Risk Management Final Exam
Elizabeth wants to use the human life value approach in determining her life insurance needs....
$228,240
Amy owns a small thrift store that is insured for $100,000 under a commercial property insurance policy ...
$7,500
Erin has two insurance policies covering her commercial building for property damage. She suffers a covered loss of $100,000...
$80,000
Human life value approach
1. estimate the individual's average annual earnings over their lifetime 2. Deduct federal and state income taxes, SS taxes, life and health insurance premiums and the cost of self maintenance 3. Determine number of years from the person's present age to the contemplated age of retirement 4.Using a reasonable discount rate, determine the present value of the family's share of earnings for the period determined in step 3
Expected loss
10 percent chance in any year that each building will be destroyed by a peril (valued at $50,000) Expected loss= .90($0)+ .10($50,000)= $5,000 Both owners decide to pool their loss exposures-- Neither building destroyed: .90x.90=.81 First building destroyed, second no loss: .10x.90=.09 Both destroyed: .10x.10=.01 Expected loss=.81x$0 + .09x $25,000 + .09x $25,000 + .01x $50,000= $5,000
What is the most someone would be willing to pay for insurance calculation
14.11?
Connor owns a commercial office building that is insured under 3 separate property insurance contracts
16,667
Expected Utility
=.75*sqrt(100)+ .25*sqrt(50)
What is someone's utility if they purchase insurance for their pure premium
=sqrt(87.5) 87.5 is the expected loss
Catastrophic Loss
A large proportion of exposure units should not incur loss at the same time.
Principle of Indemnity
A principle that states the insurer agrees to pay no more than the actual amount of the loss. The insured should not profit from a covered loss but should be restored to approximately the same financial position that existed prior to the loss.
Underwriting cycle
A term to describe the cyclical pattern in underwriting standards, premium levels, and profitability. Property and liability insurance industry is characterized by this
Stranger Owned life policy
A type of life insurance policy in which a third party stands to gain, without insurable interest
Credit default swap
An agreement in which the risk of default of a financial instrument is transferred from the owner of the financial instrument to the issuer of the instrument When a third party takes on the risk of a debt instrument with no inherent insurable interest
Stranger owned life insurance
An insurance contract that may not always have an insurable interest from the policy holder's perspective
Deductibles and premiums, all other things constant, have what typeof a relationship?
An inverse relationship
Individual Mandate
Beginning in 2014, the Affordable Care Act requires that most US citizens and legal residents have qualifying health insurance or pay a financial penalty. This is a provision of the affordable care act.
Peril
Cause or source of loss
Legal Hazard
Characteristics of the legal system or regulatory environment that increase the frequency or severity of losses Dalton Tobacco Company is concerned that the company may be held liable in a court
Indemnification
Compensation to the victim of a loss, in whole or in part, by payment, repair, or replacement This is a characteristic of insurance. Other characteristics: pooling of losses, payment of fortuitous losses, risk transfer
Enterprise Risk Management program
Comprehensive risk management program that considers and organization's pure risks, speculative risks, strategic risks, and operational risks. Combines into a single unified treatment program all major risks faced by the firm (Reduces overall risk) Anne was just named Risk Manager of ACE company and decided to create a risk management program scenario
Law of Large Numbers
Concept that the greater the number of exposures, the more closely will actual results approach the probable results expected from an infinite number of exposures
Principal of Subrogation
Contractual provision that allows the substitution of the insurer in place of the insured for the purpose of claiming indemnity from negligent third party for a loss covered by insurance
Moral hazard
Dishonesty or character defects in an individual that increases the chance of loss Sean borrowed money from a bank to purchase a fishing boat (sinking boat when not making money on investment)
Adverse selection (number 2)
ENO appliances offers a warranty requiring an annual fee question. Adverse selection is the reason insurance costs more after sale for ENO
Pro-rata liability
Each insurer's share of the loss is based on the proportion that its insurance bears to the total amount of insurance on the property
Expense ratio
Expense Ratio= Underwriting expenses/Premiums written
T or F: An insurer that operates at an underwriting loss will also have total (overall) loss
False
Reasons for insurer insolvency
Inadequate rates Inadequate reserves for claims Rapid growth and inadequate surplus Catastrophic loss
Reasons an insurer may choose to reinsure
Increase underwriting capacity Stabilize profits Reduce the unearned premium reserve Provide protection against catastrophic loss (NOT TO DECREASE UNDERWRITING CAPACITY)
Foreign Insurer
Insurance company chartered by one state but licensed to do business in another (An insurance company incorporated in another state that has been licensed to operate in your state is called this)
Captive Insurer
Insurance company established and owned by a parent firm in order to insure its loss exposures while reducing premium costs, providing easier access to a reinsurer, and perhaps easing tax burdens.
