Brightmoor Systems, with 40,000 employees, establishes a funded programme with actuarial loss studies, dedicated reserves and its own claims staff to pay a predictable category of losses, and buys no policy for it. A neighbouring firm with nine employees has no plan at all and simply pays such losses out of cash flow whenever they happen. What distinguishes the two arrangements?
- A.Nothing meaningful; both are equivalent forms of retention and the label self-insurance is purely cosmetic.The label describes a real difference. Genuine self-insurance requires enough exposure units to predict losses, plus funding and administration, none of which the small firm has.
- B.Brightmoor is engaged in formal, funded self-insurance, which is planned retention supported by loss prediction and reserves; the smaller firm is engaged in unplanned retention.Correct. Self-insurance is a deliberate, funded programme resting on the law of large numbers. Simply paying losses as they arise, with no plan or reserve, is unplanned retention.
- C.Brightmoor has transferred the risk, because establishing reserves shifts the loss onto the reserve fund.A reserve is the firm's own money set aside for its own losses. Transfer requires a different party to bear the financial consequences, and no other party is involved.
- D.The smaller firm has avoided the risk, since it has taken no action at all.Avoidance is an affirmative decision not to undertake the activity. Doing nothing about an exposure the firm still faces is retention by default, not avoidance.
Why: Both firms are RETAINING the risk, but only Brightmoor is self-insuring. True self-insurance is planned, funded retention: it requires enough homogeneous exposure units for the law of large numbers to make losses predictable, plus reserves and administration to pay them. The small firm is engaged in unplanned retention, which is simply an absence of any technique and offers no loss prediction and no funding.
An insurer's product committee is asked why the company will happily write ordinary life on many thousands of individuals scattered across the country, but will not write a single contract covering every resident of one coastal town against a named hurricane. Which characteristic of an INSURABLE risk explains the refusal?
- A.The loss must arise from a pure rather than a speculative risk, and hurricane damage is speculative.Hurricane damage is a pure risk: it can produce a loss or no loss, but never a gain. The pure-versus-speculative test is satisfied here, so it is not what disqualifies the arrangement.
- B.The loss must NOT be catastrophic to the insurer, meaning a large share of the insured units must not be able to suffer loss from a single event at the same time.Correct. Insurability depends on spreading exposure so that one occurrence cannot strike most of the pool at once. Concentrating every insured unit in one coastal town facing one storm destroys that spread.
- C.The loss must be intentional on the part of the insured before an insurer will pay.The requirement is the exact opposite: an insurable loss must be accidental and outside the insured's control. Intentional losses are excluded precisely because they are not fortuitous.
- D.The premium must be large enough to fund a total loss on every insured unit at the same time.No insurer prices to that standard, and a premium that did so would be unaffordable. The requirement is that a simultaneous total loss across the pool not be a realistic possibility in the first place.
Why: One requirement of an insurable risk is that the loss must not be CATASTROPHIC to the insurer, meaning a large proportion of the insured units must not be capable of suffering loss from a single event at the same time. Geographic and demographic spread is what makes the law of large numbers work; concentrating every unit in one town facing one storm destroys that spread and exposes the insurer to ruin from a single occurrence.