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Principles of insurance on the P&C exam

The principles block hands you the vocabulary every later P&C topic is built from: risk, peril, hazard and loss, the five ways to handle a risk, and the pooling ideas that make a premium possible, down to the one-letter gap between moral and morale hazard.

Risk and the pool behind it

Insurance starts from risk, the uncertainty of loss. This part covers which risks an insurer will take on, how a large pool makes losses predictable, and what an insurer does with more risk than it wants to keep.

Each of the five handling methods in the table below fits a different mix of frequency (how often losses happen) and severity (how large they are). Small, frequent losses such as broken glassware in a restaurant are cheapest to retain and reduce. Rare but large losses, such as a fire that destroys the building, are what insurance exists to transfer. Losses that are both frequent and severe usually call for avoiding the activity altogether, and rare, small ones are simply absorbed.

Pure and speculative risk

Insurers write pure risk, where the only outcomes are a loss or no loss. Speculative risk also carries a chance of gain, like buying shares or betting on a stock price, and stays uninsurable because a policy would end up underwriting a bet.

The pool behind the premium

The law of large numbers is why insurers want many similar exposure units: the bigger the group, the closer actual losses come to predicted ones. Adverse selection is the pull in the other direction, where the people likeliest to suffer a loss are the keenest buyers, for example owners on a river bank shopping for flood coverage. Underwriting rules and waiting periods are the insurer's defense.

Reinsurance is insurance bought by insurers. The company that passes the risk on cedes it; a treaty covers a whole class of business automatically, while facultative reinsurance is negotiated one risk at a time. The insured has no contract with the reinsurer.

What makes a risk insurable

The textbook list has six parts: the loss is accidental and outside the insured's control; it is definite and measurable; it is predictable across a large group of similar units; one event cannot hit most of the group at once; the premium is affordable; and the loss is significant enough to be worth insuring.

Five words that sound alike

Risk
Uncertainty about whether a loss will happen. It names neither the cause nor the condition behind it.
Peril
The cause of a loss: fire, windstorm, theft, explosion. A gas leak is a hazard; the explosion it leads to is the peril.
Hazard
A condition that makes a loss likelier or worse. Physical: oily rags beside a furnace. Moral: dishonesty, such as an owner willing to stage a burglary. Morale: indifference, such as leaving a car unlocked because it is insured. The moral vs morale hazard page drills that pair.
Loss
The reduction in value that follows. A direct loss is the physical damage; an indirect (consequential) loss flows from it, such as the income a print shop loses while its press is repaired. How property losses are valued is on property insurance basics.
Exposure unit
What an insurer counts when it prices a pool: a car, a building, $100 of payroll. The law of large numbers needs many similar ones.

Five ways to handle a risk

Risk-management methods, with our own examples and the words that signal each
MethodWhat it doesExampleSignal words
AvoidanceRemoves the exposure entirelyA roofer stops bidding on high-rise jobsnever, stops, refuses
ReductionCuts how often or how badly losses happenA warehouse adds forklift training and a no-smoking ruleinstalls, trains, inspects
RetentionKeeps the loss and pays itA homeowner picks a $2,500 deductible to lower the premiumdeductible, self-insures, absorbs
TransferShifts the financial burden to another partyBuying a policy, or a hold-harmless clause in a leasecontract, policy, hold harmless
SharingSpreads losses across a groupMembers of a reciprocal exchange each carry part of every losspool, members, exchange

Risk, hazard and handling methods: practice set

0 of 16 answered · 0 right

Notes on each optionCommit to an answer first. The notes under the item then open on every option: what rules it in or out, and the one word that splits the runner-up from the key.

  1. Item 01

    This principle asserts that as the number of occurrences increases, the actual outcomes will align more closely with the anticipated results:

    1. AA fortuitous loss is one that happens by chance; it says nothing about predictions improving with volume.
    2. BCorrect: the law of large numbers says that the more exposure units there are, the closer actual losses come to expected losses.
    3. CPooling spreads losses across a group, which is what insurance does, but it is not the predictability principle itself.
    4. DIndemnity restores the insured to the pre-loss condition; it is not about predicting outcomes.
  2. Item 02

    Which of the following risks faced by a restaurant owner is a speculative risk?

    1. ACorrect: a second location can make or lose money, and a chance of gain is what makes a risk speculative.
    2. BA kitchen fire can only cause loss or no loss, so it is a pure risk.
    3. CEmployee theft offers no chance of gain, so it is a pure risk.
    4. DA lawsuit over food poisoning can only cost money, so it is a pure risk.
  3. Item 03

    Why do property policies exclude wear and tear and gradual deterioration?

    1. AMoral hazard concerns dishonesty, which has nothing to do with gradual wear.
    2. BManufacturer warranties are irrelevant to why property policies exclude wear and tear.
    3. CCatastrophic potential is the reason for excluding war and nuclear events, not wear and tear.
    4. DCorrect: deterioration is certain to happen over time, so it is a maintenance cost rather than an accidental loss.
  4. Item 04

    Underwriters refuse to bind new windstorm coverage in coastal counties once a hurricane watch has been issued. The main purpose of this restriction is to prevent:

    1. AA uniform binding rule treats every coastal applicant alike, so it is not unfair discrimination.
    2. BCorrect: owners rushing to buy coverage only when a storm approaches is adverse selection, which the binding freeze blocks.
    3. CMorale hazard is carelessness once insured, which a binding restriction does not address.
    4. DMoral hazard is dishonesty, which a binding restriction does not address.
  5. Item 05

    A tornado wrecks Nadine's house, and she must stay in a motel for three months during repairs. Which statement is CORRECT?