Mutual company
Insurance corporation owned by the policyholders, who elect the board of directors. The board appoints managing executives, and the company may pay a dividend or give a rate reduction in advance to insureds.
Why do individuals purchase insurance?
Insurance increases the insured's expected utility -- offers peace of mind
What happens to measurable risk as we increase the size of our pool?
It decreases
Liability risk
Lawsuits for bodily injury and property damage are common. Firms are sued for defective products that harm others, pollution of the environment, discrimination against employees, etc. James is concerned that if he injures someone or damages someone's property he could be help legally responsible and requires to pay damages.
Risk management matrix
Low Frequency & Low severity: retention High Frequency and low severity: Loss prevention and retention Low Frequency and High Severity: Transfer (Insured) High Frequency and High severity: Avoidance
The worst possible loss that could ever happen to a firm is referred to as the?
Maximum possible loss
Regression Analysis
Method of characterizing the relationship between two or more variables and then using this characterization as a prediction. Based on historical data and used for linear relationship, it is more than correlation.
Methods of ensuring solvency
Minimum capital and surplus requirements Risk based capital standards Review of annual financial statements Field examinations Early warning system (IRIS ratios) FAST system analysis
The tendency of individuals to behave differently when insured is referred to as?
Moral hazard
If Aetna and Humana announce plans to merge, the stock price reactions around the announcement date would be _______ from competitors if the health insurance industry itself is competitive.
NEGATIVE
Are insurers totally exempt from regulation by federal agencies and laws?
No
Do insurers hold a large amount of assets?
No
Amy purchased a life insurance policy. If she commits suicide in 3 months after the policy is purchased what happens?
Nothing because the policy is void
Contribution of equal share
Often in liability insurance. Each insurer shares equally in the loss until the share paid by each insurer equals the lowest limit of liability under any policy or the full amount of the loss is paid
AM Best Company (ratings)
One of the most important rating agencies, which rates insurers based on their relative financial strength (the strongest predictors for insurer insolvency)
Overall operating ratio
Overall operating ratio= Combined Ratio- Investment income ratio Investment income ratio= Net investment income/earned premiums
Actuary
Person who determines rates and premiums
Which of the following is a result of adverse selection?
Persons most likely to have losses are also most likely to seek insurance at standard rates
Which of the following is a source of information a risk manager could use to identify pure loss exposures?
Physical inspections
A group of farmers agree that if any farmer suffered a property loss, the loss would be spread over the entire group, what is this an example of?
Pooling of losses
What are the main sources of revenue for insurers?
Premiums and Investments
Primary and excess insurance:
Primary insurer pays first and excess insurer pays only after the policy limits under the primary policy are exhausted
Rescission
Prior to the passage of the Affordable Care Act, insurers could go back to the date a health insurance policy became effective and render the policy void due to clerical error
Guaranty Fund
Provide for the payment of unpaid claims of insolvent property and casualty insurers (if SCDP becomes insolvent--they had much larger losses than forecasted and the company did not charge adequate premiums nor did the company purchase reinsurance)
"Crowding out" effect
Public Demand for Insurance (Usually health) "crowds out" private demand
Pure premium
Pure premium= Incurred losses and loss adjustment expenses/ Number of exposure units expected loss (probability * loss)
Pure and speculative risk
Pure risk: situation in which there are only the possibilities of loss or no loss Speculative risk: situation in which either profit or loss are clear possibilities An integrated risk management program is a risk management program which combines these.
Advantages of state regulation of insurance over federal regulation of insurance
Quicker response to local insurance problems *** Promotion of uniform laws by NAIC Greater opportunity for Innovation Unknown Consequences of federal regulation Decentralization of political power
Class Rating
Rate-making method in which similar insureds are placed in the same underwriting class and each is charged the same rate (groups the potential insured with others based on their risk profile)
Objective risk
Relative variation of actual loss from expected loss, which varies inversely with the square root of the number of cases under observation
Material misrepresentation
Representations: statements made by the applicant for insurance Material: if the insurer knew the true facts, the policy would not have been issued, or it would have been issued on different terms
Retention
Risk management technique in which an individual or firm retains part or all of the losses resulting in a given loss exposure. Used when no other method is available, the worst possible loss is not serious, and losses are highly predictable Timothy never stopped to consider the possible consequences of long term, permanent disability (maybe passive retention)
Risk control
Risk management techniques that reduce the frequency or severity of losses, such as avoidance, loss prevention, and loss reduction. The use of fire restrictive materials when contracting a building is an example of this.
