Page 36 - DCOM309_INSURANCE_LAWS_AND_PRACTICES

Unit 2: Risk and Insurance

Notes
Example: Two accountants who are insured under separate disability-income contracts
may be injured in an auto accident, and both may be classified as totally disabled. One accountant,
however, may be stronger willed and more determined to return to work. If that accountant
undergoes rehabilitation and returns to work, the disability-income benefits will terminate.
Meanwhile, other accountant would still continue to receive disability income benefits according
to the terms of the policy. In short, it is difficult to determine when a person is actually disabled.
However, all losses ideally should be both determinable and measurable.
4. The Loss should not be Catastrophic: This means that a large proportion of exposure units
should not incur losses at the same time. As we stated earlier, pooling is the essence of
insurance. If most or all of the exposure units in a certain class simultaneously incur a loss,
then the pooling technique breaks down and becomes unworkable. Premiums must be
increased to prohibitive levels, and the insurance technique is no longer a viable
arrangement by which losses of the few are spread over the entire group.
Insurers ideally wish to avoid all catastrophic losses. In the real world, this is impossible,
because catastrophic losses periodically result from floods, hurricanes, tornadoes,
earthquakes, forest fires, and other natural disasters. Fortunately, several approaches are
available for meeting the problem of a catastrophic loss.
Firstly, reinsurance can be used by which insurance companies are indemnified by reinsurer
for catastrophic losses. Reinsurance is the shifting of part or all of the insurance originally
written by one insurer to another insurer. The reinsurer is then responsible for the payment
of its share of the loss.
Secondly, insurers can avoid the concentration of risk by dispersing their coverage over a
large geographical area. The concentration of loss exposures in a geographical area exposed
to frequent floods, tornadoes, hurricanes, or other natural disasters can result in periodic
catastrophic losses. If the loss exposures are geographically dispersed (isolated), the
possibility of a catastrophic loss is reduced.
Finally, new financial instruments are now available for dealing with catastrophic losses.
These instruments include catastrophic bonds and options sold on the Chicago board of
trade.
5. Calculable Chance of Loss: Another important requirement is that the chance of loss
should be calculable. The insurer 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 a proper premium can be charged that is sufficient to pay all claims and expenses and
yield a profit during the policy period.
Certain losses, however, are difficult to insure because the chance of loss cannot be accurately
estimated, and the potential for a catastrophic loss is present. For example, floods, wars,
and cyclical unemployment occur on an irregular basis, and prediction of the average
frequency and the severity of losses are difficult. Thus, without government assistance,
these losses are difficult for private carriers to insure.
6. Economically Feasible Premium: A final requirement is that the premium should be
economically feasible. The insured must be able to afford to pay the premium. In addition,
for the insurance to be an attractive purchase, the premiums paid must be substantially
less than the face value, or amount, of the policy.

Notes To have an economically feasible premium, the chance of loss must be relatively
low.

LOVELY PROFESSIONAL UNIVERSITY 31