Below is a clear, step-by-step explanation of key insurance concepts drawn from your notes. The language is tailored for a 19-year-old student.
1. Indemnity
Indemnity means restoring the insured to roughly the same financial condition they were in before a loss. The recovery can take several forms:
- Cash payments
- Repair of the damaged item
- Replacement of the damaged item
2. Underwriting
An underwriter is a professional who evaluates risks and decides whether they fit the insurer's guidelines. If they do, the underwriter sets the rate and approves the insurance.
Typical steps an underwriter takes:
- Review the application
- Conduct physical inspections to identify hazards or potential hazards
- Check DMV records
- Review consumer credit reports
For life, health, or disability insurance, additional information may be required such as medical exams or statements, questionnaires, or interviews.
2.1 Obtaining Reliable Information
In property and casualty or personal lines insurance, information is usually gathered from:
- Application details
- Property inspections
- DMV records
- Credit history
Other sources that may be used include:
- Attending physician statements or medical exams for relevant policies
- Questionnaires and telephone interviews
- Industry information networks
2.2 Adverse Selection & Spread of Risk
Adverse selection is the tendency for those most in need of insurance to apply, which can raise risk for the insurer if not managed. Underwriting helps protect against adverse selection by screening out or pricing higher-risk applicants. For example, a terminally ill person is more likely to seek life insurance than a healthy person.
Spread of risk refers to how insurers manage and distribute risk across many policies to stay profitable. This often involves diversification and other methods to avoid too much exposure to any single risk.
Management of Risk
Beyond insurance, there are several basic risk-management concepts used by individuals and organizations to spread or reduce risk:
- Risk avoidance — choosing not to engage in risky activities
- Risk reduction — taking steps to lower the likelihood or impact of a loss
- Risk transfer — shifting the risk to another party (for example, buying insurance or entering into contracts)
- Risk retention — accepting and absorbing a smaller loss when it occurs
Understanding these concepts helps you evaluate when insurance is the right tool and how it fits into a broader approach to managing financial risk.