Introduction to Insurance

1.Definition of Insurance
2.Characteristics of Insurable Risks
3.Managing Risks through Insurance
4.Fields of insurance
 1. Definitions of insurance

Insurance is a method in which an

individual or entity transfers to another
party the risk of financial loss from
events such as accident, illness, prop­
erty damage, or death.
 1. Definitions of insurance
A company that accepts risk and makes a promise to pay a policy
benefit if a covered loss occurs is an insurer or an insurance
company.
A policy benefit is a specific amount of money the insurer agrees
to pay under an insurance policy when a covered loss occurs.
An insurance policy, also known as a policy or insurance
contract, is a written document that contains the terms of the
agreement between the insurer and the owner of the policy.
The premium is the specified amount of money an insurer
charges in exchange for agreeing to pay a policy benefit when a
covered loss occurs.
 1. Definitions of insurance
The applicant is the person or business that applies for an
insurance policy.
Once an insurer issues a policy, the person or business that owns
the insurance policy is known as the policyowner.
The insured is the person whose life, health, or property is insured
under the policy.
A third-party policy is a policy purchased by one person or
business on the life of another person.
The beneficiary is the person or party the policyowner names to
receive the life insurance policy benefit
A request for payment under the terms of an insurance policy is
called a claim
2. Characteristics of Insurable Risks
 2. Characteristics of Insurable Risks

■ Loss should be fortuitous [accidental or

unintentional]
■ Loss should be beyond the control of the insured
■ Problem of moral hazard might arise
■ Presence of insurance changes behavior of the
insured so as to increase frequency and/or
severity of losses
■ Why a problem?
 2. Characteristics of Insurable Risks

■ Loss should be definite and measurable

[time, place and amount]

■ Definite
 Easy to verify that a loss has in fact occurred

■ Measurable
 Easy to measure or determine the amount of the loss
 2. Characteristics of Insurable Risks

■ Insuring loss must be economically feasible

■ Loss should be significant to the insured

■ Cost of premium [pure premium + loading]

should be small compared to the size of the
potential loss
 2. Characteristics of Insurable Risks

■ Individual losses cannot be predicted

■ Insurers can predict the loss rate — the
frequency of losses — that the insureds are likely
to experience
■ To predict the loss rate the insurer must be able
to predict the number and timing of covered
losses that will occur in that group of insureds.
 2. Characteristics of Insurable Risks

■ No catastrophic loss possibility to the

insurer – correlated risks
■ Occurrence of a single event should not
cause multiple losses
 Earthquake, flood, hurricane, terrorism
■ Solved partially by geographic and financial
diversification [reinsurance]
 3. Managing Risks through Insurance

Insurance involves transfer and pooling

Risk transfer from the insured to the insurer

•Insurer assumes financial responsibility
for the loss
•Insurer agrees to indemnify the insured in the
event of a covered loss
3. Managing Risks through Insurance

Insurance plan or arrangement typically includes

the following characteristics:

■ Pooling of losses
■ Payment of fortuitous losses
■ Risk transfer
■ Indemnification
 3. Managing Risks through Insurance
■ Pooling of losses
If the economic losses that actually result from a given peril can
be spread across a large pool (or number) of people who are
all subject to the risk of such losses and the probability of loss is
relatively small for each person, then the cost to each person will
be relatively small.
Pooling implies
• the sharing of losses by the entire group
• the prediction of future losses with some accuracy based on the
law of large numbers.
3. Managing Risks through Insurance

■ Payment of fortuitous losses

A fortuitous loss is one that is unforeseen and
unexpected by the insured and occurs as a
result of chance. In other words, the loss must
be accidental.
The law of large numbers is based on the
assumption that losses are accidental and occur
randomly.
3. Managing Risks through Insurance
■ Risk transfer
Risk transfer means that a pure risk is transferred
from the insured to the insurer, who typically is in a
stronger financial position to pay the loss than the
insured.

■ Indemnification
Indemnification means that the insured is restored
to his or her approximate financial position prior to
the occurrence of the loss.
3. Managing Risks through Insurance

Underwriting or risk selection - the process

of assessing and classifying the degree of risk
represented by a proposed insured and making
a decision to accept or decline that risk is called.

Underwriters - insurance company employees

who are responsible for evaluating pro­posed
3. Managing Risks through Insurance

Underwriting
■ Identify risks with similar characteristics
– physical hazard
– moral hazard

■ Place them in the same risk pool (class)

■ Pools should be relatively homogeneous
■ People in different risk classes are charged
different premium rates
 4. Fields of insurance

Insurance can be classified into:

Private insurance consists for the most part of
voluntary insurance programs available to the
individual as a means of protection against the
possibility of loss. This voluntary insurance is usually
provided by private firms.
Government insurance is compulsory insurance,
usually operated by the government, whose benefits
are determined by law and in which the primary
emphasis is on social adequacy
 4. Fields of insurance

Private insurance may be classified into three

broad categories:
■ Life insurance
■ Health insurance
■ Property and liability insurance