    1. ACorrect: the physical damage to the house is direct, and the motel bills are its financial consequence, an indirect loss.
    2. BThis reverses the two: physical damage is direct, and the extra living cost is indirect.
    3. CThe physical damage to the house is a direct loss, not indirect.
    4. DThe motel bills are not damage to property, so they are indirect, which is why loss of use is a separate coverage.
  6. Item 06

    All of the following are characteristics of an ideally insurable risk EXCEPT:

    1. AAccidental loss from the insured's viewpoint is a required trait of an insurable risk.
    2. BCorrect: many units suffering loss at once is a catastrophic exposure, the opposite of an ideal insurable risk.
    3. CA calculable chance of loss is required so a premium can be set.
    4. DA loss definite in time, place and amount is required so it can be adjusted.
  7. Item 07

    Mervyn drives on an icy road with badly worn tires, skids, and collides with another car. In this situation, the peril is the:

    1. ACorrect: the peril is the cause of the loss, and the collision is what directly damaged the cars.
    2. BThe icy road is a physical hazard that raised the chance of loss, not the cause.
    3. CThe chance of a loss is risk, not peril.
    4. DThe worn tires are a physical hazard that raised the chance of loss, not the cause.
  8. Item 08

    An insurer that transfers part of its risk to a reinsurer is called the:

    1. AA retrocessionaire is on the other side, reinsuring a reinsurer.
    2. BA captive is owned by a parent business to insure the parent's own risks.
    3. CCorrect: the primary insurer that cedes part of its risk to a reinsurer is the ceding insurer.
    4. DA fronting company issues a policy on paper while passing almost all the risk to another insurer.
  9. Item 09

    A trucking company signs contracts that make its customers responsible for any damage to their goods while in transit. Which risk management method is the trucking company using?

    1. AThe company still hauls the goods, so it has not avoided the risk.
    2. BRetention would mean the company pays the losses itself.
    3. CCorrect: shifting the financial burden of a loss to customers by contract is transfer, even without insurance.
    4. DReduction would lessen the chance or size of a loss, which a contract does not do.
  10. Item 10

    A large company pays its own small property losses from a funded reserve instead of buying insurance for them. Which risk management method is it using?

    1. ASharing requires pooling losses with other parties.
    2. BTransfer would shift the losses to someone else, such as an insurer.
    3. CCorrect: paying its own losses from a funded reserve is retention, or formal self-insurance.
    4. DA reserve does nothing to lessen the chance or size of a loss, so it is not reduction.
  11. Item 11

    What type of hazard does reckless driving represent?

    1. AA legal hazard arises from laws or court attitudes, not from how someone drives.
    2. BMoral hazard is dishonesty aimed at gain; recklessness is indifference, not fraud.
    3. CCorrect: reckless driving shows carelessness or indifference to loss, which is morale hazard.
    4. DA physical hazard is a tangible condition, like worn tires or an icy road, not a behavior.
  12. Item 12

    __________ refers to the unpredictability related to the possibility of experiencing a loss.

    1. APeril is the cause of a loss, not the uncertainty about it.
    2. BLiability is legal responsibility for harm to others.
    3. CCorrect: risk is the uncertainty of whether a loss will happen.
    4. DA hazard is a condition that increases the chance or severity of a loss.
  13. Item 13

    James fears dying in a plane accident, so he avoids flying altogether. Which approach to risk management is he employing?

    1. ATransfer shifts the financial burden to someone else, often an insurer.
    2. BReduction lessens the chance or size of a loss but keeps the activity.
    3. CCorrect: never flying eliminates the exposure entirely, which is avoidance.
    4. DRetention means accepting the risk and paying any loss himself.
  14. Item 14

    A business constructs its new manufacturing facility using fireproof materials and incorporates a sprinkler system. What method of risk management do these actions represent?

    1. AInsurance shifts the risk to an insurer, but these steps make the loss smaller instead.
    2. BRetention is keeping the financial consequences of a risk, not building to limit damage.
    3. CAvoidance would mean not building the facility at all.
    4. DCorrect: fireproof materials and sprinklers lessen the chance or size of a fire loss, which is reduction.
  15. Item 15

    _________ refers to dishonesty or another character flaw that raises the likelihood or intensity of loss.

    1. AA physical hazard is a tangible condition, not a character flaw.
    2. BCorrect: dishonesty or another character flaw that raises the chance or size of loss is moral hazard.
    3. CA legal hazard comes from the legal environment, not personal character.
    4. DMorale hazard is carelessness or indifference, not dishonesty.
  16. Item 16

    The principle of indemnity is BEST illustrated when:

    1. ASharing a loss in proportion to limits is pro rata other insurance, not indemnity.
    2. BA small premium for a large possible benefit describes an aleatory contract.
    3. CTaking over the insured's right to sue is subrogation, which supports indemnity but is a separate principle.
    4. DCorrect: indemnity means restoring the insured to her pre-loss financial position, with no profit.
Mixed practice test · Timed mock

Keep the vocabulary sharp

Peril, hazard and the five handling methods come back in every coverage part. Keep them fresh between study sessions with the larger general-block set inside the app (iPhone, iPad).

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