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Insurance Fundamentals for PolicymakersFour assignments:Insurance PrinciplesInsurance Coverages: Property and CasualtyInsurance Coverages: Life and HealthInsurance Regulation and LegislationInsurance Fundamentals for PolicymakersInsurance BasicsEconomic Issues Related to Insurance PricingCharacteristics of the Insurance ProductInsurance as a Risk Management TechniqueWhy Insurance Operations Are RegulatedInsurance Principles TopicsInsurance provides financial security, and it does so based on principles that ensure that all covered losses will be indemnified.

Insurance BasicsRiskPerilsHazardsFoundational Insurance TermsLossesLoss frequencyLoss severityFoundational Insurance TermsA means of treating risk by transferring the financial consequences of a loss to an insurance companyA means of protecting financial interests when losses occurWhat Is Insurance?Pays insureds covered losses (indemnifies)Reduces uncertaintyEncourages efficient use of resourcesHelps reduce and prevent losses

How Insurance Benefits InsuredsSupports creditSatisfies legal requirementsSatisfies business requirementsProvides sources of investment fundsReduces social burdensHow Insurance Benefits Business and SocietyPremiumsOpportunity costsCosts of Insurance to InsuredsOperating costs including profitFraudulent and inflated claims (moral hazards)Claims caused by carelessness or indifference (morale hazards)Frivolous lawsuits that are settled as nuisance claimsCosts Associated With InsuranceThese principles help ensure that the insurance mechanism is actuarially sound: IndemnificationLaw of large numbersInsurable interest

Fundamental Insurance PrinciplesInsurance should not benefit an insured beyond the value of a loss.Violations of this principle can increase the frequency and severity of losses.

The Principle of IndemnityThe mathematical basis of insurance.Insurance coverage provided is large relative to the premium paid.What would be an unexpected loss for an individual becomes an expected loss in aggregate for an insurer.The Law of Large NumbersMeans that the insured must suffer financially should a loss occurSupports the principle of indemnityone cannot gain from an insurable lossInsurable InterestAn insurance policy is priced to reflect the loss exposures the policy covers while allowing for expenses, profit, and contingencies.Economic Issues Related to Insurance PricingAdverse selectionMoral and morale hazardEquity: actuarial and socialTimingKey Issues in PricingAdverse selection increases insurers costs.Those with the greatest probability of loss are most likely to buy insurance.They tend to have more losses and higher claims than insureds with an average loss probability.

Adverse SelectionInsurers need information about insureds to set prices that reflect risks.Data collection raises privacy concerns:What information is relevant?How much information is too much?Avoiding Adverse Selection: Data CollectionBehaviors that increase loss frequency and/or severityMoraldishonestyMoralecarelessness or indifferenceCommon in auto, products liability, and general liability insuranceCan be discouraged with policy risk-sharing features (deductibles)Moral and Morale HazardFair discriminationequitable premium for each insuredis essential to insurance pricing.State insurance laws prohibit unfair discrimination in insurance pricing.Opinions vary about what is fair and unfair.Actuarial Equity Versus Social EquityPremium is directly proportional to each insureds loss exposures.Cost-based pricingidentifies every variable unique to each insured.Use of some variables may be prohibited by state law.Actuarial EquitySocial equity involves two concepts:Pricing should relate to ability to pay.Factors beyond an insureds control should not affect premium.Social EquityMost losses are recognized, valued, and settled quickly (short-tail losses).Some losses take a long time to manifest, value, and settle (long-tail losses).The longer the tail, the greater the uncertainty in expected losses. TimingAn ideally insurable risk has six characteristics.Insurers use these characteristics to decide which risks to insure. Insurers select only those risks that meet most of the criteria.What Is an Ideally Insurable Risk?A large quantity of similar people or objects may be subject to a loss.Loss would be fortuitous.Loss would not be catastrophic to the insurer.Characteristics of Insurable RisksTime, location, and extent of a loss can be determined.The amount of an expected loss can be predicted.Covering the expected loss is economically feasible for the insurer.Characteristics of Insurable RisksInsurance products share several characteristics that distinguish them from other types of consumer products.Characteristics of the Insurance ProductThe insurance productLacks physical characteristicsIs more than the policy on paperRepresents a promise (to pay in the event of loss)IntangibilityAn insurance policy contains complicated terms and concepts.An insurance policy is a legal contract.Insureds and claimants may hire attorneys to resolve or clarify issues.Some issues may involve courts, regulators, or legislators.Complexity and Legal StatusProduct benefits become most apparent at time of loss.Insureds or claimants may be facing unpleasant circumstances.Heightened emotions may complicate transactions.Insurance CircumstancesLoss exposures with serious financial consequences typically require the purchase of insurance.Insurance as a Risk Management TechniqueRetentionAvoidanceControlPreventionReductionTransfer (including insurance)Risk Management TechniquesSome loss exposures have the potential to cause financial ruin.Others present minimal potential costs and can be safety retained.

Retaining Loss ExposuresCeasing or never undertaking an activity eliminates potential loss from that activity.Example: Not owning or driving an auto eliminates potential auto liability losses.Avoiding Loss ExposuresLoss prevention measures reduce the frequency of injuries. Loss reduction measures reduce the severity of fire losses. Controlling Loss ExposuresSome loss exposures are most effectively managed by transfer.The financial consequences of loss are borne by another party.Insurance is a common risk transfer technique.Transferring RiskThe fundamental purpose of insurance regulation is to protect the public as consumers and policyholdersWhy Insurance Operations Are RegulatedTo protect consumersTo maintain insurer solvencyTo prevent destructive competitionReasons for RegulationRegulating and standardizing insurance policies and productsControlling market conduct and preventing unfair trade practicesEnsuring that insurance is available and affordableConsumer ProtectionEnsure an insurers claim-paying abilityProtect the public interestSafeguard insurer-held fundsInsurer Solvency RegulationTo ensure the availability of insurance by controlling ratesInsurers, to compete, may lower rates.Intense competition can drive down rate levels across the market.Some insurers may become insolvent.An insurance shortage may result.Prevention of Destructive CompetitionInsurance is A risk management technique that involves transfer of risk to an insurance company A complex legal contractAffected by adverse selection, moral and morale hazard, actuarial and social equity, and timingRegulated to protect consumers and policyholders

Summary