Chapter 1: Introduction

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Insurance Outline


Chapter 1: Introduction


  • Concept of Risk: The possibility that the actual result is different from the anticipated result

  • 2 kinds of risk

  1. Upside: Possibility things will turn out better than expected

  2. Downside: Possibility things will turn out worse than expected

-Risk is a probability-the risk of occurrence can be fro 0-100%

-Greatest concern is when risk = 50%

-4 things to do about risk:


  1. Accept it and do nothing

  2. Try to minimize w/ security & safety devices

  3. Avoid the risk

  4. Transfer risk to somebody else (insurance)

-Insurance = “risk transfer agreement”

-Other arrangements: lease, set up a corporation, try to pass the risk to somebody else (special warranty)

-Risk has subjective ramifications

-Some people pursue risk for shits & giggles

-Most people are risk averse and prefer to reduce as much as possible

-Risk transfer: why is it that somebody else is willing to take it?



  1. They love risk (not likely)

  2. Lease from a fleet (large volume/lower prices)

  3. Insurance: law of large numbers

-The larger the population, the more likely the actual experience = anticipated experience

- 1 coin flip is not a scientific predictor, but 1 million flips will yield roughly 50/50 heads & tails

-Much less risk in 1 million flips than 1 flip


  • Mortality Tables

-Expected death at age 29 = 1.03

-This means for every 1000 people age 29 on 1/1/98, 1.03 died by the end of the year

-For any individual age 29 on 1/1/98, the chances of dying are virtually unknown, but out of 1000, someone will die.

-Economic consequences can be addressed (loss of income), but the non-economic cannot be (emotional suffering)

-For parents leading families, risk addressed by pooling; for each 1000, 1 will die, each can put in $100 and the family of the one who dies gets $100K

-BUT insurers have costs-goal is for losses to equal 60% of premium

-The other 40% covers admin expenses/profits

-For 29 yr olds, each would have to pay $172 for $100K of insurance

-Gov’t statistics are the basis for calculation

-Cannot use law of large numbers w/o knowing what anticipated loss would be-traditionally broken down by age and race: white women have low risk; black women & white men have higher risk; black men have highest risk.

-Statistics must give way to mortality; unjust to have different rates for different races; insurance company was busted w/ higher black rate and had to refund-abiding by morals can create $$ problems

-Moral Hazard: risk of intentional destruction b/c of insurance

-If people take out insurance on their own lives, chances of suicide for $$ are small

-Much bigger risk for property insurance; insurers can discount for people who undertake risk prevention (club, theft alarm, etc.)

-Some people in an insurance pool are better off than others

-On 1/1/98, some 29 yr olds were terminally ill and some were in superb health

-Insurer is worried that pool = random sample of population

-Problems with redlining where insurers target only low risk insureds

-Life insurance: clean tables, steady progression of risk, easy to document

-Property/casualty: much harder to get appropriate statistics/premiums

-Essence of insurance: pooling device-comparable risks are pooled

-Everything that is “insurance” is not necessarily insurance and some things that are not really are insurance.
-Definition of Insurance given (tight, but not universal)

-If insurance definition is satisfied, there’s a number of consequences:



  1. Business of insurance is regulated in every state

    1. Cannot become an insurance company w/o a license

    2. Cannot sell insurance for a provider w/o a license

  2. Most state insurance directors are appointed; some are elected; desirable elected position; good steppingstone to governor/senator/lots of P.R.

  3. Insurance companies/policies have important tax consequences; if someone dies & leaves $$, the $$ is not part of the taxable estate if it’s insurance;

  4. Insurance for tax purposes is different than for regulatory purposes.

-Warranties are unconditional; non-insurance companies can be stuck in an insurer’s role, (i.e. a warranty to replace auto tires)

-Lots of borderline cases where it’s crucial to decide whether they’re regulated by insurance, b/c then it must be regulated/only sold by licensed insurers.

