1 Basic notions of insurance INSURANCE LAW 1 Basic notions of insurance

Payment of fortuitous losses 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.

WHAT IS RISK? 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).

LOSS EXPOSURE LOSS EXPOSURE – any situation or circumstance in which a loss is possible, regardless of whether a loss actually occurs.

OBJECTIVE RISK 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 the 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.

SUBJECTIVE RISK Subjective risk (perceived risk) – uncertainty based on a person’s mental condition or state of mind. The impact of subjective risk varies depending on the individual.

CHANCE OF LOSS 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.

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.

PERIL & HAZARD 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.

TYPES OD HAZARD Physical hazard Moral hazard There are four types of hazard which contribute to the loss caused by perils that are coverd under an insurance policy: Physical hazard Moral hazard Morale hazard (attitudinal hazard) Legal hazard

PHYSICAL HAZARD 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.

MORAL HAZARD 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.

MORALE (ATTITUDINAL)HAZARD 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.

LEGAL HAZARD 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.

CLASSIFICATIONS OF RISK Pure and speculative risk Diversifiable risk and nondiversible risk Enterprise risk Systemic risk

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.

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.

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.

Personal risk Property risk Liability risk Commercial risk

PERSONAL RISK Premature death Poor health Unemployment

PROPERTY RISK 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.

LIABILITY RISK 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.

COMMERCIAL RISKS 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

RISK MANAGEMENT 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).