Fin 3040 exam 1

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Non insurance transfers

A risk may be transferred to another party by several methods: A transfer of risk by contract, such as through a service contract or a hold-harmless clause in a contract. The risk of a defective flat screen tv can be shifted to the retailer by the purchase of a service contract by which the retailer is responsible for all repairs after the warranty expires.

Static risk

FROM UNCHANGING SOCIETY Ex: Pure - random events; lightning, windstorm, death

Natural Perils - Generally Difficult to Insure:

Flood Earthquake Epidemic Volcanic eruption Mold

Risk Managers have several sources of information to identify loss exposures:

Questionnaires Physical inspection Flowcharts Financial statements Historical loss data Industry trends and market changes can create new loss exposures. e.g., exposure to acts of terrorism

Types of Government insurance

Social Insurance Programs Financed entirely or in large part by contributions from employers and/or employees Benefits are heavily weighted in favor of low-income groups Eligibility and benefits are prescribed by statute Examples: Social Security, Unemployment, Workers Comp

The risk manager of a paint company wants to know more about the employee injuries. One loss was a wrist sprain that has a probability of .06. Another has a back sprain with a probability of .07. Yet another was over inhalation of a hazardous substance with a probability of .02. The other two losses were slips and falls with a probability of .13. If the amount of losses were $700, $3000, $2500, & $950, respectively, what is the expected value of an employee injury loss for that year?

$549.00

Standard deviation

(amount of loss-expected value) squared X probability

Binomial distribution

Requires discrete variables (loss or no loss) Small number exposures

Particular risk

Risk that affects only the individual and not the entire community or country Ex.: car thefts, bank robberies, dwelling fires (affects only individuals)

Risk

Uncertainty concerning the occurrence of a loss

Poisson Distribution

Use if exposure units are over 50 and probability of loss is very small

Human Perils - Generally Difficult to Insure:

War Radioactive contamination Civil unrest Terrorism

What is Underwriting Risk?

When an insurance company increases the size of the sample insured, underwriting risk (maximum insured loss) increase because more insured exposure units could suffer a loss. = # of units insured x standard error of the avg. loss distribution

Natural Perils - Generally Insurable:

Windstorm Lightning Natural combustion Heart attack

Hazard

a condition that increases the chance of loss due to a peril

Balance Sheet

a summary of what a company owns (assets) and what it owes (liabilities) Total Assets = Total Liabilities + Owners' Equity

Property insurance

indemnifies property owners against the loss or damage of real or personal property

Pooling

involves spreading losses incurred by the few over the entire group

Direct loss

is a financial loss that results from the physical damage, destruction, or theft of the property, such as fire damage to a home

Non-insurance transfer

is a method other than insurance by which a pure risk and its potential financial consequences are transferred to another party Examples: Contracts, leases, hold-harmless agreements

Self Insurance

is a special form of planned retention by which part or all of a given loss exposure is retained by the firm.

Hedging

is a technique for transferring the risk of unfavorable price fluctuations to a speculator by purchasing and selling futures contracts on an organized exchange

captive insurer

is an insurer owned by a parent firm for the purpose of insuring the parent firm's loss exposures.

Association or group captive

is an insurer owned by several parents; ex. Members of a trade association

Insurance

is appropriate for loss exposures that have a low probability of loss but for which the severity of loss is high

Moral Hazard

is dishonesty or character defects in an individual, that increase the chance of loss Ex: faking accidents, inflating claim amounts

Speculative risk

is one in which both profit or loss are possible Example: business ventures; investments

Pure risk

is one in which there are only the possibilities of loss or no loss Example: premature death

fortuitous loss

is one that is unforeseen, unexpected, and occur as a result of chance

Pure captive

is owned by only one parent such as a corp.

Policyholders' surplus

is the difference between an insurance company's assets and liabilities The stronger a company's surplus position, the greater is the security for its policyholders Assets - Liabilities = Surplus

Subjective probability

is the individual's personal estimate of the chance of loss A person's perception of the chance of loss may differ from the objective probability

Adverse selection

is the tendency of persons with a higher-than-average chance of loss to seek insurance at standard rates

Indirect loss

results indirectly from the occurrence of a direct physical damage or theft loss, such as the additional living expenses after a fire to a home

Peril

specific contingency that may cause a loss

income and expense statement

summarizes revenues and expenses paid over a specified period of time The two principal sources of revenue are premiums and investment income

Expenses include

the cost of adjusting claims, paying the insured losses that occurred, commissions to agents, premium taxes, and general insurance expenses

According to the Law of Large numbers

the greater the number of exposures, the more closely will the actual results approach the probable results that are expected from an infinite number of exposures.

