Risk and Insurance Exam 1

Risk Financing: Commercial Insurance

"Insurance is appropriate for loss exposures that have a low probability of loss but the severity of loss is high."

Experience Rating - Z/Credibility Factor from 0-1 with higher meaning more credibility given to the insured's past losses; Don't choose Z - statistical calculation; If high history of claims, want low Z score

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Co-Insurance Clause: Definition, Calculate, and Purpose

- A coinsurance clause in a property insurance contract encourages the insured to insure the property to a stated percentage of its insurable value. If the coinsurance requirement is not met at the time of loss, the insured must share in the loss as a coinsurer. - Purpose o "to achieve equity in rating." if the coinsurance requirement is met, the insured receives a rate discount, and the policyholder who is underinsured is penalized through application of the coinsurance formula.

Reinsurance Definitions & Facultative vs Treaty Reinsurance

- Reinsurance: is an arrangement by which the primary insurer (ceding company) that initially writes the insurance transfers to another insurer (called the reinsurer) part or all of the potential losses associated with such insurance. o Retention limit: is the amount of insurance retained by the ceding company

Deductibles: Definitions, Calculate, and Why Needed

- Deductible: is a provision by which a specified amount is subtracted from the total loss payment that otherwise would be payable. - Purpose o Eliminate small claims that are expensive to handle and process o Reduce premiums paid by the insured o Reduce moral hazard and attitudinal (moral) hazard - Straight deductible: the insured must pay a certain amount before the insure makes a loss payment (ex: auto insurance...For instance, assume that Ashley has collision insurance on her new Toyota, with a $1,000 deductible. If a collision loss is $10,000, she would receive only $9,000 and would have to pay the remaining $1,000 herself.) - Aggregate deductible: means that all losses that occur during a specified time period, usually a policy year, are accumulated to satisfy the deductible amount. - Calendar year deductible: is a type of aggregate deductible that is found in basic medical expense and major medical insurance contracts - Elimination (waiting) period: is a stated period of time at the beginning of a loss during which no insurance benefits are paid

Types of Exclusions

- Excluded Perils: The contract may exclude certain perils or causes of loss. (In a homeowners policy, the perils of flood, earth movement, and nuclear radiation or radioactive contamination are specifically excluded. In the physical damage section of the personal auto policy, loss to a covered auto is specifically excluded if the car is used as a public taxi.) - Excluded Losses: Certain types of losses may be excluded. (For example, in a homeowners policy, failure of an insured to protect the property from further damage after a loss occurs is excluded.) - Excluded Property: The contract may exclude or place limitations on the coverage of certain property. (For example, in a homeowners policy, certain types of personal property are excluded, such as cars, planes, animals, birds, and fish.)

Facultative vs Treaty Reinsurance

- Facultative reinsurance: is an optional, case-by-case method that is used when the ceding company receives an application for insurance that exceeds its retention limit. o Often used when the primary insurer has an application for a large amount of insurance - Treaty reinsurance: is an agreement under which the primary insurer must automatically cede to the reinsurer all business written in a certain category, and the reinsurer must accept the business. o All business that falls within the scope of the agreement is automatically reinsured according to the terms of the treaty.

Ratemaking Methods: Judgment, Manual/Class, Merit (special rating classes, schedule rating, experience rating, retrospective rating)

- Judgement rating: means that each exposure is individually evaluated, and the rate is determined largely by the judgment of the underwriter. (This method is used when the loss exposures are so diverse that a class rate cannot be calculated, or when credible loss statistics are not available.) - Class rating: means that exposures with similar characteristics are placed in the same underwriting class, and each is charged the same rate. - Merit rating: is a rating plan by which class rates (manual rates) are adjusted upward or downward based on individual loss experience. (Merit rating is based on the assumption that the loss experience of a particular insured will differ substantially from the loss experience of other insureds.) o Schedule rating plan: each exposure is individually rated. A basis rate is determined for each exposure, which is then modified by debits or credits for undesirable or desirable physical features. (Schedule rating is based on the assumption that certain physical characteristics of the insured's operations will influence the insured's loss experience.) o Experience rating: the class or manual rate is adjusted upward or downward based on past loss experience. (The most distinctive characteristic of experience rating is that the insured's past loss experience is used to determine the premium for the next policy period.) o Retrospective rating plan: the insured's loss experience during the current policy period determines the actual premium paid for that period. (Under this rating plan, a provisional premium is paid at the start of the policy period. At the end of the period, a final premium is calculated based on actual losses that occur during the policy period.)

