Revised chp3 - Nature& Functions of Insurance In its...

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Unformatted text preview: Nature & Functions of Insurance In its simplest aspect, insurance has two fundamental characteristics: 1. 2. Transfer of risk from the individual to the group. Sharing of losses on some equitable basis. 1. 1,000 dwellings valued at $100,000 each. Operation of Insurance Illustrated 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). 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. 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. 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. Illustration of Sampling of Losses Year Houses that Burn 7 11 10 9 13 50 10 1 2 3 4 5 Total Average Illustration of Sampling of Losses Year Houses that Burn 16 4 10 12 8 50 10 1 2 3 4 5 Total Average Standard Deviation Year 1 2 3 4 5 Average Actual Losses Losses Differences 10 10 10 10 10 7 11 10 9 13 3 1 0 1 3 9 1 0 1 9 20 Variance = 4, Standard Deviation = 2 Standard Deviation Year Average Actual Losses Losses Differences 1 2 3 4 5 10 10 10 10 10 16 4 10 12 8 6 6 0 2 2 36 36 0 4 4 80 Variance = 16, Standard Deviation = 4 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." Dual Application of Law of Large Numbers 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 1. Life Insurance Classification of Private Insurance 2. Accident and health Insurance 3. Property and liability insurance fire marine casualty fidelity and surety bonds Social Insurance Definition 1. Coverage is compulsory 2. Eligibility derived from contributions: no requirement to demonstrate need 3. 4. Method of determining benefits prescribed by law Benefits not directly related to contributions Social Insurance Programs in the U.S. 1. OldAge, Survivors and Disability Insurance 2. Railroad Retirement, Disability and Unemployment Insurance 3. Unemployment Insurance 4. Medicare 5. State Compulsory Temporary Disability 1. Federal Deposit Insurance Corporation 2. National Credit Union Administration 3. Securities Investor Protection Corporation 4. Pension Benefit Guarantee Corporation Federal Public Guarantee Programs ...
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