The higher the standard deviation

the greater uncertainty of loss

Subjective risk

uncertainty based on a person's mental condition or state of mind Two persons in the same situation may have different perceptions of risk Difficult to measure

In a "hard" market

when profitability is declining, underwriting standards are tightened, premiums increase, and insurance becomes more difficult to obtain

In a "soft" market

when profitability is improving, standards are loosened, premiums decline, and insurance become easier to obtain

Risk Transfer

A pure risk is transferred from the insured to the insurer, who typically is in a stronger financial position

Normal distribution

More versatile More realistic Small number exposures

Binomial Distribution

Only two possible outcomes exist: Loss or No Loss n x p = mean The standard deviation of a distribution is a measure of risk or dispersion. For a binomial distribution, the standard deviation is √(𝑛 𝑥 𝑝 𝑥 𝑞)

Dynamic risk

PRODUCED BY CHANGES IN SOCIETY Ex: Increasingly complex technology, change in legislation due to changes in attitudes

Private insurance coverages can be grouped into two major categories

1. Personal lines 2. Commercial lines

Risk Management Process

-Identify potential losses -Measure and analyze the loss exposures -Select the appropriate combination of techniques for treating the loss exposures -Implement and monitor the risk management program

Characteristics of an Ideally Insurable Risk

-Large number of exposure units -Accidental and unintentional loss -Determinable and measurable loss -No catastrophic loss -Calculable chance of loss -Economically feasible premium

Basic Characteristics of Insurance

-Pooling of losses -Payment of fortuitous losses -Risk Transfer -Indemnification

Adverse selection can be controlled by:

-careful underwriting (selection and classification of applicants for insurance) -policy provisions (e.g., suicide clause in life insurance)

How to Recession Proof yourself?

1. $1000 to start an emergency fund. 2. Pay off all debt using the Debt Snowball 3. 3 to 6 months of living expenses in savings 4. Invest 15% of pre tax household income into Roth IRAs and/or pre-tax retirement such as 401k 5. College funding for children 6. Pay off home early 7. Build wealth and give (invest in mutual funds and real estate) (Insurance is infused in all of the steps not a specific step)

Techniques for Managing Risk

1. Avoidance 2. Loss control 3. Retention 4. Non-insurance transfers 5. Insurance

Normal Probability distribution

68% of all losses will be within 1 standard deviation of the mean 95% of all losses will be within 2 standard deviations of the mean 99% of all losses will be within 3 standard deviations of the mean More realistic More useful Can be employed in more situations

Avoidance

A drug manufacturer can avoid producing a dangerous drug that may result in a lawsuit.

Fundamental risk

Affects the entire economy or large number of persons or groups within the economy Ex.: Hurricane Katrina-largest single catastrophe in U.S. history (property damage exceeded Sept. 11, 2001)

Expected value

Amount of loss X Probability of loss

Retention

An individual or firm retains all or part of a given risk.

Loss exposure

Any situation or circumstance in which a loss is possible, regardless of whether a loss occurs.

Methods for Treating the Loss Exposures

Avoidance Retention Noninsurance transfers Loss Control Insurance

Assume the riskiness of a company is under consideration by an insurance company. This company anticipates incurring 20% losses within a specified period, such as a year. This company's exposure units are 3,000. What is the standard deviation of this distribution if there are only two possible outcomes: loss or no loss? What is this distribution called?

Binomial Distribution: n x p = mean Standard deviation = square root of n x p x q (Remember q = 1-p); q = .80 here √(3000 𝑥 .20 𝑥 .80)= √480=21.909 What is the coefficient of variation of this company's possible losses? Standard deviation/mean = 21.909/600 = .0365

A loss reserve is an estimated amount for:

Claims reported and adjusted but not yet paid Claims reported and filed, but not yet adjusted Claims incurred but not yet reported to the company

Measure and Analyze loss exposures

Estimate the frequency and severity of loss for each type of loss exposure Once loss exposures are analyzed, they can be ranked according to their relative importance

Insurance

For most people, insurance is the most practical method for handling a major risk Ex: An automobile insurance policy can be purchased covering the negligent operation of an automobile.

