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Insurance and Pensions Management

2 – Insurance and Risk

 Agenda
• Definition of Insurance
• Knightian Uncertainty
• Basic Characteristics of Insurance
• Characteristics of An Ideally Insurable Risk
• Problems in Insurance Markets
– Adverse Selection
– Moral Hazard
• Insurance vs. Gambling
• Insurance vs. Hedging
• Types of Insurance
• Benefits and Costs of Insurance to Society

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 Definition of Insurance
• There are many definitions of insurance:
– “a device for the reduction of risk of one party, called the insured, through the transfer of
particular risks to another party, called the insurer, who offers a restoration, at least in part, of
economic losses suffered by the insured” (Pfeffer, 1956, p. 56)
– Insurance is the pooling of fortuitous losses by transfer of such risks to insurers, who agree to
indemnify insureds for such losses, to provide other pecuniary benefits on their occurrence, or
to render services connected with the risk
• NOTE THAT: “for insurance to be insurance, it needs to involve a risk pooling
mechanism that combines the resources of the many to compensate for the losses
of the few” (Churchill, 2002, p. 4).
• The definitions of insurance have embedded in them the aspect of risk:
– Risk is the “variability or volatility in unexpected outcomes” (Jorion & Khoury, 1995, p. 2);
– It is an element which attaches uncertainty to the occurrence of an event (W. G. Johnson,
1983).
• In discussing risk, Weston (1954) and Stigler (1987) propose that:
– risk alludes to insurable outcomes;
– whereas uncertainty to non-insurable outcomes (G. Stigler, 1987; J. F. Weston, 1954).

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 Knightian Uncertainty
• Frank Knight developed the Knightian Theory of Uncertainty:
– describing that the main function of an entrepreneur is to act in anticipation of
future events.
• An entrepreneur faces non-insurable risks and such an entrepreneur
would earn his profit for bearing the non-insurable risks
• Frank Knight made two distinct definitions of uncertainty:
– between ‘risk’ (for which probability distributions are known) and
– ‘true uncertainty’ (for which probability distributions are not known and as
such is unmeasurable).
• Uncertainty is a situation where:
– an event is uncertain or ambiguous if it has unknown probability.
• NOTE: that Knightian Uncertainty reflects ignorance of underlying
processes, functional relationships, strategies or intentions of relevant
actors, on future events.
• The principles of uncertainty underline many insurance processes.

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 Knightian Uncertainty
• Frank Knight divides future outcomes into three categories:
– first are outcomes to which “mathematical” probabilities apply;
– “second are outcomes that can be grouped and the expected outcome
for the group as a whole can be determined with certainty”; and
– thirdly are outcomes “that cannot be grouped and cannot be estimated
from historical data”
• This implies that outcomes subject to risk are insurable, whereas
those that are not subject to risk are uninsurable
– there will always be risks that are insurable and those that are uninsurable.
• The concept of uncertainty is important as it shapes key
decisions in insurance business
• The non-insurable risks pose a situation of ambiguity

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 Takaful (Islamic Insurance)
• The Islamic Financial Services Board (IFSB) defines Takaful:
– as the Islamic counterpart of conventional insurance which exists in both family (or ‘life’) and
General forms (IFSB, 2009).
• Takaful means “guaranteeing each other” and that in the Islamic
interpretation, it “is a pact among a group of members or participants that
agree to always give mutual assistance to one another”
• The origin of Islamic Insurance
– dates before the era of the Holy Prophet Muhammad;
– it is based on “Aquilah” mutual co-operation; and
– the first person to come up with the meaning and concept and legal entity of an
insurance contract was a Hanafi Lawyer, Ibn Abdin
• The first Islamic insurance company (called the Islamic Insurance Company
Limited) was established in Sudan in 1978
• The main purpose of Takaful is to:
– bring equity to all parties involved and the objective of the contract is to help the
policyholder through bad times
• Takaful is based on social solidarity, cooperation and joint indemnification of
losses of the members
• Takaful is no longer a new phenomenon as Takaful businesses are spread out in
the world in Muslim and non-Muslim countries with varied growth levels.
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 Takaful (Islamic Insurance)
• The characteristic of sharia compliant insurance are that:
– both parties be sincere;
– the policy is for the sake of the hereafter; and
– there is nothing illegal in its aim and operations.
• Islamic Insurance has certain aspects that are forbidden:
– Riba, or usury (interest);
– Gharar or uncertainty;
– Maisir, or gambling;
– haram, or forbidden designs are concepts found in conventional insurance that are not
permissible in Islamic insurance as defined under Islamic law
• Takaful is not a type of insurance, but rather an alternative to insurance
• Just like conventional insurance, Takaful faces challenges and they include:
– low levels of public awareness;
– low levels of education among the consumers;
– lack of consumer awareness, scarcity of human resources with both insurance and
Shariah expertise; and
– Solvency and capital requirements, diverging regulatory approaches and lack of
centralised regulations

