Insurance and Risk

1. Insurance and Risk 2nd Session By Abdullatif Alrasheed

2. I. Agenda • Definition • Basic Characteristics of Insurance • Requirements of an Insurable Risk

3. I. Meaning of Insurance • A. Definition of Insurance – There is no single definition of Insurance. • A working definition that captures the basic characteristics of a true insurance arrangement : • Insurance is the pooling of fortuitous losses by transfer of risks to insurers, who agree to indemnify insured for such losses

4. I. Meaning of Insurance • B. Basic Characteristics of Insurance There are certain common elements that are typically present in any Insurance Plan: • Pooling of Losses – Losses incurred by the few are spread over the entire group, so that in the process, average loss is substituted for actual loss. • Example: assume 1000 farmers agree to indemnify any loss that occures to any any farmer if his/her home get destroyed by a fire. Assume each house worth $200,000. in the absence of insurance, the maximum loss to each farmer is $200,000. However, by pooling the loss, it can be spread over the entire group,so the maximum loss each farmer must pay is 200$ ($200,000/1000) • Pooling implies 1- sharing of losses 2- prediction of future losses. • The law of large number can perate to provide a subsantially accurate preduction of future losses.

5. I. Meaning of Insurance The law of large number can perate to provide a subsantially accurate preduction of future losses. Payment of Fortuitous Losses – Fortuitous loss is unforeseen, unexpected, and occur as a result of chance. The lost must accidental. Insurance policies do not cover intentional losses. • Risk Transfer – In private Insurance, 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. • The final characteristic of insurance is Indemnification – Indemnification means that the insured is restored to his or her approximate position prior to the occurrence of the loss.

6. II. Requirements of an Insurable Risk There are six general requirements that must be fulfilled befire a pure risk can be insured: • Large number of exposure units – to predict the average loss, there should be a large group of roughly similar, but not necessarily identical. Ex: The purpose of this requirement is to enable the insurer to predict loss based on the law o large numbers. • Accidental and unintentional loss – Ideally, the loss should be fortuitous and outside the insured’s control. Thus if an individual deliberately causes a loss, he or she should not be indemnified for the loss. If Intentional losses are allowed > premiums will increase> could result in relatively fewer insured firms > which means not having a sufficient number of exposure units to predict future losses.

7. II. Requirements of an Insurable Risk 3. Loss should be Determinableand measureable loss – This means the loss should be definite as to cause, time, place and amount. Ex: Life insurance easy to measure and determine. Disability income policy is difficult to measure. Enable the insurer to determine if the loss is covered under the policy, and if it is covered, how much should be paid? 4- No catastrophic loss – This means that a large proportion of exposure units should not incur losses at the same time. Pooling is the essence of Insurance. Ex: catastrophic losses periodically result from floods, tornadoes, or eathquakes. One solution is to apply reinurance strategy. Another one is that insurance company should avoid conventration in one geographical area. Moreover, financial instruments can be used an insurance company to finance the losses

8. II. Requirements of an Insurable Risk • Calculable chance of loss – The Insurer must be able to calculate both the average frequency and the average severity of future losses with some degree of accuracy. This requirment enables insurance company to have a sufficient money to pay all claims and expenses and yield a profit. • Some losses are difficult to predict. For example, floods, wars, cyclical unemplyment. So, insurance company may need goverment assistance to predict these losses. • Economically feasible premium – The insured must be able to afford to pay the premium. In addition, for the Insurance to be an attractive purchase, the premiums paid must be substantially less than the face value, or amount, of the policy. For some types of risk such as political ,personal, and financial risk are difficult to estimate. For example, political risk such as the risk of a war. ------------------------------------------------------- * Look at the table on page 23 &24.

9. III. Description of Insurable and Uninsurable Risks These Risks are generally uninsurable for several reasons: 1. Many of these risks are speculative risks, which are very difficult to insure privately. 2. The potential for a catastrophic loss is great; this is particularly true for political risks, such as the risk of war. 3. Calculation of the proper premium may be difficult because the chance of loss cannot be accurately estimated.

