I.

Griffith Insurance Edu: Insurance Principles

Insurance Basics
Foundational Insurance Terms
• Risk
- Pure risk - uncertainty regarding future outcomes and certainty regarding loss or events that
produce loss
▪ Ex. Random event occur creates loss or random event doesn’t occur, doesn’t create
loss
▪ Insurable risk
- Speculative risk - possibility of game
▪ Ex. Gambling, buying stock
▪ Not insurable risk
• Perils - immediate cause of loss
- Ex. Fire, theft, floods, earthquakes, death negligent acts
- Random event
• Hazard - increase frequency, probability or dollar amount of loss
- Ex. Drunk driver increases likelihood of accident
- Ex. Distance of structure of source of water or fire hydrant
• Losses - result of perils, loss that can be measured
- Ex. Property loss
- Ex. Death - loss of income
• Loss frequency - how likely loss is to happen, probability of loss is, lower/higher
- Ex. Low frequency - hurricane sandy
• Loss severity – given loss, how much is it going to be
- Ex. High severity - hurricane sandy

What Is Insurance?
Insurance - means of treating risk by transferring consequences of loss to insurance company
• Protecting financial interest when losses occur
• Random even occurs, experiences loss, transfers financial responsibility to 3rd party insurer

How Insurance Benefits Insureds

• Pays insured's covered losses (indemnifies - compensate)
• Reduces uncertainty - in event of loss, insurer will provide restitution. Paying a known loss,
• Encourages efficient use of resources - provides liquidity to company to cover loss
• Helps reduce and prevent losses

How Insurance Benefits Bus/Society

• Support credit - bank would loan money to people w/o insurance
• Satisfies legal requirements - law to have auto insurance, workers comp, affordable care act etc.
• Satisfies business requirements
• Provides sources of investments funds - take premiums and invest it, big source of investable
capital
• Reduce social burdens

Cost of Insurance to Insureds

• Premium - direct cost, money given to insurer
 • Opp cost - the more money given to insurer, loss alt to spend money elsewhere

Cost Associated w/ Insurance

• Operating costs - including profit
- employees, property maintence, premium taxes
- Stock insurance co - have investors want ROR on capital
• Moral hazards - fraudulent and inflated claims
- Ex. Arson, murdering someone for life insurance, involves morally suspect behavior
- Ex. Unemployed, has 18 mo. of unemployment insurance, no effort to look for a job.
Increases severity of loss by not aggressively looking for a job
- Ex. Students know exams will have 10+ (insurance), students study less (changed behavior)
- Someone who has insurance and behavior changes in a way that increase frequency or
severity of loss
• Morale hazards - claims caused by carelessness or indifference
- Ex. Text while driving, don’t lock up property
• Frivolous lawsuits that are settles as nuisance claims

Principle of Indemnity
• Insurance should not benefit insured beyond value of loss
- Ex. Car accident, insurance gives value of car totaled
- Insured should not profit from loss
• Violations of this principle can increase frequency and severity of losses
- Creates moral hazard

Law of Large Numbers - use past info to predict future

• Mathematical basis of insurance
• Insurance coverage provided is large relative to premium paid
• What would be an unexpected loss for individual becomes expected loss in aggregate for insurer

Insurable Interest
• Means insured must suffer financial should a loss occur
• Supports principle of indemnity - one cannot gain from insurable loss

Economic Issues Related to Insurance Pricing

• Insurance policy is priced to reflect loss exposures policy covers while allowing expenses, profit
and contingencies

Adverse Selection - increases insurers cost

• Those w/ greatest probability of loss are most likely to buy insurance
• Tend to have more losses and higher claims than insureds w/ avg loss probability
• Ex. Auto insurer think everyone who buy contract will be good risks/good driver, prices without
assessment time. If insureds are good drivers, priced accordingly. If theyre high risk drivers, it
increases cost
• High risk people in risk pool who are not paying high risk premium because they have not been
identified as high risk
• To avoid adverse selection - data collection
- Insurers needs info about insureds to set pries that reflects risk
- Info is key to controlling adverse selection
Moral and Morale Hazard
• Behaviors that increase loss frequency/severity
- Moral - dishonestly
- Morale - carelessness/indifference
• Common in auto, products liability
• Reduce moral/morale hazard w/ policy risk sharing features (deductibles) - if there are
deductibles, losses are not free

