Chapter_01

LOMA
LOMA 280
280
Principles
of
Insurance:
Life,
Health,
and
Annuities
LESSON
LESSON 11
Introduction to Risk and Insurance
© 2005 LOMA All Rights Reserved LESSON One 1

Lesson 2
The Concept of Risk

Risk exists when there is uncertainty about the
future. Individuals and businesses experience two
kinds of risk:
Speculative risk involves three possible outcomes:
(1) gain, (2) loss, or (3) no change.
Pure risk involves no possibility of gain; either a loss
occurs or no loss occurs.
The possibility of financial loss without the possibility
of gain—pure risk—is the only kind of risk that can
be insured.
The purpose of insurance is to compensate for
financial loss, not to provide an opportunity for
financial gain.
© 2005 LOMA All Rights Reserved Press “Esc” to return to main menu LESSON TWO 2
Lesson 2
Risk Management
Risk management involves identifying and assessing
the risks we face.
Four risk management techniques that people and
businesses can use to eliminate or reduce their
exposure to financial risk are:
1. Avoiding the risk
2. Controlling the risk
3. Accepting the risk
4. Transferring the risk
Lesson 2
Insurance
Insurer
Policy Benefit
Insurance Policy
Premium
Types Of Risks
Personal Property Damage Liability
Individual Group
Lesson 2
Characteristics of Insurable Risks

Insurance products are designed in accordance with
basic principles that define which risks are insurable.
For a risk—a 1. The loss must occur by chance.

potential loss—to 2. The loss must be definite.
be considered 3. The loss must be significant.
insurable, it must 4. The loss rate must be
have certain predictable.
characteristics. 5. The loss must not be
catastrophic to the insurer.
 These five basic characteristics define an insurable risk and

form the foundation of the business of insurance.
 A potential loss that does not have these characteristics
generally is not considered an insurable risk.
Lesson 2

1. The loss must occur by chance. For a potential loss to be
insurable, the element of chance must be present.
The loss should be caused either by an unexpected event or by an

event that is not intentionally caused by the person covered by the
insurance.
For example, people cannot generally control whether they will
become seriously ill; as a result, insurers can offer medical
expense insurance policies to protect against financial losses
caused by the chance event that an insured person will become ill
and incur medical expenses.
When this principle of loss is applied in its strictest sense to life

insurance, an apparent problem arises: death is certain to occur.
The timing of an individual’s death, however, is usually out of the
individual’s control and, therefore, usually occurs by chance.
Lesson 2

2. The loss must be definite. For most types of insurance, an
insurable loss must be definite in terms of time (when to pay
policy benefits) and amount (how much those benefits should be).
Because death, illness, disability, and retirement are generally
identifiable conditions, insurers typically can determine when a loss
occurred. Determining the amount of benefits depends on whether
the insurance policy is a contract of indemnity or a valued contract.
contract of indemnity: an insurance policy under which the amount
of the policy benefit payable for a covered loss is based on the
actual amount of financial loss that results from the loss, as
determined at the time of loss
Many medical expense insurance policies are contracts of indemnity.
valued contract: specifies the amount of the policy benefit that will
be payable when a covered loss occurs, regardless of the actual
amount of the loss that was incurred
Most life insurance policies are valued contracts.
Lesson 2

3. The loss must be significant. In general, insurable losses are
losses that cause financial hardship to most people.
Insignificant losses are not normally insured.
For example, the administrative expense of paying benefits for a

very small loss, such as the loss of an umbrella, would drive the
cost for such insurance protection so high in relation to the amount
of the potential loss that most people would find the protection
unaffordable.
On the other hand, insurance coverage is available to protect
against a potential loss, such as an accidental injury, which might
cause a person to miss work and lose a significant amount of
income.
Lesson 2

4. The loss rate must be predictable. To provide a specific type of
insurance coverage, an insurer must be able to predict the
probable rate of loss—the loss rate—that the people insured by
the coverage will experience.
Although insurers cannot predict when a person will experience a
loss, they can predict with a fairly high degree of accuracy the
number of people in a given large group who will die, become
disabled, or need hospitalization during a given period of time.
These predictions of future losses are based on the concept that,
even though individual events occur randomly, we can use
observations of past events to determine the likelihood—or
probability—that a given event will occur in the future.
When insurers make predictions about the covered losses a given
group is likely to experience during a given period of time, they rely
on the law of large numbers and statistical records contained in
mortality and morbidity tables.
Lesson 2

