Insurance And Risk-Credit and Risk Managment-Lecture Notes, Study notes of Credit and Risk Management

Download Insurance And Risk-Credit and Risk Managment-Lecture Notes and more Study notes Credit and Risk Management in PDF only on Docsity! LECTURE – 35 INSURANCE AND RISK Insurance is a system to protect persons against the risks of financial loss by transferring the risks to a large group who share the financial losses Insurance is based on two principles: risk transference and the law of large numbers. Risk transference, sometimes called ‘pooling’, involves the transfer of risk from the individual to a pool of the insurance company’s policyholders. The insurance company charges a fee, the premium (or part thereof), for accepting the risk and ‘pools’ the premiums from a group of policyholders into a general fund to fund the death benefits under contract. The law of large numbers basically relies on the principle that the larger the pool, the more predictable the amount of losses will be in a given period. Since not all members of the pool are the same age or in the same health condition, we can assume not all of them will be making a claim at the same time. In fact, by recording and studying the number of claims over a very large population, the number of 62 year old men, for example, who will die in a particular year can be fairly predicted. This is not to say the year a particular person will die can be predicted. It only says that in a given year there is a high probability that X number of men who are 62 will die at that age. All insurance is based on these two principles. A teenager commands a higher auto insurance rate because the statistical history has shown they have more accidents and the accidents are more serious than for a 40 year old driver. Homeowners located on the eastern seaboard of Florida have a higher incidence of losses than a homeowner located in Idaho and, statistically, should pay a higher insurance premium. It would not be fair to charge the Idaho homeowner additional fees to cover the costs of hurricanes in Florida, would it? A 40 year old man with two heart by-passes and who smokes statistically has less of a chance of living to age 70 than a 40 year old man who runs marathons. Again, this is not to say there will not be instances of a 40 year old marathon runner dying from heart problems or other causes but, statistically, those incidences will be less for the marathon runner than for the heart patient who smokes. Should both 40 year old men pay the same premium for the same amount of insurance coverage? The application submitted by an applicant is extremely important to the insurance company. The application not only becomes essentially a legal document for purposes of recording what the insurance company knew about the applicant when the insurance company assumed the risk it is very important to the underwriter in rating the insurability of the applicant(s). There are generally rules within the policy to address errors, omissions or falsehoods provided on the application. Insured Risk A risk that meets the following criteria: 1. The insured loss must have a definite time and place; 2. The insured event must be accidental; 3. The insured must have an insurable interest in the subject of coverage; 4. The insured risks must belong to a sufficiently large group of homogeneous exposure units to make losses predictable; 5. The risk must not be subject to a catastrophic loss where a large number of exposure units can be damaged or destroyed in a single event; 6. The coverage must be provided at a reasonable cost; 7. The chance of loss must be calculable. docsity.com Spread of risk A principle of insurance that insurers need to accept homogeneous exposure units spread over a wide geographic area, with the knowledge that only a given number of risks will result in claims or losses. This dispersion of exposure units allows insurers to project expected losses from the entire body of insured, lessens the potential for catastrophic losses that could occur to exposure units close to each another, and allows for the development of rates. Reduction of risk A method of handling risk by the scope or volume of a firm's operations or through the purchase of insurance. Example: A large outdoor advertising firm reduces its risk of lost revenue due to damaged billboards in a way that a small billboard company cannot because of its large number of dispersed exposure units. The scale of operations makes losses relatively predictable. Insurance reduces risk for the small company by combining a number of similar companies' risks into a more predictable group. What's the difference between an insurance score and a credit score? The use of credit information by insurance companies is not the same as by banks. It's easy to understand how credit applies to getting a bank loan, but insurers aren't as interested in credit- worthiness as in stability. The logic is similar, because while it's not a loan, insurance is like a line of credit. Customers pay premiums so that, in the event of a loss, they will have money to repair or replace their homes, cars, etc. What is a Credit Score? In order to streamline the decision making process, the lending industry has developed a system which scores the borrower's credit history. The score is seen as predictive of the borrower's ability and willingness to repay the loan. Such scoring gives the lender the ability to give the borrower a rapid credit decision by using automated underwriting software currently available. What does my credit score have to do with insurance? Most, if not all, insurance companies use credit scoring as a tool to qualify you for the best premiums possible. It is not a pure credit score, but barometer for estimating your potential for having a claim. Financial history does have an effect on your ability to properly maintain your property. What is an insurance-based credit score? Insurance-based credit score is a number or rating that is generated when information from a consumer's credit history is plugged into a highly specialized insurance formula or rating model. The purpose for selecting and using a consumer's credit information in this manner is to predict the potential risk of loss that consumer poses to the insurance company. How can my credit insurance score benefit me? The way that you manage your credit is very important - it helps determine things like home mortgage interest rates and auto insurance rates. A credit-based insurance score allows insurers to quote the fairest, most appropriate rate for every customer. Our experience shows that about half of our existing customers receive a rate decrease based on credit score. Why do Insurance Companies run a credit score? The use of credit history helps provide a consistent tool to look at every risk. It does not discriminate against any specific group of customers. The results usually help each customer pay his or her fair share of premium for insurance. Is an insurance credit score different from the credit score a bank or financial institution uses? Yes. An insurance credit score differs from the credit score used by banks and financial institutions. Though both scores rely on the same source of information, the scores and the models that generate the scores are designed to predict different outcomes. docsity.com