Actuarial Equity vs. Social Equity

• Fair discrimination - equitable premium for each insured is essential to insurance pricing
- Ex. High risk driver, higher rates
• State insurance laws prohibits unfair discrimination in insurance pricing
• Opinions for fair/unfair vary

Actuarial Equity -
• Premium is directly proportional to each insured's loss exposures
• Cost based pricing - identifies every variable unique to each insured
• Risk classification variables used to figure how much risk is being transferred to insurer

Social Equity - Pricing should relate to ability to pay

Timing
• Short tail losses - most losses are recognized, valued and settles quickly
- Ex. Property insurance - property burns, property rebuilt
• Long tail - losses take long time to manifest, value and settle
- Ex. Workers comp
• Longer the tail, greater uncertainty in expected loss

Characteristics of Insurable Risks

• Large quantity of similar people or objects may be subject to loss
• Loss would be fortuitous - loss happens randomly, no moral hazard
• Loss would not be catastrophic to insurer - one event happening should not cause multiple events
• Time, location and extent of loss can be determined
• Amount of expected loss can be predicted
• Covering expected economically feasible for insurer

Characteristics of Insurance Products

Intangibility
• Lacks physical characteristics
• Policy on paper
• Represents promise - to pay in event of loss

Complexity and Legal Status

• Insurance policy contains complicated terms and concepts
• Insurance policy is legal contract
 Insurance as Risk Management Technique
Retaining Loss Exposure
• Some loss exposure has potential to cause financial ruin
• Other present minimal potential costs and can be safety retained
• If loss exposure can be predicted and affordable - retain

Avoiding Loss Exposure

• Ceasing or never undertaking an activity eliminates potential loss from that activity
- Ex. Not owning or driving auto eliminates potential auto liability losses

Controlling
• Loss prevention measure reduce freq of injuries
• Loss reduction measure reduce severity of fire losses
- Ex. Fire extinguisher

Transferring Risk - transfer financial responsibility to someone else through contract/lease agreement
commonly insurance co.

Why Insurance Operations Are Regulated

Consumer Protection
• Regulating and standardizing insurance policies and products
- Makes it easy to compare policies
• Controlling mkt conduct and preventing unfair trade practices
• Ensuring insurance is avail and affordable
• Preventing fraud and unethical mkt behavior

Insurer Solvency Regulation

• Ensure insurer's claim paying ability
• Protect public interest
• Safeguard insurer-held funds

Prevention of Destructive Competition

• To ensure avail of insurance by controlling rates
• Insurer lower rates to compete

II. Fundamentals of Insurance Pt 1 & 2

7 basic principles
1. Must be relationship b/t insured and beneficiary. Beneficiary must be someone who would suffer
if it weren't insurance.
• Ex. Life insurance for spouse, car insurance
2. Insured must provide full and accurate info to insurance company - how insurance determine
premium
3. Insured is not to profit as result of insurance coverage
4. If 3rd party compensates insured for loss, insurance co's obligation is reduced by amnt of
compensation
• Ex. Car accident, other person's fault, no fault coverage. if insurance co can recover some
costs from other driver's insurance co, then their losses are reduced
 5. Insurance company must have large number of insured so that risk can be spread out among
many difference policies
• Ex. Insure thousands, know 2-3 will pass away they will make money from those who don’t
pass away pay for those who did pass away
6. Loss must be quantifiable
• Ex. Oil company cant buy policy on an unexplored oil field
7. Insurance must be able to compute probability of loss's occurring

How Insurance Co. Make Money

• Pay for product before company provides service
• Gives insurers positive cash flow known as float which they can invest
• Insurers have future liability in claims they will have to pay - has to think about who theyre doing
business w/, what kind of people theyre insuring

Insurers earn money from 2 activities:

• Underwriting - evaluates risks of insuring individual/asset
• Underwriting profitability is determined by
- Loss ratio - losses incurred as % of premiums earned
- Expense ratio - expenses incurred as % of written premiums (sometimes earned premiums)
▪ Distinguish b/t written and earned premiums b/c sometimes people cancel policy and
insurers has to refund what they haven’t earned
- Combined ratio - sum of loss ratio and expense ratio
▪ Combined ratio less than 100% indicated underwriting profit
• Investment activities - deals w/ company's investment of money they have received but have not
yet paid out claims (float)
- Possible for insurer to have underwriting losses and still be profitable if investment return is
high enough
- Underwriting cycle
▪ Times of high int rate - insurer lax in underwriting standards so they can generate float
- don’t mind taking high risk people with expectations of investing well
▪ High rates - easy to buy
▪ Rates fall - insurers earn less income on investments and may have higher payouts
from poor underwriting standards (insuring bad drivers)
▪ Raise premiums, use higher underwriting standards

