Chapter 2

Insurance and Risk

What do you think people would do

for fraudulent insurance claims?

Takeoutapaperandwriteitdown.
Letsseewhatpeoplewoulddoto
cheatinsurancecompanies!
2-2

Child worth more dead than alive

Little Ashley McLellans lungs filled with freezing water in the
familys backyard swimming pool near Seattle. Her final, futile
gasps for air mustve terrified her.
But Ashleys stepfather Joel Zellmer wasnt concerned. The threeyear-olds life meant little; her death meant more. Zellmar
drowned Ashley for a $200,000 life-insurance payout. Hed been
married to Ashleys mother Stacey Ferguson for only a few months
when the toddler died in December 2003. Fire fighters found her
wet, unconscious body flopped on the living-room floor. Zellmer
claimed he discovered her floating in the pool. She probably went
outside to the deck for some cake left there and somehow slid into
the water, he told investigators.
It was nearly the perfect crime; no witnesses saw Zellmer drown
her. But astute prosecutors still wove a convincing murder case that
earned him 50 years in prison.
http://www.insurancefraud.org/
2-3

 Arsonist stokes flames of greed

Debra Morris dashed back into the flaming house, trying to
rescue her cat. But the second-floor tenant never made it
back out. Morris perished in the voracious smoke and flames
that devoured the structure.
The buildings owner Jeffrey Alnutt had set the place afire,
hoping to steal a $277,000 insurance payday to bail himself
out of crushing debt and failed business ventures in the
Johnstown, N.Y. area. Someone set the fire as revenge
because he was a drug informant for local police, Alnutt
contended.
But the court didnt buy his story. The case against Alnutt
was largely circumstantial, but was convincingly pieced
together by investigators and prosecutors.

2-4

Sinister seniors.
Two elderly women befriended a pair of homeless men in Los
Angeles, then took out $3 million in life policies naming
themselves as beneficiaries. Some of the mens signatures
were forged.
Helen Golay and Olga Rutterschmidt then had cars run down
Paul Vados and Kenneth McDavid in dark alleys at night.
McDavid was so packed with booze, painkillers and sleeping
pills that he was virtually immobile when the car ran over his
prone body. Both women received life without parole.

2-5

 Skin deep scheme. Michigan skin doc Robert Stokes

inflated claims while exposing patients potentially to HIV and
hepatitis by reusing sutures, scalpels and syringes without
proper cleaning. Stokes also removed facial lesions but billed
insurers at least $1 million for more invasive procedures. He
also falsely diagnosed these patients with an infectious skin
disease. Stokes received 10 years in federal prison.
Case like burning ones own house while family member
sleeping upstairs can be heard over time.

What have you learned after reading these

four cases?
2-6

Agenda
Definition and Basic Characteristics of Insurance
Characteristics of An Ideally Insurable Risk
Adverse Selection and Insurance
Insurance vs. Gambling
Insurance vs. Hedging
Types of Insurance
Benefits and Costs of Insurance to Society
Outcome
Understand the terms above and their
applications in an insurance contract
Understand the basics of different types of
insurance contracts
2-7

Definition of Insurance
Insurance is the pooling of fortuitous
losses by transfer of such risks to insurers,
who agree to indemnify insureds for such
losses, to provide other pecuniary benefits
on their occurrence, or to render services
connected with the risk
HowDoesInsuranceWork,
https://www.youtube.com/watch?v=M1yzSOxxAjk

2-8

Basic Characteristics of Insurance

Pooling of losses

Spreading losses incurred by the few over the entire group

Risk reduction based on the Law of Large Numbers

Example:

Two business owners own identical buildings valued at $50,000

There is a 10 percent chance each building will be destroyed by
a peril in any year; loss to either building is an independent
event
Expected value and standard deviation of the loss for each
owner is:

Expected loss 0.90 * $0 0.10 * $50,000 $5,000

Standard deviation 0.90 0 $5,000 0.10 $50,000 $5,000
2

$15,000

Willyoucharge$5000premiumforfireinsuranceif
youwereinsurer?

2-9

Basic Characteristics of Insurance

Example, continued:
If the owners instead pool (combine) their loss exposures, and
each agrees to pay an equal share of any loss that might occur:
What will be the expected loss and standard deviation? SAME?

