Under this arrangement, vehicle owners who suffer financial loss will be indemnified by those who do not suffer the accident hence owner who escape loss will be willing to pay those who suffer loss, because by doing so, they eliminate the possibility of themselves suffering the sh 1M loss. The potential difficulty of this arrangement is that some group members may refuse to pay their assessment of sh 1M at the time of loss and this problem can only be solved by requiring advance payment of cash by each person contributing to the arrangement. The assessment that each individual is required to pay will be calculated on the basis of past exposure and experience. Example: If in the above only 3 out of 1000 vehicles suffer loss. Then each group member will be required to pay sh 3000. In addition to the cost of the loss costs, there will be some administrative costs for the arrangement of risk sharing and cost to cater for the eventuality.
29 | P a g e The insurance company administering the arrangement will also add up some mark up or profit to the entire cost the arrangement. From above example; 3000 Add admin costs xxxx Add imprecise prediction possibility xxxx Add profit mark-up xxxx Cost of arrangement xxxx Prediction of probable losses In addition to eliminating losses, at the individual level, through risk transfer to a group, the insurance mechanism reduces risks for the society as a whole. The risk that insurance companies face is not merely a summation of the risk transfer from individuals to itself but insurance companies are able to do something that the group of individuals cannot, which to predict, in a more precise manner the amount of losses that are likely to occur. If the insurer could predict future losses with absolute precision, then the insurer would face no possibility of loss because they would collect precisely each individual’s share of the expected losses in the group. But because the insurance predictions are not precise, the premiums that they may charge are likely to be inaccurate. The accuracy of the insurance prediction is based on the law of large numbers. 3.2.3 The law of Accuracy and large numbers in insurance Accuracy of an insurance prediction is base on the law of large numbers. By combining a sufficiently large number of similar exposure units (insured persons), the insurer is able to make predictions for the group as a whole, and this is done through the theory of probability. The primary function of insurance is the creation of the counterpart of risk which is security . Insurance does not decrease uncertainty of financial losses or alter the probability of occurrence, but reduces the probability of financial loss connected to the event. 3.2.4 Expectation gap in risk pooling arrangement
30 | P a g e (i) Some people believe that it’s a waste to purchase insurance especially if a loss does not occur and they are indemnified.
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- Summer '19
- concepts of risk