**Chapter 2: Insurance and Risk**
### **Agenda**
1. Definition and Basic Characteristics of Insurance
2. Requirements of an Insurable Risk
3. Adverse Selection and Insurance
4. Insurance vs. Gambling
5. Insurance vs. Hedging
6. Types of Insurance
7. Benefits and Costs of Insurance to Society
### **1. Definition of Insurance**
- **Meaning:**
- Pooling of unexpected losses.
- Transferring risks to insurers who indemnify (compensate) insureds.
- Insurers provide financial benefits or services related to risks.
### **2. Basic Characteristics of Insurance**
- **Pooling of Losses:**
- Sharing losses of a few across a large group.
- Uses the **Law of Large Numbers** to predict future losses accurately.
- **Payment of Fortuitous Losses:**
- Covers unforeseen and accidental losses (e.g., slipping on ice and
breaking a leg).
- **Risk Transfer:**
- Transfers pure risks (e.g., theft, liability) from insured to insurer.
- **Indemnification:**
- Restores insured to their financial position before the loss (e.g., home
insurance after a fire).
### **3. Requirements of an Insurable Risk**
1. **Large Number of Exposure Units:**
- Groups with similar risks help predict average losses.
2. **Accidental and Unintentional Losses:**
- Losses must be accidental to prevent intentional misuse.
3. **Determinable and Measurable Losses:**
- Clear cause, time, place, and amount (e.g., life insurance is
straightforward).
4. **Non-Catastrophic Losses:**
- Avoid large-scale losses (e.g., floods, hurricanes) through:
- **Reinsurance** (sharing risks).
- Geographic risk dispersal.
5. **Calculable Loss Probability:**
- Insurers calculate frequency and severity to set premiums.
6. **Economically Feasible Premiums:**
- Premiums should be affordable relative to the risk covered.
### **4. Adverse Selection and Insurance**
- **Definition:**
- High-risk individuals are more likely to seek insurance at standard rates.
- **Problems:**
- Leads to higher-than-expected losses for insurers.
- **Controls:**
- Careful underwriting.
- Policy provisions (e.g., suicide clause in life insurance).
### **5. Insurance vs. Gambling**
- **Insurance:**
- Deals with existing pure risks.
- Socially productive: both parties aim to prevent loss.
- **Gambling:**
- Creates speculative risks.
- Not socially productive: one party’s gain is another’s loss.
### **6. Insurance vs. Hedging**
- **Insurance:**
- Transfers insurable risks through a contract.
- Reduces objective risks via pooling and the Law of Large Numbers.
- **Hedging:**
- Manages financial risks, often uninsurable (e.g., currency fluctuations).
- Does not reduce overall risks.
### **7. Types of Insurance**
#### **Private Insurance:**
1. **Life and Health Insurance:**
- **Life Insurance:** Pays death benefits, covers funeral expenses, and
provides income to beneficiaries.
- **Health Insurance:** Covers medical costs from illness or injury.
- **Disability Plans:** Pay income during disability.
2. **Property and Liability Insurance:**
- **Property Insurance:** Covers damage to real or personal property.
- **Liability Insurance:** Covers legal liabilities and defense costs.
- **Personal Lines:** For individuals (e.g., home, auto).
- **Commercial Lines:** For businesses and organizations.
#### **Government Insurance:**
1. **Social Insurance:**
- Funded by employer/employee contributions (e.g., Social Security,
Workers’ Compensation).
- Benefits favor low-income groups.
2. **Other Government Programs:**
- Federal flood insurance, state health insurance pools.
### **8. Benefits of Insurance to Society**
1. **Indemnification for Loss:**
- Provides stability for families and businesses.
2. **Reduction of Worry:**
- Insured individuals feel secure about potential losses.
3. **Investment Funds:**
- Insurers invest premiums, boosting economic growth.
4. **Loss Prevention:**
- Insurers promote safety measures to reduce losses.
5. **Enhanced Credit:**
- Insurance makes individuals/businesses better credit risks.
### **9. Costs of Insurance to Society**
1. **Cost of Doing Business:**
- Includes commissions, administration, and taxes (expense loading).
2. **Fraudulent and Inflated Claims:**
- Increases premiums for everyone, reducing overall spending power.
This breakdown covers all slides in the presentation. Let me know if you’d
like further explanations or details for specific sections!