Expected loss 0.81* $0 0.09 * $25,000 0.09 * $25,000 0.01* $50,000

$5,000
Standard deviation 0.81 0 $5,000 (2)(0.09) $25,000 $5,000 0.01($50,000 $5,000) 2
2

$10,607

As additional individuals are added to the pooling arrangement,

the standard deviation continues to decline while the expected
value of the loss remains unchanged

Charging$7500maybeOKif200contracts

2-10

Basic Characteristics of Insurance

Payment of fortuitous losses

Insurance pays for losses that are unforeseen, unexpected, and

occur as a result of chance

Risk transfer

A pure risk is transferred from the insured to the insurer, who

typically is in a stronger financial position

Indemnification

The insured is restored to his or her approximate financial

position prior to the occurrence of the loss

2-11

Characteristics of an Ideally
Insurable Risk
1.Large number of exposure units
to predict average loss

2.Accidental and unintentional loss

to control moral hazard
to assure randomness
otherwise, inaccurate prediction of future losses

3.Determinable and measurable loss

to facilitate loss adjustment
insurer must be able to determine if the loss is
covered and if so, how much should be paid.

Lossofafinger?

2-12

Requirements of an Insurable Risk

4.No catastrophic loss
to allow the pooling technique to work
exposures to catastrophic loss can be
managed by:
dispersing coverage over a large geographic
area
using reinsurance
catastrophe bonds

5.Calculable chance of loss

to establish an adequate premium
2-13

Requirements of an Insurable Risk

6.Economically feasible premium
so people can afford to buy
Will you pay $8,000 car insurance for your used car worth
$10,000?

Premium must be substantially less than the face

value of the policy
Pay $500,000 for a $1,000,000 life insurance?

Based on these requirements:

Most personal, property and liability risks can be
insured
Market risks, financial risks, production risks and
political risks are difficult to insure
2-14

Does the risk of fire satisfy the above

requirement for insurable risk?

2-15

In class exercise :
Risk of Fire as an Insurable Risk

Takeoutapieceofpaperandanswerthequestions
2-16

Exhibit 2.2 Risk of Unemployment as an

Insurable Risk
Largenumberofexposureunits?
Accidental/unintentionalloss?
Determinableandmeasureloss?
Nocatastrophicloss?
Calculablechanceofloss?
Economicallyfeasiblepremium?
2-17

Exhibit 2.2 Risk of Unemployment as an

Insurable Risk

2-18

Adverse Selection and Insurance

Adverse selection is the tendency of persons with
a higher-than-average chance of loss to seek
insurance at standard rates
If not controlled, adverse selection result in
higher-than-expected loss levels
Adverse selection can be controlled by:
careful underwriting (selection and classification of
applicants for insurance)
policy provisions (e.g., suicide clause in life insurance)

2-19

Insurance vs. Gambling

Are they the same?

2-20

Insurance vs. Gambling

Insurance
Insurance is a technique
for handing an already
existing pure risk
Insurance is socially
productive:

both parties have a

common interest in the
prevention of a loss

Gambling
Gambling creates a new
speculative risk
Gambling is not socially
productive

The winners gain comes

at the expense of the
loser

2-21

Insurance vs. Hedging

Insurance
Risk is transferred by a
contract
Insurance involves the
transfer of insurable
risks
Insurance can reduce
the objective risk of an
insurer through the Law
of Large Numbers

Hedging
Risk is transferred by a
contract
Hedging involves risks
that are typically
uninsurable
Hedging does not result
in reduced risk
Why?

2-22

Types of Insurance
Private Insurance
Life and Health
Property and Liability

Government Insurance
Social Insurance
Other Government Insurance

2-23

Private Insurance
Life and Health

NYCdisabilityinsurance
fraudmaytotal$400millionCBSNews

Life insurance pays death benefits to beneficiaries when the

insured dies
Health insurance covers medical expenses because of sickness
or injury
Disability plans pay income benefits

Property and Liability (also called property and casualty)

Property insurance indemnifies property owners against the
loss or damage of real or personal property
Liability insurance covers the insureds legal liability arising
out of property damage or bodily injury to others
Casualty insurance refers to insurance that covers whatever is
not covered by fire, marine, and life insurance, e.g. auto,
theft, health insurance, etc.
2-24