The law of large numbers states that, typically, the more times we
observe a particular event, the more likely it is that our observed
results will approximate the “true” probability that the event will occur.
Insurers collect specific information about large numbers of people
to identify the pattern of losses those people experienced. Using
these statistical records, insurers develop
mortality tables: charts that morbidity tables: charts
indicate with great accuracy the that display the rates of
number of people in a large group morbidity, or incidence of
(100,000 people or more) who are sickness and accidents,
likely to die at each age; these by age, occurring among
charts display the rate of mortality, a given group of people.
or incidence of death, by age,
among a given group of people.
Insurers use predicted loss rates to establish premium rates that will
be adequate to pay claims.
Lesson 2

5. The loss must not be catastrophic to the insurer. A potential loss
is not considered insurable if a single occurrence is likely to
cause or contribute to catastrophic financial damage to the
insurer.
Such a loss is not insurable because the insurer could not

responsibly promise to pay benefits for the loss.
To prevent the possibility of catastrophic loss and ensure that
losses occur independently of each other, insurers spread the
risks they choose to insure.
For example, a property insurer would be unwise to issue policies

covering all homes within a 50-mile radius of an active volcano
because one eruption of the volcano could result in more claims at
one time than the insurer could pay. Instead, the insurer would
also issue policies covering homes in areas not threatened by the
volcano.
Lesson 2
By purchasing Reinsurance, insurer can reduce the

possibility that it will suffer catastrophic losses.
Cedes/purchases
Direct Writer/ Reinsurer/Assuming
Ceding Company Company
Lesson 2
Insurance Underwriting
Insurance is sold on a case-by-case basis and insurers determine
whether each proposed risk is an insurable risk.
 Not all individuals of the same sex and age have an equal
likelihood of suffering a loss.
 Further, those individuals who believe they have a greater-than
average likelihood of loss tend to seek insurance protection to a
greater extent than do those who believe they have an average or
less-than-average likelihood of loss. This tendency is called
antiselection, adverse selection, or selection against the insurer.
Insurers carefully review each application to assess the degree of

risk the company will be assuming if it issues a requested policy.
Process of identifying degree of risk is underwriting or risk
selection. Insurance Company employees responsible for this task
is Underwriter
Lesson 2
Insurability of Specific Risks

The process of identifying and classifying the degree
of risk represented by a proposed insured is called
underwriting or selection of risks. It consists of
1. Identifying 2. Classifying
the risks and the degree
that a of risk
proposed that a
insured proposed
presents insured
represents
Lesson 2

Identifying risks: insurers have identified a number of factors that
can increase or decrease the likelihood that an individual will suffer a
loss. The most important of these factors are
physical hazard: a physical characteristic that may increase the

likelihood of loss
Example: a person with a history of heart attacks possesses a physical

hazard that increases the likelihood of dying sooner than a person of the
same age and sex who does not have a similar medical history
moral hazard: a characteristic that exists when the reputation, financial

position, or criminal record of an applicant or proposed insured indicates
that the person may act dishonestly in the insurance transaction
Example: a person who has a confirmed record of illegal or unethical

behavior is likely to behave similarly in an insurance transaction
Lesson 2

Classifying risks: after identifying the risks presented by a
proposed insured, the underwriter can classify the proposed
insured into an appropriate risk class
risk class: a grouping of insureds who represent a similar level of

risk to the insurer
 Classifying risks into classes enables the insurer to determine the
equitable premium rate to charge for the requested coverage.
 People in different risk classes are charged different premium
rates.
To classify proposed insureds, underwriters apply general rules of
risk selection, known as underwriting guidelines, established by
the insurer.
Lesson 2

Life insurers’ underwriting guidelines generally
identify at least four risk classes for proposed
insureds: (1) standard risks, (2) preferred risks, (3)
substandard risks, and (4) declined risks.
standard risks: proposed insureds who have a
likelihood of loss that is not significantly greater than
average; traditionally, most individual life and health
insurance policies have been issued at standard
premium rates
The premium rates that standard risks are charged
are called standard premium rates.
Lesson 2

preferred risks: proposed insureds who present a
significantly less-than-average likelihood of loss;
preferred risks are charged lower-than-standard
premium rates
Insurance company practices vary widely as to what
qualifies a proposed insured as a preferred risk or a
standard risk.
declined risk: proposed insureds who are

