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Risk Management and Insurance Principles, Rejda G. and M. McNamara, 13th ed.
 Law of Large Numbers (Chapter 2)

Spreading losses incurred by

the few over the entire A fortuitous loss is one that is
group unforeseen, unexpected, and
occur as a result of chance.

Insurance is the pooling of fortuitous losses by

transfer of such risks to insurers, who agree to
indemnify insureds for such losses, to provide
other pecuniary benefits on their occurrence, or
to render services connected with the risk.

Risk transfer
A pure risk is transferred Indemnification
from the insured to the The insured is restored to his or her
insurer, who typically is in approximate financial position prior to the
a stronger financial occurrence of the loss.
position.
 A large number of similar but not
necessarily identical exposure units are
subject to perils

Pooling involves the grouping of a large number

of exposure units so the law of large numbers
can operate to provide a substantially accurate
prediction of future losses.
➢ Large number of exposure units to predict average loss

➢ Accidental and unintentional loss

• to control moral hazard
• to assure randomness

➢ Determinable and measurable loss:

to facilitate loss adjustment insurer must be able to determine if the loss is
covered and if so, how much should be paid.

➢ No catastrophic loss
to allow the pooling technique to work exposures to catastrophic loss can be
managed by:
• dispersing coverage over a large geographic area
• using reinsurance
• catastrophe bonds
➢ Large number of exposure units to predict average loss

➢ Accidental and unintentional loss

• to control moral hazard
• to assure randomness

➢ Determinable and measurable loss:

to facilitate loss adjustment insurer must be able to determine if the loss is
covered and if so, how much should be paid.
➢ Calculable chance of loss to establish an adequate premium

➢ Economically feasible premium

• so people can afford to buy
• Premium must be substantially less than the face value of the policy

Based on these requirements:

➢ Most personal, property and liability risks
can be insured.
➢ Market risks, financial risks, production risks
and political risks are difficult to insure
 Insurance Hedging
• Risk is transferred by a • Risk is transferred by a
contract contract
• Involves the transfer of pure • Involves risks that are
(insurable) risks typically uninsurable
• Moral hazard and adverse • Fewer problems of moral
selection are more severe hazard and adverse
problems for insurers selection for entities who
buy or sell futures contracts
• Rating and Ratemaking
• Underwriting
• Production
• Claims settlement
• Reinsurance
• Alternatives to Traditional Reinsurance
• Investments
• Other Insurance Company Functions
Ratemaking refers to the pricing of insurance and the calculation of insurance premiums.

• A rate is the price per unit of insurance

• An exposure unit is the unit of measurement used in insurance pricing

Total premiums charged must be adequate for paying all claims and expenses during
the policy period.
Rates and premiums are determined by an actuary, using the company’s past loss
experience and industry statistics.
Actuaries also determine the adequacy of loss reserves, allocate expenses, and
compile statistics for company management and state regulatory officials.
Underwriting refers to the process of selecting, classifying, and pricing applicants for
insurance.

A statement of underwriting policy establishes policies that are consistent with the
company’s objectives.

The underwriting policy is stated in an underwriting guide, which specifies:

• Acceptable, borderline, and prohibited classes of business
• Amounts of insurance that can be written
• Territories to be developed
• Forms and rating plans to be used
• Business that requires approval by a senior underwriter
The basic principles of underwriting include:

➢ Attain an underwriting profit

➢ Select prospective insureds according to the company’s underwriting

standards
• Reduce adverse selection against the insurer
• Adverse selection is the tendency of people with a higher-than-
average chance of loss to seek insurance at standard rates. If not
controlled by underwriting, this will result in higher-than-expected
loss levels.

➢ Provide equity among the policyholders

One group of policyholders should not unduly subsidize another group
Underwriting starts with the agent
Information for underwriting comes from:
• The application
• The agent’s report
• An inspection report
• Physical inspection
• A physical examination and attending physician’s report
• MIB report

After reviewing the information, the underwriter can:

• Accept the application and recommend that the policy be issued
• Accept the application subject to restrictions or modifications
• Reject the application
Many insurers now use computerized underwriting for certain personal
lines of insurance that can be standardized

Other factors considered in underwriting include:

• Rate adequacy
• Availability of reinsurance
• Whether a policy can or should be cancelled or renewed
Production refers to the sales and marketing activities of insurers
• Agents are often referred to as producers
• Life insurers have an agency or sales department
• Property and liability insurers have marketing departments

The marketing of insurance has been characterized by a trend toward

professionalism
➢ An agent should be a competent professional with a high degree of
technical knowledge in a particular area of insurance and who also
places the needs of his or her clients first

Several organizations have developed professional designation programs for

insurance personnel:
▪ The American College: CLU, ChFC
▪ The American Institute for Chartered Property and Casualty Underwriters:
CPCU
▪ Certified Financial Planner Board of Standards, Inc.: CFP
▪ National Alliance for Insurance Education & Research: CIC
The objectives of claims settlement include:
• Verification of a covered loss
• Fair and prompt payment of claims
• Provide personal assistance to the insured
Some laws prohibit unfair claims practices, such as:
• Refusing to pay claims without conducting a reasonable investigation
• Not attempting to provide prompt, fair, and equitable settlements
• Offering lower settlements to compel insureds to institute lawsuits to
recover amounts due
Major types of claims adjustors include:
• An insurance agent often has authority to settle small first-party claims up to
some limit
• A staff claims representative is usually a salaried employee who will investigate
a claim, determine the amount of loss, and arrange for payment.
• An independent adjustor is an organization or individual that adjusts claims for
a fee
• A public adjustor represents the insured and is paid a fee based on the amount
of the claim settlement
The claim process begins with a notice of loss, typically immediately or as soon as
possible after a loss has occurred.