Characteristics of an Insurable Risk

- Large number of exposure units o ‐ Accidental and unintentional losses o ‐ Determinable and measurable loss o ‐ No catastrophic loss o o exposures to catastrophic loss can be managed by using reinsurance, dispersing coverage over a large geographic area, or using financial instruments such as catastrophe bonds ‐ Calculable chance of loss o to establish a premium that is sufficient to pay all claims and expenses and yields a profit during the policy period ‐ Economically feasible premium o o For insurance to be an attractive purchase, the premiums paid must be substantially less than the face value, or amount, of the policy ‐ Based on these requirements: o o Market risks, financial risks, production risks and political risks are difficult to insure.

Named Perils vs Open-Perils (Used to be called All-Risk) Coverage

- Named Perils: only those perils specifically named in the policy are covered. If the peril is not named, it is not covered. - Open-Perils: all losses are covered except those losses specifically excluded, if the loss is not excluded, then it is covered. - An open-perils policy generally is preferable to named-perils coverage, because the protection is broader with fewer gaps in coverage. If the loss is not excluded, then it is covered. In addition, a greater burden of proof is placed on the insurer to deny a claim.

Other-Insurance Provision: Why needed? How could someone violate indemnity if not in contract? Calculate Pro Rata and Contribution by Equal Shares

- Purpose o Is to prevent profiting from insurance and violating of the principle of indemnity...these provisions apply when more than one contract covers the same loss. - How could someone violate indemnity if not in contract? o If the insured could collect the full amount of the loss from each insurer, there would be profiting from insurance and a substantial increase in moral hazard. Some dishonest insureds would deliberately cause a loss to collect multiple benefits.

Ratemaking Definitions: Rate, Exposure Unit, Pure Premium, Loading, Gross Rate, Gross Premium

- Ratemaking: refers to the pricing of insurance and the calculation of insurance premiums. - Rate: is the price per unit of insurance - Exposure Unit: is the unit of measurement used in insurance pricing - Pure Premium: is the portion of the rate needed to pay losses and loss adjustment expenses - Loading: is the amount that must be added to the pure premium for other expenses, profit, and a margin for contingencies - Gross Rate: consists of the pure premium and a loading element - Gross Premium: payed by the insured consists of gross rate multiplied by the number of exposure units

Risk:

Uncertainty concerning the occurrence of a loss (For example, the risk of being killed in an auto accident is present because uncertainty is present. The risk of lung cancer for smokers is present because uncertainty is present.)

There are three main methods to determine actual cash value:

- Replacement cost - depreciation (For example, Sarah has a favorite couch that burns in a fire. Assume she bought the couch five years ago, the couch is 50 percent depreciated, and a similar couch today would cost $1,000. Under the actual cash value rule, Sarah will collect $500 for the loss because the replacement cost is $1,000, and depreciation is $500, or 50 percent. ) - Fair market value: is the price a willing buyer would pay a willing seller in a free market (In one case, a building valued at $170,000 based on the actual cash value rule had a market value of only $65,000 when a loss occurred. The court ruled that the actual cash value of the property should be based on the fair market value of $65,000 rather than on $170,000.) - Broad evidence rule: means that the determination of ACV should include all relevant factors an expert would use to determine the value of the property (Relevant factors include replacement cost less depreciation, fair market value, present value of expected income from the property, comparison sales of similar property, opinions of appraisers, and numerous other factors.)

Underwriting & Main Goal/Responsibility

- Underwriting: refers to the process of selecting, classifying, and pricing applicants for insurance. The underwriter is the person who makes those decisions. o Objective is to produce a profitable book of business - Main goal/responsibility: evaluate insurance applications in order to decide whether to provide the insurance and, if so, the coverage amounts and premiums.

Reasons for Exclusions

-Certain perils considered uninsurable (catastrophic losses due to war) -Presence of extraordinary hazards -Coverage provided by other contracts (e.g., use of auto excluded on homeowners policy) -Moral hazard problems (e.g., coverage of money limited to $200 in homeowners policy) -Attitudinal hazard problems (e.g., individuals are forced to bear losses that result from their own carelessness) -Coverage not needed by typical insureds (e.g., homeowners policy does not cover aircraft)

A hazard is

A condition that increases the chance of loss

A pure risk is

A situation in which there are only the possibilities of loss or no loss (earthquake) Ex) premature death, job-related accidents, catastrophic medical expenses, and damage to property from fire, lightning, flood, or earthquake.