considered to present a risk that is too great for the
insurer to cover
Lesson 2

substandard risks (or special class risks): proposed
insureds who have a significantly greater-than-average
likelihood of loss but are still found to be insurable
Insurers use several methods to compensate for the
additional risk presented by insureds who are classified
as substandard risks. For example
 In individual life insurance, insurers typically charge
substandard risks a higher-than-standard premium
rate, called a substandard premium rate or special
class rate.
 In individual health insurance, insurers charge a
substandard premium rate or modify the policy in
some way—such as by excluding a particular risk
from coverage—to compensate for the greater risk.
Lesson 2
Insurable Interest
Laws in the United States and many countries require
that, when an insurance policy is issued, the
policyowner must have an insurable interest in the risk
that is insured—the policyowner must be likely to suffer
a genuine loss or detriment should the event insured
against occur.
For life insurance, the presence of an insurable interest
usually can be found by applying the following rule:
An insurable interest exists when the policyowner
is likely to benefit if the insured continues to live
and is likely to suffer some loss or detriment if the
insured dies.
Lesson 2
Insurable Interest
 Underwriters screen every life insurance application to make
sure that the insurable interest requirement imposed by law in the
applicable jurisdiction will be met when the policy is issued.
 Insurers also make sure that applications meet the company’s
underwriting guidelines, which frequently include insurable
interest requirements that go beyond the requirements imposed
by law.
 If the insurer determines that the proposed policyowner does not
meet insurable interest requirements, then the insurer will not
issue the policy.
 Even if the insurable interest requirement imposed by the
applicable jurisdiction is met, an insurer can refuse to issue the
policy if its own, more stringent insurable interest requirements
are not met.
Lesson 2
Insurable Interest
Insurable interest requirement…
when a person purchases life insurance on her own life
 All persons are considered to have an insurable interest in their
own lives.
 A person is always considered to have more to gain by living
than by dying.
 Therefore, an insurable interest between the policyowner and
the insured is presumed when a person seeks to purchase
insurance on her own life.
 Insurable interest laws do not require that the named
beneficiary have an insurable interest in the policyowner-
insured’s life.
 However, most insurance company’s underwriting guidelines
require that the beneficiary also must have an insurable interest
in the life of the insured when a policy is issued.
Lesson 2
Insurable Interest
Insurable interest requirement…
when a person purchases life insurance on another person’s life
(third-party policy)
 Laws in many countries and in most states in the United States
require only that the policyowner have an insurable interest in
the insured’s life when the policy is issued.
 However, most insurance company underwriting guidelines and
the laws in some states require both the policyowner and the
beneficiary of a third-party policy to have an insurable interest
in the insured’s life when the policy is issued.
The insurable interest requirement must be met before a life
insurance policy will be issued. After the policy is in force, the
presence or absence of insurable interest is no longer relevant.
Therefore, a beneficiary need not provide evidence of insurable
interest to receive the benefits of a life insurance policy.
Lesson 2
Insurable Interest
Certain family relationships are assumed by law to create an
insurable interest between an insured and a policyowner or
beneficiary. In these family relationships, even if the policyowner or
beneficiary has no financial interest in the insured’s life, the bonds of
love and affection alone are sufficient to create an insurable interest.
According to laws in most jurisdictions, the insured’s
spouse mother grandparent sister
child father grandchild brother
are deemed to have an insurable interest in the life of the insured.
An insurable interest is not presumed when the policyowner or
beneficiary is more distantly related to the insured than these
relatives or when the parties are not related by blood or marriage.
In these cases, a financial interest in the continued life of the insured
must be demonstrated to satisfy the insurable interest requirement.
Lesson 2
End of Lesson 1

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Chapter_01

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LOMA

Introduction to Risk and Insurance

© 2005 LOMA All Rights Reserved LESSON One 1

The Concept of Risk

1. Avoiding the risk

2. Controlling the risk

3. Accepting the risk

4. Transferring the risk

Personal Property Damage Liability

Characteristics of Insurable Risks

For a risk—a 1. The loss must occur by chance.

 These five basic characteristics define an insurable risk and

Characteristics of Insurable Risks

The loss should be caused either by an unexpected event or by an

When this principle of loss is applied in its strictest sense to life

Characteristics of Insurable Risks

Characteristics of Insurable Risks

Insignificant losses are not normally insured.

For example, the administrative expense of paying benefits for a

Characteristics of Insurable Risks

Characteristics of Insurable Risks

Characteristics of Insurable Risks

Such a loss is not insurable because the insurer could not

For example, a property insurer would be unwise to issue policies

Characteristics of Insurable Risks

By purchasing Reinsurance, insurer can reduce the

Insurers carefully review each application to assess the degree of

Insurability of Specific Risks

Insurability of Specific Risks

physical hazard: a physical characteristic that may increase the

Example: a person with a history of heart attacks possesses a physical

moral hazard: a characteristic that exists when the reputation, financial

Example: a person who has a confirmed record of illegal or unethical

Insurability of Specific Risks

risk class: a grouping of insureds who represent a similar level of

Insurability of Specific Risks

Insurability of Specific Risks

declined risk: proposed insureds who are

Insurability of Specific Risks

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