taking proper care to protect insured property because the insured knows the insurance company will replace it if it is damaged or stolen.

Morale Hazard

Negligence, carelessness or disregard on the part of the insured that could lead to probable loss.

Peril

A specific risk or cause of loss covered by an insurance policy, such as death, cancer, or disability.

Physical Hazard

Physical hazards include factors such as a person’s weight, medical history, and occupation.

Premium

Money charged for the insurance coverage reflecting expectation of loss. A small certain loss (the premium) exchanged for protection against a large uncertain loss.