A mature student friend of ours was struggling with his first year accountancy exams when asked to write an essay on the following, so he thought he’d approach us for some answers and help writing his assignment.

1.Explain how Insurance shares risk across the population?
2.What is a fair insurance premium?
3.How can adverse selection prevent Insurance being available at a fair premium?
4.What strategies do insurance companies follow to reduce the problem of adverse selection?

So we farmed it out to our technical expert Dave Healey and this is what he came up with.

The Primary Functions Of Insurance As A Service Industry

By Dave Healey

There are three primary functions of Insurance which determine how Insurance companies operate and how the public interacts with these companies.

The first is as a risk transfer mechanism, whereby the individual or business can shift some of the uncertainty of life onto the shoulders of others. In return for a known premium, usually a very small amount compared to the potential loss, the cost of that loss can be transferred to an insurance company. Without Insurance there would be a great deal of uncertainty experienced by both the individual and the enterprise, not only as to how and whether a loss would occur, but also to the extent and size of the potential loss.

The second primary function is the establishment of the common pool. The Insured’s premium is received by the Insurer into a fund or pool for that type of risk, and the claims of those suffering losses are paid out this pool. Applying Bernoulli’s ‘Law of Large Numbers’, because of the large number of clients that any particular risk fund or pool will have, Insurance companies can predict with high accuracy the amount of claims or losses that might be suffered over a period of time. The will be some variations in losses over different years and Insurance companies include an element of premium to build up a reserve, to pay for additional losses in bad or catastrophic years. Therefore in principle, subject to the limitations of the type of cover bought, the client should not have to pay additional premiums into the common fund after a loss or claim.

The third primary function of Insurance is to provide fair and equitable premiums. Assuming that a risk transfer mechanism has been set up through a common fund or pool, the contributions paid into the fund should be fair to all parties participating. Each party wishing to insure and paying into the fund will bring with it varying degrees of risk. To avoid adverse selection and provide equitable premiums each risk is broken down into various components and rating factors that can be priced individually on a statistical scale of probability determined by Actuaries. Therefore those who present the greater statistical risk will pay more into the common fund for the same cover, when their individual premiums are calculated.

Insurance companies employ underwriters to reduce the problem of adverse selection and protect the fund. The underwriters will determine parameters of the hazard and value of a risk that is acceptable for the fund, and decline risks that fall outside these parameters. In fixing a fair level of premium they must also take into account the contributions made by others into the common fund and price accordingly.

Underwriters and insurance companies will employ many techniques to deter or price adverse selection out of the risk pool. These typically include exclusions to cover in the form of policy wordings and additional conditional clauses, exempting the risk under certain conditions. They will employ all types of mechanisms and devices to install fear into the population to increase the size of the risk pool and attract the niche or sector of the market that they are aiming for. For example large marketing campaigns aimed at the ‘safe’ sector e.g. women drivers who are statistically less likely to claim. On the Internet, Insurance companies employ automated underwriting that excludes cover to everything that does not fit the desired risk pool parameters.

Ultimately the Government can in certain cases decide the size of the risk pool through leglislation and compulsory insurance as is the case for car insurance where it is illegal to drive without cover and business insurance where it is illegal to trade without liability insurance cover.

Insurance companies can also take further risk transfer from the insurer to a reinsurer (reinsurance) laying of some of their exposure as a mechanism for adverse risk control.

We originally published the Article at: http://EzineArticles.com/?expert=Dave_Healey

http://EzineArticles.com/?The-Primary-Functions-Of-Insurance-As-A-Service-Industry&id=6292397

Well there’s obviously a lot more to write on this subject so if some of you FCII fellows out there who read this blog  wish to contribute, feel free to leave your comments on the questions!

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however , a report released this week from Aon Benfield’s Impact forecasting team has predicted that the cost of recent natural disasters is likely to cost both the reinsurance and insurance sector billions.

The capital advisory unit provided the damning verdict in the latest edition of its Monthly Cat Recap report its regular analysis of worldwide catastrophic events. A combination of the Chilean earthquake, Windstorm Xynthia and savage winter conditions across the US and Europe in February has left many in the industry feeling the financial impact.

The magnitude 8.8 earthquake in Chile, the seventh strongest earthquake ever record, has devastated the South American country and has taken the life of at least 795 people. The tragic disaster follows only weeks on from the horrific Haiti earthquake disaster which has sadly now claimed over 200,000 lives.

However, it is the impact of the Chilean earthquake which may effect the tentative recovery of the global economy as the country has far more exposure to risk than the poverty stricken Caribbean island. With more than 1.5 million homes, buildings and other structures affected insured losses alone are set to be in single figure billions of dollars whilst the economic losses are expected to reach tens of billions of dollars. (USD)

There was further suffering in South America with flooding across four regions of Bolivia killing 15 people and more than 100,000 people having to abandon their homes. It is believed that well over than 35,000 homes have been damaged. Also in the continent 20,000 homes have been damaged or destroyed in Peru due severe flooding which also affected Uruguay and Argentina.

In Europe Windstorm Xynthia ravaged Spain, Portugal, France, Belgium and Germany causing damage right across western Europe and leaving close to two million homes without electricity. The report predicts that the insured losses resulting from the storm are expected to be in excess of 1.8 billion dollars (USD)

Meanwhile the heavy rains that soaked the continent were responsible for extensive flood damage in Bulgaria, Turkey and Italy. Greece’s current troubles were also deepened with 20,000 hectares of land flooded and damage to homes and infrastructure likely to cost approximately 10 million dollars (USD). Other areas hit by torrential rain and flooding were Madeira and Spain with reports of further lives being lost in Madeira and extensive property infrastructure damage resulting in reconstruction costs which are likely to approach 1.35 billion dollars.

The US too has also suffered severe winter storms as commentators suggest that the effects of climate change are beginning to take hold. Several key regions including Washington, New Jersey, Baltimore and Philadelphia which resulted in widespread blackouts and disruption to schools, airports, roads and railways. Over 35,000 claims have been filed in the US across February totalling 125 million dollars (USD)

With plenty of insurers posting strong financial profits after the benign hurricane season last year it seems Mother Nature is intent and making herself felt once again – or are we feeling as some would have us believe the first real effects of the climate change?

Either way February 2010 will be a month that will marked in history as a tumultuous and tragic year which has resulted in heavy costs both financial term and also tragically the loss of innocent life.

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