Rejda Solution

Chapter 2

Insurance and Risk

 Teaching Note

Three areas should be emphasized in teaching this chapter. First, the nature of insurance should be discussed. Second, the requirements of an insurable risk should also be stressed. Mention that the requirements of an insurable risk are ideal requirements and are seldom met completely in the real world. Finally, show how insurance differs from both gambling and speculation.

The remaining material is descriptive and fairly easy to grasp. It is not necessary to discuss in detail the various fields of insurance, other than to point out that the different fields of insurance are covered in future chapters. Likewise, the social benefits of insurance are quickly grasped by students and may not require a large amount of class time. However, it is worthwhile to spend some time on the less obvious costs of insurance, such as moral and attitudinal (morale) hazard. Point out that moral hazard has increased enormously in recent years, especially in the submission of fraudulent claims.

 Outline

I. Meaning of Insurance

A. Definition of Insurance

B. Basic Characteristics of Insurance

1. Pooling of losses

2. Payment of fortuitous losses

3. Risk transfer

4. Indemnification

II. Requirements of an Ideally Insurable Risk

A. General Requirements

1. Large number of exposure units

2. Accidental and unintentional loss

3. Determinable and measurable loss

4. No catastrophic loss

5. Calculable chance of loss

6. Economically feasible premium

B. Application of the Requirements

1. The risk of fire to a private dwelling satisfies the requirements.

2. The risk of unemployment does not completely meet all requirements.

C. Adverse Selection and Insurance

1. Nature of adverse selection

2. Consequences of adverse selection

III. Insurance and Gambling Compared

A. Insurance eliminates a pure risk, while gambling creates a new speculative risk.

B. Insurance is socially productive, while gambling is socially unproductive.

IV. Insurance and Hedging...