Topic 8 Definition and Characteristics of Insurance I How Insurance Reduces Risk A Pooling 1 Pool financial arrangement that combines the loss exposures and financial resources of individuals or organizations within the group to share losses experienced by members of the group a Although insurance is primarily a risk transfer technique insurers use and benefit from pooling when they insure large numbers of loss exposures 2 Pooling arrangements function best reduce the most risk to the group when the loss exposures being pooled are independent of uncorrelated with one another a Losses are independent when a loss at one loss exposure has no effect on the proba bility of a loss at another loss exposure b Ex Two warehouse properties one in Hawaii and the other in PA would be inde pendent loss exposures in terms of the possibility of fire A fire at one warehouse would not affect the frequency or severity of a fire at the other 3 Loss exposures can be correlated not independent of each other and benefit from pooling provided that the loss exposures are not perfectly positively correlated if a loss happens to one loss exposure it definitely happens to the other B How Pooling Reduces Risk 1 The standard deviation of the pool will increase as the number of members increases However the standard deviation increases at a decreasing rate which means that the standard deviation of losses on a per member basis actually decreases 2 Although the pooling arrangement does not change either person s expected cost it makes the actual cost more consistent and less variable thereby reducing risk in soci ety 3 Pooling arrangements do not prevent losses or transfer risk they reduce each individ ual s risk or uncertainty through sharing of losses and resources C How Insurance Uses Pooling Insurers benefit from pooling and act as large well financed pools 1 2 There are two key differences between insurance and pooling a Pooling is a risk sharing mechanism whereas insurance is primarily is a risk trans fer mechanism 1 In a pool losses are shared among all pool members not transferred to the pool b The insurer has additional financial resources that enable it to provide a stronger guarantee that sufficient funds will be available in the event of a loss further reduc ing risk 1 Initial capital 2 Retained earnings 3 Just as insurance buyers transfer risks that they are unwilling to retain to insurers in surers can transfer risks that they are unwilling to retain to reinsurers II Contract of Indemnity A The purpose of insurance is the indemnify an insured who suffers a loss 1 2 Contracts of Indemnity restore a party who has had a loss to the same financial positional that party Indemnify held before the loss occurred Most property and liability insurance policies a contract in which the insurer agrees in the event of a covered loss to pay an amount directly re lated to the amount of the loss B Principle of Indemnity greater than the loss suffered by an insured 1 The insured cannot collect from both the insurer and the responsible party the risk is the principle that insurance policies should provide a benefit no transferred subrogated 2 A person usually cannot buy insurance unless that person is in a position to suffer a fi nancial loss C Valued Policy loss regardless of the actual value of the loss 1 In most Valued Policies the insurer and insured agree on a limit that approximates the current market value of the insured property a policy in which the insurer pays a stated amount in the event of a specified III Benefits of Insurance A Paying For Losses 1 Primary role of insurance is to indemnify restore to pre loss status individuals and or 2 ganizations for covered losses Insurers will indemnify the insured subject to any applicable deductibles and policy limits B Managing Cash Flow Variability 1 Insurance provides financial compensation when covered losses occur Therefore in surance greatly reduces the uncertainty created by many loss exposures 2 Insurance provides the insured with some degree of financial security and stability 3 As long as a loss is covered the financial effect on the insured s cash flow is reduced to any deductible payments and any loss amounts that exceed the policy limits C Meeting Legal Requirements D Promoting Risk Control Insurance can be used both to meet the statutory and contractual requirements of in surance coverage and to provide evidence of financial resources Insurance often provides the insured with the incentive to undertake cost effective risk control measures deductibles premium credit incentives and contractual require ments 2 These incentives can lead to a reduction in losses paid by the insurer and therefore lower premiums they benefit not only the individual insured but also all other insureds E Enabling Efficient Use of Resources 1 People and businesses that face an uncertain future often set aside funds to pay for fu ture losses Insurance makes it unnecessary to set aside a large amount of money to pay for the fi nancial consequences of loss exposures that can be insured 3 The money that would otherwise be set aside to pay for possible losses can be used to improve an individual s quality of life or to contribute to the growth of the organization F Providing Support for Insured s Credit Insurance facilitates loans to individuals and organizations by guaranteeing the lender will be paid if the collateral for the loan such as a house or commercial building is de stroyed or damaged by an insured event thereby reducing the lender s uncertainty G Providing Source of Investment Funds 1 Insureds are not required to set aside large retention funds to pay for losses that are covered by insurance 2 The premiums collected by insurers are invested until needed to pay claims can pro vide money for projects such as new construction research and technology advance ments 1 1 2 1 H Reducing Social Burdens 1 Insurance helps reduce the burden natural disasters by providing compensation for affected parties rather than having those parties rely on state or federal governments IV Additional Notes A Why do people use insurance as a RM tool 1 It s a legal requirement 2 Cover expected losses 3 Cover unexpected losses 4 Promotes risk control 5 Reduce worry value 6 Protection of your assets 7 Enhance creditworthiness B The known is the money value of the insurance premium The unknown is the severity of the loss Insurance combines the loss exposures of individuals into a group Pooling C