-CB 175: Exclusions: (1) ordinance; (2) Earth movement; (3) Water damage; (4) power failure; (5) Neglect; (6) War; (7) Nuclear Hazard; (8) Intentional Loss

-Some people thought that 9/11 fell within war exception, insurers were criticized, covered the 9/11 damages then began to add terrorism exclusion which created problems-reluctance to build/loan $$ to build resulted

-Congress required insurers to cover $0-$10 bln in damage, then Congress covers $10-$100 bln

-Issue of what rate of coverage-this varies from state to state

-Un like life insurance rate calculation, it’s very difficult to develop a rate chart for terrorism insurance

-Insurance Services Organization (ISO): pools info from insurers, develops statistics, provides rates to companies, helps give guidance for setting premiums


  • Why Regulate Insurance

  1. It’s important & vital & necessary (home, care, health, dependents, property, etc.)

  2. If insurers don’t perform, a lot of problems are created

Why more concern than other entities non-performance? Premiums are paid in advance, while other business transactions tend to have performance upon payment

-More reliance on a promise in an insurance setting

-Real concern about fraud

-concern about necessity to make sure there will be performance, owing to the need for insurance



  1. “The lag”

-Consequence of lag: insurance cos. can be viewed as a cash cow: they take in all kinds of $$ but only make periodic payouts

-Insurance cos. have lots of $$ to invest-normal investors get 5% return on investment-if insurers get 30% returns the rest is all gravy

-People are @ insurers’ mercy for premiums

-Difficult to appraise reasonableness of premiums

-Insurers are much more knowledgeable about cost

-Policies are enormously complicated




  • Re-Insurance Companies: Insure insurance companies; insurer with too much risk in a small area can go to the re-insurance company to take on some of the concentrated risk

-Insurance cannot be self-regulated by re-insurance b/c of re-insurer’s self-interests

-Typical interaction w/ insurer is after a “disastrous occurrence”-insured is unusually vulnerable; can be taken advantage of; needs somebody to protect their interest

-Similar to gambling-gambling deemed to be sinful throughout history-concern that insurers would “gamble” under “insurance” pretext

-Must have license to sell insurance-cannot sell insurance with a standard sales/business license

-Need a license for life or property/casualty

-With exception of Lloyd’s, individuals cannot be licensed as insurance companies-can only be done by entities w/ perpetual existence (corporations) – must have reserves – required amount varies – now requires at least $5 million

-2 Organizations



  1. Stock Company: Investors get dividends

  2. Mutual Company: Policy owners put up the reserve

-Property and Casualty were originally stock companies

-Life insurance was originally a mutual company

-B/c of cash cow phenomenon, large life insurers have been de-mutualizing and becoming stock companies

-Insurance is regulated, but unlike utilities, insurers are not obligated to insure anybody

-In fact, many insurers specialize any only serve a specific group (i.e. Lutherans only)

-Lack of obligation can create a problem, esp. w/ property & liability insurance, b/c what if someone cannot find a willing, licensed insurer

-Supreme Court established that people have Constitutional right to be insured, even if the provider is not licensed in their own state

-Known as excess/surplus line insurers-provide insurance to those who cannot insure on reasonable terms from licensed companies (i.e. Lloyd’s of London)-NY & TX allow Lloyd-like companies to be started

-Individuals cannot be insurers-Lloyd’s is comprised of “nothing but individuals”

-Originally the only people who could be principals of Lloyd’s were the landed gentry-landed gentry had to make all assets liable to pay claims-people w/ lots of assets were admitted as principles

-Lloyd’s is a group of individuals organized into syndicates-people seeking unusual insurance can go to Lloyd’s (i.e. stripper insuring her tits, movie producers insure against actors playing hooky, Caribbean resorts insure against bad weather)

-Law of lg #’s of tragedies in the aggregate

-Lloyd’s always operated on the notion that shit happened, but could turn a profit

-expanded membership in 1970’s

-Lloyd’s has no reserves-principals didn’t have to put up any $$, just gave profits every yr

-Started opening up to Americans including Justice Breyer-had a conflict w/ joining federal bench so he sold his status at Lloyd’s

-Late 70’s-80’s: Lloyd’s started issuing policies on computers that were going obsolete; other bad risks were taken; members began losing $$; filed suit claiming fraud

-Lloyd’s actually went bankrupt, but restored to viable status and still works the same way-syndicates still decide on what to insure

-A number of excess/surplus line cos still exist-states have begun to regulate

-MO gives a list of approved, non-admitted carriers




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