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1 Basic notions of insurance
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Fortuitous loss is one that is unforseen and
unexpected by the insured and occurs as a
result of chance.
Loss must be accidental and occur randomly.
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Risk is defined as uncertainty concerning the
occurence of a loss.
Sometimes it is distinguished between
situations where the probabilities of possible
outcomes are known or can be estimated with
some degree of accuracy (risk) and situations
where such probabilities cannot be estimated
(uncertainty).
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LOSS
EXPOSURE
–
any
situation
or
circumstance in which a loss is possible,
regardless of whether a loss actually occurs.
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Objective risk (degree of risk) – the relative
variation of actual loss from expected loss.
Objective risk declines as the number of
exposure increases.
The law of large numbers.
The law of large numbers enables insurers to predict future loss
experience.
In probability theory, the law of large numbers is a theorem that
describes the result of performing the same experiment a large
number of times.
According to the law of large numbers, the average of the results
obtained from a large number of trials should be close to the
expected value, and will tend to become closer as more trials are
performed.
As the number of exposure units increases, the more closely the
actual loss experience will approach the expected loss
experience.
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Subjective risk (perceived risk) – uncertainty
based on a person’s mental condition or state
of mind.
The impact of subjective
depending on the individual.
risk
varies
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Chance of loss – the probability that an event
will occur; not to be mistaken with risk.
Objective probability refers to long-run
relative frequency of an event based on the
assumptions of an infinite number of
observations and of no change in underlying
conditions.
Subjective probability is the individual’s
personal estimate of the chance of loss.
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For most insurance lines it is impossible to
assess the true probability and severity of
loss. Therefore, estimates of both the average
frequency and the average magnitude of loss
must be based on previous loss experience.
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Peril is defined as the cause of loss.
e.g. fire, earthquake, flood, tornado, hail,
lightning, car accident, burglary, etc.
Hazard is a condition that creates or
increases the frequency or severity of loss. It
is a condition thet feeds the cause of loss.
There are four types of hazard which
contribute to the loss caused by perils that
are coverd under an insurance policy:
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Physical hazard
Moral hazard
Morale hazard (attitudinal hazard)
Legal hazard
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Physical hazard – physical condition that
increases the frequency or severity of loss.
Examples: broken stair step, worn tyres, wet
or icy road, defective wiring, defective lock,
lack of burglar alarm, inadequate fire
protection, etc.
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Moral hazard involves dishonest intent or
exposure to dishonest persons. It can be
defined as dishonesty or character defects in
an individual that increase the frequency or
severity of loss.
Examples: embezzlement, arson, faking an
accident, submitting a fraudulent claim,
inflating the amount of claim, etc.
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Morale (attitudinal) hazard is carelessess,
laziness or indifference to a loss, which
increases the frequency or severity of a loss.
Examples: leaving car keys in an unlocked
car, leaving a door unlocked, carlessness of a
driver, smoking where prohibited, removing
guards from machinery, not wearing safety
equipment, etc.
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Legal hazard refers to characteristics of the
legal system or regulatory environment that
increase the frequency or severity of loss.
These are the conditions brought about by
statute, judicial decision or administrative
regulation which create potential loss
exposure that has not existed before.
Examples: decision of public authority to
remove a certain product from a market, etc.
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Pure and speculative risk
Diversifiable risk and nondiversible risk
Enterprise risk
Systemic risk
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Pure risk – situation in which there are only
the possibilities of loss or no loss.
Speculative risk – situation in which either
profit or loss is possible.
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Diversifiable
risk
(nonsystematic
risk,
particular risk) is a risk that affects only
individuals or small groups and not the entire
economy. This risk can be reduced or
eliminated by diversification.
Nondiversifiable risk (fundamental risk) is a
risk that affects the entire economy or large
numbers of persons or groups within the
economy. It cannot be eliminated or reduced
by diversification.
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Enterprise risk is a term that encompasses all
major risks faced by a business firm. Such
risks include pure risk, speculative risk,
strategic risk, operational risk and financial
risk.
Systemic risk is the risk of collapse of an
entire system or entire market due to failure
of a single entity or group of entities that can
result in the breakdown of the entire financial
system.
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Personal risk
Property risk
Liability risk
Commercial risk
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Premature death
Poor health
Unemployment
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Risk of having property damaged, destroyed
or stolen.
Direct loss – financial loss that results from the
physical damage, destruction or theft of the property.
Indirect consequential loss – financial loss that results
indirectly from the occurance of a direct physical
damage or theft loss.
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In major law regimes you can be held legally
liable for your behaviour that results in bodily
injury or property damage to someone else.
 Special rules on professional misconduct (malpractice)
if you are a physician, attorney, accountant, etc.
 Special rules on liability on a defective product.
 No maximum upper limit on the amount of the loss.
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Property risks
Liability risks
Loss of business income
Identity theft
Cybersecurity
Other risks
Human resources exposures
Foreign loss exposures (especially foreign currency
operations)
Intangible property exposures (goodwill and IP rights)
Government exposures
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Risk control – techniques that reduce the
frequency or severity of losses (avoidance,
loss prevention, loss reduction).
Risk financing – techniques that provide for
the
funding
of
losses
(retention,
noninsurance transfers of risk, insurance).