Chapter 2 Insurance and Risk

Answers to Review Questions

1. Insurance plans have four distinct characteristics:
(a) Insurance can be defined as the pooling of fortuitous losses by transfer of such risks to insurers, who
agree to indemnify those insured for such losses, to provide other pecuniary benefits on their
occurrence, or to render services connected with the risk.
(b) Based on the definition above, four basic characteristics of insurance can be identified:
(1) Pooling of losses
(2) Payment of fortuitous losses
(3) Risk transfer
(4) Indemnification

2. The law of large numbers states that the greater the number of exposures, the more closely the actual
results will approach the probable results expected from an infinite number of exposures. As the
number of exposures increases, the relative variation of actual loss from expected loss will decline.
Thus, the insurer can predict future losses with a greater degree of accuracy as the number of
exposures increases. This is important, since an actuary must charge a premium that is adequate for
paying all losses and expenses during the policy period. The lower the degree of objective risk, the
more confidence an insurer has that the actual premium charged will be sufficient to pay all claims and
expenses and leave a margin for profit.

3. There are several requirements of an ideally insurable risk:

(a) There must be a large number of exposure units.
(b) The loss must be accidental and unintentional.
(c) The loss must be determinable and measurable.
(d) The loss should not be catastrophic.
(e) The chance of loss must be calculable.
(f) The premium must be economically feasible.

4. Social insurance is a government-aided insurance program that is financed entirely or in large part by
mandatory contributions from employers, employees, or both, and not primarily by the general
revenues of government. Social insurance was introduced into law to deal with socio-economic
problems and has been made compulsory. Covered workers and employers are required by law to pay
contributions and participate in these programs. The contributions are generally earmarked for special
trust funds and the benefits, in turn, are paid from these funds. The right to reserve benefits is
generally related to an individual’s contributions in the past or coverage under the program. Usually,
however, the benefits are heavily weighted in favor of low-income groups. Further, eligibility
requirements are prescribed exactly by statute.

5. Examples of fraudulent claims include the following:

(1) Auto accidents being faked or staged to collect benefits
(2) Dishonest claimants faking slip-and-fall accidents
(3) Phony burglaries, thefts, or acts of vandalism being reported to insurers
(4) Dishonest policy owners taking out life insurance policies on insureds whose deaths are
reported much later.

6. (a) Adverse selection is the tendency of persons with a higher-than-average chance of loss to seek
insurance at standard (average) rates, which, if not controlled by underwriting, results in higher-than-
expected loss levels.
(b) Adverse selection can be controlled by careful underwriting, by charging higher premiums to
substandard applicants for insurance, and by certain policy provisions.
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7. (a) The benefits of insurance to the society are:

(1) Indemnification for loss: Compensation is given to the victim of a loss, in whole or in part, by payment,
repair, or replacement.
(2) Reduction of worry and fear: Worry and fear are reduced after a loss occurs because the insured
individuals know that they have insurance that will pay for the loss.
(3) Source of investment funds: Premiums are collected in advance, and funds not needed to pay immediate
losses and expenses can be loaned to business firms. These funds typically are invested in capital goods,
such as housing developments, shopping centers, new plants, and machinery and equipment.
(4) Loss prevention: Loss-prevention activities (like highway safety and fire prevention) reduce both direct
and indirect losses. Society benefits as both types of losses are reduced.
(5) Enhancement of credit: Insurance makes a borrower a better credit risk because it guarantees the value of
the borrower’s collateral or gives greater assurance that the loan will be repaid.
(b) The costs of insurance to society are:
(1) Cost of doing business
(2) Fraudulent claim
(3) Inflated claim

8. Insurance differs from hedging. An insurance transaction usually involves the transfer of risks that are
insurable, since the requirements of an insurable risk can generally be met. Hedging is a technique for
handling risks that are typically uninsurable, such as protection against a substantial decline in the
price of commodities. A second difference is that moral hazard and adverse selection are more severe
problems for insurers than for speculators who buy or sell futures contracts.

