FIN 138 EXAM 1 QUESTIONS WITH CORRECT ANSWERS LATEST UPDATE 2026
Financial Definition of Insurance - Answers 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 - Answers 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 - Answers uncertainty concerning the occurrence of a loss.
the term Loss exposure is often used
objective risk - Answers 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 - Answers *
Objective risk/ expected loss
pure risk - Answers Situation in which there are only the possibilities of loss or no loss.
ex: earthquake
speculative risk - Answers Situation in which either profit or loss are clear possibilities.
ex: gambling
chance of loss - Answers 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? - Answers •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? - Answers Risk averse individuals will be willing to pay morethan the "MFP" to
transfer risk.
What is mathematically fair price? "MFP" - Answers COL * Average Pool of loss
mean
How does risk aversion relate to insurance and risk management? - Answers 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? - Answers 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? - Answers Money spent on
insurance/Premiums received
"-'' spending/ "+" collecting
, What are the basic characteristics of insurance? - Answers pooling of losses, payment of fortuitous
losses, risk transfer, indemnification
-Pooling of losses
Spreading losses incurred by the few over the entire group
Risk reduction based on the Law of Large Numbers
-Payment of fortuitous losses
Insurance pays for losses that are unforeseen, unexpected, and occur as a result of chance
-Risk transfer
A pure risk is transferred from the insured to the insurer, who typically is in a stronger financial
position
-Indemnification
The insured is restored to his or her approximate financial position prior to the occurrence of the loss
Explain the essential requirement of an insurable risk:
A large group of homogeneous units exposed to the same peril. - Answers -to predict average loss
Explain the essential requirement of an insurable risk:
Accidental and unintentional loss. - Answers -to control moral hazard
-to assure randomness
Explain the essential requirement of an insurable risk:
Determinable and measurable loss. - Answers -to facilitate loss adjustment•insurer must be able to
determine if the loss is covered and if so, how much should be paid.
Explain the essential requirement of an insurable risk:
No catastrophic loss - Answers -to allow the pooling technique to work
-exposures to this loss can be managed by:
•dispersing coverage over a large geographic area
•using reinsurance
•special bonds
Explain the essential requirement of an insurable risk:
Calculable COL - Answers -to establish an adequate premium
Explain the essential requirement of an insurable risk:
Economically feasible premium - Answers -so people can afford to buy
-Premium must be substantially less than the face value of the policy
expected loss calculation - Answers any individual or group is equal to the probability that a loss will
occur multiplied times the amount of the loss.
P*L
If p = .2 and L = $1,000, then __________= .2 x $1,000 = $200
expected loss distribution - Answers The sum of all the probability * The sum of all losses
What is adverse selection? - Answers -Tendency of persons with a higher-than-average chance of loss
to seek insurance at standard (average) rates, if not controlled by underwriting, results in higher-than-
expected loss levels.
How does adverse selection impact the insurance system? - Answers if not controlled by
underwriting, results in higher-than-expected loss levels.
-can be controlled by:
-careful underwriting (selection and classification of applicants for insurance)
-policy provisions (e.g., suicide clause in life insurance)
-competition
-If premiums are based on the average expected loss for all individuals, high-risk people will be more
likely to purchase insurance than low-risk people.
-can cause a risk pool to collapse as low-risk people leave and the average loss and premium
escalates.
How do insurers alleviate adverse selection in their operation? - Answers -Underwriting: Screening,
qualification, decide:-Accept or reject an applicant.
-Reinsurance: When an insurance company buys insurance
What is re-insurance?
How does it work?
Examples?
Explain the reasons for re-insurance. - Answers •When an insurance company buys insurance, it is
called reinsurance.
Financial Definition of Insurance - Answers 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 - Answers 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 - Answers uncertainty concerning the occurrence of a loss.
the term Loss exposure is often used
objective risk - Answers 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 - Answers *
Objective risk/ expected loss
pure risk - Answers Situation in which there are only the possibilities of loss or no loss.
ex: earthquake
speculative risk - Answers Situation in which either profit or loss are clear possibilities.
ex: gambling
chance of loss - Answers 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? - Answers •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? - Answers Risk averse individuals will be willing to pay morethan the "MFP" to
transfer risk.
What is mathematically fair price? "MFP" - Answers COL * Average Pool of loss
mean
How does risk aversion relate to insurance and risk management? - Answers 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? - Answers 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? - Answers Money spent on
insurance/Premiums received
"-'' spending/ "+" collecting
, What are the basic characteristics of insurance? - Answers pooling of losses, payment of fortuitous
losses, risk transfer, indemnification
-Pooling of losses
Spreading losses incurred by the few over the entire group
Risk reduction based on the Law of Large Numbers
-Payment of fortuitous losses
Insurance pays for losses that are unforeseen, unexpected, and occur as a result of chance
-Risk transfer
A pure risk is transferred from the insured to the insurer, who typically is in a stronger financial
position
-Indemnification
The insured is restored to his or her approximate financial position prior to the occurrence of the loss
Explain the essential requirement of an insurable risk:
A large group of homogeneous units exposed to the same peril. - Answers -to predict average loss
Explain the essential requirement of an insurable risk:
Accidental and unintentional loss. - Answers -to control moral hazard
-to assure randomness
Explain the essential requirement of an insurable risk:
Determinable and measurable loss. - Answers -to facilitate loss adjustment•insurer must be able to
determine if the loss is covered and if so, how much should be paid.
Explain the essential requirement of an insurable risk:
No catastrophic loss - Answers -to allow the pooling technique to work
-exposures to this loss can be managed by:
•dispersing coverage over a large geographic area
•using reinsurance
•special bonds
Explain the essential requirement of an insurable risk:
Calculable COL - Answers -to establish an adequate premium
Explain the essential requirement of an insurable risk:
Economically feasible premium - Answers -so people can afford to buy
-Premium must be substantially less than the face value of the policy
expected loss calculation - Answers any individual or group is equal to the probability that a loss will
occur multiplied times the amount of the loss.
P*L
If p = .2 and L = $1,000, then __________= .2 x $1,000 = $200
expected loss distribution - Answers The sum of all the probability * The sum of all losses
What is adverse selection? - Answers -Tendency of persons with a higher-than-average chance of loss
to seek insurance at standard (average) rates, if not controlled by underwriting, results in higher-than-
expected loss levels.
How does adverse selection impact the insurance system? - Answers if not controlled by
underwriting, results in higher-than-expected loss levels.
-can be controlled by:
-careful underwriting (selection and classification of applicants for insurance)
-policy provisions (e.g., suicide clause in life insurance)
-competition
-If premiums are based on the average expected loss for all individuals, high-risk people will be more
likely to purchase insurance than low-risk people.
-can cause a risk pool to collapse as low-risk people leave and the average loss and premium
escalates.
How do insurers alleviate adverse selection in their operation? - Answers -Underwriting: Screening,
qualification, decide:-Accept or reject an applicant.
-Reinsurance: When an insurance company buys insurance
What is re-insurance?
How does it work?
Examples?
Explain the reasons for re-insurance. - Answers •When an insurance company buys insurance, it is
called reinsurance.
