Nature & Functions of Insurance

In its simplest aspect, insurance has two

fundamental characteristics:
1. Transfer of risk from the individual to the
group.
2. Sharing of losses on some equitable basis.

2-1

Operation of Insurance Illustrated

1.

1,000 dwellings valued at $100,000 each.

2.

Each owner faces risk of a $100,000 loss.

3.

Owners agree to share losses that occur.

4.

If one house burns (total loss) each owner

pays $100 ($100 X 1,000 = $100,000).

5.

This is a pure assessment mutual insurance

plan.
2-2

Operation of Insurance (continued)

6.

Potential difficulty: some members might

refuse to pay their assessment.

7.

This problem can be overcome by requiring

advance payment for predicted future
losses (based on past experience).

8.

If 2 total losses are predicted, each owners

cost is $200.

9.

If we add $100 for a cushion and for

operating expenses, the cost is $300.
2-3

Insurance Defined: Individual Perspective

Insurance is an economic device whereby the
individual substitutes a small certain cost (the
premium) for a large uncertain financial loss
(the contingency insured against) which would
exist if it were not for the insurance.

2-4

Risk Reduction Through Pooling

1.

The risk an insurer faces is not merely a

summation of risks transferred to it by
individuals.

2.

Insurer can predict within narrow limits the

amount of losses that will occur.

3.

If insurer could predict future losses with

absolute precision, it would have no risk.

4.

Accuracy of insurers prediction is based

on the law of large numbers.
2-5

Probability Theory and Law of Large Numbers

Probability theory is the body of knowledge
concerned with measuring the likelihood that
something will happen and making predictions
based on this likelihood.

2-6

Probability Theory and Law of Large Numbers

1.

Likelihood of an event is assigned a

numerical value between 0 and 1.

2.

Impossible events assigned a value of 0.

3.

Inevitable events assigned value of 1.

4.

Events that may or may not happen are

assigned a value between 0 and 1, with
higher values assigned to those with
greater likelihood.
2-7

Two Interpretations of Probability

1. Relative frequency interpretation
signifies the relative frequency of
occurrence that would be expected, given
a large number of separate independent
trials.
2. Subjective interpretation
probability is measured by the degree of
belief (e.g., student says she has a 50:50
chance of getting a B in the course).

2-8

Determining the Probability of an Event

1. A priori estimates determined from the
underlying conditions
the probability of flipping a head is .5
the probability of drawing the Ace of
Spades is 1/52
2. A priori estimates not significant for us
except in illustrating Law of Large Numbers

2-9

Law of Large Numbers

1. Even though we know the probability of
head is .5, we know we cannot predict
whether a given flip will be a head or a tail.
2. Given a sufficient number of flips, we
would expect the result to approach one-half
heads and one-half tails.
3. This common sense notion that probability
is meaningful only over a large number of
trials is recognition of the Law of Large
Numbers.
2-10

Law of Large Numbers

The observed frequency of an event more
nearly approaches the underlying probability of
the population as the number of trials
approaches infinity.

2-11

A Posteriori Probabilities
1.

When probability cannot be determined by

underlying conditions (i.e., a priori), it can
be estimated based on past experience.

2.

A posteriori probabilities are based on

observed frequencies of past events.

3.

After observing proportion of the time that

various outcomes occur, we construct an
index of relative frequencies of occurrence
called a probability distribution.
2-12

Probability Distribution
1.

Probability distribution is an index of the

relative frequency of all outcomes.

2.

The probability assigned to the event is the

average rate at which the outcome is
expected to occur.

3.

Probability distributions generally

constructed on basis of a sample.

2-13

Illustration of Sampling of Losses

Year
1
2
3
4
5

Houses that Burn

7
11
10
9
13

Total

50

Average

10
2-14

Illustration of Sampling of Losses

Year
1
2
3
4
5

Houses that Burn

16
4
10
12
8

Total

50

Average

10
2-15

Standard Deviation
Year

1
2
3
4
5
20

Average
Losses

10
10
10
10
10

Actual
Difference
Losses Difference Squared

7
11
10
9
13

3
1
0
1
3

Summation of Differences Squared

Number of Years

9
1
0
1
9

20
5

Variance = 4, Standard Deviation = 2

2-16

Standard Deviation

Year

1
2
3
4
5
80

Average
Losses

10
10
10
10
10

Actual
Difference
Losses Difference Squared

16
4
10
12
8

6
6
0
2
2

Summation of Differences Squared

Number of Years

36
36
0

80
5

16

Variance = 16, Standard Deviation = 4

2-17

Significance of Standard Deviation

1.

The smaller the standard deviation relative

to the mean, the less the dispersion of the
values in the population.

2.

In our example, if a large number of

samples were taken, 68.27% of the means
(of the samples) would fall between 10 + the
standard deviation.

3.

For the first set of data, 10 + 2.

4.

For the second set, 10 + 4.

2-18

Dual Application of Law of Large Numbers

1.

To estimate the underlying probability

accurately, insurer must have a large
sample of experience.

2.

Once the estimate of probability has been

made, it must be applied to a large number
of exposure units to permit the underlying
probability to work itself out.

2-19

Insurance Defined Social Perspective

Insurance is an economic device for reducing
and eliminating risk through the process of
combining a sufficient number of homogeneous
exposures to make the losses predictable for
the group as a whole.

2-20

Insurance: Transfer or Pooling?

1.

The view that the essence of insurance is

risk transfer emphasizes the individuals
substitution of a small small certain cost for
large uncertain loss.

2.

Emphasis on pooling or risk sharing

emphasizes the role of reducing risk in the
aggregate.

3.

Insurance can exist without pooling, but not

without transfer.
2-21

Insurance and Gambling

1.

In gambling, there is no chance of loss (and

therefore no risk) prior to the wager.

2.

In the case of insurance, the chance of loss

exists whether or not insurance is
purchased.

3.

Gambling creates risk, while insurance

provides for the transfer of existing risk.

2-22

Economic Contribution of Insurance

1.

Creates certainty about burden of loss

2.

Spreading losses that do occur

3.

Provides for an optimal utilization of capital

2-23

Elements of an Insurable Risk

1.

Large numbers of exposure units

2.

Definite and measurable loss

3.

The loss must be fortuitous

4.

The loss must not be catastrophic

2-24

Other Facets of Insurable Risk

1.

Randomness-adverse selection

2.

Economic feasibility

2-25

Self-Insurance
1.

Definitional impossibility

2.

Acceptable operational definition

enough exposures for predictability
financially dependable
geographic dispersion

2-26