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 Basic Characteristics of Insurance
• Pooling of losses
– Spreading losses incurred by the few over the entire group
– Risk reduction based on the Law of Large Numbers
• Example 1:
– Two business owners own identical buildings valued at $50,000
– There is a 10 percent chance each building will be destroyed by a peril in any
year; loss to either building is an independent event
– Expected value and standard deviation of the loss for each owner is:

Expected loss = 0.90 * $0 + 0.10 * $50,000 = $5,000

Standard deviation = 0.90(0 - $5,000) + 0.10($50,000 - $5,000)

2 2

= $15,000

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Example 1: Working

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 Basic Characteristics of Insurance
• Example 2: (.. Continued)
– If the owners instead pool (combine) their loss exposures, and each agrees to pay an
equal share of any loss that might occur:

Expected loss = 0.81* $0 + 0.09 * $25,000 + 0.09 * $25,000 + 0.01* $50,000

= $5,000

Standard deviation = 0.81(0 - $5,000) + (2)(0.09)($25,000 - $5,000) + 0.01($50,000 - $5,000) 2

2 2

= $10,607

– As additional individuals are added to the pooling arrangement, the standard

deviation continues to decline while the expected value of the loss remains
unchanged

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Example 2: Working

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 Basic Characteristics of Insurance
• Payment of fortuitous losses
– Insurance pays for losses that are unforeseen, unexpected,
and occur as a result of chance
• Risk transfer
– A pure risk is transferred from the insured to the insurer,
who typically is in a stronger financial position
• Indemnification
– The insured is restored to his or her approximate financial
position prior to the occurrence of the loss

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Characteristics of an Ideally Insurable Risk

• Large number of exposure units

– to predict average loss
• Accidental and unintentional loss
– to control moral hazard
– to assure randomness
• Determinable and measurable loss
– to facilitate for accurate underwriting
– to facilitate loss adjustment
• insurer must be able to determine if the loss is
covered and if so, how much should be paid.

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….Characteristics of an Ideally Insurable Risk
• No catastrophic loss
– to allow the pooling technique to work
– exposures to catastrophic loss can be managed by:
• dispersing coverage over a large geographic area
• using reinsurance
• catastrophe bonds
• Calculable chance of loss
– to establish an adequate premium
• Economically feasible premium
– so people can afford to buy
– Premium must be substantially less than the face
value of the policy

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!!Based on these requirements!!
– Most personal, property and liability risks can be insured
– Market risks, financial risks, production risks and political risks
are difficult to insure

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Example 1: Risk of Fire as an Insurable Risk

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Example 2: Risk of Unemployment as an Insurable Risk

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 Adverse Selection and Insurance
• Introduced by Rothschild and Stiglitz (1976) during their work
on competitive equilibrium in the insurance markets
• Adverse selection has been defined:
– Adverse selection is the tendency of persons with a higher-than-
average chance of loss to seek insurance at standard rates
– It is a situation where “heterogeneous individuals have more
information about their risk type than the insurer does” (Soika,
2018, p. 5)
– makes it impossible for the insurer to charge higher premiums
for high-risk persons and vice-versa

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 Adverse Selection and Insurance
• Adverse selection occurs when high-risk individuals are more likely
to purchase insurance than low-risk individuals (Rejda, 2011).
• If not controlled, adverse selection results in higher-than-expected
loss levels
– a situation which could lead to collapse of insurance companies; and
– eventual market failure
• because of information constraints that insurers face
• causing the market to provide an amount of insurance that is not optimal
• Key Products affected – Annuities Markets, automobile insurance,
health insurance, inter alia.
• Adverse selection can be controlled by:
– careful underwriting (selection and classification of applicants for
insurance)
– policy provisions (e.g., suicide clause in life insurance)

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 Adverse Selection and Insurance
HOWEVER,
• Adverse selection may “lead to a positive coverage-risk
correlation whereas advantageous selection leads to the
opposite”(Soika, 2018, p. 6).
• It is thus imperative that insurers
– try as much as possible to reduce adverse selection; and
– at the same time devise mechanisms of avoiding situations of
advantageous selection;
– in order to avoid their effects that affect insurance business

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 Moral Hazard and Insurance

• Moral Hazard:
– is a situation when having been insured causes individuals to
become careless and as such fail to avoid losses and may in
some circumstances intentionally cause losses.
– “Moral Hazard in insurance markets refers to changed
behaviour under insurance coverage”(Soika, 2018, p. 4),
• Moral Hazard can be split into two categories: ex ante and ex post moral
hazard.
• Ex ante moral hazard defines a situation where there is a change in the
precaution of the insured as a result of insurance
• Ex post moral hazard defines a situation where there is an insurance-
induced change in loss claiming behaviour aimed at keeping the costs of
the loss low

