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Assumption question

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Assumption question

by Winner2013 » Tue Oct 15, 2013 11:25 am
Technically a given category of insurance policy is
under priced if, over time, claims against it plus
expenses associated with it exceed total income from
premiums. But premium income can be invested and
will then yield returns of its own. Therefore, an
under priced policy does not represent a net loss in
every case.
The argument above is based on which of the
following assumptions?
(A) No insurance policies are deliberately
underpriced in order to attract customers to the
insurance company offering such policies.
(B) A policy that represents a net loss to the
insurance company is not an underpriced policy
in every case.
(C) There are policies for which the level of claims
per year can be predicted with great accuracy
before premiums are set.
(D) The income earned by investing premium income
is the most important determinant of an insurance
company's profits.
(E) The claims against at least some underpriced
policies do not require paying out all of the
premium income from those policies as soon as it
is earned.

answer is e
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by [email protected] » Tue Oct 15, 2013 5:16 pm
Hi Winner2013,

This CR prompt uses some technical vocabulary, but the logic behind it is straight-forward enough. You would need to take some notes and "connect" the ideas.

The Facts:
-An insurance policy is "under-priced" if claims + expenses > total premiums
(to an insurance company, this situation requires the company to spend more money on the policy than it takes in)
-The money from premiums can be invested and yield returns
(to an insurance company, this means that the money from premium can be used to make additional money)

The Conclusion:
-An "under-priced" policy does not represent a net loss in every case.

The Logic:
It appears that "under-priced" policies would cost an insurance company money, UNLESS the premiums are invested and the TOTAL of the premium + the "interest" is more than the total of the claims + expenses.

The logic/argument really only "works" if the premiums + interest are "high enough" to offset the claims+expenses. I'd be looking for an answer that confirms that this is the case.

Answer A no policies are deliberately underpriced as a way to attract customers. This answer certainly looks tempting (I even misread it the first time), but this answer doesn't address the possibility of a policy that might be accidentally underpriced. Out of Focus.

Answer B: Talks about something that "is not an underpriced policy" We know NOTHING about other policies. Out of Focus.

Answer C: Prediction "with great accuracy" is not talked about in this prompt. Out of Focus.

Answer D: The "MOST important determinant in a company's profits" is not what this prompt is about. Out of Focus.

Answer E: The length of payout on a claim doesn't change the fact that the claim still happens, BUT it does allow for the possibility that the slow payout would allow the insurance company to continue to make money (on the premium interest) before paying out the entire claim.

Final Answer: E

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Rich
Last edited by [email protected] on Wed Oct 16, 2013 8:06 pm, edited 1 time in total.
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by Winner2013 » Wed Oct 16, 2013 7:55 am
Hi Rich,

thank you for making me understand the prompt. At times, under the pressure of time, every answer option looks same to me :-) The answer to this prompt is E.

Can you help me understand how E is not an answer? I tried to negate E but I am confused. How do we negate a statement with Some-not ? I am still confused between A and E.

Can you help? thank you Rich. Your explanations are always very helpful.

- Pj
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by AppleBees » Wed Oct 16, 2013 11:47 am
It's E because it is a necessary assumption.

Maybe this is easier for me because I am an actuary.

Think of this way:

The conclusion: an underpriced policy is not necessarily a loss for the company

Why: Net profit = Premium - payout + investment income

In order for net profit to be positive when payout > premium (underpriced), there has to be investment income. Where does the investment income come from? it comes from investing the premiums. Therefore, premiums CANNOT be payout immediately (or else there is nothing to invest)

The claim assumes premiums are NOT payed out as soon as it is earned so that it can be invested for some time. This generates "investment income" to offset any loss.

In this case, length of time from collecting the premium to payout does matter because it takes time for the premium to generate returns. If the premiums are payed out (as claims+expense) the second the insurance company receive the company, then how can they invest it?
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by [email protected] » Wed Oct 16, 2013 8:10 pm
Hi Winner2013,

AppleBees explanation is absolutely correct (I originally misread the answer choices, but have since edited my explanation - it goes to show that not getting enough sleep can cause "attention to detail" problems for just about anybody).

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by Winner2013 » Sat Oct 19, 2013 11:54 am
Thank you AppleBees and Rich.

This makes sense. I understand now why E is the answer but I have one more question. Does this mean the premium is invested only at that time when the claim is submitted?

Say, I have been paying premium to an insurance company for a policy for 5 years and now at the end of 6th year I submit the claim. So does it mean the insurance company did not invest my premium in the duration of 5 years? If they do then why would it be necessary that there should be some time between the claim is submitted and the claim is paid? (for the investment and returns)

Can you help my understanding? I mean to say why should we assume that insurance companies will invest the premium only after the claim is submitted? (and not in d duration of regular payment of premium by the client) Because if they do then the reasoning for option E may not make sense.

Please let me know your views on this.
thank you very much for taking out time to answer my queries. It really helps a lot :-)
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by AppleBees » Mon Oct 21, 2013 7:08 am
Hi,

Although outside knowledge does help sometimes when taking the GMAT, based on suggestions from my study guide, it is NOT recommended to rely on external knowledge - meaning you should focus on the passage and what it provides.

With that being said, to answer your question, insurance policies are heavily regulated and very complicated. I will give you a ultra-simplified version to help you understand how premium works.

For example:

You paid $1000 premium on 1/1/2014 for your car insurance for the whole year. Based on your driving history, demographic information and other factors, your policy is actually going cost the insurance company $1100. But the insurance company believe that they will have an equal or more than 10% investment gain on your premium.

it is ALWAYS required that premium to be paid ahead of time before you're insured. So the insurance company can invest your premium and generate returns as long as you dont file a claim.

Now you will ask, what if you do file a claim of $20,000 on 6/30/2013. To an insurance company, it really does not matter. You're most likely one of 5 million people insured, actuarial probability, investment return assumption, interest....etc are already pre-determined when you purchased your insurance. Law of large numbers will smooth things out.

Hope that helps... it's difficult to try to explain everything about insurance. If you're interested in insurance, I suggest you research further online.
Winner2013 wrote:Thank you AppleBees and Rich.

This makes sense. I understand now why E is the answer but I have one more question. Does this mean the premium is invested only at that time when the claim is submitted?

Say, I have been paying premium to an insurance company for a policy for 5 years and now at the end of 6th year I submit the claim. So does it mean the insurance company did not invest my premium in the duration of 5 years? If they do then why would it be necessary that there should be some time between the claim is submitted and the claim is paid? (for the investment and returns)

Can you help my understanding? I mean to say why should we assume that insurance companies will invest the premium only after the claim is submitted? (and not in d duration of regular payment of premium by the client) Because if they do then the reasoning for option E may not make sense.

Please let me know your views on this.
thank you very much for taking out time to answer my queries. It really helps a lot :-)
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