What is the main risk life insurance policies are designed to cover?
Risk of premature death
Standard deviation
SD= SQARE ROOT(.90(0-$5,000)^2 + .10($50,000-$5,000)^2)=$15,000
Broker
Someone who legally represents the insured, soliciting or accepting applications for insurance that are not in force until the company accepts the business (Someone who legally represents the potential insured on their behalf)
Pooling of losses
Spreading of losses incurred by the few over the entire group, so that in the process, average loss is substituted for actual loss. Implied: sharing of losses by an entire group
What taxes must insurers pay?
State, local, and federal taxes
Term life insurance has which of the following properties?
TERM POLICIES ARE RENEWABLE Most term policies are convertible Term insurance policies have no cash value or savings element
Adverse selection
Tendency of persons with a higher than average chance of loss to seek insurance at standard rates, which, if not controlled by underwriting, results in higher than expected loss levels.
In the standard CAPM model, what does the Beta coefficient represent?
The asset's volatility to the general market premium AND The systematic (or non-diversifiable) risk associated with the asset being priced
State guaranty funds are argued to be inadequate due to...
The claims process taking longer following insolvency AND Firm pay not taking into account firm risk
Net Underwriting loss
The combined ratio= loss ratio + expense ratio Loss ratio= (Incurred losses+ Loss adjustment expenses)/ Premiums earned
Declaration page
The item that lists who, what, when, and where in an insurance contract
PHI insurance Company write coverage for most perils which can damage property.....
The loss should not be catastrophic
Which graph depicts the relationship between risk and return, considering systematic (non-diversifiable) and unsystematic (diversifiable risks)
The one that says systematic risk at the bottom and decreases
True or False:
The principle of indemnity states that an insured will be compensated for at least 100 percent of their financial loss
According to the Law of Large Numbers, what should happen as an insurance company increases the number of loss exposures that it insures?
The spread, or deviation, about the expected loss should decrease
How do life insurers differ from Property/Casualty insurers?
They hold less policy reserves (loss reserves) than P/C insurers Loss reserve: amount set aside by property and casualty insurers for claims reported and adjusted but not yet paid, claims reported and filed but not yet adjusted, and claims incurred but not yet reported to the insurer
How are FSA's different from HSA's?
They usually require the account holder to use all (or most) of their funds by the end of the policy
Risk
Traditionally, uncertainty concerning the occurrence of a loss
Subjective Risk
Uncertainty based on one's mental condition or state of mind.
Risk Based Capital
Under NAIC standards, insurers are required to have a certain amount of capital that is based on the riskiness of their investments and operations This is also one metric for determining an insurer's insolvency risk
In theory, bankruptcy risk as a measure of distress is best classified as..
Unsystematic (or diversifiable) risk
Maximum possible loss
Worst loss that could happen to a firm during its lifetime Assuming only one loss will occur: $25,000
Internal reinsurance transactions can be seen, from the parent company's perspective, as...
a capacity shift across affiliates
Risk- Based Capital Standards is...
a method used to help ensure the solvency of insurers
The purpose of coinsurance
achieve equity in rating (all of the above)
Admitted Assets
assets that an insurer can show on its statutory balance sheet in determined its financial condition Nonadmitted assets: premiums overdue by 90 or more days, OFFICE FURNITURE and equipment, and certain investments or amounts that exceed statutory limits for certain types of securities
Excess of Loss Reinsurance policy
designed largely for protection against a catastrophic loss. Reinsurer pays part or all of the loss that exceeds the ceding company's retention limit up to a max level (Apex Company wants to retain 1 M of its expected liability losses in the future. They use Geneva Re to cover for any catastrophic loss from 1M up to 25M)
Opponents of credit based insurance ratings argue that credit scoring ratings are.....
discriminatory to lower income individuals and minorities
In an alternate, Amy from the previous question lives a long happy life. She passes away on her 122nd birthday....
no
A pure risk is defined as a situation in which there is..?
only the possibility or loss or no loss
Mutual companies dissolve the agency costs arising from...
owner and policy holder
Risk adverse individual
prefers more wealth to less and experiences diminishing returns in regards to the utility of wealth (prefer the one with lower risk)
One provision of the Affordable Care Act is designed to benefit young adults to age 26. This provision allows these young adults to...
remain covered under their parents' health insurance policies
Prisoner's Dilemma
the tendency of two completely rational individuals to not cooperate even if it appears that it is in their best interest to do so
The principal/ agent problem can be best described as...
the tension that arises between the manager of the firm and shareholders
