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
,FIN 138 EXAM 1 | QUESTIONS AND ANSWERS | 2026 UPDATE | WITH COMPLETE SOLUTION
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.
, FIN 138 EXAM 1 | QUESTIONS AND ANSWERS | 2026 UPDATE | WITH COMPLETE SOLUTION
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
-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. - (ANSWER)-to predict average loss
Explain the essential requirement of an insurable risk:
Accidental and unintentional loss. - (ANSWER)-to control moral hazard
-to assure randomness
Explain the essential requirement of an insurable risk:
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
,FIN 138 EXAM 1 | QUESTIONS AND ANSWERS | 2026 UPDATE | WITH COMPLETE SOLUTION
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.
, FIN 138 EXAM 1 | QUESTIONS AND ANSWERS | 2026 UPDATE | WITH COMPLETE SOLUTION
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
-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. - (ANSWER)-to predict average loss
Explain the essential requirement of an insurable risk:
Accidental and unintentional loss. - (ANSWER)-to control moral hazard
-to assure randomness
Explain the essential requirement of an insurable risk:
