Saturday, April 20, 2013

5 Basic Principles of Insurance. 2 Different Forms of Insurance.

Taking risks is one of the principal characteristics of enterprises. This concept is most valid for insurance companies whose main purpose is to assume risks that other economic entities do not wish to bear and whose principal factor of production is equalization of risks by forming a suitable portfolio of insured risks over time. These two characteristics make an insurance company a prototype risk bearer that other economic entities might use to learn the essentials of risk taking and use the information to their advantage.

It is worth noting that all insurance companies are large institutional investors. Premiums for all lines of insurance are usually necessarily paid in advance. For that reason it is desirable for insurance companies to invest premium funds until they are required to pay claims. However, investment is not the core business of insurance. Moreover, since safety is an important target, insurance companies are not comparable to other investors.

5 Basic Principles of Insurance

1. Distribution of Risk

Insurance is a financial agreement that redistributes the costs of unexpected loss. The insurer (insurance company) concludes contracts (risk transfers) with a large number of parties (insureds) and operates on the basis of the mathematical law of large numbers. This core technique aims at reducing variation, thus making expenses for compensation more calculable. Since insurance plays an important role in society, it operates under special laws that regulate access to the market, reporting, supervising and facilitating the business, for example, by allowing the building of reserves as other economic entities are allowed to do.
Insurance involves both pure and speculative risks. Pure risks present only a possibility of loss. The converse speculative risk may produce a gain or loss. The objection commonly raised against this distinction is that it has no definite zero point, that is, whether a result is considered a gain or loss may depend on a given situation. Thaler and Johnson (1990) found that gaining first and losing later during a visit to a casino is different from experiencing losses from the beginning of a gaming session, and both situations utilize different decision patterns.
Tversky and Kahneman (1981) elaborated a theoretical basis for this behavior and called it framing. For example, whether a glass is half full or half empty is a matter of view (frame). The prospect theory is built around the related concept of reference points that serve as a basis for the reasoning of a decision maker.
The insurance situation, however, is different . In the most basic case, both alternatives (paying a premium and bearing uncertain loss) are framed as negative deviations from a reference point. In other words, the analysis of insurance by distinguishing pure from speculative risks makes sense since there is general agreement on the position of the reference point.

2. Principles of Pricing

Risk transfer impacts insurance premiums. A premium consists of specific elements: (1) a net risk premium calculated on the basis of individual loss exposure, (2) a security loading to absorb variance, (3) a loading to cover costs that are not directly risk-related, (4) a profit margin, and (5) taxes.

3. Fair Premiums

An insurance premium is actuarially fair if based on individual expected loss. A premium calculated on this principle has advantages for insured and insurer, but it is not always feasible to develop actuarially fair premiums. The result may be over- or under-pricing relative to individual risk and the insurance pool may become less predictable (and consequentially more expensive if higher security loadings and reserves become necessary). Poor risk allocation (adverse selection) may even ruin insurance companies.
To explain the importance of an actuarially fair premium, the following example is widely used. Consider a market with two insurance companies and a large number of insurance buyers. Company A charges premiums based on individual expected loss. Company B charges an average premium based on collective expected loss. Let us assume that at the beginning, policyholders are randomly and evenly distributed between the two companies. At the end of each period, contracts must be renewed. Insurance buyers thinking that they pay more than their individually fair premium will switch to Company A. Since all A’s insurance contracts are calculated on the basis of individual loss exposure (the company’s portfolio is called structurally neutral), A is not negatively affected by the switch. Company B is affected because its remaining policyholders have relatively high loss expectations, forcing B to raise premiums to the new average. This procedure repeats itself at the end of each period. Ultimately Company B will leave the market or go bankrupt.
Taking the individual expected loss as a starting point for premium calculation has the additional merit that it can induce risk-reducing or risk-avoiding behavior on the part of the buyer. In fact, as a starting point of risk management, insurance companies rewarded the implementation of risk reduction or risk avoidance measures of policyholders by reducing premiums. It is obvious that such incentives work best when pricing is a matter of individual expected risk.
Another possibility to induce risk avoidance or reduction and reduce premiums is to cut off loss distribution at its lower end by agreeing upon deductibles. In practice, that means insureds pay their smaller losses. This technique again requires calculation of premiums on the basis of individual expected risk.
On the other hand, a complete transfer of risk from insured to insurance company is widely suspected to generate additional risk, usually referred to as “moral risk” that implies that a policyholder has a higher expected risk when he carries insurance against it. Although little empirical evidence indicates this interrelation, insurance companies try to counter such effect by including deductibles in their insurance agreements. It should be noted that this concept also applies to reinsurance contracts concluded between reinsurers and primary insurers, where (unlike other insurance contracts) both parties are highly knowledgeable about risk and risk transfer.

4. Security Loading

Security loading is intended to provide for the variations of losses inevitable in every portfolio. It can be shown (Karten, 1991) that without security loading, an insurance company will go bankrupt. The reason for this lies in so-called long tail risks that have very small probabilities and very high loss potentials. Security loadings can be replaced by reserves. A new insurance company would require higher security loadings than an insurance company that already has sufficient reserves.

5. Forms of Insurance

Different forms of insurance are often developed because full insurance (complete transfer of risk to insurer) is unfeasible. One reason is that complete transfer may result in unintended consequences. Another is that premiums for full transfers are often prohibitively high. Therefore, the parties try to find a more suitable solution. Different forms of insurance vary the amounts of risk transfer and risk premium as a solution to the problem.
Full insurance—As noted, full insurance means a complete transfer of a risk to an insurer. A contract can include deductibles that limit the insurer’s liability for low and moderate size risks. The result of deductibles, of course, is not a complete risk transfer.
Limited transfer of risk—By setting a maximum sum insured, risk transfer is modified at its upper limit, that is, for large, improbable risks. Basically, the two common forms are used. The first is agreement on a specific sum of money for indemnification. No matter how large a loss actually is, the insurance company will pay only the specific sum in compensation. Settlement of damages is easy and therefore economical, resulting in a reduction in premium. The second type of contract compares an incurred loss to the sum insured and indemnification is calculated proportionally.

The author of the aboved writing:  Maximillian Edelbacher



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