1. Insurance and Its Functions
Lecture Three：
Insurance and Its Functions

2. Learning objectives
Defining insurance and explain the basic characteristics of insurance
Explain the law of large numbers
Describe the requirements of an insurable risk
Describe the major types of insurance
Explain the functions of insurance

3. Main Contents Definition of insurance
Basic characteristics of insurance
Insurable risk
Adverse selection and insurance
Insurance and gambling
Types of insurance
Insurance functions

4. Insurance – what is it?

5. Definition of insurance
There is no single definition of insurance.
Insurance can be defined from the viewpoint of several disciplines, including law, economics, history, actuarial science, risk theory, and sociology.

6. Definition of insurance
Different definitions given by scholars
from both abroad and home

7. Financial definition
Insurance is a financial arrangement that redistributes the costs of unexpected losses. Insurance involves the transfer of potential losses to an insurance pool, the pool combines all the potential losses and then transfers the cost of the predicted losses back to those exposed. Thus, insurance involves the transfer of loss exposures to an insurance pool, and redistribution of losses among the members of the pool---by Mark S. Dorfman

8. Financial Definition (Page 16 of textbook)
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.

9. Legal definition
Insurance is a contractual arrangement whereby one party agrees to compensation another party for losses. We call the party agreeing to pay for the losses the insurer, call the party whose loss causes the insurer to make a claims payment the insured. We call the payment the insurer receives a premium, call the insurance contract a policy. Call the insured’s possibility of loss the insured’s exposure to loss.

10. 我国《保险法》（2002年10月28）第二条：本法所称保险，是指投保人根据合同约定，向保险人支付保险费，保险人对于合同约定的可能发生的事故因其发生所造成的财产损失承担赔偿保险金责任，或者当被保险人死亡，伤残、疾病或者达到合同约定的年龄、期限时承担给付保险金责任的商业保险行为。

11. Basic characteristics of insurance
An insurance plan or arrangement typically has certain characteristics. They include the following:
Pooling of losses
Payment of fortuitous losses
Risk transfer
Indemnification

12. Pooling of losses Pooling or sharing losses is the heart of insurance.
Pooling is the spreading of losses incurred by the few over the entire group, so that in the process, average loss is substituted for actual loss.

13. Pooling of losses Pooling implies:
the grouping of a large number of exposure units, so that the law of large numbers can operate to provide a substantially accurate prediction of future losses.
The sharing of losses by the entire group

14. Pooling of losses The Law of Large numbers
it states that the greater the number of exposure, the more closely will the actual results that are expected from an infinite number of exposures.
The insurer can predict future losses with a greater degree of accuracy as the number of exposures increases.
(explains it by examples)

15. For most insurance lines, estimates of both average frequency and the average severity of loss must be based on previous loss experiences
The insurer must charge a premium that will be adequate for paying all losses and expenses during the policy period.

16. Payment of fortuitous losses
A fortuitous loss is one that is unforeseen and unexpected and occurs as a result of chance.
That’s the loss must be accidental.
Insurance policies do not cover intentional losses.

17. Risk transfer
Risk transfer means that 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.

18. Risk transfer
Pure risk that typically transferred to insurers includes:
Premature death
Poor health
Disability
Destruction and theft of property
Liability lawsuits

19. Indemnification
Indemnification means that the insured is restored to his or her approximate financial position prior to the occurrence of the loss

20. Insurable Risk —what kinds of risks are insurable for a private insurer?

21. six requirements of Insurable risk
Insurers normally insure only pure risks. However, not all pure risks are insurable.
From the viewpoint of the insurer, there are ideally six requirements of an insurable risk:

22. six requirements of Insurable risk
There must be a larger number of exposure units;
The loss must be accidental and unintentional;
The loss must be determinable and measurable;
The loss should not be catastrophic;
The chance of loss must be calculable;
The premium must be economically feasible.

23. large number of exposure units
There should be a large group of roughly similar, but not necessarily identical, exposure units that are subject to the same peril or group of perils. (examples)
The purpose is to enable the insurer to predict loss based on the law of large numbers.
The loss costs can be spread over all insureds.

24. Accidental and Unintentional Loss
the loss should be accidental and unintentional
the loss should be fortuitous and outside the insured’s control
If an individual deliberately causes a loss, he or she should not be indemnified for the loss

25. Determinable and measurable loss
The loss should be both determinable and measurable.
It means the loss should be definite as to cause, time, place, and amount.
The purpose is to enable an insurer to determine if the loss is covered under the policy, and how much should be paid.

26. No catastrophic loss The loss should not be catastrophic
It means that a large proportion of exposure units should not incur losses at the same time
Otherwise, the insurance pooling would break down and become unworkable.

27. Calculable chance of loss
The chance of loss should be calculable .
The insurers must be able to calculate both the average frequency and the average severity of future losses with some accuracy.
This requirement is necessary so that the premium can be charged and sufficient to pay all claims and expenses and yield profit.