10. Practical example • 1. Explain each of the following characteristics of a typical insurance plan. • Pooling of losses • Payment of fortuitous losses • Risk transfer • Indemnification • 2. Explain the law of large numbers? • 3. Certain requirement ideally should be fulfilled before a pure risk can be privately insured. Explain the six requirements of an insurable risk?

11. III. Gambling vs insurance A. How Insurance differs from Gambling 1-Gambling creates a new Speculative Risk that did not exist before, while Insurance is a technique for handling an already existing Pure Risk. 2- gambling is socially unproductive because the gain comes at the expense of the loser. In contrast, insurance is always socially productive. Both parties benifits if the loss does not occurs.

12. III. The types of insurance Major types of insurance can be classified as private or government insurance • Private Insurance • Life and Health insurance • Property and Liability insurance • Government Insurance • Social Insurance • Other Government Insurance

13. Types of insurance: private insurance • Life and Health insurance • Life insurancepays death benefits to beneficiaries when the insured dies (funeral expenses and are sometimes included in the benefits). Two main types: term and permanent coverage. • Health insurancecovers medical expenses because of sickness or injury • Disability planspay income benefits during a period disability

14. Property and Liability or casualty insurance • Property insuranceindemnifies property owners against the loss or damage of real or personal property caused by various perils (fire, lightning, windstorm or tornado) • Liability insurancecovers the insured’s legal liability arising out of property damage or bodily injury to others • Property and liability insurance is also called Property and Casualty insuranceIt is mainly liability coverage of an individual or organization for negligent acts or omissions.

15. Private insurance • Private insurance coverages can be grouped into two major categories • Personal lines • Coverages that insure the real estate and personal property of individuals and families or provide protection against legal liability • Commercial lines • Coverages for business firms, nonprofit organizations, and government agencies

16. Casualty insurance

17. Government Insurance: Social Insurance Programs: is a type of government insurance programme: • It is financed entirely or in large part by contributions from employers and/or employees or both. “It is a compulsory”. • Eligibility and benefits depends on the statute of the beneficiaries. • Benefits are heavily weighted in favor of low-income groups • Examples of social insurance: Social Security (old age, survivors, disability insurance), Unemployment, Workers Compensation, Medicare. Other Government Insurance Programs • In the US Found at both the federal and state level • Examples: Federal flood insurance, state health insurance pools, retirement.

18. Benefits of insurance to society • The major social and economic benefits of insurance include the following: • Indemnification for loss. This enables individuals to be restored to their former financial position • Reduction of worry and fear. • Source of investment funds. Premiums are collected in advance, so money can be lent to business firms.

19. Loss prevention: insurance companies actively involves in numerous loss prevention programs. Ex: - reduction of job-related injuries and disease -Prevention of auto thefts -Prevention of defective product that could injure the user • Enhancement of credit: makes barrower a better credit risk. In other words, this will give a greater assurance that the loan will be repaid.

20. Costs of insurance to society • Insurance also can be viewed as costs to the society. • Cost of doing business: insurance company consume large amount of resources for the company such as land, human resources, and administrative expenses. • Fraudulent claims: Ex: fake accidents, false heath care insurance. • Inflated claims: premiums must be increased to pay the additional loss.

21. Practical Examples • Private insurance provides numerous coverage that can be used to meet specific loss situations. For each of the following situations, identify a private insurance coverage that would provide the desired protection. • Emily, age 28, is a single parent with two dependent children. She wants to make certain that funds are available for her children's education if she dies before her youngest child finishes college. • Danielle, age 16, recently obtained her driver's license. Her parents want to make certain they are protected if Danielle negligently injuries another motorist while driving a family car.

