Insurance Fundamentals

for Policymakers

Insurance Fundamentals for Policymakers

Four assignments:
Insurance Principles
Insurance Coverages: Property and Casualty
Insurance Coverages: Life and Health
Insurance Regulation and Legislation

Insurance Principles Topics

Insurance Basics
Economic Issues Related to Insurance Pricing
Characteristics of the Insurance Product
Insurance as a Risk Management Technique
Why Insurance Operations Are Regulated

Insurance Basics

Insurance provides financial security, and it does so based on

principles that ensure that all covered losses will be indemnified.

Foundational Insurance Terms

Risk
Perils
Hazards

Foundational Insurance Terms

Losses
Loss frequency
Loss severity

What Is Insurance?

A means of treating risk by transferring the financial consequences

of a loss to an insurance company
A means of protecting financial interests when losses occur

How Insurance Benefits Insureds

Pays insureds covered losses (indemnifies)

Reduces uncertainty
Encourages efficient use of resources
Helps reduce and prevent losses

How Insurance Benefits Business and

Society

Supports credit
Satisfies legal requirements
Satisfies business requirements
Provides sources of investment funds
Reduces social burdens

Costs of Insurance to Insureds

Premiums
Opportunity costs

Costs Associated With Insurance

Operating costs including profit

Fraudulent and inflated claims (moral hazards)
Claims caused by carelessness or indifference (morale hazards)
Frivolous lawsuits that are settled as nuisance claims

Fundamental Insurance Principles

These principles help ensure that the insurance mechanism is
actuarially sound:

Indemnification
Law of large numbers
Insurable interest

The Principle of Indemnity

Insurance should not benefit an insured beyond the value of a loss.

Violations of this principle can increase the frequency and severity
of losses.

The Law of Large Numbers

The mathematical basis of insurance.

Insurance coverage provided is large relative to the premium paid.
What would be an unexpected loss for an individual becomes an
expected loss in aggregate for an insurer.

Insurable Interest

Means that the insured must suffer financially should a loss occur
Supports the principle of indemnityone cannot gain from an
insurable loss

Economic Issues Related to Insurance Pricing

An insurance policy is priced to reflect the loss exposures the policy

covers while allowing for expenses, profit, and contingencies.

Key Issues in Pricing

Adverse selection
Moral and morale hazard
Equity: actuarial and social
Timing

Adverse Selection
Adverse selection increases insurers costs.
Those with the greatest probability of loss are most likely to buy
insurance.
They tend to have more losses and higher claims than insureds with an
average loss probability.

Avoiding Adverse Selection: Data Collection

Insurers need information about insureds to set prices that reflect

risks.
Data collection raises privacy concerns:
What information is relevant?
How much information is too much?

Moral and Morale Hazard

Behaviors that increase loss frequency and/or severity

Moraldishonesty
Moralecarelessness or indifference

Common in auto, products liability, and general liability insurance

Can be discouraged with policy risk-sharing features (deductibles)

Actuarial Equity Versus Social Equity

Fair discriminationequitable premium for each insuredis

essential to insurance pricing.
State insurance laws prohibit unfair discrimination in insurance
pricing.
Opinions vary about what is fair and unfair.

Actuarial Equity

Premium is directly proportional to each insureds loss exposures.

Cost-based pricingidentifies every variable unique to each
insured.
Use of some variables may be prohibited by state law.

Social Equity
Social equity involves two concepts:
Pricing should relate to ability to pay.
Factors beyond an insureds control should not affect premium.

Timing

Most losses are recognized, valued, and settled quickly (short-tail

losses).
Some losses take a long time to manifest, value, and settle (long-tail
losses).
The longer the tail, the greater the uncertainty in expected losses.

What Is an Ideally Insurable Risk?

An ideally insurable risk has six characteristics.

Insurers use these characteristics to decide which risks to insure.
Insurers select only those risks that meet most of the criteria.

Characteristics of Insurable Risks

A large quantity of similar people or objects may be subject to a

loss.
Loss would be fortuitous.
Loss would not be catastrophic to the insurer.

Characteristics of Insurable Risks

Time, location, and extent of a loss can be determined.

The amount of an expected loss can be predicted.
Covering the expected loss is economically feasible for the insurer.

Characteristics of the Insurance Product

Insurance products share several characteristics that distinguish them

from other types of consumer products.

Intangibility
The insurance product
Lacks physical characteristics
Is more than the policy on paper
Represents a promise (to pay in the event of loss)

Complexity and Legal Status

An insurance policy contains complicated terms and concepts.

An insurance policy is a legal contract.
Insureds and claimants may hire attorneys to resolve or clarify
issues.
Some issues may involve courts, regulators, or legislators.

Insurance Circumstances
Product benefits become most apparent at time of loss.
Insureds or claimants may be facing unpleasant circumstances.
Heightened emotions may complicate transactions.

Insurance as a Risk Management Technique

Loss exposures with serious financial consequences typically require

the purchase of insurance.

Risk Management Techniques

Retention
Avoidance
Control
Prevention
Reduction

Transfer (including insurance)

Retaining Loss Exposures

Some loss exposures have the potential to cause financial ruin.

Others present minimal potential costs and can be safety retained.

Avoiding Loss Exposures

Ceasing or never undertaking an activity eliminates potential loss

from that activity.
Example: Not owning or driving an auto eliminates potential auto
liability losses.

Controlling Loss Exposures

Loss prevention measures reduce the frequency of injuries.

Loss reduction measures reduce the severity of fire losses.

Transferring Risk

Some loss exposures are most effectively managed by transfer.

The financial consequences of loss are borne by another party.
Insurance is a common risk transfer technique.

Why Insurance Operations Are Regulated

The fundamental purpose of insurance regulation is to protect the

public as consumers and policyholders

Reasons for Regulation

To protect consumers
To maintain insurer solvency
To prevent destructive competition

Consumer Protection

Regulating and standardizing insurance

policies and products
Controlling market conduct and
preventing unfair trade practices
Ensuring that insurance is available and
affordable

Insurer Solvency Regulation

Ensure an insurers claim-paying ability

Protect the public interest
Safeguard insurer-held funds

Prevention of Destructive Competition

To ensure the availability of insurance by controlling rates

Insurers, to compete, may lower rates.

Intense competition can drive down rate levels across the market.
Some insurers may become insolvent.
An insurance shortage may result.

Summary
Insurance is
A risk management technique that involves transfer of risk to an
insurance company
A complex legal contract
Affected by adverse selection, moral and morale hazard, actuarial
and social equity, and timing
Regulated to protect consumers and policyholders