Legal Characteristics of Insurance Contracts: Aleatory, Unilateral, Conditional, Personal, Contract of Adhesion

Aleatory: values exchanged are not equal Unilateral: only the insurer makes a legally enforceable promise Conditional: policy owner must comply with all policy provisions to collect for a covered loss Personal: property insurance policy cannot be validly assigned to another party without the insurer's consent Contract of Adhesion: the insured must accept the entire contract with all of its terms and conditions

Risk Financing: Funded vs Unfunded Retention

Funded Retention: funded reserve: losses are deducted from a liquid fun, self insurance is a special form of plan retention, part or all of given loss exposure is retained by firm, and more accurate term would be sell funding, why are they used for Worker's Compensation and group health benefits ("A funded reserve is liquid funds that have been set aside to pay losses. A self-insurance program (discussed later) that is funded is an example of a funded reserve. However, if not required to do so, many businesses do not establish funded reserves because the funds might yield a higher return by being used elsewhere in the business. ") Unfunded Retention: current net income: losses are treated as current expenses, unfunded reserve: losses are deducted from a bookkeeping account, credit line: phones are borrow to pay losses as they occur

Actual Cash Value (ACV)

In property insurance, the basic method for indemnifying the insured is based on the actual cash value of the damaged property at the time of loss.

Payment of fortuitous losses

Is one that is unforeseen, unexpected, occur at a result of change " In other words, the loss must be accidental. The law of large numbers is based on the assumption that losses are accidental and occur randomly. For example, a person may slip on an icy sidewalk and break a leg. The loss would be fortuitous."

Risk Control Methods: Avoidance

Means a certain loss exposure is never acquired or an existing loss exposure is abanded the chance of loss is reduced to zero, it is not always possible, or practical, to avoid all bosses (For example, flood losses can be avoided by building a new plant on high ground, well above a floodplain. A pharmaceutical firm that markets a drug with dangerous side effects can remove the drug from the market to avoid possible legal liability.)

Risk Financing: Retention

Means that the firm retains part or all of the losses that can result from a given loss retention is effectively used when no other method of treatment is available, the worst possible loss is not serious, losses are highly predictable The retention level is the dollar amount of losses at the firm will retain a financially strong can have a higher attention level than a financially weak firm

Risk Financing: Planned vs Unplanned Retention

Plan retention: the delivery choice to assume all or part of a loss exposure ("For example, a risk manager might decide to retain physical damage losses to a fleet of company cars.") Unplanned retention: the unconscious decision to assume all or part of a loss exposure often results from ignorance or laziness ("For example, a risk manager might fail to identify all company assets that could be damaged in an earthquake.")

Risk Control Methods: Loss Prevention

Refers to measures that reduce the frequency of a particular loss, for example installing safety features on hazardous products ("For example, measures that reduce truck accidents include driver training, zero tolerance for alcohol or drug abuse, and strict enforcement of safety rules.")

Risk Control Methods: Loss Reductions

Refers to measures that reduce the severity of a loss after it occurs for example installing an automatic sprinkler system (Examples include installation of an automatic sprinkler system that promptly extinguishes a fire; first-aid boxes in production areas;)

Social Benefits vs Social Costs of Insurance

Social Benefits: - Indemnification for Loss ("Indemnification permits individuals and families to be restored to their former financial position after a loss occurs.") o contributes to family and business stability ‐ Reduction of Worry and Fear ("less likely to worry about the financial security") ‐ Source of Investment Funds o Premiums may be invested, promoting economic growth ‐ Loss Prevention ‐ Enhancement of Credit o Insureds are better credit risks than those without insurance Social Costs of Insurance: ‐ Cost of Doing Business o An expense loading is the amount needed to pay all expenses, including commissions, general administrative expenses, state premium taxes, acquisition expenses, and an allowance for contingencies and profit. ‐ Fraudulent and Inflated Claims o Higher premiums to cover additional losses reduce disposable income and consumption of other goods and services

