Solutions Manual for Principles of Risk
Management and Insurance 13th Edition by
Rejda
, 9
Chapter 2
Insurance and Risk
Teaching Note
Three areas should be emphasized in teaching this chapter. First, the nature of insurance should be
discussed. Second, the requirements of an insurable risk should also be stressed. Mention that the
requirements of an insurable risk are ideal requirements and are seldom met completely in the real world.
Finally, show how insurance differs from both gambling and speculation.
The remaining material is descriptive and fairly easy to grasp. It is not necessary to discuss in detail the
various fields of insurance, other than to point out that the different fields of insurance are covered in
future chapters. Likewise, the social benefits of insurance are quickly grasped by students and may not
require a large amount of class time. However, it is worthwhile to spend some time on the less obvious
costs of insurance, such as moral and attitudinal (morale) hazard. Point out that moral hazard has
increased enormously in recent years, especially in the submission of fraudulent claims.
Outline
I. Meaning of Insurance
A. Definition of Insurance
B. Basic Characteristics of Insurance
1. Pooling of losses
2. Payment of fortuitous losses
3. Risk transfer
4. Indemnification
II. Requirements of an Ideally Insurable Risk
A. General Requirements
1. Large number of exposure units
2. Accidental and unintentional loss
3. Determinable and measurable loss
4. No catastrophic loss
5. Calculable chance of loss
6. Economically feasible premium B. Application of the Requirements
1. The risk of fire to a private dwelling satisfies the
requirements.
2. The risk of unemployment does not completely meet all
requirements. C. Adverse Selection and Insurance
1. Nature of adverse selection
Copyright © 2017 Pearson Education, Inc. All rights reserved.
, 2. Consequences of adverse selection
Copyright © 2017 Pearson Education, Inc. All rights reserved.
Full all chapters instant download please go to Solutions Manual, Test Bank site: downloadlink.org
Chapter 2 Insurance and Risk
III. Insurance and Gambling Compared
A. Insurance eliminates a pure risk, while gambling creates a new speculative risk.
B. Insurance is socially productive, while gambling is socially unproductive.
IV. Insurance and Hedging Compared
A. Insurance transfers a pure risk, while hedging involves the transfer of a speculative risk.
B. Moral hazard and adverse selection are more severe problems for insurers than for speculators who buy or sell futures
contracts.
V. Types of Insurance
A. Private Insurance
1. Life insurance
2. Health insurance
3. Property and liability insurance B. Government Insurance
1. Social insurance
2. Other government insurance programs
VI. Social Benefits and Costs of Insurance
A. Benefits of Insurance to Society
1. Indemnification for loss
2. Less worry and fear
3. Source of investment funds
4. Loss prevention
5. Enhancement of credit
B. Costs of Insurance to Society
1. Cost of doing business
2. Fraudulent claims
3. Inflated claims
Answers to Case Application
a. This is not insurance. Although the risk of a defective television set is transferred to the manufacturer, there is no pooling of losses
b. This is not insurance. Although the risk of defective tires for the first 50,000 miles is transferred to the manufacturer, there is no
pooling of losses.
c. This guarantee is not insurance. Although the risk of a defective home is transferred to the builder, there is no pooling of losses,
which is the essence of insurance. Any losses would fall directly on the builder.
d. This is not insurance. The risk of default has been transferred to the cosigner. If the debtor defaults, the cosigner must make the
payments. The loss would fall directly on the cosigner, and there is no pooling of losses.
, 11
e. The elements of insurance are present here. First, risk transfer is present; the homeowner transfers the risk of fire to the group.
Second, poolin
of losses is also present. Pooling is the essence of insurance.
Fire losses would be pooled over the entire group, and average loss is substituted for actual loss.
Third, fire losses generally are fortuitous. Finally, the homeowner would be indemnified for any los
10 Rejda/McNamara • Principles of Risk Management and Insurance, Thirteenth Edition
Answers to Review Questions
1. Insurance plans have four distinct characteristics:
(a) Pooling. Losses incurred by the few are spread over the entire group so that in the process, average loss is substituted for
actual loss.
(b) Fortuitous loss. Insurance plans provide for the payment of fortuitous losses. A fortuitous loss is one that is unforeseen and
unexpected and occurs as a result of chance.
(c) Risk transfer. In private insurance, a pure risk is transferred from the insured to the insurer, which is typically in a better
financial position to pay the loss than the insured.
