Unit
- Pure risk vs speculative risk: Pure risk involves only loss or no loss (e.g., fire, theft), while speculative risk offers chance of gain or loss (e.g., investments). Insurance transfers pure risk through pooling.
- Law of large numbers: Insurers rely on this principle to predict losses accurately. As the number of independent exposure units increases, actual loss experience converges to expected loss, enabling stable premium pricing.
- Insurable risk requirements: Loss must be definite, measurable, accidental, and not catastrophic to the pool. The risk must have a large number of similar exposure units and premiums must be affordable.
- Adverse selection: Higher-risk individuals are more likely to seek insurance. Insurers combat this through underwriting, risk classification, and policy provisions like waiting periods or exclusions.
- Moral hazard: Insurance may incentivize riskier behavior. Policy features such as deductibles, coinsurance, and limits align incentives and reduce moral hazard effects.
- Risk management process: Identify exposures, analyze loss potential, evaluate risk control options (avoidance, reduction, transfer, retention), implement chosen methods, and monitor results.
- Insurance as risk transfer: Policyholders transfer potential financial loss to an insurer in exchange for a premium. The insurer pools risks and invests premiums to ensure claim-paying ability.
- Social value of insurance: Insurance promotes economic stability by indemnifying losses, enabling credit, encouraging savings (life insurance), and reducing anxiety. It also funds long-term investments.
- Reinsurance: Insurers transfer portions of risk to reinsurers to manage catastrophic exposure and stabilize financial results. This mechanism allows primary insurers to underwrite larger policies and maintain solvency margins by spreading extreme losses across multiple entities while also providing expertise in complex risk assessment.
- Types of insurance: Life, health, property, casualty, and liability insurance each address different pure risks. Each type has unique underwriting principles, policy structures, and regulatory frameworks tailored to the nature of the loss exposure and the needs of policyholders, requiring specific actuarial calculations for each line of business.
- Premium determination: Premiums are based on expected losses, expense loading, and profit margin. Actuaries use statistical models incorporating loss frequency, severity, investment income, and administrative costs to set rates that are adequate, not excessive, and not unfairly discriminatory. Regulatory oversight ensures that these rates comply with state insurance laws and protect consumers.
- Claims process: When a loss occurs, the insured files a claim. The insurer investigates, verifies coverage, assesses damages, and pays the claim according to policy terms. Efficient claims handling maintains trust and controls loss costs, while fraud detection measures protect the risk pool.
Regulatory Requirement
Regulation: NAIC Model Laws and state insurance codes define the legal definition of insurance and require risk transfer to be clearly documented in policy language to avoid ambiguity.
Insurers must demonstrate that the risk is insurable under the law, with clear policy terms and conditions that meet regulatory standards for consumer protection.
Quick Revision
- Insurance operates on risk pooling and the law of large numbers to predict losses.
- Insurable risks must meet criteria like definiteness, measurability, and fortuity.
- Adverse selection and moral hazard are key challenges managed through underwriting and policy design.
- The risk management process includes identification, analysis, control, and monitoring.