Pooling of losses

Spreading losses incurred by the few over the entire group, risk reduction is based on the law of large numbers, according to the law of large numbers the greater the number of exposures, the more closely will the actual results approach the problem results that are expected from an infinite number of exposures

Subrogation - Definition, Rules, & Why

Substitution of the insurer in place of the insured for the purpose of claiming indemnity from a third party for a loss covered by insurance (Stated differently, the insurance company is entitled to recover from a negligent third party any loss payments made to the insured.) ‐ Purpose: o To prevent the insured from collecting twice for the same loss o To hold the negligent person responsible for the loss o To hold down insurance rates ‐ The insurer is only entitled to the amount it has paid under this policy ‐ The insured cannot impair the insurer's subrogation rights ‐ Subrogation does not apply to life insurance contracts ‐ The insurer cannot subrogate against its own insureds

A peril is

The cause of the loss Ex) If your house burns because of a fire, the peril, or cause of loss, is the fire.

Indemnification

The insured is restored to his or her approximate financial position prior to the occurrence of the loss. "Thus, if you carry adequate property insurance, and your home burns in a fire, a homeowners policy will indemnify or restore you to your previous financial position, less a relatively small deductible. If you are sued because of the negligent operation of an automobile, your auto liability insurance policy will pay those sums that you are legally obligated to pay. Similarly, if you become seriously disabled, a disability-income insurance policy will restore at least part of the lost wages."

Principles of Indemnity- Definition & Different Methods to Calculate (Actual Cash Value/Replacement Cost Less Depreciation, Fair Market Value, Broad Evidence Rule)

The insurer agrees to pay no more than the actual amount of the lost stated differently, the insured should not profit from a loss. Purpose: o To prevent the insured from profiting from a loss o To reduce moral hazard ‐ In property insurance, indemnification is based on the Actual Cash Value (ACV) of the property at the time of loss

Burden of Risk on Society

The presence of risk results in three major burdens on society: o In the absence of insurance, individuals and business firms would have to maintain large emergency funds to pay for unexpected losses ("The size of an emergency fund must be increased.") o The risk of a liability lawsuit may discourage innovation, depriving society of certain goods and services. o Risk causes worry and fear

Risk transfer

Your risk is transferred from the insured to the insurer who is typically in a strong financial position "From the viewpoint of the individual, pure risks that are typically transferred to insurers include the risk of premature death, excessive longevity, poor health, disability, destruction and theft of personal and commercial property, and personal and professional liability lawsuits"

Utmost Good Faith - Representations, Concealment, Warranty

a higher degree of honesty is imposed on both parties to an insurance contract than is imposed on parties to other contracts. - Representations: or statements made by the applicant for insurance to induce the insurer to enter into an insurance contract. (For example, if you apply for life insurance, you may be asked questions concerning your age, weight, height, occupation, state of health, family history, and other relevant questions. Your answers to these questions are the representations. Representations are not part of the contract but are an inducement to the contract.) - Concealment: is intentional failure of the applicant for insurance to reveal a material fact to the insurer. - Warranty: is a statement that becomes part of the insurance contract and is guaranteed by the maker to be true in all respects. (For example, in exchange for a reduced premium, a liquor store owner may warrant that an approved burglar alarm system will be operational at all times.)

Physical hazards

a physical condition that increases the frequency or severity of loss Ex) icy roads that increase the chance of an auto accident, defective wiring in a building that increases the chance of fire, and a defective lock on a door that increases the chance of theft.

A speculative risk is

a situation in which either profit or loss is possible (gambling)

Loss Exposure:

any situation or circumstance in which a loss is possible, regardless of whether a loss occurs (Examples of loss exposures include manufacturing plants that may be damaged by an earthquake or flood, defective products that may result in lawsuits against the manufacturer, possible theft of company property because of inadequate security)

Attitudinal hazard

carelessness or indifference to a loss, which increases the frequency or severity of a loss Ex) leaving car keys in an unlocked car, which increases the chance of theft; leaving a door unlocked, which allows a burglar to enter; and changing lanes suddenly on a congested expressway without signaling, which increases the chance of an accident.

