FIN 138 EXAM 1 | QUESTIONS AND ANSWERS | 2026
UPDATE | WITH COMPLETE SOLUTION
Financial Definition of Insurance Answer - The collection of a small premium
payment from all exposed and distributed to the smaller number of insureds
suffering loss
-provides for the funding of the losses
Loss redistribution; redistribution of the cost of unexpected losses. (works like
a financial intermediary)
*The collection of a small premium payment from all exposed and distributed
to the smaller number of insureds suffering loss*
Legal definition of Insurance Answer - focuses on a contractual arrangement
whereby one party agrees to compensate another party for specific losses.
•Insurance is a legal contract.
•One party agrees to compensate another party for losses.
•Insured vs. Insurer
-provides for the parameters to the agreement - the legally enforceable
contract that spells out the legal rights, duties and obligations of all the parties
to the contract.
risk Answer - uncertainty concerning the occurrence of a loss.
,the term Loss exposure is often used
objective risk Answer - the relative variation of actual loss from expected loss
(i.e., standard deviation or coeff. of variation)
•It can be statistically calculated using a measure of dispersion, such as the
standard deviation
relative objective risk Answer - *
Objective risk/ expected loss
pure risk Answer - Situation in which there are only the possibilities of loss or
no loss.
ex: earthquake
speculative risk Answer - Situation in which either profit or loss are clear
possibilities.
ex: gambling
chance of loss Answer - The probability that a loss will occur.
[actual(or expected)/number of exposures]
,000 or 0.003 or 0.3%
-We (State Farm) expect 3 houses out of 1,000 houses in an insurance pool to
be destroyed by fire.
Explain the Law of Large Number(LLN).
Why is the LLN used in the insurance mechanism?
Examples? Answer - •Objective risk declines with the number of exposures.
, Need for predictive accuracy, allows this to work. Homogeneous implies
characteristics as well as size of the exposure.
•"Regression to the mean."
•Coin toss example: the more times you toss a coin, the closer the frequency of
heads (and tails) approaches 1/2.
What is risk aversion? Answer - Risk averse individuals will be willing to pay
morethan the "MFP" to transfer risk.
What is mathematically fair price? "MFP" Answer - COL * Average Pool of loss
mean
How does risk aversion relate to insurance and risk management? Answer -
Most people are risk averse and therefore they buy insurance to avoid risk.
The risk premium is the amount of money that a risk-averse individual will be
willing to pay to avoid the risk. By paying the risk premium the individual can
insure himself against a large loss from a fire and to get an assured or certain
income.
What is cash flow underwriting? Answer - Pricing insurance below the level of
anticipated losses while relying on investment income to make a profit.
Use the combined ratio to explain cash flow underwriting? Answer - Money
spent on insurance/Premiums received
"-'' spending/ "+" collecting
What are the basic characteristics of insurance? Answer - pooling of losses,
payment of fortuitous losses, risk transfer, indemnification
UPDATE | WITH COMPLETE SOLUTION
Financial Definition of Insurance Answer - The collection of a small premium
payment from all exposed and distributed to the smaller number of insureds
suffering loss
-provides for the funding of the losses
Loss redistribution; redistribution of the cost of unexpected losses. (works like
a financial intermediary)
*The collection of a small premium payment from all exposed and distributed
to the smaller number of insureds suffering loss*
Legal definition of Insurance Answer - focuses on a contractual arrangement
whereby one party agrees to compensate another party for specific losses.
•Insurance is a legal contract.
•One party agrees to compensate another party for losses.
•Insured vs. Insurer
-provides for the parameters to the agreement - the legally enforceable
contract that spells out the legal rights, duties and obligations of all the parties
to the contract.
risk Answer - uncertainty concerning the occurrence of a loss.
,the term Loss exposure is often used
objective risk Answer - the relative variation of actual loss from expected loss
(i.e., standard deviation or coeff. of variation)
•It can be statistically calculated using a measure of dispersion, such as the
standard deviation
relative objective risk Answer - *
Objective risk/ expected loss
pure risk Answer - Situation in which there are only the possibilities of loss or
no loss.
ex: earthquake
speculative risk Answer - Situation in which either profit or loss are clear
possibilities.
ex: gambling
chance of loss Answer - The probability that a loss will occur.
[actual(or expected)/number of exposures]
,000 or 0.003 or 0.3%
-We (State Farm) expect 3 houses out of 1,000 houses in an insurance pool to
be destroyed by fire.
Explain the Law of Large Number(LLN).
Why is the LLN used in the insurance mechanism?
Examples? Answer - •Objective risk declines with the number of exposures.
, Need for predictive accuracy, allows this to work. Homogeneous implies
characteristics as well as size of the exposure.
•"Regression to the mean."
•Coin toss example: the more times you toss a coin, the closer the frequency of
heads (and tails) approaches 1/2.
What is risk aversion? Answer - Risk averse individuals will be willing to pay
morethan the "MFP" to transfer risk.
What is mathematically fair price? "MFP" Answer - COL * Average Pool of loss
mean
How does risk aversion relate to insurance and risk management? Answer -
Most people are risk averse and therefore they buy insurance to avoid risk.
The risk premium is the amount of money that a risk-averse individual will be
willing to pay to avoid the risk. By paying the risk premium the individual can
insure himself against a large loss from a fire and to get an assured or certain
income.
What is cash flow underwriting? Answer - Pricing insurance below the level of
anticipated losses while relying on investment income to make a profit.
Use the combined ratio to explain cash flow underwriting? Answer - Money
spent on insurance/Premiums received
"-'' spending/ "+" collecting
What are the basic characteristics of insurance? Answer - pooling of losses,
payment of fortuitous losses, risk transfer, indemnification
