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35 Cards in this Set
- Front
- Back
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Characteristics of Ideal Insurable Loss Exposures ( from insurer's point of view) |
- Large number of homogeneous units - Accidental and unintentional losses - Definite in time and place - Extremely low probability of CAT losses to insurance pool |
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Large number of homogeneous units |
- exposed to the same peril, otherwise mispricing
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Accidental and unintentional losses |
- moral hazard (can lead to insurance fraud, beyond control of insurer), deductibles, etc. - when losses produce no regret for policyowner, # of insured claims often will increase |
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Definite in place and time |
- losses should be definite, verifiable, measurable and of sufficient severity to cause economic hardship; otherwise can argue whether loss occurred - - large-loss principle
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Large-loss principle |
- losses are large and uncertain (this is when insurance should be purchased)
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Extremely low probability of CAT loss to insurance pool |
- typically concentrated in limited geographic areas, forecasting efforts are difficult to predict (ex.: climate change)
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Insurance works well when... |
- industry adheres to guidelines; however in practice insurance is provided in less than idea conditions - if depart too far from ideal conditions, likely to require financial subsidization from government - balance maintained between number of insured exposures and number/severity of losses in pool |
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Insurance will have difficulties or fails to function when.... |
- more and more people collect - frequency/severity increases - price must rise - fewer people buy - risk premiums increase - pool shrinks in size, cycle starts again (insurer death spiral) - results in small pools, many collecting, unaffordable premiums |
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Insurer death spiral
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- vicious circle of premium increases that stops when pool contains overwhelming number of high-risk member who are willing to pay high price b/c most exposed to peril
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Risk Classification Systems |
- used to sort policy holders into different pricing groups based on their risks of suffering insured losses - allow for more accurate forecasting of expected losses of customers within risk classes
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Goals for Risk Classification |
- Actuarially fair premium - Risk classification minimizes subsidization (ex.: cross subsidization of premiums- charging same average premiums where good ppl act as subsidy for bad ppl) - competition also reduces subsidization - goal is to have all pay fair share - provide structure for evaluation of classification schemes |
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Adverse Selection and Subsidization |
- undisclosed information causing people to pay less than their "fair" share - causes subsidization- b/c included with people actually paying their fair share
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How to reduce adverse selection ? |
- limit coverage - compulsory - risk classification |
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When Subsidization is Caused by Government |
- setting or eliminating classification schemes prevents competition - called mandated subsidization - examples: females vs. males for annuity, life insurance or group employee pension benefits
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Principles of Risk Classification |
- separation and class homogeneity - reliability - incentive value - social acceptability |
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Separation and class homogeneity
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- separation: each classification will have significantly different chance of loss - class homogeneity: each member in classification will have approximately same chance of loss
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Reliability |
- info easily obtained and not subject to manipulation - info is verifiable (otherwise can provide false info)
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Incentive Value
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- provides incentive to act in socially and economically positive ways - better insurance rates - ex.: good driving means lower premiums |
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Social Acceptability |
- mathematically fair outcome conflicts with social goals - some rating criteria socially or legally unacceptable b/c beyond insured's control - ex.: race, gender, etc. - race eliminated - gender eliminated for pension, but still used for individual life insurance and annuities - highly debatable: genetic testing, credit scoring, etc. |
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Types of Insurance Companies |
- Stock companies - Mutual companies - Reciprocal exchanges - Fraternal life insurers - Blue Cross & Blue Shield - Lloyd's of London |
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Mutual Insurers |
- incorporated, nonprofit organizations - policy holders are owners and vote proxies - no corporate stock - less access to sources of financial capital - can receive dividends if board declares them, not taxable, considered return of excess premium - relatively larger initial premium (compared to stock company), followed by year-end dividends if results are favorable
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Types of Mutuals
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- Advanced Premium - Assessment - Factory - Perpetual - Demutualization
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Advanced Premium |
- typical format - premium paid at beginning of year - policy owner eligible for dividend at end of year - cannot expect policy holders to cover unmet claims |
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Assessment |
- small initial premium - followed by year end assessment of pro-rata costs - assessment based on policy holder paying fair share of premium , based on year-end proxy for exposure - policyholders share in legal liability to meet any assessment if required to do so - may not pay premium at beginning of period but required to pay at end |
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Factory |
- lower premiums if qualify for pool - insurers highly protected risks - emphasis on safety engineering and regular inspections - cannot assess b/c it would create wrong incentive (safety inspections would fall on insured) |
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Perpetual |
- very high initial deposit w/no additional premium - pool operates on interest income from deposit - refund of deposit occurs when contract terminated
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Demutualization |
- year 2000, several of largest mutual companies demutualized- changed their legal form to stock insurance company
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Why demutualized? |
- more flexible capital structure - merger and acquisition possibilities - how to value "ownership" interest - how to compensate owners/policyholders was hard question - need for "stock" to perform will be new experience for managers |
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Stock Insurers
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- shares of stock exist and can be traded on an organized exchange such as NYSE or NASDAQ - for profit companies - typically lower initial premium - profits distributed to investors without necessarily benefiting policyholders - if insurer suffers loss, stockholder's loss limited to amount invest in stock of troubled insurer
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Reciprocal Exchange
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- comparable to mutual insurers except organization is unincorporated, non-profit organization - insureds pay pro-rata share of losses in advance through premium - not liable for assessment since surplus accounts provide cushion - if no surplus, individual assessments required to meet goal of providing insurance at minimum cost to all policy owners - everyone is insuring each other - manager known as "attorney in fact" has legal power to invest money, pay expenses, claims, etc. (like an administrator) |
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Lloyd's of London |
- independent underwriters who offer insurance for their own accounts - each lead underwriter represents a syndicate of names who participate in underwriting, agreeing to share profits and accept liability for losses - Lloyd's provides central government for underwriters and handles internal governance, policy issuing and other required insurance services - all underwriters agreed to pool resources to support organization, giving Lloyd's reputation of financial strength - limited liability - large insurance marketplace - each syndicate has freedom to accept, reject, or price its own exposures - future has been in doubt |
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What is so great about Lloyd's of London |
- Unique positioning - reputation for honoring agreements - financial capacity - reputation for innovation - expertise in various areas - investigation intelligence |
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Fraternal Insurance |
- formed around common bond (religion) and provide members with health and life insurance, often exempt from federal income taxes |
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Savings Bank Life Insurance |
- allowed to sell SBLI - one of first types of insurance sold successfully by non-insurance entity |
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Insurance Industry
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- large numbers of buyers and sellers (1200 -life, 900- property) - collusion is unlikely - little product differentiation b/c standard policy forms but services variable - employs over 2 million people - few barriers to entry - cost structure requires law of large numbers to work to generate accurate predictions - declining cost industry |
