Insurance Fundamentals
Domain 1: Insurance Fundamentals
LOMA 291 tests whether you can explain how insurers make risk transfer work economically and legally: pooling, insurable interest, underwriting selection, and the pricing logic beneath every product.
Core mechanics
- Risk, peril, hazard. Risk is uncertainty about loss; a peril is the cause of loss (death, accident); a hazard increases the chance or severity (smoking, hazardous hobby). Pure risk is insurable; speculative risk is not.
- Pooling and the law of large numbers. Combining independent, homogeneous exposure units makes aggregate claims more predictable. Larger pools do not lower expected cost per policy; they narrow the relative spread around it.
- Insurable interest. In life insurance it must exist at policy inception; in property insurance it must exist at the time of loss.
- Adverse selection is the tendency of higher-risk people to buy or keep coverage. Insurers counter it with underwriting, waiting periods, exclusions, and accurate classification.
- Moral hazard is behavior changed by insurance; deductibles, limits, and claims investigation manage it.
Worked example
A block of 10,000 lives each has a 0.01 annual claim probability and a $100,000 face amount. Expected claims = 10,000 x 0.01 x $100,000 = $10 million, or $1,000 per policy. Claim-count standard deviation = sqrt(10,000 x 0.01 x 0.99) = about 9.95 claims, roughly 10% of the 100 expected claims. Grow the pool to 100,000: expected claims rise to 1,000, but the standard deviation is about 31.5, only 3.2% of the mean. Expected cost per policy is unchanged; predictability improves.
Traps
- Confusing adverse selection (pre-contract) with moral hazard (post-contract).
- Assuming a bigger pool reduces expected claims rather than relative volatility.
- Placing life insurable interest at death instead of at inception.
- Treating hazard and peril as synonyms.