28. Economically feasible premium
The premium should be economically feasible.
The insured must be able to afford to pay the premium;
Low premium is attractive and competitive in market;
To have an economically feasible premium, the chance of loss must be relatively low.

29. Risk—insurable or non-insurable?
personal risks, property risks, and liability risks can be privately insured.
most market risks, financial risks, production risks, and political risks are usually uninsurable by private insurers. The reasons are:
First, being speculative, and difficulty to insure privately;
Second, a great potential to cause catastrophic loss;
Finally, calculation of premium is difficult.

30. Adverse selection and insurance
Adverse selection is the tendency of persons with a higher-than-average chance of loss to seek insurance at standard (average) rate, which if not controlled by underwriting, results in higher-than-expected loss levels. (Examples) .
There are some ways to control adverse selection:
careful underwriting; (Examples)
policy provisions (Examples：waiting period, suicide clause)

31. Insurance Versus Gambling
Insurance is often confused with gambling. Actually they are quite different from the following viewpoints:
Gambling creates a new speculative risk, while insurance is a technique for handling an already existing pure risk. (examples)
gambling is socially unproductive, while insurance is always socially productive.
Gambling is illegal in China.

32. Ideal Requisites Examples (Page 20-21 of text)
Examples 1: Risk of fire as insurable risk
Examples 2: Risk of unemployment as insurable risk
A. Large Number of Similar Exposure Units
B. Accidental and unintentional loss
C. Determinable and measurable loss
D. No catastrophic loss
E. Calculable chance of losses
F. Economically feasible premium

33. Types of Insurance

34. Types of Insurance Insurance can be classified as various types:
Personal or Commercial
Life-Health or Property-Liability
Private or Government
Voluntary or Involuntary

35. Types of Insurance
Insurance can be classified as either private or government insurance
private insurance
Life insurance, health insurance, property insurance and liability insurance
government insurance
Social insurance
Other government insurance

36. Private insurance Life and health insurance
Property and liability insurance:
Fire and insurance and allied lines.
Marine insurance :
ocean marine
inland marine
casualty insurance:
automobile insurance
general liability insurance
burglary and theft insurance
workers compensation insurance
glass insurance
boiler and machinery insurance
nuclear insurance
crop-hail insurance
health insurance
other miscellaneous lines
Multiple-line insurance
Fidelity and surety bonds

37. Government insurance
Government insurance can be divided into social insurance programs and other government insurance programs：
social insurance: (in the U.S)
Old-age, survivors, and disability insurance( social security)
Medicare
Unemployment insurance
Workers compensation
Compulsory temporary disability insurance
Railroad Retirement Act
Railroad Unemployment Insurance Act
Other government insurance programs (in the U.S.)

38. Social insurance programs in China
Pension system
Urban Employee Health Insurance
New Rural Co-operative Medical System
Unemployment insurance
Other social insurance programs

39. Insurance functions

40. Insurance functions Various argues on the functions of insurance:
Unique function: Indemnification for loss
Fundamental functions: spreading risks and
indemnification for loss
Multi-function: besides the fundamental functions, there more other function as pooling funds, deposit, etc.

41. Insurance functions Basic functions: dispersing risk indemnifying loss
Derived functions:
pooling funds
risk-supervising

42. Insurance functions in national economy
Insurance in micro-economy
Help the disaster companies by compensating loss
Emphasize financial budget
Emphasize risk management
Insurance in macro-economy
Ensure the operation of social production
Promote import and export

43. Benefits of insurance to society
The major social and economic benefits of insurance include the following:
indemnification for loss
less worry and fear
source of investment funds
loss prevention
enhancement of credit

44. Costs of insurance to society
Although the insurance industry provides enormous social and economic benefits to society, the social costs of insurance should also be recognized.
The major social costs of insurance include the following:
cost of doing business
fraudulent claims
inflated claims

45. Summary
There is no single definition of insurance. However, a typical insurance plan contains four elements:
pooling
payment of fortuitous losses
risk transfer
indemnification
There are several ideal requirements of an insurable risks:
There must be a larger number of exposure units;
The loss must be accidental and unintentional;
The loss must be determinable and measurable;

46. Insurance is not the same as gambling
The loss should not be catastrophic;
The chance of loss must be calculable;
The premium must be economically feasible
Insurance is not the same as gambling
Insurance can be classified into private and government insurance
Insurance plays important functions in national economy
Insurance brings both benefits and costs to society. But we benefit a lot from it.

47. Review questions
Explain the major characteristics of a typical insurance plan
Why is the pooling technique essential to insurance?
Explain the law of large numbers and show how the law can be used by an insurance to estimate future losses
Explain the major requirements of an insurable risk
Why most market risks, financial risks, production risks, and political risks considered to be uninsurable by private insurers? ?
Identify the major fields of private and government insurance in China
Explain the insurance functions, and how insurance is beneficial to society and what kind of costs does bring to society?