(d) Indemnification. Compensation is given to the victim of a loss, in whole or in part, by payment, repair, or replacement.
2. The law of large numbers states that the greater the number of exposures, the more closely the actual results will approach the
probable results expected from an infinite number of exposures. As the number of exposures increases, the relative variation of
actual loss from expected loss will decline. Thus, the insurer can predict future losses with a greater degree of accuracy as the
number of exposures increases. This is important, since an actuary must charge a premium that is adequate for paying all losses
and expenses during the policy period. The lower the degree of objective risk, the more confidence an insurer has that the actual
premium charged will be sufficient to pay all claims and expenses and leave a margin for profit.
3. There are several requirements of an ideally insurable risk:
(a) There must be a large number of exposure units.
(b) The loss must be accidental and unintentional.
(c) The loss must be determinable and measurable.
(d) The loss should not be catastrophic.
(e) The chance of loss must be calculable.
(f) The premium must be economically feasible.
4. Insurers can deal with the problem of a catastrophe loss by (1) reinsurance, (2) avoiding the concentration of risk by dispersing
coverage over a large geographical area, and (3) use of certain financial instruments in the capital markets, such as catastrophe
bonds.
5. These risks are generally uninsurable for several reasons. First, many of these risks are speculative risks, which are difficult to
insure privately. Second, the potential for a catastrophic loss is great; this is particularly true for political risks, such as the risk o
war. Finally, calculation of the correct premium may be difficult because the chance of loss cannot be accurately estimated.
6. (a) Adverse selection is the tendency of persons with a higher-than-average chance of loss to seek insurance at standard (average
rates, which, if not controlled by underwriting, results in higherthan-expected loss levels.
(b) Adverse selection can be controlled by careful underwriting, by charging higher premiums to substandard applicants for
insurance, and by certain policy provisions.
7. Insurance differs from gambling in two ways. First, gambling creates a new speculative risk that did not exist before, while
insurance is a technique for handling an already existing pure risk. Second, gambling is socially unproductive, since the winner’
gain comes at the expense of the loser. Insurance is always socially productive, since both the insured and insurer win if the loss
does not occur.
Copyright © 2017 Pearson Education, Inc. All rights reserved.
Management and Insurance 13th Edition by
Rejda
, 9
Chapter 2
Insurance and Risk
Teaching Note
Three areas should be emphasized in teaching this chapter. First, the nature of insurance should be
discussed. Second, the requirements of an insurable risk should also be stressed. Mention that the
requirements of an insurable risk are ideal requirements and are seldom met completely in the real world.
Finally, show how insurance differs from both gambling and speculation.
The remaining material is descriptive and fairly easy to grasp. It is not necessary to discuss in detail the
various fields of insurance, other than to point out that the different fields of insurance are covered in
future chapters. Likewise, the social benefits of insurance are quickly grasped by students and may not
require a large amount of class time. However, it is worthwhile to spend some time on the less obvious
costs of insurance, such as moral and attitudinal (morale) hazard. Point out that moral hazard has
increased enormously in recent years, especially in the submission of fraudulent claims.
Outline
I. Meaning of Insurance
A. Definition of Insurance
B. Basic Characteristics of Insurance
1. Pooling of losses
2. Payment of fortuitous losses
3. Risk transfer
4. Indemnification
II. Requirements of an Ideally Insurable Risk
A. General Requirements
1. Large number of exposure units
2. Accidental and unintentional loss
3. Determinable and measurable loss
4. No catastrophic loss
5. Calculable chance of loss
6. Economically feasible premium B. Application of the Requirements
1. The risk of fire to a private dwelling satisfies the
requirements.
2. The risk of unemployment does not completely meet all
requirements. C. Adverse Selection and Insurance
1. Nature of adverse selection
Copyright © 2017 Pearson Education, Inc. All rights reserved.
, 2. Consequences of adverse selection
Copyright © 2017 Pearson Education, Inc. All rights reserved.
Full all chapters instant download please go to Solutions Manual, Test Bank site: downloadlink.org
Chapter 2 Insurance and Risk
III. Insurance and Gambling Compared
A. Insurance eliminates a pure risk, while gambling creates a new speculative risk.
B. Insurance is socially productive, while gambling is socially unproductive.
IV. Insurance and Hedging Compared
A. Insurance transfers a pure risk, while hedging involves the transfer of a speculative risk.
B. Moral hazard and adverse selection are more severe problems for insurers than for speculators who buy or sell futures
contracts.