22. Practical Examples • c. Jacob, age 30, is married with two dependents. He wants his income to continue if he becomes totally disabled and unable to work. • d. Tyler, age 35, recently purchased a house for $200, 000 that is located in an area where tornadoes frequency occur. He wants to make certain that funds are available if the house is damaged or destroyed in a tornado. • e. Nathan, age 40, owns an upscale furniture store. Nathan wants to be protected if a customers sues him for the bodily injury.

23. Fundamental Legal Principles 5th Session By MR Abdullatif Alrasheed

24. Fundamental Legal Principles • This chapter discusses the fundamental legal principles on which insurance contracts are based, legal requirements for a valid insurance contract, and legal characteristics of insurance contracts that distinghuish them from other types of contracts.

25. Fundamental Legal Principles • Agenda: • Principle of Indemnity • Principle of Insurable Interest • Principle of Subrogation • Principle of Utmost Good Faith

26. Principle of Indemnity The insurer agrees to pay no more than the actual amount of the loss • This has two purposes: • To prevent the insured from profiting from a loss. • To reduce moral hazard: if dishonest insured could profit from a loss, they might deliberately cause losses with intention of collecting he insurance.

27. Principle of Indemnity • In property insurance, the basic method for indemnifying the insured is based on the actual cash value of the property at the time of loss. • What is the actual cash value? • There are three main methods to determine actual cash value: • Replacement cost less depreciation: This means insurance company takes into account both inflation and depreciation of property values over time. -replacement cost: is the cost of restoring the damage - Depreciation is a reduction in the value of an asset over time,

28. Principle of Indemnity • ACV: what you would pay for a similar item at today’s cost minus depreciation. • Replacement cost: what you would pay for the item at today’s cost. • Depreciation: decrease in value due to wear and tear or age.

29. Assume Hamad paid $50,000 to purchase a house 5 years ago. The house has been depreciated with 50%. If Hamad’s house burns in a fire, the insurance company would pay to Hamad ( ……. ). Replacement cost – Depreciation= ….. Fair market value is the price a buyer would pay an seller in a free market. The fair market value is often below the replacement cost less depreciation * If a loss occurs, the fair market value may be more accurate on determining the value of the loss.

30. Broad evidence rulemeans that the determination of actual cash value should include all relevant factors an expert would use to determine the value of the property such as replacement cost less depreciation, fair market value, present value of the expected income, and the opinions of appraisers.

31. Principle of Indemnity • There are some exceptions to the principle of indemnity: • Valued policywhich is a policy that pays the face amount of insurance if a total loss occurs. In other words, pays a stated sum when loss occurs. They are used to insure antiques, fine arts, rare paintings and family heirlooms. This policy used due to the difficulty of determining the value of the property at the time of loss. • Replacement cost insurancethe insured can purchase this insurance if there is no deduction for depreciation in determining the amount paid for a loss.

32. Example • Your home and some fournishing were damaged during a recent fire.. Now you are looking at replacing the damaged fournishings. • Last year, you bought a sofa for your living room for $2000. The amount of money you will receive depend on the type of coverage you have. • If you have ACV coverage, the compagny might pay you $1500 because that is the ACV of the sofa today (Replacement cost minus depreciation) • If you have replacement cost coverage, the compagny will pay $2100 because that is what cost to buy a similar sofa today.

33. A life insurance contract is a valued policy that pays a stated sum to the beneficiary upon the insured’s death. This type is not contact of indemnity. Hence, the indemnity principle can’t be applied in life insurance.

34. Principle of Insurable Interest The insured must be in a position to lose financially if a covered loss occurs (not profiting from the insurance) . Ex: you have a insurable interest in your car because you may lose financially if the car is damaged or stole. Insurance contracts must be supported by insurable interest for the these reasons. • Purpose: • To prevent gambling (you can insure the property of another and hope for the loss to occur) • To reduce moral hazard (if an insurable interest were not required, a dishonest person could purchase a property insurance contract on someone else’s property and then deliberately cause a loss to receive the proceeds).

