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CHAPTER 7
Insurable Perils
and Insuring Organizations
I. SUGGESTED CLASSROOM TIME: 60–75 MINUTES
II. CHAPTER OVERVIEW
Chapter 7 covers the characteristics of insurable risks, as well as the principles of risk
classification. The chapter also covers the subject of private insurance companies from a
macro standpoint, providing a careful analysis of the various types of insurance providers.
Market shares of insurance companies, and in some respect the types of contracts that
they write, are often a function of their form of organization.
III. LECTURE OUTLINE
A. Introduction—no matter the form of legal organization, an insurance company’s
function is to redistribute or share the cost of losses among a pool of insureds. The two
most important types of insurance companies are the mutual and stock forms. Risk
classifications schemes determine what persons, and exposures, make up those pools
of insureds.
B. Ideally Insurable Loss Exposures have the following characteristics:
1. A large number of homogeneous loss exposures, i.e., a group of similar items, are
exposed to the same perils.
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D. Risk Classification and Insurable Events—the insurance company seeks to achieve the
following goals:
1. Actuarially fair premiums, i.e., they must cover loss costs
4. Minimum adverse selection
E. Principles of Risk Classification
1. Separation of exposure units and class homogeneity
F. Types of Insurance Companies
1. Stock insurance companies
a. Typical corporate arrangement with stockholder/owners, a corporate entity,
and consumer/policyholders
2. Mutual insurance companies
a. Nonprofit corporation—Manager/executives are not motivated by altruism;
they are efficient and goal-oriented and must compete in the marketplace.
“Nonprofit” does not mean the company is a charitable organization.
b. Policyholders are “owners” and vote proxies. No corporate stock. You can’t buy
Connecticut Mutual or Prudential or State Farm as an investment.
Chapter 7/Insurable Perils and Insuring Organizations 43
up” by the company when sufficient capital is available to cushion for adverse
underwriting or investment results.
f. Types of mutuals
i. Advanced Premium—Typical format of large mutuals issuing participating
policies. Premium paid at the beginning of the year. The policy owner is
iii. Factory—The insurance company is a member of the Factory Mutual
Association and insures highly protected risks (HPRs). Emphasis is on
safety engineering and regular inspections. Lower premiums if you qualify
for the pool. Factory mutuals cannot assess because failure of engineering
3. Other Types of Insurers
a. Lloyd’s of London
i. An association of independent underwriters who accept business (offer
insurance) for their own accounts.
ii. Each lead underwriter represents a syndicate of “names” who participate in
each underwriting, agreeing to share the profits and accepting liability for
the losses. Unlimited liability is no longer the rule since organizations such
iv. All the underwriters have agreed to pool resources to support the
organization, giving Lloyd’s the reputation for financial strength. Recent
years have been quite troublesome, and one syndicate had substantial
losses related to computer leasing. This loss has lead to a major review
44 Chapter 7/Insurable Perils and Insuring Organizations
b. The reciprocal exchange
i. It is comparable to mutual insurers except the organization is
unincorporated.
ii. All insureds pay a pro-rata share of losses in advance through a premium,
but are not liable for assessment since surplus accounts provide a cushion.
If no surplus, individual assessments are required to meet goal of providing
insurance at a minimum cost to all policy owners.
4. Market share trends have varied over time; product line(s) remain(s) a major
factor.
IV. ANSWERS TO REVIEW QUESTIONS
1. Which of the following exposures to loss would be a likely basis for an
insurance system? Explain why the exposures would or would not qualify
as a basis for insurance.
a. The potential loss of domestic pets: No, unlikely to cause economic hardship,
except for the most expensive of breeds (sentimental loss is not an issue).
Chapter 7/Insurable Perils and Insuring Organizations 45
2. What is the definition of a catastrophic loss? A catastrophic loss is one that
3. Why are certain crime losses, such as the theft of furs and jewelry, a more
difficult exposure to insure than fire loss? (Refer to ideal insurance
4. What difficulties would be present in combining a group of men and
women of the same age in the same life insurance pool? Women as a group
5. What would happen to an insurance system in which the insureds were
indifferent to the occurrence of losses? The system would quickly break down in
6. Why are floods and earthquakes difficult to insure in a privately operated
insurance system? These perils present a catastrophic exposure, with numerous
7. What is adverse selection? How do insurers try to prevent adverse
selection? Adverse selection is the tendency of those who believe they will need
8. Explain the statement that adverse selection causes subsidization. When
insurance consumers commit adverse selection, losses will be higher than expected for
9. Explain the four major principles of risk classification.
1) There must be separation of exposures and homogeneity within the class.
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4) There must be social acceptability, i.e., the insurer may not use factors, i.e. , race, that would cause the public to doubt the system.
10. What is meant by incentive value in a risk classification scheme? The classic
11. Why is it difficult for insurers to satisfy the social acceptability of risk
classification criteria? Some of the factors that show a statistically significant
12. Explain why the legal organization of an insurance system is important to
the consumer. The form of legal organization is important under certain
13. Describe the differences between stock insurers, mutual insurers, and
reciprocal exchanges. A stock insurer is a proprietary institution, operating to
make a profit for the shareholders, who may receive a taxable dividend if there are
14. Why are the dividends on mutual insurance company policies not subject
to the federal income tax, while dividends paid by stock insurers to their
owners are subject to the tax? The dividend from the mutual insurance company
15. How does an advance premium mutual insurer differ from an assessment
mutual? The advance premium mutual collects premiums in advance, based on
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V. ANSWERS TO OBJECTIVE QUESTIONS
1. The criteria for ideally insurable losses include all except which of the following?
2. One reason that floods have not been insured in the United States is that
d. insurance companies do not know how to define the peril of flood.
3. According to _____, insurance should be bought only when losses are significant and
uncertain.
4. Which of the following perils is not privately insurable because of its catastrophic loss
potential?
5. Insurers cannot use credit scores as a risk classification variable in several U.S. states
because their use does not satisfy which of the requirements of risk classification
variables?
6. If only those most exposed to loss try to buy insurance, the insurance pool will fail
because
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8. Stock insurance companies have all except which of the following characteristics?
9. The largest and most frequently found form of mutual company is the _____ mutual.
10. Lloyd’s of London is a very important source of what type of insurance coverage?
11. The reciprocal exchange is managed by a(n)
VI. IDEAS FOR INSTRUCTORS AND TEACHING METHODS
1. Split the classroom into two groups. Place one group in the guise of a stock company
and the second in the guise of a mutual company. Have the two groups explain why
their method of providing coverage is superior to the other.
3. Create a chart on the board or overhead showing the characteristics of the stock,
mutual, Lloyd’s, and reciprocal, relative to the following factors: How they are
Chapter 7/Insurable Perils and Insuring Organizations 49
4. Ask students to explain why Lloyd’s of London is still a dominant force in the world’s
reinsurance market, despite U.S. domination of other financial (bank, securities)