Property & Casualty Lesson 1
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Risk can be defined in different ways, depending on the context in which the word is used. When used in insurance, risk means the chance of loss.The term “risk” is also sometimes used to refer to the person, property, or activity that is insured. For example, an insurer may refer to the insured under an auto insurance policy as a “risk.”
Exposure (to risk) is the state of being subject to a possible loss. For example, a motorist is subject to the risk that he or she will be involved in an auto accident that could result in damage to the car, serious injury, or even death. Each item or activity that is exposed to lossmay be referred to as an exposure unit.The term “exposure” is also used to refer to the extent of risk. This is particularly common with property and casualty insurance. For example, the exposure of an insurer that provides workers compensation insurance may increase as an insured company’s workforce increases
Hazard is generally defined as a condition that increases the likely number of losses or the likely severity of a loss. For example, insufficient light in a high-crime commercial area is considered to be a hazard. Potholes along a busy highway are considered road hazards. Similarly, an individual’s cigarette smoking is a health hazard that may result in disability and early death.
Moral hazards are the tendencies or traits of an individual that increase the chance of a loss. Alcoholism, smoking, and bad credit are examples of moral hazards.
Morale hazards are also individual tendencies, but they arise from a state of mind, attitude, or indifference to loss. Not locking one’s car or driving recklessly are examples of morale hazards.
Physical hazards are characteristics that increase the chance of loss. They exist due to the presence of some physical condition in or surrounding the property. Examples: slippery floors, unsanitary conditions, congested traffic, and unguarded premises.
A peril is a cause of loss. Examples: fire, explosion, windstorm, flood, theft, and collision. An insurance policy provides financial protection against losses caused by some perils.
A loss is an unwelcomed and unplanned reduction in economic value. When property is completely destroyed by some peril, its economic value may be reduced to zero.
A direct loss is the immediate result of an event caused by a covered peril. Example: Suppose a home with a poorly maintained furnace (a hazard) is severely damaged by fire (a peril). The damage to the building is considered a direct loss.
An indirect loss is a more remote ramification than a direct loss, but is still a result of loss from a covered peril. Example: Because the home has been damaged, the home owner has no place to live. He or she will incur additional living expenses, over and above the home owner’s normal expenses, until the home has been repaired. These additional living expenses are an indirect loss that follows the direct loss of the home, and they are incurred in direct proportion to the amount of time it will take to repair the home.
Choosing to avoid risks. Example: Not owning a car means it can never be damaged or stolen.
Risk prevention measures reduce the likelihood that a loss will occur. For example, shoveling the snow off of a sidewalk makes it less likely that a visitor will slip and fall on it.
Risk reduction measures reduce the severity of any loss that does occur. Having fire extinguishers does not keep fires from starting, but when extinguishers are available and used, they often limit fire damage.
Under a risk-sharing arrangement, groups form with the intention that each member will share the financial burden of a loss suffered by any member of the group.
A modern example of risk sharing.
Using one's own funds to pay for any losses that occur. Usually when the financial loss would be small, or the chance of loss is remote.
By buying insurance, a person or business transfers certain risks to an insurance company in return for the payment of a premium. The terms of the risk transfer are specified in a contract, known as an insurance policy.
Fundamental Goal of Insurance
The fundamental goal of insurance is to indemnify policyholders against covered losses or, in other words, to restore them to the same financial position they were in before the loss occurred. Indemnity financially restores the victim of a loss up to the amount of the loss.
Requirements for a Risk to be Insurable
- A covered loss must be definite to time, cause, and location.
- The value of the loss that is to be insured must be measurable.
- The insured event must be accidental or outside the insured's control. Only losses that occur due to chance are insurable.
- The defined risk must not be a catastrophic event affecting thousands of people.
- Pure risks are generally insurable, but speculative risks are not.
- The defined risk must be part of a large group of similar risks that the insurance company can use to predict future losses. When this condition is met, the insurance company is able to apply the law of large numbers.
can result in loss or gain and are generally uninsurable. Example: stock market
Pure risk involves only the chance of a loss. Gain is not possible. Pure risks include the possibility of loss of a home as a result of a fire, and the possible death of a person.In general, only pure risks are insurable.
Law of Large Numbers
Applying the law of large numbers to insurance, this means that the larger the number of units independently exposed to loss, the greater the probability that actual loss experience will equal expected loss experience.
Underwriting determines whether a particular risk should be insured and at what rate. An important function of the underwriting process is to avoid adverse selection.
It is the tendency of persons more likely to have a claim to buy and maintain insurance. For example, a person with a high-performance car and a bad driving record is especially likely to recognize the need for auto insurance, but an insurer might be reluctant to provide it for those same reasons.
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