III. Lesson 12: Protecting Yourself Through Insurance

• Low frequency, high severity - death, transfer risk
• High freq, low severity - assume avoid
• Low freq, low severity - assume avoid
• Cant transfer every risk

Principle of Insurance
1. Know yourself, know your values
2. Understand product
3. Insure High Severity
4. High quality
5. Review annually
Which Life Insurance is Best?
• Caution 1
- Be careful if only source of life insurance is company life insurance
▪ Ex. Get sick and lose job, insurance will be gone with job
- Get insurance outside of job
• Caution 2
- Understand product/policy before buying

Life Insurance
• Economic Value of Human Life - Monetary amnt created by person's currents and future earnings
- Ex. Breadwinner of family, stay at home parent, key employee, business partners, owner of
large estate
- Importance of life insurance vary within each role
• How economic value change over time -
- economic factor matter more with marriage, kids, house, cars and lifestyle change
- Near to retirement - economic value decreases
• Life insurance is personal affair

Customized Needs Approach

• Immediate expenses
- Mortgage
- Debt
- Funeral costs
• Future expenses
- Edu
- Missions
- Weddings
• Ongoing expenses
- How much to be comfortable/for how long?

Types of Life Insurance

Own Lease
Permanent Temporary (term)
More expense/mo Less exp/mo
Equity No equity
More control Less control
Payments will stop Pmts continue
Tax benefits No tax benefits

• Owning life insurance at young age is cheaper than older age

• Which type is better?
- Depends on goals and situations
▪ Goal - financial security
 • Having policy that lasts as long as you need it and provide benefits and take it
with you
▪ Goal - death benefit 1st, other benefits 2nd
▪ Situation - duration
▪ Situation - ability to pay premiums
• Cash value in insurance grows over time
• 1st year put a lot of money into

Different Types of Term Insurance

• Level
- Recommended for 40s-60s because less change in situation
• Annually renewable
- Gets more expensive every year
- Recommended for younger folks
• Depends on how long you're going to keep coverage, where youre at in life
• 10 yr level term
• 20 yr level term
• 30 yr level term
• Annually reneweble term
• Mrtage life insurance
• Accidental death and dismemberment (AD&D)
- Only under certain situations will this pay out
- Ex. Doesn’t include cancer
• Rider - policy add-on that creates benefit for an additional cost
- Waiver of premium
- Cost of living adjust
- Child benefits

Types of Permanent Insurance

• Whole life - built on guarantees
- Pay premium to each year, at some point company knows to pay death benefit
- Benefits
▪ Allow to take money out of total death benefit prior to passing
▪ Closer to age expected death, able to take out more
▪ Growth rate
▪ Whole life insurance acts as fixed income (2nd benefit)
• Universal Life - built on assumptions
- Ex. Assumed interest rates were 12%, interest rate started dropping 4% instead. Assumed
certain premium on 12% return. Payed $100 for 20 yrs but could pay more if co. gets wrong
assumption on return.

IV. Adverse Selection

Asymmetric information
• One party knows more information than the other
• Information is costly to obtain
- Ex. Person claims non-smoker but insurance wouldn’t know that
Adverse Selection
1. Occurs when one party in transaction has better info than other party
2. Before transaction occurs
3. Potential borrowers most likely to produce adverse outcome are ones likely to seek loan and be
selected
• Ex. Told banks they had plenty of income to pay back but banks didn’t investigate b/c too
costly

• Agency theory - analysis of how asymmetric info problems affect behavior

• Agent doesn’t always have same goals principal has

Lemons Problem
• Lemon problem in used cars
- Cant distinguish b/t good and bad (lemon) used cars, willing to pay only average of good and
bad car values
- Result: good cars wont be sold and used car mkt will function inefficiently
- Carfax helps avoid this problem
• Lemon problem in securities mkts
- Cant distinguish b/t good and bad securities, pay average
- Result: good securities undervalues and firms wont issue them; bad securities over issued,
investors wont buy bad securities so mkt malfunctions

Solve Adverse Selection

• Private production and sale of information - buy info from carfax, seek information
• Govt regulation to increase info
- Ex. Annual audits of public corp
- CEO, CFO has to sign off on audit statements
• Financial intermediation - someone provides info to you or public
• Collateral and net worth - if person has net worth or asset to support loan, considered less of a
risk