Legal Hazard

characteristics of the legal system or regulatory environment that increase the chance of loss (large damage awards in liability lawsuits) "adverse jury verdicts or large damage awards in liability lawsuits; statutes that require insurers to include coverage for certain benefits in health insurance plans, such as coverage for alcoholism; and regulatory action by state insurance departments that prevents insurers from withdrawing from a state because of poor underwriting results."

Risk Financing: Non-insurance Transfers

is a method other than insurance by which a pure risk and its potential financial consequences are transferred to another party o Examples include: contracts, leases, hold‐harmless agreements " For example, a company's contract with a construction firm to build a new plant can specify that the construction firm is responsible for any damage to the plant while it is being built. A firm's computer lease can specify that maintenance, repairs, and any physical damage loss to the computer are the responsibility of the computer firm. " ‐ Advantages of Non‐insurance Transfer o Can transfer some losses that are not insurable o Less expensive o Can transfer loss to someone who is in a better position to control losses ‐ Disadvantages of Non‐insurance Transfer o Contract language may be ambiguous, so transfer may fail o If the other party fails to pay, firm is still responsible for the loss o Insurers may not give credit for transfers

Moral hazard

is dishonesty or character defects in an individual that increase the frequency or severity of loss (faking accidents, inflating claim amounts)

Insurance

is the pooling of fortuitous losses (unseen losses) by transfer of such risks to insurers, who agree to indemnify insureds for such losses, to provide other pecuniary benefits on their occurrence, or to render services connected with the risk.

Adverse Selection

is the tendency of persons with a higher‐than‐average chance of loss to seek insurance at standard rates (ex. telling your insurance agent you dont smoke when you do) If not controlled by underwriting, adverse selection results in a higher than expected levels of loss Adverse selection can be controlled by careful underwriting and policy provisions "Thus, if you carry adequate property insurance, and your home burns in a fire, a homeowners policy will indemnify or restore you to your previous financial position, less a relatively small deductible. If you are sued because of the negligent operation of an automobile, your auto liability insurance policy will pay those sums that you are legally obligated to pay. Similarly, if you become seriously disabled, a disability-income insurance policy will restore at least part of the lost wages."

Risk Management objectives: Pre‐loss objectives:

o Prepare for potential losses in the most economical way ("This preparation involves an analysis of the cost of safety programs, insurance premiums paid, and the costs associated with the different techniques for handling losses.") o reduce anxiety ("Certain loss exposures can cause greater fear and worry for the risk manager and key executives. For example, the threat of a catastrophic lawsuit because of a defective product can cause greater anxiety than a small loss from a minor fire. Having a risk management plan in place reduces fear and worry.") o meet any legal obligations ("For example, government regulations might require a firm to install safety devices to protect workers from harm, to dispose of hazardous waste materials properly, and to label consumer products appropriately. State laws mandate that workers' compensation benefits must be available to workers who are injured while at work. The firm must see that these legal obligations are met")

Risk Management objectives: Post‐loss objectives:

o Survival of the firm ("Survival means that after a loss occurs, the firm can resume at least partial operations within some reasonable time period.") o continue operating, ("Banks, dairies, bakeries, newspapers, and other competitive firms must continue to operate after a loss. Otherwise, business will be lost to competitors.") o stability of earnings, ("Earnings stability can be maintained if the firm continues to operate. However, a firm might incur substantial additional expenses to achieve this goal (such as operating at another location), and perfect earnings stability might be difficult to attain.") o continued growth of the firm, ("A company can grow by developing new products and markets or by acquiring or merging with other companies. ") o minimize the effects that a loss will have on other persons and on society (social responsibility)

Risk Management 4 step Process ‐ Identify potential losses ‐ ‐ Select the appropriate combination of techniques for treating the loss exposures

page 50 in textbook

Chart of which to choose - High/Low Frequency and High/Low Severity

risk management matrix on chapter 3

Insurable Interest - Definition & When

states that the insured must be in a position to lose financially if a covered loss occurs. (For example, you have an insurable interest in your car because you may lose financially if the car is damaged or stolen. You have an insurable interest in your personal property, such as your car, cell phone, books, and clothes, because you may lose financially if the property is damaged or destroyed.) ‐ Purpose: o to prevent gambling o to reduce a moral hazard o to measure the amount of the insured loss ‐ When must insurable interest exist? o Property insurance: at the time of the loss o Life insurance: only at inception of the policy, not at the time of death.

Risk control refers to

techniques that reduce the frequency and severity of losses