LectureThree

1、Lecture Three： Insurance and Its Functions1Learning objectives Defining insurance and explain the basic characteristics of insurance Explain the law of large numbersDescribe the requirements of an insurable riskDescribe the major types of insurance Explain the functions of insurance 2Main ContentsDe

2、finition of insurance Basic characteristics of insuranceInsurable risk Adverse selection and insurance Insurance and gamblingTypes of insurance Insurance functions 3Insurance what is it?4 Definition of insurance There is no single definition of insurance.Insurance can be defined from the viewpoint o

3、f several disciplines, including law, economics, history, actuarial science, risk theory, and sociology.5 Definition of insurance Different definitions given by scholars from both abroad and home6Financial definition Insurance is a financial arrangement that redistributes the costs of unexpected los

4、ses. Insurance involves the transfer of potential losses to an insurance pool, the pool combines all the potential losses and then transfers the cost of the predicted losses back to those exposed. Thus, insurance involves the transfer of loss exposures to an insurance pool, and redistribution of los

5、ses among the members of the pool-by Mark S. Dorfman 7Financial Definition (Page 16 of textbook)Insurance is the pooling of fortuitous losses by transfer of such risks to insurers, who agree to indemnify insureds for such losses, to provide other pecuniary benefits on their occurrence, or to render

6、services connected with the risk. 8Legal definition Insurance is a contractual arrangement whereby one party agrees to compensation another party for losses. We call the party agreeing to pay for the losses the insurer, call the party whose loss causes the insurer to make a claims payment the insure

7、d. We call the payment the insurer receives a premium, call the insurance contract a policy. Call the insureds possibility of loss the insureds exposure to loss. 9我國(guó)保險(xiǎn)法（2002年10月28）第二條：本法所稱保險(xiǎn)，是指投保人根據(jù)合同約定，向保險(xiǎn)人支付保險(xiǎn)費(fèi)，保險(xiǎn)人對(duì)于合同約定的可能發(fā)生的事故因其發(fā)生所造成的財(cái)產(chǎn)損失承擔(dān)賠償保險(xiǎn)金責(zé)任，或者當(dāng)被保險(xiǎn)人死亡，傷殘、疾病或者達(dá)到合同約定的年齡、期限時(shí)承擔(dān)給付保險(xiǎn)金責(zé)任的商業(yè)保險(xiǎn)行為。

8、10Basic characteristics of insurance An insurance plan or arrangement typically has certain characteristics. They include the following: Pooling of losses Payment of fortuitous losses Risk transfer Indemnification 11Pooling of lossesPooling or sharing losses is the heart of insurance.Pooling is the

9、spreading of losses incurred by the few over the entire group, so that in the process, average loss is substituted for actual loss. 12Pooling of lossesPooling implies:the grouping of a large number of exposure units, so that the law of large numbers can operate to provide a substantially accurate pr

10、ediction of future losses. The sharing of losses by the entire group13Pooling of lossesThe Law of Large numbers it states that the greater the number of exposure, the more closely will the actual results that are expected from an infinite number of exposures. The insurer can predict future losses wi

11、th a greater degree of accuracy as the number of exposures increases. (explains it by examples) 14For most insurance lines, estimates of both average frequency and the average severity of loss must be based on previous loss experiencesThe insurer must charge a premium that will be adequate for payin

12、g all losses and expenses during the policy period. 15Payment of fortuitous lossesA fortuitous loss is one that is unforeseen and unexpected and occurs as a result of chance. Thats the loss must be accidental. Insurance policies do not cover intentional losses. 16Risk transfer Risk transfer means th

13、at a pure risk is transferred from the insured to the insurer, who typically is in a stronger financial position to pay the loss than the insured. 17Risk transfer Pure risk that typically transferred to insurers includes: Premature death Poor health DisabilityDestruction and theft of property Liabil

14、ity lawsuits 18IndemnificationIndemnification means that the insured is restored to his or her approximate financial position prior to the occurrence of the loss 19Insurable Riskwhat kinds of risks are insurable for a private insurer? 20 six requirements of Insurable riskInsurers normally insure onl

15、y pure risks. However, not all pure risks are insurable. From the viewpoint of the insurer, there are ideally six requirements of an insurable risk:21 six requirements of Insurable riskThere must be a larger number of exposure units;The loss must be accidental and unintentional;The loss must be dete

16、rminable and measurable;The loss should not be catastrophic; The chance of loss must be calculable;The premium must be economically feasible. 22 large number of exposure unitsThere should be a large group of roughly similar, but not necessarily identical, exposure units that are subject to the same

17、peril or group of perils. (examples) The purpose is to enable the insurer to predict loss based on the law of large numbers.The loss costs can be spread over all insureds. 23 Accidental and Unintentional Loss the loss should be accidental and unintentional the loss should be fortuitous and outside t