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 Moral Hazard and Insurance
• Ex ante moral hazard plays a remote role in health insurance because an
individual would not wish to suffer reduced health as a result of moral
hazard.
– However, conflicting results on ex ante moral hazard in health insurance are
not uncommon but empirical evidence support the notion of people not
wishing to lose health due to moral hazard
• Evidence for Ex post moral hazard has been found in insurance markets
with health insurance and workers’ compensation suffering the most
• Moral hazard can be combated through:
– policy limits,
– imposing deductibles and co-insurance characteristics that may force the
insured to bear a portion of their loss.
– In some instances, the loss of the accumulated No Claim Discount (NCD) when
one makes a claim can work towards reducing moral hazard.
• Severe moral hazard can make insurance policies impossible and in its
worst case scenario can lead to market failure.

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 Insurance vs. Gambling
Insurance Gambling

• Insurance is a technique for • Gambling creates a new

handling an already existing pure speculative risk
risk

• Insurance is socially productive: • Gambling is not socially

– both parties have a common productive
interest in the prevention of a – The winner’s gain comes at the
loss expense of the loser

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 Insurance vs. Hedging
Insurance Hedging
• Risk is transferred by a contract • Risk is transferred by a contract
• Insurance involves the transfer of • Hedging involves risks that are
insurable risks typically uninsurable
• Insurance can reduce the • Hedging does not result in
objective risk of an insurer reduced risk
through the Law of Large
Numbers

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 Types of Insurance
• Private Insurance
– Life and Health
– Property and Liability
• Government Insurance
– Social Insurance
– Other Government Insurance

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 Private Insurance
• Life and Health
– Life insurance pays death benefits to beneficiaries when the insured
dies
– Health insurance covers medical expenses because of sickness or injury
– Disability plans pay income benefits
• Property and Liability
– Property insurance indemnifies property owners against the loss or
damage of real or personal property
– Liability insurance covers the insured’s legal liability arising out of
property damage or bodily injury to others
– Casualty insurance refers to insurance that covers whatever is not
covered by fire, marine, and life insurance

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 Private Insurance
• Private insurance coverage can be grouped
into two major categories
– Personal lines
• coverage that insure the real estate and personal
property of individuals and families or provide
protection against legal liability
– Commercial lines
• coverage for business firms, nonprofit organizations,
and government agencies

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Example 3: Property and Casualty Insurance Coverage

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 Government Insurance
• Social Insurance Programs
– Financed entirely or in large part by contributions from employers
and/or employees
– Benefits are heavily weighted in favor of low-income groups
– Eligibility and benefits are prescribed by statute
– Examples:
• Social Security, Unemployment Benefits, Workers Compensation
• Other Government Insurance Programs
– Examples:
• Flood insurance, State health insurance pools

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 Social Benefits of Insurance
• Indemnification for Loss
– Contributes to family and business stability
• Reduction of Worry and Fear
– Insureds are less worried about losses
• Source of Investment Funds
– Premiums may be invested, promoting economic growth
• Loss Prevention
– Insurers support loss-prevention activities that reduce direct and indirect losses

• Enhancement of Credit
– Insured individuals are better credit risks than individuals without insurance

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 Social Costs of Insurance
• Cost of Doing Business
– Insurers consume resources in providing insurance to society
– An expense loading is the amount needed to pay all expenses, including
commissions, general administrative expenses, state premium taxes,
acquisition expenses, and an allowance for contingencies and profit
• Cost of Fraudulent and Inflated Claims
– Payment of fraudulent or inflated claims results in higher premiums to
all insureds, thus reducing disposable income and consumption of other
goods and services

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 Further Reading
• Churchill, C. (2002). Trying to understand the demand for
microinsurance. Journal of International Development, 14(3), 381–
387.
• Jorion, P., & Khoury, S. J. (1995). Financial risk management:
Domestic and international dimensions. Blackwell.
• Knight, F. H. (1957). Risk uncertainty and profit (8th ed.). Houghton
Miffin Co.
• Pfeffer, I. (1956). Insurance and Economic Theory, Homewood, IL:
Richard D. Irwin. Inc. Google Scholar.
• Rejda, G. E. (2011). Principles of risk management and insurance.
Pearson Education India.
• Soika, S. (2018). Moral hazard and advantageous selection in private
disability insurance. The Geneva Papers on Risk and Insurance-Issues
and Practice, 43(1), 97–125.
• Stigler, G. J. (1950). The development of utility theory. II. Journal of
Political Economy, 58(5), 373–396.
• Weston, J. F. (1954). The profit concept and theory: a restatement.
Journal of Political Economy, 62(2), 152–170.
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