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Chapter 10 Nature of the Insurance Industry
The law of large numbers is at play when you flip a coin. In a
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is the expected outcome. However, if you flip the coin only ten times,
the outcome might be different from the expectation. The coin may
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numbers says if you flip the coin a thousand times, the outcome will
approach the expected result. So, the larger the “pool” of coin flips,
the more likely you are to achieve the expected outcome of the coin
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Here is an example of the law of large numbers in action. Suppose
that in a pool of 100,000 people, statistics suggest each person faces a
2% probability of incurring a loss in a year. This means 2,000 people
will likely experience a loss. Now, if each person in the pool pays
$1,500 in premiums, the insurer collects $150 million. This gives the
insurer enough money to pay $75,000 to 2,000 policyholders who
experience a loss.
100,000 policyholders in pool × 2% chance of loss = 2,000
policyholders experiencing a loss
100,000 policyholders × $1,500 premium = $150,000,000 total
revenue for insurance company
$150,000,000 revenue ÷ 2,000 policyholders with loss =
$75,000 paid per claim
What if more than 2,000 policyholders experience a loss? Based
on the law of large numbers, this is very unlikely. But, if it does occur,
the insurance company may have to pay more in claims than it has
collected in premiums.
Underwriting
Spreading risk across a large population is not the only way
insurance companies manage the risks they assume. Insurance
companies also analyze the risk of each policy applicant before approving
the policy. They use information the applicant provides to determine the
likelihood of that person or business experiencing a loss. For example, a
chronic smoker who does not exercise or eat well represents a greater risk
to a health or life insurance carrier than a physically fit nonsmoker.
Underwriting is the process of determining whether to accept the
risk of an applicant and what premium to charge. Underwriting is a
key factor in an insurance company’s profitability. If the underwriter’s
decision results in high payouts, it will affect the company’s bottom line.
The underwriter’s job is to minimize adverse selection. Adverse
selection happens when someone has a need for insurance because of
a particular risk. For example, a young male who is otherwise healthy
applies for a life insurance policy. Data show that young men typically
do not buy life insurance policies. It may be that the applicant faces a
terminal illness. In this case, he represents a poor risk to the carrier. If
the insurance carrier approves him for a life insurance policy, adverse
selection has occurred.
Ethical Insurance
Practices
Everyone has a
responsibility to use
information technology
in an ethical manner.
Using material illegally
downloaded from the
Internet or software that you
do not hold a lawful license
for is not only unethical
but illegal. Because
trust is so central to the
whole insurance industry,
insurance professionals
must take special care to
avoid any appearance of
impropriety in any area.