Next, the claim is investigated:

An adjustor must determine that a covered loss has occurred and determine the
amount of the loss

The adjustor may require a proof of loss before the claim is paid

The adjustor decides if the claim should be paid or denied.

Policy provisions address how disputes may be resolved.
Reinsurance is an arrangement by which the primary insurer that initially
writes the insurance transfers to another insurer part or all of the potential
losses associated with such insurance

• The primary insurer is the ceding company

• The insurer that accepts the insurance from the ceding company
is the reinsurer
• The retention limit is the amount of insurance retained by the
ceding company
• The amount of insurance ceded to the reinsurer is known as a
cession
• Retrocession is when a reinsurer insures part or all of a risk with
another insurer
Reinsurance is used to:
➢ Increase underwriting capacity

➢ Stabilize profits

➢ Reduce the unearned premium reserve, which represents the unearned

portion of gross premiums on all outstanding policies at the time of valuation

➢ Provide protection against a catastrophic loss

➢ Retire from business or from a line of insurance or territory

➢ Obtain underwriting advice on a line for which the insurer has little experience
The Ten Most Costly Catastrophes in the US ($ millions)
There are two principal forms of reinsurance:

Facultative reinsurance is an optional, case-by-

case method that is used when the ceding
company receives an application for insurance
that exceeds its retention limit.
Often used when the primary insurer has an
application for a large amount of insurance.

Treaty reinsurance means the primary insurer

has agreed to cede insurance to the reinsurer,
and the reinsurer has agreed to accept the
business.
All business that falls within the scope of the
agreement is automatically reinsured
according to the terms of the treaty.
There are two basic methods for sharing losses:
1) Under the Pro rata method, the ceding company and reinsurer agree to
share losses and premiums based on some proportion
2) Under the Excess method, the reinsurer pays only when covered losses
exceed a certain level
➢ surplus-share treaty
➢ excess-of-loss treaty

1) Under a quota-share treaty, the ceding insurer and the reinsurer agree to share
premiums and losses based on some proportion.
Example:
Assume that Apex Fire Insurance and Geneva Re enter into a quota-share
arrangement by which losses and premiums are shared 50-50.

If a $100,000 loss occurs, Apex Fire pays $100,000 to the insured but is reimbursed
by Geneva Re for $50,000.
2) Under a surplus-share treaty, the reinsurer agrees to accept insurance in excess
of the ceding insurer’s retention limit, up to some maximum amount
Example:
Assume that Apex Fire Insurance has a retention limit of $200,000 (called a line)
for a single policy, and that four lines, or $800,000, are ceded to Geneva Re.
Assume that a $500,000 property insurance policy is issued. Apex Fire takes the
first $200,000 of insurance, or two-fifths, and Geneva Re takes the remaining
$300,000, or three-fifths.
Apex Fire $200,000 (1 line)
Geneva Re $800,000 (4 lines)
Total Underwriting Capacity $1,000,000
$500,000 policy issued
Apex Fire $200,000 (2/5)
Geneva Re $300,000 (3/5)
If a $5000 loss occurs: $5000 loss occurs
Apex Fire $2000 (2/5)
Geneva Re $3000 (3/5)
An excess-of-loss treaty is designed for protection against a catastrophic loss.
A treaty can be written to cover a single exposure, a single occurrence, or excess
losses
Example:
Apex Fire Insurance wants protection for all windstorm losses in excess of $1 million.
Assume Apex enters into an excess-of-loss arrangement with Franklin Re to cover
single occurrences during a specified time period. Franklin Re agrees to pay all losses
exceeding $1 million but only to a maximum of $10 million.
If a $5 million hurricane loss occurs, Franklin Re would pay $4 million.
A reinsurance pool is an organization of insurers that underwrites insurance on
a joint basis

Reinsurance pools work in two ways:

• Each pool member agrees to pay a certain percentage of every loss.

• Each pool member pays for his or her share of losses below a certain
amount; losses exceeding that amount are then shared by all members
in the pool.
 Some insurers use the capital markets as an alternative to traditional
reinsurance.

Securitization of risk means that an insurable

risk is transferred to the capital markets
through the creation of a financial instrument,
such as a catastrophe bond or futures contract

Catastrophe bonds (CAT) are corporate bonds that

permit the issuer of the bond to skip or reduce the
interest payments if a catastrophic loss occurs.
Catastrophe bonds are growing in importance and are
now considered by many to be a standard supplement to
traditional reinsurance.
• Because premiums are paid in advance, they can be invested until needed to
pay claims and expenses

• Investment income is extremely important in reducing the cost of insurance

to policy owners and offsetting unfavorable underwriting experience

• Life insurance contracts are long-term; thus, safety of principal is a primary

consideration

• In contrast to life insurance, property insurance contracts are short-term in

nature, and claim payments can vary widely depending on catastrophic
losses, inflation, medical costs, etc