Private Insurance (Property and

Liability
)
Private insurance
coverages can be grouped into
two major categories
Personal lines

coverages that insure the real estate and personal

property of individuals and families or provide
protection against legal liability, e.g. auto insurance
(covering physical damage of the auto, theft, etc.) ,
medical expense coverage, homeowner insurance,
personal umbrella liability insurance (covering
catastrophic lawsuit), boatowners insurance (covering
both the boats and the families, can be very
comprehensive covering medical, physical damage,
liability, etc.) you can find this in your textbook

Commercial lines
coverages for business firms, nonprofit organizations,
and government agencies

2-25

Exhibit 2.3 Property and Casualty Insurance

Coverages

2-26

Fireandalliedlines
alliedlines:purchasedalongwithfireinsurancelikestorm,
hail,vandalismorevenlossofbusinessincome,extraexpenses,etc.
Multipleperilinsurance:apackageofpolicyincludingproperty,
generalliability,businessincomeloss,equipmentfailureoreven
criminalinsurance.
Generalliabilityinsurancecoversthelegalliabilityof
business(e.g.propertydamageorbodilyinjury,salesof
productsorcontractoperation).
Workercompensationinsurance:jobrelatedaccidentsor
diseasescoveringmedicalbills,disabilitybenefits,death
benefit,etc.
Inlandmarineinsurancecoversgoodsbeingshippedonlandand
Personalpersonalpropertylikejewelry,antiquepainting,etc.
2-27

Oceanmarineinsurancecoversoceangoingvesselandthecargo
orlegalliabilityofshippersandowners
Professionalliabilityinsurancecoverse.g.malpracticeof
lawyersandmedicalperson
Directorsandofficersliabilityinsurance:providesfinancial
supportiftheyaresuedformismanagement.
Fidelitybondsforlosscausedbythedishonestorfraudulent
actsofemployees
e.g.banksandfinancialinstitutions
Suretybondscoverlosscausedbythefailureof
bondedperson,e.g.contractor
2-28

Government Insurance
Social Insurance Programs

Financed entirely or in large part by contributions from

employers and/or employees
Benefits are heavily weighted in favor of low-income
groups
Eligibility and benefits are prescribed by statute
Examples:
Social Security, Unemployment, Workers Comp

Other Government Insurance Programs

Found at both the federal and state level
Examples:

Federal flood insurance, state health insurance pools

2-29

Social Benefits of Insurance

Indemnification for Loss
Contributes to family and business stability

Reduction of Worry and Fear

Insureds are less worried about losses
Workers killed in construction site. The wife.

Source of Investment Funds

Premiums may be invested, promoting economic growth

Loss Prevention
Insurers support loss-prevention activities that reduce direct
and indirect losses

Enhancement of Credit
Insured individuals are better credit risks than individuals
without insurance
2-30

Social Costs of Insurance

Cost of Doing Business

Insurers consume resources in providing insurance to

society
An expense loading is the amount needed to pay all
expenses, including commissions, general administrative
expenses, state premium taxes, acquisition expenses,
and an allowance for contingencies and profit

Sales & administrative expenses (property and casualty) account for

26% of each underwriting dollars
Operating expenses for life insurance: 12%
The U.S. spends more than $2 trillion on healthcare annually. At
least 3 percent of that spending or $68 billion is lost to fraud
each year. (National Health Care Anti-Fraud Association, 2008)

Justified by:

millions of jobs created

Uncertainty of payment reduced
Insurer engaged in loss prevention activities

Every$2millioninvestedinfightinghealthcarefraudreturns$17.3millioninrecoveries,
courtorderedjudgments,plusbogusclaimsthatwerentpaidandotherantifraudsavings.
(NationalHealthCareAntiFraudAssociation,2008)

2-31

Social Costs of Insurance

(similar figures can be found in the Text)

Cost of Fraudulent and Inflated Claims

Payment of fraudulent or inflated claims results in higher

premiums to all insureds, thus reducing disposable income
and consumption of other goods and services
Cost estimated to be greater than $80 billion annually
Suspected fraud of bodily injury up from 9% to 11% (2002 to 2007)
Of which 20% (2007) involve buildup up from 18%, 2002

Buildup: Excessive treatment, unnecessary treatment or diagnosis leading

to inflation

about 45 million (20%) US adult believe it is

acceptable to defraud insurers under certain
conditions

Three percent of slip-and-fall injuries are fraudulent. (National

Floor Safety Institute)
Bogus injury claims and related costs such as litigation
amount to nearly $2 billion a year. (ibid)
2-32