35. Principle of Insurable Interest • To measure the amount of loss. In property insurance, an insurable interest measures the amount of the insured’s loss. Most of the property insurance contracts are contract of indemnity. • When must insurable interest exist? • In property insurance: at the time of the loss. Otherwise the insured would incur financial loss. • Life insurance: only at beginning of the policy, not at the death. Life insurance isn’t a contract of indemnity but is a valued policy that pays a stated sum at the insured’s death.

36. Principle of Insurable Interest Substitution of the insurer in place of the insured for the purpose of claiming indemnity from a third person for a loss covered by insurance. • Purpose: • To prevent the insured from collecting twice for the same loss • To hold the negligent person responsible for the loss • To hold down insurance rates

37. Principle of subrogation Subrogation is the right for an insurer to pursue a third party that caused an insurance loss to the insured(investopedia,2015). • Ex: If a negligent guy smashes my car. If I have insurance, the insurance company will indemnifying me for example $2000. Then, the insurance company will pursue that guy to get the $2000. • Purpose: • To prevent the insured from collecting twice for the same loss • To hold the negligent person responsible for the loss not the insurance since the insurance will pursue the negligent person.

38. the Principle of subrogation General rules of the principle of subrogation • The insurer is entitledonly to the amount it has paid under the policy. • The insured cannot impair the insurer’s subrogation rights. • Subrogation does not apply to life insurance and to most individual health insurance contracts. • The insurer cannot subrogate against its own insured.

39. Principle of Utmost Good Faith In the Principle of Utmost Good Faith, a higher degree of honesty is imposed on both parties to an insurance contract than is imposed on parties to other contracts. Ex: ocean marine insurance is difficult to control it can’t be visually inspected every time the goods are shipping from a location to another. • Supported by three legal doctrines: • Representations are statements made by the applicant for insurance • A contract is voidable if the representation is material, false, and relied on by the insurer • An innocent misrepresentation of a material fact (unintentional), if relied on by the insurer, makes the contract voidable

40. Principle of Utmost Good Faith • A concealment is intentional failure of the applicant for insurance to reveal a material fact to the insurer. (Hiding information) • A warrantyis a statement that becomes part of the insurance contract and is guaranteed by the maker to be true in all respects • Statements made by applicants are considered representations, not warranties.

41. Requirements of an insurance contract 1- Offer and Acceptance: The applicant make the offer and the company choose to accept or reject. 2- Consideration: The value that each party gives to the other. Such as the amount of the premiums, promises by insurer to do certain things… 3- Legal purpose: The contract must be legal and moral.

42. Jake borrowed $ 800, 000 from the Gateway Bank to purchase a finishing boat. He keeps the boat at a dock owned by the Harbor Company. He uses the boat to earn income by fishing. Jake also has a contract with the White Shark Fishing Company to transport tuna from one port to another. • Do any of the following parties have an insurable interest in Jake or his property? If an insurable interest exists, explain the extent of the interest. • i. Gateway Bank • ii. Harbor Company • iii. White Shark Fishing Company • b. If Jake did not own the boat but operated it on behalf of the White Shark Fishing Company would he have an insurable interest in the Boat? Explain.

43. Ashley purchased a dinning room set for $ 5000 and insured the furniture on an actual cash value basis. • Three years later, the set was destroyed in a fire. At the time of loss, the property had depreciated in value by 50 percent. • The replacement cost of a new dinning room set at the time of loss was $ 6000. ignoring any deductible, how much will Ashley collect from her insurer? Explain your answer.

44. 3. Nicholas owns a laptop computer that was stolen. The laptop cost $ 2000 when it was purchased two years ago. A similar laptop computer today can be purchased for $1800. • Assuming that the laptop was 50 percent depreciated at time the theft occurred, what is the actual cash value of the loss?