Definition and
Characteristics of
Insurance
BUS 200
Introduction to Risk Management and Insurance
Jin Park
Definition of Insurance

A social device in which a group of
individuals (called “insureds”) transfer
risk to another party (called an
“insurer”) in order to combine loss
experience, which permits statistical
prediction of losses and provides for
payment of losses from funds
contributed (premiums) by all members
who transferred risk.
Definition of Insurance

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.
Definition of Insurance

A formal social device for reducing risk
by transferring the risks of several
individual entities to an insurer. The
insurer agrees, for a consideration, to
assume, to a specified extent, the
losses suffered by the insured.
Definition of Insurance

A system under which individuals,
businesses, and other organizations or
entities, in exchange for payment of a
sum of money (a premium), are
guaranteed compensation for losses
resulting from certain perils under
specified conditions.
Characteristics of Insurance
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Risk Transfer
Loss Sharing (pooling)
Discrimination via underwriting
Characteristics of Insurance

Risk Transfer
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An insurer, a professional risk-bearer,
assumes the financial aspects of risks
transferred to it by insureds.
In return, the insurer receives a premium.
Insurer is typically in a stronger financial
condition to pay the loss.
Characteristics of Insurance

Loss sharing (pooling)
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Loss sharing is accomplished through
premiums; therefore, group losses are
shared by the group’s members. This is
the essence of pooling.
Pooling arrangement changes the
probability distribution of accident costs
facing each person.
Characteristics of Insurance

Loss sharing (pooling)
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Assume 1,000 individuals each have homes
worth $100,000
On average, 1 home burns per year
Without Insurance: max loss = $100,000
Suppose all agree to share the loss
 average loss = 100,000 / 1,000 = $100
Trading 100 ‘loss’ for sure for chance of
losing 100,000
Characteristics of Insurance
No pooling between two persons
Person A
Person B
Outcomes
Prob.
$0
0.80
0
$ 2,500
0.20
500
Expected Loss = $500
Std. Dev. = $1,000
Outcomes
Prob.
$0
0.80
0
$ 2,500
0.20
500
Expected Loss = $500
Std. Dev. = $1,000
Characteristics of Insurance
Two-person pooling arrangement
Scenarios
Total cost A Loss
B Loss
Prob.
Neither loss
$0
$0
.64
$0
0
A loss – B no loss $2,500
$1,250 $1,250 .16
200
A no loss – B loss $2,500
$1,250 $1,250 .16
200
Both losses
$2,500 $2,500 .04
100
$5,000
Each individual’s expected loss amount = $500
Std. Dev. = $707
compare this with $1,000
Characteristics of Insurance
Three-person pooling arrangement
Scenarios
Total cost Participant’s
share
Prob.
No loss
$0
$
0
.512
$
1 loss – 2 no loss
$2,500
$ 833.33
.384
$320
2 loss – 1 no loss
$2,500
$1,666.67
.096
$160
Three losses
$7,500
$2,500.00
.008
$ 20
1.00
$500
0
Each individual’s expected loss amount = $500
Std. Dev. = $577.35
compare with $1,000 or $707
Discrimination via underwriting

Underwriting

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The process of selecting risks (insurance
applicants) and classifying them according
to their degrees of insurability so that
the appropriate rates may be assigned.
The process also includes rejection of
those risks that do not qualify.
Note: insurance profits may come from
both underwriting and investment.
Discrimination via underwriting

Life/Health Insurance
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Type of policies
Face amount
Insured’s age, gender
Tobacco use
Residence
Health status
Family diagnosis
Driving records
… and more

Property/Liability
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Type of policies
Limit of insurance
Nature of business
Location
Past claim history
Total revenue
Type of property
Construction type
Credit history
… and more
Discrimination via underwriting
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Underwriting Decisions
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Accept the application
Accept the application subject to certain
restrictions or modifications
Reject the application
Discrimination via underwriting

Young person
Expected Claim ($)
= 0 x (.95) + (10,000) x (.95)
= $ 500

Old person
Expected Claim ($)
= 0 x (.90) + (10,000) x (.10)
= $ 1,000
Outcome
Payment
Prob.
Outcome
Payment
Prob.
No Claim
$0
.95
No Claim
$0
.90
Claim
$10,000
.05
Claim
$10,000
.10
Discrimination via underwriting
If they are put into the same pool and share the losses, then
total expected claim for the pool
= $0x(.855) + $10,000x(.095) + $10,000x(.045) + $20,000x(.005)
= $1,500.
Thus, the share for each participant in the pool is $750.
Scenarios
Total cost
Prob.
Neither claims
$0
.855
$
Only Young claims $10,000
.095
$950
Only Old claims
$10,000
.045
$450
Both claim
$20,000
.005
$100
0
Discrimination via underwriting
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If you were the young person, paying $750,
what would you do?
???___________
If you were the old person, paying $750,
what would you do?
???___________
Then, what will happen to the insurer that
sets the pure premium at $750?
???___________
Discrimination via underwriting
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Adverse Selection
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The phenomenon of selecting an insurer that charges lower
rates for a specific risk exposures.
The tendency of persons with a higher-than-average chance
of loss to seek insurance at standard (average) rate, which
if not controlled by underwriting, results in higher-thanexpected loss levels.
To mitigate the adverse selection
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Detailed application
Medical examination
On-Site investigation
Suicide clause
Preexisting conditions provision
Reading Assignment
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Insurers back marketer’s contest awards.

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Loss sharing ???
WTC Insurance fight

Indemnification ???