Minor fraud?
Will you claim for insurance for work-related
injury which is actually a sport injury?
You have property insurance, an expensive
mirror (HKD2000) is broken due to your
carelessness, will you claim for the insurance
saying the mirror is broken with unknown
cause?
Would you stay home after your have
recovered from illness to continue collecting
compensation?
AnswerYesorNoonthesamepaper

2-33

Case application
Based on the definition of insurance mentioned,
indicates which of the following is considered
insurance.
a. A TV set is guaranteed by the manufacturer against
defects for 90 days.
b. A new set of radial tires is guaranteed by the
manufacturer against road defects for 50,000 miles.
c. A builder of new homes gives a 10-year guarantee
against structural defects in the home.
d. A cosigner of a note agrees to pay the loan balance if
the original debtor defaults on the payments.
Dont do that

e. A large group of homeowners agrees to pay for losses

to homes that burn during the year because of fire.
2-34

Appendix
Basic Statistics and the Law of Large
Numbers

2-35

Probability and Statistics

The probability of an event is the long-run relative
frequency of the event, given an infinite number
of trials with no changes in the underlying
conditions.
Events and probabilities can be summarized
through a probability distribution
A probability distribution is characterized by:
A mean, or measure of central tendency
A variance, or measure of dispersion

2-36

Probability and Statistics

The mean or expected value is:

or EV X i Pi
Amountof
Loss(Xi)

Probability
ofLoss(Pi)

X i Pi

$0

0.30

$0

$360

0.50

$180

$600

0.20

$120

X P

$300

i i

2-37

Probability and Statistics

The variance of a probability distribution is:

2 Pi X i EV

For the previous loss distribution,

2 0.30(0 300) 2 0.50(360 300) 2

0.20(600 300) 2
27,000 1,800 1,800
46,800

The standard deviation = 216.33

Higher standard deviations, relative to the mean, are
associated with greater uncertainty of loss; therefore, the risk
is greater
2

2-38

Law of Large Numbers

The law of large numbers is the mathematical
foundation of insurance.
Average losses for a random sample of n exposure
units will follow a normal distribution because of the
Central Limit Theorem.
Regardless of the population distribution, the distribution
of sample means will approach the normal distribution as
the sample size increases.
The standard error of the sampling distribution can be
reduced by simply increasing the sample size

2-39

Exhibit A2.1 Sampling Distribution

Versus Sample Size

2-40

Exhibit A2.2 Standard Error of the Sampling

Distribution Versus Sample Size

2-41

Law of Large Numbers

When an insurer increases the size of the
sample of insureds:
Underwriting risk increases, because more
insured units could suffer a loss.
But, underwriting risk does not increase
proportionately. It increases by the square root
of the increase in the sample size.
There is safety in numbers for insurers!

2-42

Questions to recap the concepts

learned

2-43

Question 1
Compare the risks of
Fire with
War
in terms of how well they meet the requirements
of an ideally insurable risk
So what are the 6 requirements?

Large number of exposure units.

Accidental and unintentional loss.
Determinable and measurable loss.
No catastrophic loss.
Calculable chance of loss.
Economically feasible premium.

Nomodelanswersgiven

2-44

Question 1.1
As a private insurer, you are considering
insuring buildings of a flooding zone, which
of the requirements of insurable risk are
not met?

2-45

Question 2
Explain the following benefits of insurance
to the society
Indemnification for loss
Enhancement of credit
Source of funds for capital investment and
accumulation

What are the major costs of insurance to

society

2-46

Question 3
You want to buy a flat. You pay 30 percent of the cost of the
flat as a down payment and borrow the other 70 percent
from a bank. The flat will serve as collateral for the loan. The
lender (bank) requires you to purchase property insurance
on the home so that the collateral supporting the loan will be
protected. This scenario illustrates which benefit of insurance
to society?

Enhancement of credit

2-47

Question 4
What does adverse selection mean?
What are the methods insurer can use to
control for adverse selection?

2-48

Question 5
Of insurance plan,

What is pooling of losses?

What is payment of fortuitous losses?
Risk transfer?
Indemnification?

2-49

Question 6
How can insurers deal with catastrophic
loss of exposures?

2-50