18、he insureds control If an individual deliberately causes a loss, he or she should not be indemnified for the loss24Determinable and measurable loss The loss should be both determinable and measurable. It means the loss should be definite as to cause, time, place, and amount. The purpose is to enable

19、 an insurer to determine if the loss is covered under the policy, and how much should be paid. 25No catastrophic lossThe loss should not be catastrophic It means that a large proportion of exposure units should not incur losses at the same timeOtherwise, the insurance pooling would break down and be

20、come unworkable. 26 Calculable chance of lossThe chance of loss should be calculable .The insurers must be able to calculate both the average frequency and the average severity of future losses with some accuracy.This requirement is necessary so that the premium can be charged and sufficient to pay

21、all claims and expenses and yield profit. 27 Economically feasible premiumThe premium should be economically feasible.The insured must be able to afford to pay the premium;Low premium is attractive and competitive in market;To have an economically feasible premium, the chance of loss must be relativ

22、ely low. 28personal risks, property risks, and liability risks can be privately insured. most market risks, financial risks, production risks, and political risks are usually uninsurable by private insurers. The reasons are:First, being speculative, and difficulty to insure privately;Second, a great

23、 potential to cause catastrophic loss;Finally, calculation of premium is difficult. Riskinsurable or non-insurable? 29 Adverse selection and insurance Adverse selection is the tendency of persons with a higher-than-average chance of loss to seek insurance at standard (average) rate, which if not con

24、trolled by underwriting, results in higher-than-expected loss levels. (Examples) .There are some ways to control adverse selection: careful underwriting; (Examples) policy provisions (Examples：waiting period, suicide clause) 30 Insurance Versus GamblingInsurance is often confused with gambling. Actu

25、ally they are quite different from the following viewpoints: Gambling creates a new speculative risk, while insurance is a technique for handling an already existing pure risk. (examples) gambling is socially unproductive, while insurance is always socially productive. Gambling is illegal in China.

26、31Ideal Requisites Examples (21 of text) Examples 1: Risk of fire as insurable riskExamples 2: Risk of unemployment as insurable riskA. Large Number of Similar Exposure UnitsB. Accidental and unintentional lossC. Determinable and measurable loss D. No catastrophic loss E. Calculable chance of losses

27、F. Economically feasible premium 32Types of Insurance33Types of InsuranceInsurance can be classified as various types: Personal or CommercialLife-Health or Property-LiabilityPrivate or GovernmentVoluntary or Involuntary34Types of Insurance Insurance can be classified as either private or government

28、insurance private insuranceLife insurance, health insurance, property insurance and liability insurance government insuranceSocial insuranceOther government insurance 35 Private insuranceLife and health insurance Property and liability insurance: Fire and insurance and allied lines.Marine insurance

29、: ocean marine inland marine casualty insurance:automobile insurance general liability insurance burglary and theft insurance workers compensation insurance glass insurance boiler and machinery insurance nuclear insurance crop-hail insurance health insurance other miscellaneous linesMultiple-line in

30、suranceFidelity and surety bonds36Government insurance Government insurance can be divided into social insurance programs and other government insurance programs： social insurance: (in the U.S) Old-age, survivors, and disability insurance( social security) Medicare Unemployment insurance Workers com

31、pensation Compulsory temporary disability insurance Railroad Retirement Act Railroad Unemployment Insurance ActOther government insurance programs (in the U.S.) 37Social insurance programs in ChinaSocial insurance Pension systemUrban Employee Health InsuranceNew Rural Co-operative Medical System Une

32、mployment insurance Other social insurance programs 38Insurance functions39 Insurance functions Various argues on the functions of insurance:Unique function: Indemnification for lossFundamental functions: spreading risks and indemnification for loss Multi-function: besides the fundamental functions,

33、 there more other function as pooling funds, deposit, etc. 40Insurance functionsBasic functions: dispersing risk indemnifying lossDerived functions: pooling funds risk-supervising 41Insurance functions in national economy Insurance in micro-economy Help the disaster companies by compensating loss Em

34、phasize financial budget Emphasize risk managementInsurance in macro-economy Ensure the operation of social production Promote import and export42Benefits of insurance to society The major social and economic benefits of insurance include the following:indemnification for lossless worry and fearsour

35、ce of investment funds loss prevention enhancement of credit 43Costs of insurance to society Although the insurance industry provides enormous social and economic benefits to society, the social costs of insurance should also be recognized. The major social costs of insurance include the following: cost of doing business fraudulent claims inflated claims 44Summary There is no single definition of insurance. However, a typical insurance plan contains four elements: pooling payment of fortuitous losses risk transfer inde