V. Types of Insurance
A. Private Insurance
1. Life insurance
2. Health insurance
3. Property and liability insurance B. Government Insurance
1. Social insurance
2. Other government insurance programs
VI. Social Benefits and Costs of Insurance
A. Benefits of Insurance to Society
1. Indemnification for loss
2. Less worry and fear
3. Source of investment funds
4. Loss prevention
5. Enhancement of credit
B. Costs of Insurance to Society
1. Cost of doing business
2. Fraudulent claims
3. Inflated claims
Answers to Case Application
a. This is not insurance. Although the risk of a defective television set is transferred to the manufacturer, there is no pooling of losses
b. This is not insurance. Although the risk of defective tires for the first 50,000 miles is transferred to the manufacturer, there is no
pooling of losses.
c. This guarantee is not insurance. Although the risk of a defective home is transferred to the builder, there is no pooling of losses,
which is the essence of insurance. Any losses would fall directly on the builder.
d. This is not insurance. The risk of default has been transferred to the cosigner. If the debtor defaults, the cosigner must make the
payments. The loss would fall directly on the cosigner, and there is no pooling of losses.
, 11
e. The elements of insurance are present here. First, risk transfer is present; the homeowner transfers the risk of fire to the group.
Second, poolin
of losses is also present. Pooling is the essence of insurance.
Fire losses would be pooled over the entire group, and average loss is substituted for actual loss.
Third, fire losses generally are fortuitous. Finally, the homeowner would be indemnified for any los
10 Rejda/McNamara • Principles of Risk Management and Insurance, Thirteenth Edition
Answers to Review Questions
1. Insurance plans have four distinct characteristics:
(a) Pooling. Losses incurred by the few are spread over the entire group so that in the process, average loss is substituted for
actual loss.
(b) Fortuitous loss. Insurance plans provide for the payment of fortuitous losses. A fortuitous loss is one that is unforeseen and
unexpected and occurs as a result of chance.
(c) Risk transfer. In private insurance, a pure risk is transferred from the insured to the insurer, which is typically in a better
financial position to pay the loss than the insured.
(d) Indemnification. Compensation is given to the victim of a loss, in whole or in part, by payment, repair, or replacement.
2. The law of large numbers states that the greater the number of exposures, the more closely the actual results will approach the
probable results expected from an infinite number of exposures. As the number of exposures increases, the relative variation of
actual loss from expected loss will decline. Thus, the insurer can predict future losses with a greater degree of accuracy as the
number of exposures increases. This is important, since an actuary must charge a premium that is adequate for paying all losses
and expenses during the policy period. The lower the degree of objective risk, the more confidence an insurer has that the actual
premium charged will be sufficient to pay all claims and expenses and leave a margin for profit.
3. There are several requirements of an ideally insurable risk:
(a) There must be a large number of exposure units.
(b) The loss must be accidental and unintentional.
(c) The loss must be determinable and measurable.
(d) The loss should not be catastrophic.
(e) The chance of loss must be calculable.
(f) The premium must be economically feasible.
4. Insurers can deal with the problem of a catastrophe loss by (1) reinsurance, (2) avoiding the concentration of risk by dispersing
coverage over a large geographical area, and (3) use of certain financial instruments in the capital markets, such as catastrophe
bonds.
5. These risks are generally uninsurable for several reasons. First, many of these risks are speculative risks, which are difficult to
insure privately. Second, the potential for a catastrophic loss is great; this is particularly true for political risks, such as the risk o
war. Finally, calculation of the correct premium may be difficult because the chance of loss cannot be accurately estimated.
6. (a) Adverse selection is the tendency of persons with a higher-than-average chance of loss to seek insurance at standard (average
rates, which, if not controlled by underwriting, results in higherthan-expected loss levels.
(b) Adverse selection can be controlled by careful underwriting, by charging higher premiums to substandard applicants for
insurance, and by certain policy provisions.
7. Insurance differs from gambling in two ways. First, gambling creates a new speculative risk that did not exist before, while
insurance is a technique for handling an already existing pure risk. Second, gambling is socially unproductive, since the winner’
gain comes at the expense of the loser. Insurance is always socially productive, since both the insured and insurer win if the loss
does not occur.
Copyright © 2017 Pearson Education, Inc. All rights reserved.
