Chapter 9 The Insurance Decision The Concept of Risk –Risk is the uncertainty of injury or loss...

Chapter 9The Insurance Decision

• The Concept of Risk– Risk is the uncertainty of injury or loss– Two key elements common to all risks• The possibility of loss

• The uncertainty about when or if the loss will occur


• Two Major Types of Risks

– Speculative risk --- the possibility exists for gain as well as loss. If you choose correctly you could be rewarded.

Example: gambling on a horse race


• Two Major Types of Risks– Pure risk -- there is NO possibility for

gain, only for loss

Example: an auto accident where a car is totaled

Insurance companies only deal with pure risk.


• Ways of Dealing With RisksAvoiding RisksReducing RisksAssuming RisksTransferring Risks


• Avoiding RisksAvoiding risks involves taking a conservative

approach to life.

– don’t become a hang glider or a firefighter

– refuse to go out on New Year’s Eve to avoid being hit by an intoxicated driver

BUT regardless of any actions you may take to avoid risks, you cannot avoid all risks in life.


• Reducing RisksMinimizing the possibility or severity of the

loss

– adding smoke detectors to your house

– buying a car with air bags

– going for regular medical checkups

NEVERTHELESS, while you can reduce risks, you cannot eliminate them entirely.


• Assuming RiskTaking responsibility (financial) for the loss.

SELF-INSURANCE: This involves setting up a contingency fund as a financial resource in case of a disaster.

In other words, if your car is totaled, you must have enough funds in savings to buy another car.

Because self-insurance is so expensive, it is IMPRACTICAL for most people.


• Transferring the RiskGiving someone else the responsibility of the

financial loss.

Most people choose this route by purchasing insurance (a contract).

This privilege requires a fee (premium) to compensate the insured person (third party or beneficiary) for certain kinds of losses.


• What Constitutes an Insurable Risk?

Companies look for five characteristics before they will issue insurance.

– Risk must be common to a large number of people

– Risk must be present

– Loss should be fortuitous

– Loss must be definite– Risk should be spread over a wide geographic area


• A Risk Must Be Common to Many People– Companies operate under the law of large numbers

– This law enables companies to predict future losses and set premiums

What is NOT PREDICTABLE for the individual IS PREDICTABLE for a large group of people

(Example: mortality tables)


• Risk Must Be Present– Policyholder must be able to demonstrate

he/she will suffer financial loss due to an occurrence of the potential misfortune---AKA “insurable interest”

You cannot have an insurable interest in your neighbor’s car, because you WOULD NOT SUFFER FINANCIAL LOSS IF HE HAD AN ACCIDENT.


• Loss Must Be Fortuitous (Happenstance)– Loss cannot be expected or deliberately

created by policyholder– Suicide which happens during first two

years of buying a life insurance policy is not covered for this reason


• Loss Must Be Definite– Each risk is measured in terms of insured’s

financial loss– Though difficult to define, insurance policies

always issued for specific financial losses– Collision insurance: maximum collectible

amount is the car’s current value


• Risk Should Be Spread Over Wide Geographical Area

– Keeps insurance rates reasonable

– Minimizes ins. company’s exposure to catastrophic loss

– Disaster in one area of country can be covered because companies insure millions of people throughout the country, not just that area


• Major Categories of Insurance

Life Insurance

Health

Disability

Homeowners

Auto

Personal liability


• Life Insurance– Protects people against the financial losses

that occur with premature death

– Americans pay close to $100 billion in premiums and collect around $75 billion annually in benefits

– One of the nation’s largest businesses


• Health and Disability Insurance– More than 72% of Americans have some

type of private health insurance

– Covers most or all of the expenses connected with medical and hospital care due to illness or accident

– Disability Insurance• Provides payment when insured is unable to

work because of injury or illness


• Property and Liability Insurance– Automobile Insurance• The country’s largest single type of property

and liability insurance

• Economic loss associated with accidents in ONE recent year totaled over $100 billion

• Most states require a minimum amount of automobile insurance


• Homeowners Insurance– Protects homeowners from damage to house

by “perils”

– Typical “perils” covered include fire, windstorms and burglary.

– Most policies do NOT cover damage from widespread catastrophes such as floods and earthquakes


• Personal Liability Insurance– Usually attached to homeowners and automobile

policies– Compensates others for losses you have caused– Sometimes policyholders purchase umbrella

liability policies• Provide additional liability protection• Good idea for consumers with substantial assets

to protect


• Basic Elements of Insurance1. The Insurance Premium– Underwriting -- the process of determining

who to insure and what to charge– Money needed to pay claims and cover

expenses divided among policyholders according to amount of risk each faces


• The Insurance Premium– Cost paid per policyholder, is termed a

“premium”– Variations of risk influence how high the

premium is for each person

Example: Young male drivers pay more than older male drivers because of higher risk associated with that category


• Basic Elements of Insurance

2. The Insurance PolicyA legally binding contract between

policyholder and insurance company. It details:• Amount and type of insurance• Amount and date due for premiums• Beneficiaries• Restrictions


• Items Found in an Insurance PolicyA. DeclarationsProvide basic descriptive information about policy:

• What is being insured

• How long and for how much

• Policy limits

• Premiums to be paid• May also include promises by the insured to

lower insured’s risk


• Items Found in an Insurance PolicyB. Insuring Agreements

Broadly defines coverages provided by the policy.

For example, homeowners policy promises to pay for damages covered by fire and tornado.


• Items Found in an Insurance Policy

C. ExclusionsLists the items for which the insurance

company WILL NOT PAY.

For example, most homeowners policies will not pay for damages caused by a flood, earthquake, nuclear accident, and war.


• Items Found in an Insurance PolicyD. Conditions

Impose a set of obligations on both insurance company and insured party.

For example: time limits for making claims and rules for cancellation of policy. Violation can lead to denial of coverage.


• Items Found in an Insurance PolicyE. Endorsements (or Riders)

Amendments and additions to basic insurance policy which picks up where standard insurance coverage leaves off.

Many people carry riders for jewelry because standard liability limits are very low.


• Basic Elements of Insurance3. The Insurance AgentThe agent (exclusive or independent) is the

legal representative of the company. – Agents usually do NOT have the authority to

bind their customer to an insurance company

– Part of premium paid goes to agent’s sales commission


• The Insurance Company1. Mutual Insurance Companies (Nonprofit)– Owned by policy holders who receive cash refunds

(after company pays claims, deducts for operating expenses and puts aside money in fund)

2. Stock Insurance Companies – Owned by stockholders

– May distribute dividends

Chapter 9 The Insurance Decision The Concept of Risk –Risk is the uncertainty of injury or loss...

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Transcript of Chapter 9 The Insurance Decision The Concept of Risk –Risk is the uncertainty of injury or loss...