FINA 406 - ANSWERS TO ASSIGNMENT NO: 1 1. The term insurance can be defined in both financial and legal terms. How do these definitions differ? From financial point of view Insurance is a financial arrangement that redistributes the cost of unexpected losses. Legally, Insurance is a contract in which one party agrees to compensate another party for losses. 2. Describe the difference between direct and indirect losses. Give examples of each. Direct losses are the immediate or first result of an insured peril. Indirect losses are a secondary result of an insured peril. When fire destroys a home, the loss of the home is a direct loss. The expense of living in a hotel while the home is being rebuilt is an example of indirect loss. 3. What is the difference between a hazard and a peril? Give examples of each. Peril is the cause of the loss, like fire, tornados, heart attacks … Hazards are conditions that increase the frequency or the severity of losses. Storing gasoline gallons in a garage is an example of hazard. 4. How does insurance redistribute the costs of losses? An insurance system redistributes the cost of losses by collecting a premium payment from every participant in the system. In exchange for the premium payment the insurer promises to pay the insured’s claims in the event of a covered loss. Generally only a small percentage of insureds suffer losses. Thus, an insurance system redistributes the costs of losses from the unfortunate few members experiencing them to all the members of the insurance system who pay premiums. 5. How does a moral hazard differ from a morale hazard? Give examples of each. If an individual causes or exaggerates a loss to collect insurance proceeds, the loss results from the moral hazard. For example: burning down a building to collect insurance the cause is fire but the moral hazard in responsible for the increased frequency of loss. Morale hazard refers to an attitude or carelessness or indifference to loss created by the purchase of an insurance contract. if a person remains unnecessarily in hospital to collect health insurance benefit rather than returning to work the moral hazard is responsible for the increased severity of the loss. 6. Explain the term proximate cause. The proximate cause of a loss is the first peril in a chain of events resulting in a loss. The loss wouldn’t have occurred without this step. 7. Explain the difference between pure and speculative risk. Pure risk refers to possibilities that can result only in either loss or no change. Speculative risk refers to those exposures to price change that may result in either gain or loss. 8. Define the law of large numbers. What are its implications for an insurance system? The law states that the greater the number of observations of an event based on chance, the more likely the actual result will approximate the expected result. By this law an insurance company can predict accurately the dollar amount of losses that it will experience in a given period. 9. In what ways do insurance systems benefit society? First is stability of families by preventing the family from experiencing hardship caused by unexpected losses of property or premature death and allows the family to continue its activities. Insurance is also useful for businesses by aiding the planning process. The planners know that a property loss does not mean financial ruin. Insurance aids credit transactions. Also insurance has functions as an antimonopoly device. It also lowers the firms coasts. Insurance companies are very important financial intermediaries. 10. What are the major costs of insurance systems? The cost of resources that the system uses (labor, land and capital) Costs of fraudulent attempts to collect insurance proceeds 11. What is cash flow underwriting? Cash flow underwriting describes the practice of trying to attract new business by pricing insurance ‘at a loss’. MULTIPLE CHOICE QUESTIONS An insurable loss is: 1. An unexpected reduction of economic value Choose the true statement. 2. Risk-averse people are willing to pay more than the mathematically fair price to transfer risk. 3. The definition of peril is The actual cause of the loss 4. A moral hazard is: The increase of loss caused by attempts to defraud the insurer 5. “A financial arrangement that redistributes the costs of unexpected losses” is the definition of: Insurance 6. A person storing 100 pounds of gunpowder in the basement so that he can load his own shotgun shells is an example of: A hazard 7. A pure risk is one where: The result can be only either a loss or no change. 8. The expense ratio is defined as: Total expenses divided by written premiums.