Other Government insurance programs

Found at both the federal and state level Examples:Federal flood insurance, state health insurance pools

Uncertainty

If the probability of an event occurring is either zero or one, there is no risk since there is no

The presence of risk results in three major burdens on society:

In the absence of insurance, individuals would have to maintain large emergency funds The risk of a liability lawsuit may discourage innovation, depriving society of certain goods and services Risk causes worry and fear

Soft market

Insurance companies lower premiums More "liberal" underwriting Investment earnings exceed underwriting losses Deductibles are lower and contract terms are more attractive ex-life insurance

Hard market

Insurance companies raise their premiums or less coverage for the same premium More "conservative" in their underwriting Restricted contract provisions September 11 resulted in a hard market (large losses & bad investment returns ex-director's & officer's liability insurance

Types of Private insurance

Life, health, property, Liability, causality

The central limit theorem

The distribution of the sample mean will approach the normal distribution as the sample size increases

Indemnification

The insured is restored to his or her approximate financial position prior to the occurrence of the loss

Loss severity is more important than loss frequency:

The maximum possible loss is the worst loss that could happen to the firm during its lifetime The probable maximum loss is the worst loss that is likely to happen

Captives are formed for several reasons, including:

The parent firm may have difficulty obtaining insurance To take advantage of a favorable regulatory environment Costs may be lower than purchasing commercial insurance Easier access to a reinsurer Profit center Premiums paid to a captive may be tax-deductible under certain conditions

Chance of loss

The probability that an event will occur

Human Perils - Generally Insurable:

Theft -E-commerce Vandalism Hunting accident Negligence Fire & smoke

Consequential loss

These additional expenses would be

Case reserves

are loss reserves that are established for each individual claim

Physical Hazard

are physical conditions that increase the chance of loss Ex: icy roads, defective wiring

Morale Hazard

carelessness or indifference to a loss, which increases the frequency or severity of a loss Ex: leaving keys in an unlocked car

Loss Control

certain activities are undertaken to reduce both the frequency & severity of losses

Enterprise risk management

combines into a single unified treatment program all major risks faced by the firm: Pure risk Speculative risk Strategic risk Operational risk Financial risk

Commercial lines

coverages for business firms, nonprofit organizations, and government agencies

Personal lines

coverages that insure the real estate and personal property of individuals and families or provide protection against legal liability

Health insurance

covers medical expenses because of sickness or injury

Liability insurance

covers the insured's legal liability arising out of property damage or bodily injury to others

Enterprise risk

encompasses all major risks faced by a business firm, which include: pure risk, speculative risk, strategic risk, operational risk, and financial risk

Avoidance

means a certain loss exposure is never acquired, or an existing loss exposure is abandoned The chance of loss is reduced to zero It is not always possible to avoid all losses Ex. Paint factory stops producing paint to avoid losses; will no longer be in business

Passive retention

means risks may be unknowingly retained because of ignorance, indifference, or laziness.

Active retention

means that an individual is consciously aware of the risk and deliberately plans to retain all or part of it. Ex. An individual may retain the first $500 of physical damage to his auto by purchasing an automobile collision policy with a $500 deductible.

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

Incorporation

of a business firm transfers to the creditors the risk of having insufficient assets to pay business debts

Life insurance

pays death benefits to beneficiaries when the insured dies

Insurance is the

pooling of fortuitous 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

Loss prevention

refers to activities to reduce the frequency of losses

Loss reduction

refers to activities to reduce the severity of losses

Causality insurance

refers to insurance that covers whatever is not covered by fire, marine, and life insurance

Objective probability

refers to the long-run relative frequency of an event assuming an infinite number of observations and no change in the underlying conditions

Financial risk

refers to the uncertainty of loss because of adverse changes in commodity prices, interest rates, foreign exchange rates, and the value of money.

Objective risk

relative variation of actual loss from expected loss Measurable, statistical If a loss is certain to occur, objective risk is zero.


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