9. Casualty insurance is a broad field of insurance that covers whatever is not covered by fire, marine and
liability insurance; casualty lines include auto, liability, burglary and theft, workers compensation and
health insurance.
10. (a) The loss-prevention activities reduce both direct and indirect or consequential losses. The society
benefits from this, since both types of losses are reduced.
(b) Insurers are actively involved in numerous loss-prevention programs. Examples may include,
among many others, the following:
(1) Fire prevention
(2) Theft prevention
(3) Regulating safety on roads
(4) Educational programs on loss prevention
(5) Reduction of work-related injuries and disease

Application Questions
1. (i) Risk of fire
(a) Large number of exposure units. This is generally met, since there are millions of homes
that are insured.
(b) Accidental and unintentional loss. This requirement is generally met, since most insureds
do not deliberately start a fire.
(c) Determinable and measurable loss. A fire loss can be determined and measured. In case of
disagreement, a property insurance policy has a provision for resolving disputes.
(d) No catastrophic loss. This requirement is met, since most homes do not burn at the same
time.
(e) Calculable chance of loss. Insurers can estimate within ranges the probability of a fire loss.
(f) Economically feasible premium. For most insureds, this requirement is fulfilled.
(ii) Risk of war
(a) Large number of exposure units. This requirement is not fulfilled. Based on the law of
large numbers, it is difficult to estimate accurately the number of wars that will occur.
Chapter 2 Insurance and Risk

(b) Accidental and unintentional loss. This requirement is not met. Most wars are not
accidental, but intentional.
(c) Determinable and measurable loss. Although a war loss can be determined, the
measurement of loss would be difficult.
(d) No catastrophic loss. This requirement is not fulfilled, since large numbers of exposure
units would simultaneously incur losses.
(e) Calculable chance of loss. This requirement cannot be easily met.
(f) Economically feasible premium. Because of the catastrophic potential of war, the premiums
would not be economically feasible.

2. (a)

(1) Indemnification means that insureds are restored to their former financial position after a
loss occurs, either partly or wholly. As a result, individuals and families can maintain their
economic security and are less likely to apply for public assistance or welfare, or seek
financial assistance from relatives and friends.
(2) Insurance makes a borrower a better credit risk because it guarantees the value of the
borrower’s collateral, or gives greater assurance that the loan will be repaid. For example, life
insurance can be used to pay off a bank loan if the creditor dies prematurely, and so makes the
creditor a better credit risk.
(3) Premiums are collected in advance, and funds not needed to pay immediate losses and
expenses can be loaned to business firms. These funds typically are invested in capital goods,
such as housing developments, shopping centers, new plants, and machinery and equipment.
Since the stock of capital goods is increased, economic growth and full employment are
promoted. In addition, since the supply of loanable funds is increased, the cost of capital to
business firms is lower than it would be in the absence of insurance.
(b) The major social and economic costs of insurance are the following:
• Cost of doing business
• Fraudulent claims
• Inflated claims

3. Each country has its unique way of approaching the issue of social security and insurance for
movable and immovable assets. Some of these insurance solutions are provided by the federal and
state governments, contributory group insurance schemes like employees’ group health insurance,
crop insurance for farmers, disability insurance for soldiers and hazardous sector employees. Others
are pure term life insurances, health insurance and fire and allied perils type insurances provided by
private and public sector insurance providers. Other major social insurance programs include:
(a) Old-age, survivors, and disability insurance (Social Security)
(b) Medicare
(c) Unemployment insurance
(d) Workers compensation

4. (a) In case of a mortgage loan, mortgage insurance is needed. In case the insured is rendered
disabled, the insurer should pay the loan.
(b) In the event of Peter’s premature death, life insurance can provide the needed funds for his family.
(c) Fire insurance or commercial multi-peril insurance (including business interruption coverage) will
be useful in such a case.
(d) Health insurance (public or private plans) would be necessary in this case.