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CHAPTER 6
Fundamentals of Insurance
I. SUGGESTED CLASSROOM TIME: 60–75 MINUTES
II. CHAPTER OVERVIEW
This chapter details the principles of insurance, probably the most important risk
financing method. Insurance, as later chapters will details, has a long and effective history
in transferring risk from individuals to loss-sharing groups. Definitions of insurance are
III. LECTURE OUTLINE
A. Introduction: Chapter 6 lays out the principles under which insurance operates and
discusses the loss-sharing aspects of insurance.
B. First, Insurance Is Defined
1. Financial definition has these elements.
a. A risk pool (group of exposure units)
2. The legal definition is based on the transaction where one party to a contract
agrees to compensate the other party for losses covered by the contract. (This is
usually found in the state insurance codes.)
3. The combined definition involves the exchange of premium for a promise to pay.
C. Next, Loss, Peril, and Hazard Are Defined
1. A loss is an undesired, unplanned reduction of economic value.
36 Chapter 6/Fundamentals of Insurance
D. Insurance and Risk Reduction
1. The law of large numbers is used when an insurer pools the exposure units.
E. Private and Social Insurance Programs
1. Social insurance is not based on group equity but on benefit adequacy.
2. Private insurance is based on group equity, i.e., there is underwriting to decide
acceptance to programs (underwriting is covered in a later chapter).
F. Types of Insurance
1. Life and health
a. Life insurance
2. Property and liability insurance
G. Building Blocks of Insurance Premiums (Example is auto insurance.)
1. Expected losses, associated with the loss ratio
H. Benefits and Costs to Society of Insurance Systems
1. Costs
2. Benefits
a. Family stability
Chapter 6/Fundamentals of Insurance 37
IV. ANSWERS TO REVIEW QUESTIONS
1. The term insurance can be defined in both financial and legal terms. How
do these definitions differ? The financial definition stresses the grouping and loss-
2. How does insurance redistribute the costs of losses? By allowing members of a
3. What is the difference between insurable losses and depreciation
expenses? Insurable losses are indefinite and random, whereas depreciation
4. Describe the difference between a named-perils policy and an open-perils
5. What is the difference between a hazard and a peril? Give examples of
6. Why is it the chance of loss, and not the loss itself, that creates the need for
insurance? Some persons in a loss-sharing group, but not all of them, will have
7. How does a moral hazard differ from a physical hazard? Give examples of
8. Define the law of large numbers. What are its implications for an
insurance system? The law of large numbers states that, as sample size increases (as
38 Chapter 6/Fundamentals of Insurance
9. Explain the differences between social insurance and private insurance
10. Describe four types of life and health insurance. In your answer, describe
the personal risk that is insured by each type of insurance.
1) Life insurance—premature death
11. In the property and liability insurance industry, describe the difference
between personal lines insurance and commercial lines insurance. Give
12. List the four building blocks of an insurance premium. Why are
investment earnings included in the calculations? 1) Expected losses,
13. What are the definitions for the loss ratio and the expense ratio? Describe
what each ratio measures. The loss ratio is incurred losses compared to earned
14. In what ways do insurance systems benefit society? The major benefits of
15. What are the major costs of insurance systems? The major costs of insurance
systems are the overhead costs and moral hazard.
Chapter 6/Fundamentals of Insurance 39
V. ANSWERS TO OBJECTIVE QUESTIONS
1. An insurable loss is
2. The definition of peril is
3. A moral hazard is
4. “A financial arrangement that redistributes the costs of unexpected losses” is the
definition of
5. A person storing 100 pounds of gunpowder in the basement so that he can load his
own shotgun shells is an example of
6. The expense ratio is defined as
7. Which of the following is not an example of a social insurance program?
40 Chapter 6/Fundamentals of Insurance
8. In property-liability insurance, which of these is not considered personal lines
insurance?
9. Which of the following is not a component in the calculation of insurance premiums?
10. Which of the following is a cost incurred by society through the operation of the
insurance mechanism?
V. IDEAS FOR INSTRUCTORS AND TEACHING METHODS
1. Get a copy of Business Insurance or The National Underwriter and point out some
articles about losses. Have the class discuss what perils and hazards are involved.
2. Find your state’s insurance code and provide the definition of insurance that is there. To which of the definitions of insurance is it closest? (This could also be done by the students.)