Insurance I

Based on:
Rob Thoyts (2010) Insurance Theory and Practice,
Routledge
 The primary function of insurance
• a risk transfer
mechanism
• a risk-spreading
mechanism
• a risk transformation
mechanism

Source: Thoyts (2010)

 The reduction of risk and investment:
secondary economic functions of insurance
• Stimulation via security.
• Availability of finance
• Business promotion
• Business continuity
• Reduced tax burden
• Source of investment
• Loss reduction
• Promoting savings
• Invisible earnings
 The language of risk
• Uncertainty concerning the occurrence of a loss
• Probability – long-run relative frequency of an event on the assumptions of an infinite
number of observations and no change in the underlying conditions (deductive
reasoning – a priori probabilities; inductive reasoning – cannot be logically deduced)
• Hazard (positive and negative) – something that affects the probability of a risk occurring.
– Physical hazard – physical conditions
– Moral hazard – dishonesty or character defects of the individuals
– Morale hazard – carelessness or indifference to a loss because of the existence of insurance
• Peril – the precise means by which the risk could come about.
• Risk can be defined as: ‘the probability of an uncertain event, causative of economic loss’
(Thoyts, 2010)
• Risk within insurance [Frank Knight]
– uncertainty,
– potential for loss
– measurement
– financial quantification of economic loss
 The classification of risk

Source: Thoyts (2010)

 Objective risk vs. subjective risk
Objective probability vs. subjective probability
• Objective risk – defined as the relative variation of actual loss from
expected loss (statistically calculated using a measure of dispersion –
the standard deviation)
• Subjective risk – defined as uncertainty based on a person’s mental
condition or state of mind
• Chance of loss – the probability that an event will occur
• Objective probability refers to the long-run relative frequency of an
event assuming an infinite number of observations and no
change in the underlying conditions (determined by deductive or
inductive reasoning)
• Subjective probability – the individual’s personal estimate of the
chance of loss. Individual perception of the chance of loss may
differ from the objective probability.
•
 Personal risks
• Personal risks involve the possibility of a loss or reduction in
income, extra expenses or depletion of financial assets:
– Premature death of breadwinner
– Accident
– Sickness (health care costs or loss of earned income)
– Involuntary unemployment
• Property risks involve the possibility of losses associated with
the destruction or theft of property (physical damage to home
and personal property from fire, strong wind, vandalism, or other causes)
• Liability risks – possibility of being held liable for bodily injury or property
damage to someone else
–
•
 Commercial Risks
• Property risks
• Liability risks (defective products, pollution of the
environment)
• Loss of business income (after a physical damage loss)
• Other risks (crime exposures, human resource exposures,
foreign loss exposures, intangible property exposures,
and government exposures)
•
 Direct loss vs. indirect loss
• A direct loss is a financial loss that results from the physical damage,
destruction, or theft of the property, such as fire damage to a
home
• An indirect loss results indirectly from the occurrence of a direct
physical damage or theft loss, such as the additional living
expenses after a fire to a home. These additional expenses
would be a consequential loss.
•
 Human response to risk
• The risk averse
utility
• The risk neutral
• The risk A
preferrers (alternative B

ly risk lovers) C

wealth
 The insurance concept

Source: Thoyts (2010)

 The insurance concept
The role of insurers
• Controlling membership of the
pool
• Calculation of the equitable
premium
• Arrangement of reinsurance
• Risk improvement
• Investment of the pool funds
• Control of claim payments
• Guaranteeing the solvency of
the pool
•
 The components
of an insurance premium
• Traditional model of pure risk premium
•
•
• Source: Thoyts (2010)
• Probable insurance premium model
•

Source: Thoyts (2010)

• I = P(1+r)t Where:
I = the cost of insurance,
• P = the premium,
1 + r = the return potentially gained by investing the premium,
t = the period the premium can be invested for.
 Why buy insurance?
• Risk aversion
• Legal compulsion
• Contractual obligation
 The insurability of risk
• Financial measurement
• Insurable interest
• Pure risk
• Particular risk
• Common risk
• Reasonably low probability
of loss
• Fortuitous loss
• Conforming to public policy
•

Source: Thoyts (2010)

Insurance as a risk financing mechanism
The risk management function:
• risk analysis (the identification and
measurement of risk);
• risk control (the reduction of the frequency
and severity of risk);
• risk financing (the sourcing and application of
funds to meet the cost of risk occurrence).
 Methods of handling risks
• Risk control
– Avoidance (certain loss exposure is never acquired, or an existing loss exposure is
abandoned)
– Loss control
• Loss prevention (measures that reduce the frequency of a particular loss) as active and
passive retention
• Loss reduction (measures that reduce the severity of loss after it occurs)
• Risk tansfer
– Insurance
– Noninsurance transfer
• Financial hedge
• Legal contract
• Risk financing
– Internal financing
– External financing
– Compensation
•
 Marcin Kawiński

mkawin@sgh.waw.pl
Wiśniowa 41/35 (building W)
Tuesdays 1330-1430