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Fundamentals of Insurance

Basis of Insurance

 

Insurance is based on two fundamental principles: loss sharing (also known as pooling of risk) and the law of large numbers.

 

 

Law of Large Numbers

 

Events – over a long enough period of time -- occur in predictable patterns.  One cannot be sure whether any one coin toss will result in “heads” or “tails”, but given enough time and tosses, we can be certain half the tosses will come up “heads”. The problem most of us have is that we don’t have a long-enough period of time to rely on a predictable pattern when making decisions. One of the central principles of probability, the “Law of Large Numbers”, states that the larger the number of exposures to loss that are combined into a group, the more certainty (or predictability) there is as to the amount of loss that group will incur in any given period.    Remember, risk is defined as the “uncertainty of loss”, so if the uncertainty can be reduced, so can “risk”.   A car rental company with thousands of cars on the road can accurately predict how many of its cars will be involved in accidents each year.  A person owning one car cannot be as certain about his chances of being in an accident.  In a real sense, then, the individual faces more risk than the company – as he or she is more uncertain.

 

Given an large given a large enough pool of risks, an insurer can predict with reasonable accuracy the number of claims it will face during any given time. No one can predict when any one person will die or if any one person will become disabled. However, it is possible to predict the approximate number of deaths or the likelihood of disability that will occur among a certain group during a certain period. The larger and more homogeneous the group is, the more certain its mortality (death) or morbidity (disease) predictions will be. By insuring a large enough group of exposures, an insurance company can turn uncertainty to certainty – and “eliminate” risk.

 

For example, consider a group of 35-year males.  Statistics may show that among a group of 100,000 35-year-old males, 250 will die within one year. While it is not possible to predict which 250 individuals will die, the number will prove very accurate. The same cannot be said of a small group.  In a group of 100 , it is not statistically feasible to predict if any in the group will die within one year. Because insurers cover thousands and thousands of lives, it is possible to predict when and to what extent deaths and disabilities will occur and, consequently, when claims will arise.

 

Consequently, there must be a sufficiently large pool of insureds, and those in the pool (the "exposures") must be grouped into classes with similar (homogenous) risks. Individuals, for example, are grouped according to age, health, sex, occupation, and other classifications. 

 

 

Risk Pooling

 

By insuring a large enough pool of insureds, the insurance company can turn uncertainty to certainty and “eliminate” risk.  This is not to say that the company will not face financial losses.  It’s just that those losses become very predictable – they can be planned for.  In life insurance, for example, the company will have to pay a death claim when an insured member of the pool dies.   

 

Using the above example, the insurance company can reasonably plan that 250 of it 100,000 insureds will die this year.  If each insured is promised $10,000 upon their death, the company will have to pay $2.5 million ($100,000 x 250) this year.  To offset this predictable cost, the insurance company collects $25 from each member of the pool.  It raises $2.5 million from all of the insureds – which balances projected claims. In effect, each insured shares a little bit of the predicted losses.

 

 

 

 

 

In this example, each individual faces uncertainty as to whether he’ll die in the upcoming year and whether his family will have the resources to cope with that possibility.  In other words, he faces a large and uncertain loss.  By contrast, if each insured pays $25, he can be assured that if he dies in the next year his family will receive $10,000. This is the most basic purpose of insurance: substituting a small known cost for a large unknown loss.    Companies are able to offer this “substitution” because the Law of Large Numbers transforms financial uncertainty into financial certainty and risk pooling allows members of the pool to share in paying those predictable costs.

 

By using insurance, the risk is transferred from an individual to a group, each member of which shares the losses and has the promise of a future benefit. Insurance companies pool risks among thousands and thousands of insureds and apply certain mathematical principles to guarantee policyowners that the money will be there to pay a claim when it arises.   All forms of insurance — life, health, accident, property and casualty — rely on risk pooling and the law of large numbers. These principles form the foundation upon which insurance is based and allow for its successful operation.

 

 

 

 

 

 

 

 

Elements of Insurable Risk

 

Though insurance may be one of the most effective ways to transfer risks, not all risks are insurable. Insurers will insure only pure risks, that is to say, only those risks that involve the chance of loss. Even then, not all pure risks are insurable. Certain characteristics or elements must be evident before a company will insure it:

 

The loss must be predictable. An insurable risk must be one whose occurrence can be statistically predicted. This enables insurers to estimate the average frequency and severity of future losses and set appropriate premiums. Death, illness and disability are all events whose rates of occurrence can be projected, based on statistics.

 

The loss exposures to be insured must be large. An insurer must be able to predict losses based on the law of large numbers. Consequently, there must be a sufficiently large pool of insureds.

 

The loss must be random. In order to be insurable, a risk must be due to chance and outside the insured's control.  A home being destroyed by fire is an insurable risk; intentional demolition is not.

 

The loss must be definite and measurable. An insurable risk must involve a loss that is definite as to cause, time, place and amount. An insurer must be able to determine how much the benefit will be and when it becomes payable.

 

The loss cannot be catastrophic. Insurers will not insure risks that will expose them to catastrophic losses that would lead to the insurer’s insolvency. There must be limits that insurers can be reasonably certain their losses will not exceed. This is why an insurer would not issue a policy for $1 billion on a single life. That one death would create a catastrophic loss to the company.

 

The loss exposures to be insured must be randomly selected. Insurers must have a fair proportion of good risks and poor risks. A large proportion of poor risks would financially threaten the insurance company since there would be many claims without sufficient premiums to offset them. Keep in mind that there is a tendency, called adverse selection, for less favorable insurance risks (for instance, people in poor health) to seek or continue insurance to a greater extent than other risks.

 

 

 

 

 

 

The Nature of Insurance

 

We are exposed to many perils. The purpose of insurance — any insurance -- is to provide economic protection against losses that may be incurred due to a random event, such as death, illness or accident by transferring that risk to a pool of insureds (the insurer) that can manage the risk. The transfer of risk is accomplished through a legally binding contract that sets forth the insurer’s promise and obligations:

 

Whereby, for a set amount of money (the premium), one party (the insurer) agrees to pay the other party (the insured or his or her beneficiary) a set sum (the benefit) upon the occurrence of some event.

 

With life insurance, the risk involved is when death will occur. It can be tomorrow, next week, next year or well into the future. Loss can result if death is premature or comes too late. With health insurance, the risk is not when, but if illness or disability will strike. Losses associated with health risks include medical costs and loss of income. With annuities, the risk is living too long and outlasting one's income. Annuities cover this risk by paying a guaranteed income to the annuitant for life.

 

 

The purpose of this course is to explore these types of insurance contracts, the various ways insurance companies offer these contracts and the role the government plays in overseeing the insurance industry. 

 

Lessons 1-6 pertain to insurance in general: the industry, rules and regulations, contract and agency law, as well as an agent’s ethical responsibilities.  These principles apply to both life and health insurance.  Lessons 7-20 explore life insurance in detail, while Lessons 21–36 deal with health insurance.  

 

 

 

 

 

 

Key Concepts

 

Students should be familiar with the following concepts:

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As you study the material, please pay particular attention to Florida laws and rules governing insurance.  These will appear prominently on the state licensing examination.  

insurable risk

 © 2010 Wall Street Instructors, Inc. All  rights reserved.

No part of this material may be reproduced without the written permission of the publisher.                    

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